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Innovation, Change, Black Swans, and Financial Crises

David Marshall*Senior Vice PresidentFederal Reserve Bank of Chicago

PhD ProjectFinance Doctoral Students Association ConferenceSanta Fe, NM June 19, 2011

* The opinions in this presentation are the presenter’s and do not reflect positions of the

Federal Reserve Bank of Chicago or the Federal Reserve System.

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Change as a factor in financial crises

Innovation and change– Shifts the distribution of key random variables – “Black Swan” events– Can disrupt risk management

Distributional change from 2000 to 2008– The Great Moderation– Capital flows into U.S.– Subprime mortgage contracts

How these changes were instrumental in the Crisis of 2008

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Historical record

Financial crises often associated with innovation and change

Examples:– Penn Central crisis of 1970

Innovation: commercial paper

– 1987 stock market crash Innovation: computerized program

trading/portfolio insurance

– 1998 LTCM crisis Innovation: highly leveraged hedge funds

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Why is change associated with crises? Essential to all finance practice: ability to quantify risk

– Estimate a probability distribution using data from the past,

Suppose something completely new happens– Shifts the distribution of relevant random variables– Distributional shift poorly understood in real time– Prevailing wisdom: old distribution still applies

Distributional shifts of this type not captured in most economic models currently in use– Rational expectations models, regime shifting models, models

with learning, behavioral models All assume an unchanging distribution or meta-distribution

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“Black Swans” Black Swans

– Tail events thought to be virtually impossible (under the old distribution) actually occur

When the Black Swan event occurs,– Market participants exposed to unforeseen risks– No reliable distribution to use in managing risks

Shift from – Statistical control (maximize risk-adjusted return) to– Robust control (avoid the worst-case outcome)

Withdraw from risks, “flight to quality”

Financial crisis.

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The distribution before the crisis

The Great Moderation 1984 - 2007– Virtually unprecedented period of low macroeconomic

volatility– Only two extremely mild recessions– Otherwise, 2% - 4% y-o-y GDP growth

Why?– New household finance instruments

Home equity credit lines, cash-out refinancing

Allows households to smooth consumption

– More sophisticated derivative instruments Allows for improved risk sharing

– Better conduct of monetary policy

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Change in real GDP (year-over-year)

-6%

-4%

-2%

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2%

4%

6%

8%

10%

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The distribution before the crisis

The Great Moderation 1984 - 2007– Virtually unprecedented period of low macroeconomic

volatility– Only two extremely mild recessions– Otherwise, 2% - 4% y-o-y GDP growth

Why?– New household finance instruments

Home equity credit lines, cash-out refinancing

Allows households to smooth consumption

– More sophisticated derivative instruments Allows for improved risk sharing

– Better conduct of monetary policy

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What shifted the distribution? Massive capital flows from abroad into U.S. markets

– By 2006, 6 ½ % of GDP– Induced very low real interest rates– Rising home prices

Innovation: Subprime mortgages– High loan-to-income ratios – Low borrower credit scores – Very low down payments – Substantial upward rate adjustment in two or three years – Bet on continued house price appreciation– Government policy: Expand use of subprime mortgages – By 2006, subprime/Alt-A mortgage issuance ≈ 30% of the

mortgage market

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Flow of capital into U.S. and real interest rates

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Flow of Capital into U.S. as % of GDP Real 30yr Mort. Rates

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Housing price index 1987-present

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Case-Shiller Index

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What shifted the distribution? Massive capital flows from abroad into U.S. markets

– By 2006, 6 ½ % of GDP– Induced very low real interest rates– Rising home prices

Innovation: Subprime mortgages– High loan-to-income ratios – Low borrower credit scores – Very low down payments – Substantial upward rate adjustment in two or three years – Bet on continued house price appreciation– Government policy: Expand use of subprime mortgages – By 2006, subprime/Alt-A mortgage issuance ≈ 30% of the

mortgage market

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What shifted the distribution? (continued) Mortgage Backed Securities (MBS)

– Cash flow from a pool of mortgages paid to investors– Senior (AAA) tranches get first claim to cash flow– Equity tranches protect senior tranches by absorbing first losses– Only works if defaults within the mortgage pool have low

correlation!

Old Distribution– Great Moderation – low risk environment– Mortgage defaults idiosyncratic– House price declines geographically localized– Nationwide major home price declines virtually impossible– Default risk diversified away through the MBS structure

As long as house prices continued to rise, subprime default rate was low– Old distribution seemed to work

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What shifted the distribution? (continued) Problem: Subprime mortgage contracts are especially sensitive to

house price declines, – Little or no equity cushion – If prices decline, the mortgage is underwater and the borrower is

likely to default.

So a nationwide decline in housing prices would trigger correlated defaults within the mortgage pool underlying subprime MBSs.– AAA tranches of subprime MBSs no longer protected by equity

tranches!– Subprime MBSs were ticking time bombs– Key shift in the returns distribution not perceived in real time!

When house prices started to decline in mid-2006, subprime mortgages started to default more rapidly than predicted by old distribution.

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Subprime defaults

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Case

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Conventional Subprime Mortgage Pmts. Past Due 90+ Days

Case-Shiller Home Price Index

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S&P ratings transition matrix pre-crisis

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Recap Periods of change

– New innovations, structures, policies – Effect on the distribution of returns initially not well understood– Market participants can’t quantify risk– Best strategy: Shift to robust control

Avoid worst case outcome

Avoid markets where risk can’t be quantified

Flight to quality

Liquidity flows attenuate or cease entirely

Financial crisis

Pace of change in the future will likely accelerate. – Higher likelihood of financial crises in the future

Best policy: Create a more robust financial structure that can better withstand the inevitable crises that will occur