Lessons from the 2007-08 Credit Crunch: What Should Be Done?

ST. LOUIS — In light of the consequences that followed the policy responses to the "credit crunch" of 2007-2008, regulators will need to increase their vigilance to avoid future crises, based on a paper published by the Federal Reserve Bank of St. Louis.

Paul D. Mizen, professor of monetary economics and director of the Centre for Finance and Credit Markets at the University of Nottingham, and a visiting scholar at the St. Louis Fed, looked at the market reactions and policy responses to the credit crunch for the September/October issue of Review, the Reserve Bank's bi-monthly journal of economic and business issues. The publication is also available online at the St. Louis Fed's web site: https://research.stlouisfed.org/publications/review.

Mizen noted that from 1993 to 2006, a number of macroeconomic conditions sowed the seeds of the credit crunch."

"Low interest rates encouraged greater borrowing, low savings ratios and higher debt to income levels for consumers in industrialized countries," said Mizen. "With low volatility, steady growth and increasing house prices, lenders did not perceive great risks. Revolving debt in the form of credit card borrowing increased significantly and, as prices in housing markets across the globe increased faster than income, lenders offered mortgages at ever higher multiples (in relation to income), raising the level of secured debt to income. Credit and housing bubbles reinforced each other."

The innovation in mortgage-backed securitization to lower quality subprime mortgage categories created assets with greater risks than the issuers or the end-investors appreciated. "Sellers of subprime mortgage securities mispriced risks by using models that assumed house prices would continue to rise while interest rates would remain low," he said. "This was a false assumption, but many other practices reinforced the error as buyers and sellers of subprime mortgage securities and collateralized debt obligations failed to assess risk characteristics properly. There was a failure in the incentives mechanism to assess risks carefully because the risk would be held by others."

Mizen said when risks were realized in mid-2007, there was a crisis of confidence in the financial markets as banks stopped funding short term paper, MBS and CDO issuance slumped, and banks reduced the lending at more than one month to maturity as they assessed the implications of the newly perceived risks.

"While many analysts have stated, rightly, that the root of the problem lay with the subprime market," said, Mizen, "any number of other high-yield asset classes could have provided the triggerfor example, hedge funds, private equity, or emerging market equity. But, it was house prices rather than equity or commodity prices that fell first, and therefore the crisis was triggered by subprime-related assets."

Assessing the overall response by central banks, Mizen said, "Central banks handled the crisis well from the perspective of providing liquidity to the markets, but spreads remain larger than before the crunch."

At the same time, however, he believed that the central banks "did less well in providing funding liquidity for failing institutions" and that the ultimate consequences to the taxpayer from these actions cannot be known right now. In the United Kingdom, the Bank of Englands rescue of Northern Rock was not regarded as a success and regulatory reforms will need to be made to avoid the same problems in the future.

In the United States Mizen said, "The Bear Stearns crisis resolution process seems to have delivered what the Federal Reserve set out to achieve. The crisis was dealt with swiftly, and as a result the financial system did not face a settlements equivalent to a 'payments problem.' The owners and fund managers of the investment bank were effectively punished for taking risky strategies." He added, however, that the cost to the taxpayer is yet to be determined and under the support operation for the GSEs, Fannie Mae and Freddie Mac, the scale of the lending is much greater, with potentially much greater cost to the taxpayer.

Mizen believes reforms will need to be made to the regulations imposed on banks, and he questioned the extent to which banks should be allowed to avoid regulation by using off-balance-sheet vehicles to conduct business in structured finance products.

"Questions also need to be asked about the incentive structures facing originators and investment banks that created the complex products for resale, the regulation of ratings agencies in rating complex financial products, and the use of fair value accounting," he said. "Regulators need to ask questions about an institution's own assessment of the risk being carried, but they also need to consider the systemic risks that arise when the actions of an individual bank impinge on other banks or the markets."

Mizen said the Fed's new rules for higher-priced mortgage loans should improve regulation of the U.S. mortgage market, but he suggested that "the setting of 'gold standards' for originators to match products (for example, alternative mortgages) offered by the GSE's or minimum borrower standards would also help."

He said several lessons from this period that can be applied to potential future crises, among them:

1. The need to create incentives that ensure the characteristics of assets "originated and distributed" (in which financial institutions lend money and sell the claims to a third party) are fully understood and communicated to end-investors.

2. Central banks should review and evaluate the effectiveness of their procedures to inject liquidity into the markets at the time of crisis and their response to funding individual institutions.

3. Regulators will need to consider the capital requirements for banks and off-balance sheet entities that are sponsored or owned banks, evaluate the scope of regulation necessary for ratings agencies, and review the usefulness of stress testing and "fair value" accounting.

With branches in Little Rock, Louisville and Memphis, the Federal Reserve Bank of St. Louis serves the Eighth Federal Reserve District, which includes all of Arkansas, eastern Missouri, southern Indiana, southern Illinois, western Kentucky, western Tennessee and northern Mississippi. The St. Louis Fed is one of 12 regional Reserve banks that, along with the Board of Governors in Washington, D.C., comprise the Federal Reserve System. As the nation's central bank, the Federal Reserve System formulates U.S. monetary policy, regulates state-chartered member banks and bank holding companies, provides payment services to financial institutions and the U.S. government, and promotes community development and financial education.

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