Kellogg School finance faculty examine the recent market volatility
note: This story reflects events as of April 11, 2008, when
Kellogg World went to press.
credit crunch began with bad news last summer about higher-than-expected
default rates among a risky segment of mortgage borrowers.
The situation was unfortunate, especially for those who might
lose their homes. But observers saw little cause for alarm,
since subprime mortgages were considered a relatively small
part of the economy, and some defaults were expected.
then, the dominoes have fallen. AAA-rated bonds that were
backed by many of those defaulting mortgages suddenly weren't
such a good investment. Large, esteemed investors took heavy
write-downs and became skittish about risking their own capital.
Home prices slumped to pre-2005 levels; retail sales growth
slowed; and the stock market fell nearly 15 percent off of
last year's record highs.
Add to the
mix recent Federal Reserve action to facilitate JPMorgan Chase's
fire-sale purchase of investment banker Bear Stearns for $2
a share (subsequently revised to $10), and what looked like
a hiccup now has the earmarks of something more troubling.
problem in the market wasn't about subprime loans; it was
that everything — all asset classes — were becoming
very expensive," says Deborah
Lucas, the Donald C. Clark/Household International Professor
in Consumer Finance. "The situation grew out of a large increase
in markets' willingness to bear risk for years. At the time,
the economy was flourishing, and professional investors became
more and more risk-tolerant while looking for higher returns."
Many of those high-risk, high-return investments
didn't pan out, which is to be expected. "Anyone who was around
the subprime market knew this was the riskiest segment, they
knew to expect defaults there," says Arvind
Krishnamurthy, the Harold Stuart Professor of Finance.
"The puzzling thing was how something so small can have such
a big effect. It seems that general uncertainty, rather than
defaults among a certain group of borrowers, was the key in
setting up the crisis."
that were partially backed by subprime mortgages slumped,
that uncertainty kicked into high gear. "If subprime mortgages
hadn't been securitized, people would have said 'These mortgages
are just riskier than we thought,' and this would be a small
crisis," says Professor of Finance Jonathan
Parker. "But they were securitized, recommended, reprocessed
and sold as significant portions of AAA-rated securities.
When those underperformed, people called into question the
entire rating system, and they became suspicious about all
Some observers believe that this credit crunch is
uncharted territory because of the relative newness of mortgage-backed
securities, the losses by established investors in an unfamiliar
market, and the increasing interconnectedness of economies
around the globe. But Kellogg professors see parallels to
present situation bears some similarity to the financial crises
common in the late 19th and early 20th century," says Sergio
Rebelo, the Tokai Bank Professor of Finance. "During those
periods, reduced confidence in a few banks often spread throughout
the financial system, leading to liquidity shortages and credit
sees an analogy in the Eastern European financial crisis a
decade ago. "The real crisis occurred in Russia, but other
developing economies with no fundamental problems in their
economy saw foreign capital exiting," Parker said. "It was
contagion, like what we're seeing now. People thought, 'If
this happened in Russia, it could happen in other developing
economies,' and so people pulled out their investments in
Closer to home, Krishnamurthy
sees a parallel to the 1990-1991 U.S. recession. "You had
drops in real-estate values and losses in the banking sector,
both then and now," he says. "This is not like the 2000-2001
slowdown when the technology sector went into contraction.
This is specifically tied to the financial sector suffering
lots of losses at the same time that the real-estate market
have intervened to stem the crisis. The Federal Reserve Board
began trying to ease credit flow last September by cutting
its benchmark federal funds rate from 5.25 percent to 4.75
percent. Since then, the rate has fallen to 2.25 percent.
the Fed's moves carry their own risks. "The Fed is using its
ammunition, just as it did in 1990 and 1991," Krishnamurthy
says. "The real concern is, we're in an environment with inflation
risk, and that might limit the Fed's options. It's hard to
know if what the Fed is doing is appropriate or not. They're
trying to strike a balance between stimulating credit and
guarding against inflation."
But inflation isn't
the only risk. Lower short-term interest rates accompanied
by higher long-term rates helped fuel the growth in subprime
and adjustable-rate mortgages.
monetary policy of lower short-term rates helps people not
to default, but the lower short-term rates were part of the
problem in the first place," Parker says. You don't want to
help firms that may have nudged people into taking out loans
that they shouldn't have taken."
the Bush Administration have a few tools at their disposal,
including a voluntary plan, backed by Treasury Secretary Henry
Paulson, which would encourage mortgage renegotiations.
spirit of that plan is the right thing to do," Lucas says.
"Some nightmare policies have been proposed like 'Let's put
a cap on mortgage rates,' which would cause an arbitrary transfer
of wealth from banks to their customers. I'm advocating intervening
more by setting the tone or framework of renegotiation, but
not by forcing any particular renegotiation. This must be
done through leadership rather than mandates."
Another tool, the $168
billion stimulus package that Congress passed in February,
may be just about right to jump-start growth again. "The package
we have is transitory, it's timely, and it's pretty well-targeted,"
clearly have been affected by the credit crunch too, and they
have roles and opportunities in the crisis.
sooner people figure out at what reasonable price they can
transact, the better, and that's not something that government
can regulate," Lucas says. "There are lots of incentives for
everyone to figure out the least costly way to fix this, and
it will take time to work that out. But focusing on improving
one's business is the responsible thing for the economy."
Quickly writing down losses should also help get
things back on track. "It is important that banks recognize
their losses and, if necessary, be recapitalized," Rebelo
says. "This restructuring process is taking place, which is
very encouraging. Otherwise, you might see a repeat of Japan's
experience with its 1992 financial crisis, where Japanese
banks avoided recognizing their losses and it took a long
time to revive the economy."
should also arise from the stimulus package. "If you're in
retail, you want to be prepared for the money that's going
to be in consumers' hands in June," Parker says.
credit crunch lends itself to several lessons that will benefit
business leaders once the economy is back on track.
"Mistakes happen, and
you should expect them to happen, especially on investments
and activities that are new, like securitized products based
on subprime mortgages," Krishnamurthy says. "You find out
what was a mistake in hindsight. You have to be wary of novel
creations — don't avoid them altogether, but be more
skeptical of them than a more established investment."
Adds Parker: "The broad
lesson is that you need to be able to value an asset before
you buy it, and that's one of the things that the Kellogg
finance curriculum teaches well."