On robust estimation of the location parameter

This paper summarizes and explains the main events of the liquidity and credit crunch in 2007-08. Starting with the trends leading up to the crisis, I explain how these events unfolded and how four different amplification mechanisms magnified losses in the mortgage market into large dislocations and turmoil in financial markets.

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Deciphering the Liquidity and Credit Crunch 2007-08

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The Theory of Industrial Organization

The financial market turmoil in 2007 and 2008 has led to the most severe financial crisis since the Great Depression and threatens to have large repercussions on the real economy The bursting of the housing bubble forced banks to write down several hundred billion dollars in bad loans caused by mortgage delinquencies At the same time, the stock market capitalization of the major banks declined by more than twice as much While the overall mortgage losses are large on an absolute scale, they are still relatively modest compared to the $8 trillion of US stock market wealth lost between October 2007, when the stock market reached an all-time high, and October 2008 This paper attempts to explain the economic mechanisms that caused losses in the mortgage market to amplify into such large dislocations and turmoil in the financial markets, and describes common economic threads that explain the plethora of market declines, liquidity dry-ups, defaults, and bailouts that occurred after the crisis broke in summer 2007 To understand these threads, it is useful to recall some key factors leading up to the housing bubble The US economy was experiencing a low interest rate environment, both because of large capital inflows from abroad, especially from Asian countries, and because the Federal Reserve had adopted a lax interest rate policy Asian countries bought US securities both to peg the exchange rates at an export-friendly level and to hedge against a depreciation of their own currencies against the dollar, a lesson learned from the Southeast Asian crisis of the late 1990s The Federal Reserve Bank feared a deflationary period after the bursting of the Internet bubble and thus did not counteract the buildup of the housing bubble At the same time, the banking system underwent an important transformation The

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Deciphering the Liquidity and Credit Crunch 2007-2008

In a financial system in which balance sheets are continuously marked to market, asset price changes appear immediately as changes in net worth, eliciting responses from financial intermediaries who adjust the size of their balance sheets. We document evidence that marked-to-market leverage is strongly procyclical. Such behavior has aggregate consequences. Changes in dealer repos—the primary margin of adjustment for the aggregate balance sheets of intermediaries—forecast changes in financial market risk as measured by the innovations in the Chicago Board Options Exchange Volatility Index (VIX). Aggregate liquidity can be seen as the rate of change of the aggregate balance sheet of the financial intermediaries.

Liquidity and Leverage

We model the dynamics of risk premia during crises in asset markets where the marginal investor is a financial intermediary. Intermediaries face an equity capital constraint. Risk premia rise when the constraint binds, reflecting the capital scarcity. The calibrated model matches the nonlinearity of risk premia during crises, and the speed of reversion in risk premia from a crisis back to pre-crisis levels. We evaluate the effect of three government policies: reducing intermediaries borrowing costs, injecting equity capital, and purchasing distressed assets. Injecting equity capital is particularly effective because it alleviates the equity capital constraint that drives the model's crisis.

https://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID2056642_code438873.pdf?abstractid=2056642&mirid=3

Intermediary Asset Pricing

We model the dynamics of risk premia during crises in asset markets where the marginal investor is a financial intermediary. Intermediaries face an equity capital constraint. Risk premia r...

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We develop a model in which the capital of the intermediary sector plays a critical role in determining asset prices. The model is cast within a dynamic general equilibrium economy, and the role for intermediation is derived endogenously based on optimal contracting considerations. Low intermediary capital reduces the risk-bearing capacity of the marginal investor. We show how this force helps to explain patterns during financial crises. The model replicates the observed rise during crises in Sharpe ratios, conditional volatility, correlation in price movements of assets held by the intermediary sector, and fall in riskless interest rates.

https://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1677613_code438873.pdf?abstractid=1359451&mirid=1&type=2

A Model of Capital and Crises

Our model shows that deterioration in debt market liquidity leads to an increase in not only the liquidity premium of corporate bonds but also credit risk. The latter effect originates from firms’ debt rollover. When liquidity deterioration causes a firm to suffer losses in rolling over its maturing debt, equity holders bear the losses while maturing debtholdersare paidinfull.Thisconflictleadsthefirmto defaultatahigher fundamental threshold. Our model demonstrates an intricate interaction between the liquidity premium and default premium and highlights the role of short-term debt in exacerbating rollover risk. THE YIELD SPREAD OF a firm’s bond relative to the risk-free interest rate directly determines the firm’s debt financing cost, and is often referred to as its credit spread. It is widely recognized that the credit spread reflects not only a default premium determined by the firm’s credit risk but also a liquidity premium due to illiquidity of the secondary debt market (e.g., Longstaff, Mithal, and Neis (2005) and Chen, Lesmond, and Wei (2007)). However, academics and policy makers tend to treat both the default premium and the liquidity premium as independent, and thus ignore interactions between them. The financial crisis of 2007 to 2008 demonstrates the importance of such an interaction— deterioration in debt market liquidity caused severe financing difficulties for many financial firms, which in turn exacerbated their credit risk. In this paper, we develop a theoretical model to analyze the interaction between debt market liquidity and credit risk through so-called rollover risk: when debt market liquidity deteriorates, firms face rollover losses from issuing new bonds to replace maturing bonds. To avoid default, equity holders need to bear the rollover losses, while maturing debt holders are paid in full. This

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Rollover Risk and Credit Risk

Firms commonly spread out their debt expirations across time to reduce the liquidity risk generated by large quantities of debt expiring at the same time. By doing so, they introduce a dynamic coordination problem. In deciding whether to rollover his debt, each maturing creditor is concerned about the rollover decisions of other creditors whose debt matures during his next contract period. We develop a model with a time-varying firm fundamental and a staggered debt structure to analyze this problem. We derive a unique threshold equilibrium with fear of a firm's future rollover risk driving preemptive runs. Our model characterizes fundamental volatility, asset illiquidity, reliability of credit lines, and debt maturity as determinants of such dynamic runs.

Zhiguo He

Papers

Intermediary Asset Pricing

Intermediary Asset Pricing

A Model of Capital and Crises

Rollover Risk and Credit Risk

Dynamic Debt Runs