Ebook Liquidity Crisis and Credit Crunch: Default, Leverage, and Pyramiding
US housing market was booming after the collapse of the technology bubble in 2000 and it peaked around mid 2006. The housing market has since declined steadily and the pace of its decline accelerates after the meltdown of the subprime mortgage market in early 2007. The collapse of the subprime market triggers a widespread liquidity crisis that spillovers into much larger fixed income markets, including mortgage-back securities (MBS), collateralized debt obligations (CDO), other credit derivatives, etc. Greenlaw, Hatzius, Kashyap, and Shin (2008) estimate that the U.S. financial institutions are likely to incur a total loss of $200 billion for mortgage-related assets during the current crisis. Furthermore, the liquidity crisis causes many large hedge funds and financial institutions to undertake a painful process of unwinding their risky bets across all kinds of fixed-income assets. Such aggressive de-leveraging activities lead to significant contraction in the balance sheets of these firms. Consequently, both the cost of borrowing and the margin requirement increase drastically across all sectors of debt market. Greenlaw, Hatzius, Kashyap, and Shin (2008) estimate that the credit crunch will eventually result in roughly $2 trillion contraction in the balance sheets of leveraged financial intermediaries.
Simultaneous de-leveraging activities among many large players in financial markets exert a tremendous pressure on the credit market. As a result, despite the recent campaign of the Fed to loosen credit by lowering the Fed Fund Rate from 5.25% in June 2006 to 2% in April 2008, a severe credit crunch in the financial market has ensued since mid 2007. Such credit crunch led to further tightening of lending practice among major banks and it culminated with the sudden collapse of the Bear Stern Co. in March 2008. Meanwhile, many hedge funds and financial institutions were forced to sell relatively “good” assets in huge discounts to cover their losses in relatively “bad” assets. Thus, the credit crunch triggers further liquidity crisis. As such, a vicious cycle in which liquidity crisis and credit crunch reinforce each other in a downward spiral, feedback loop begins.
The historical episode described above suggests that there is a close interlock among housing, mortgage, and credit markets. The interlock exacerbates liquidity crisis and credit crunch across markets in a distinct feedback loop. In this paper, we develop a theoretical framework to incorporate the interlock and its impact on the current liquidity crisis and credit crunch. To do so, like Geanakoplos (2003), we treat houses as collateral to mortgage loans. Unlike Geanakoplos (2003), however, we solve for the equilibrium where both prices of the defaultable mortgage loan and of its underlying collateral (i.e., the house) are simultaneously determined. In our model, both the margin requirement and the leverage ratio of the financial institutions are endogenously determined.
Importantly, our model shows that both the rising cost of borrowing (e.g., Fed Fund Rate) and the falling quality of collateral (e.g., recovery rate) are culpable in explaining the observed feedback loop between liquidity crisis and the credit crunch. In addition, our model shows that the pro-cyclical leveraging practice by financial intermediaries magnifies their losses in mortgage-related assets and causes significant contraction in the balance sheets of these firms. This result lends support to Adrian and Shin (2007) as both papers emphasize the role of leverage and margin requirement in the current crisis. Furthermore, our model shows that the debt pyramiding scheme across leveraged financial intermediaries can translate a modest loss in one sector of debt market, such as the mortgage market, into a huge loss for the entire debt market. This result is consistent with the evidence in Greenlaw, Hatzius, Kashyap, and Shin (2008).
The rest of the paper proceeds as follows. Section II describes the basic model of the housing market with mortgage loan. Section III examines the feedback loop between liquidity crisis and credit crunch with an emphasis on margin requirements. Section IV investigates the impacts of leverage and debt pyramiding on the balance sheets of leveraged financial intermediaries. Section V discusses numerical results derived from our model using inputs of historical data in riskfree rate and recovery rate. Section VI briefly reviews related literature. Section VIII concludes. All proofs are in the Appendix.
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