It is clear that in the period leading up to the global financial crisis of 2007-2009, credit and asset prices were growing at a ferocious pace. In the United States, for example, in the five-year period from 2002-2007, the ratio of debt to national income went up from 3.75 to one, to 4.75 to one. It had taken the prior full decade to accomplish this feat, and fifteen years prior to that. During this same period, house prices grew at an unprecedented rate of 11% per year. And, there was no evidence of appreciating borrower quality over this period either.
The credit growth was across board, in mortgages, especially sub-prime ones, in financing of leveraged buy-out transactions (LBOs), and through increasing issuance of low-rated bonds. This rapid rise in asset volume and prices met with a precipitous fall. Below are two salient examples.
First, for the past 30 years, credit markets had looked to the spread between high yield bonds and ten year treasuries as a measure of the likelihood of default of higher risk firms. On June 12, 2007, this spread reached a milestone, hitting just 2.6%, the lowest point in its 30-year history (Altman and Karlin, 2008). This low spread on June 12 was, however, not particularly prescient. Just 8 days later, the sub-prime crisis would “officially" start with the collapse of two highly leveraged hedge funds of Bear Stearns specializing in sub-prime mortgage backed securities. Figure 1: House Price to Rent Ratio. The Figure graphs the demeaned value of the ratio of the Office of Federal Housing Enterprise Oversight (OFHEO) repeat-sale house price index to the Bureau of Labor Statistics (BLS) shelter index (i.e., gross rent plus utilities components of the CPI). Because of demeaning, the average value of this ratio is zero.
Second, the median house price divided by rent in the United States over the 1975-2008 period, had varied within a relatively tight band around its long-run mean, but starting in late 2003, this ratio increased at an alarming rate. In mid 2006, however, the ratio flattened and has been falling sharply ever since albeit with much more room to fall. (See Figure 1.)
What caused this tremendous asset growth and the subsequent puncture is likely to intrigue the economists for years. Some have argued that the global economy was in a relative benign low-volatility environment in the decade up to the ongoing crisis (the so-called “Great Moderation", see Stock and Watson, 2002). In departure from this view, we argue that it is likely not a coincidence that the phase of remarkable asset growth described above started at the turn of the global recession of 2001—2002, which had witnessed unprecedented rate of corporate defaults and heightened macroeconomic risk.
In response, the Federal Reserve lowered interest rates to 1%, the lowest level since 1958, a period of abundant availability of liquidity to the financial sector ensued, bank balance-sheets grew two-fold within four years, and as the “bubble burst", a number of agency problems within banks in those years came to the fore. Such problems were primarily concentrated in centers that were in charge of undertaking, and in principle managing, large risks, and manifested as them taking huge payouts based on the volume of assets they created or traded rather than on (long-term) profits they generated.
In this paper, we present a theoretical model that combines these ingredients and explains why access to abundant liquidity aggravates the risk-taking moral hazard at banks, giving rise to asset price bubbles, that can be counteracted by Central Banks with a contractionary monetary policy, and that conversely are exacerbated by expansionary monetary policy. Some what perversely, the seeds of crisis are sown when the macroeconomic risk is high and investors in the economy switch from investments to savings in the form of bank deposits. Expansionary monetary policy is tempting in such times, but banks become flush with liquidity and ignite credit and asset price bubbles.
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