Credit Market Freezes V. V. Chari & Keyvan Eslami University of - - PowerPoint PPT Presentation

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Credit Market Freezes V. V. Chari & Keyvan Eslami University of - - PowerPoint PPT Presentation

Apr 06, 2024 376 likes •911 views

Discussion of Benmelech & Bergmans Credit Market Freezes V. V. Chari & Keyvan Eslami University of Minnesota & Federal Reserve Bank of Minneapolis April 2017 What This Paper Is About Debt issuance fluctuates a lot High for

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Discussion of Benmelech & Bergman’s

Credit Market Freezes

  • V. V. Chari & Keyvan Eslami

University of Minnesota & Federal Reserve Bank of Minneapolis April 2017

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What This Paper Is About

Debt issuance fluctuates a lot High for some period of time Abruptly collapses Collapses associated with rise in “illiquidity”

Chari & Eslami Credit Market Freezes

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Empirical Contributions

Impressive Analyze 1873 and 2008–09 crises “Illiquidity” rises a lot for bonds where price fell by a lot Opinion dispersion plays a smaller role

Chari & Eslami Credit Market Freezes

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What Paper Does Not Do

Does not offer a theory of sources of shocks Does not offer a theory of propagation mechanisms No policy implications

Chari & Eslami Credit Market Freezes

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What Paper Does Not Do

Does not offer a theory of sources of shocks Does not offer a theory of propagation mechanisms No policy implications In short, no theory

Chari & Eslami Credit Market Freezes

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My Discussion

Offer a theory

Theory consistent with data Offer ideas for sources of shocks Has policy implications

See no role for “information sensitivity” or “endogenous adverse selection” as in Dang, Gorton & Holmstr¨

  • m (2015)

Main challenge is to find linkage to macro variables

Outline nature of challenges

Chari & Eslami Credit Market Freezes

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Data on Sudden Collapses

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New Issuances of ABSs in 2000s

50 100 150 200 250 300 350

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 $Bln

50 100 150 200 250 300 350

$Bln Other Non-U.S. Residential Mortgages* Student Loans Credit Cards Autos Commercial Real Estate Subprime Home Equity

*No reliable data for Non-US RMBS after Q3 '08 Source: Morganmarkets, JP Morgan Chase

Chari & Eslami Credit Market Freezes

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Change in Stock of Real Estate Bonds in 1920s

20 40 60 80 100 120 140 160 180 200

1920 1921 1922 1923 1924 1925 1926 1927 1928 1929 1930

20 40 60 80 100 120 140 160 180 200

$Bln $Bln

Note: Data is annual change in real estate bonds divided by Nominal GDP at relevant year multiplied by Nominal GDP 2009. Source: Carter, et. al., Historical Statistics, (2006)Series Dc904

Chari & Eslami Credit Market Freezes

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Theory: Reputation, Adverse Selection and Sudden Collapses

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Chari, Shourideh & Zetlin-Jones (2014, AER)

Large number of buyers Large number of loan originators, or banks Banks endowed with a portfolio of risky loans, size 1

Loan pays ¯ v with probability π and¯ v with probability 1 − π Let v := ¯ v −¯ v be spread,¯ v is collateral value Two types of banks, π ∈ {¯ π, ¯ π}, ¯ π < ¯ π

Chari & Eslami Credit Market Freezes

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C-S-ZJ

Buyers have comparative advantage in holding loans c > 0 Each bank chooses how much of its loan portfolio to sell, x Let t denote payment bank receives for selling x loans, p is price per loan Bank π payoff from selling x loans for payment t (up to a constant): t + (1 − x) (πv − c) Buyer profits from (x, t) (up to a constant): xπv − t

Chari & Eslami Credit Market Freezes

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C-S-ZJ

Adverse selection: bank knows type of loans, potential buyers do not Buyers believe given bank is high-quality with probability µ Call µ the reputation of the bank Focus on sales of individual bank with reputation µ Focus on 2 buyers (Bertand-style price competition)

Chari & Eslami Credit Market Freezes

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Timing in Static Model

Buyers simultaneously propose contracts to the bank: z = (xh, th, xl, tl) ∈ Z Bank chooses whether to accept a contract or reject both If bank accepts a contract, then chooses which offer to accept

Focus on incentive compatible z

Restrict to pure strategies for banks, possibly mixed strategies for buyers, F(z) for z ∈ Z Equilibrium is standard

Chari & Eslami Credit Market Freezes

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Equilibrium Characterization in Static Model

Proposition 1 The static model has a (unique) separating equilibrium. When reputation is low, the equilibrium has no cross-subsidization. When reputation is high, the equilibrium has cross-subsidization Low reputation → least-cost separating outcome High reputation → mixed strategies by buyers

Chari & Eslami Credit Market Freezes

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Equilibrium Characterization in Static Model

Three general properties: for all z ∈ supp (F)

xl = 1 Buyers make zero profits Incentive constraint for low-quality bank holds with equality: tl = th + (1 − xh) (¯ πv − c)

For reputation below a threshold, ˜ µ, least cost separating outcome has tl = ¯ πv and th = xh¯ πv

Chari & Eslami Credit Market Freezes

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Equilibrium Volume of Trade

When reputation is low, expected volume for a given bank is T = µ 1 + d + 1 − µ d =(¯ π − ¯ π) v c , adverse selection discount When reputation is high, expected volume is T = µ

  • 1 − 1 − µ

µ

  • c

(¯ π − ¯ π)v + c2 [(¯ π − ¯ π)v]2 −1 In both cases, if v = (¯ π − ¯ π) increases, then T falls That is, if adverse selection worsens, trade falls Problem: No reason for “discontinuous” fall in volume

Chari & Eslami Credit Market Freezes

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C-S-ZJ

Dynamic extension Bank’s type permanent Investors learn over time Collateral values fluctuate over time Can get pooling equilibrium New banks enter with exogenous initial reputation Banks exit with given probability

Chari & Eslami Credit Market Freezes

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Dynamic Extension

Chari & Eslami Credit Market Freezes

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Dynamic Simulation

Suppose v is such at µh both types selling Collateral value fall, increases spread v Moves all banks at µh from selling to holding Results in fall in trading volume Discontinuous because of mass point at µh

Chari & Eslami Credit Market Freezes

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Dynamic Simulation

Chari & Eslami Credit Market Freezes

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Dynamic Simulation

5 10 15 20 25 30 35 40 45 50 0.45 0.5 0.55 0.6 0.65 0.7

Period Volume Collateral Value Volume

5 10 15 20 25 30 35 40 45 50 2 4 6 8 10

Collateral Value

Chari & Eslami Credit Market Freezes

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Punchline of C-S-ZJ

Adverse selection model with reputation can

produce large changes in volume associated with small changes in fundamentals Equilibrium is efficient (for large range of parameter values) No role for policy

Chari & Eslami Credit Market Freezes

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Punchline of C-S-ZJ

Why did collateral values fall? Housing prices start leveling off in 2006 TFP growth slows starting in 2005 Demographics: In 2006–07, aging and retiring of baby boomers creates anticipated slowdown of GDP growth

Chari & Eslami Credit Market Freezes

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Bid-Ask Spreads in C-S-ZJ

Consider following decentralization All sellers (banks) ask price ¯ π¯ v − (1 − ¯ π)¯ v In pooling (both types selling) region p (µ) = µ [¯ π¯ v + (1 − ¯ π)¯ v] + (1 − µ) [¯ π¯ v + (1 − ¯ π)¯ v] Spread is (1 − µ) (¯ π − ¯ π) (¯ v −¯ v) Fall in ¯ v leads to only low quality banks selling p (µ) = ¯ π¯ v + (1 − ¯ π)¯ v Spread becomes (¯ π − ¯ π) (¯ v −¯ v) Rise in spread with fall in trade volume

Chari & Eslami Credit Market Freezes

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Extending C-S-ZJ to Allow for Real Effects

Suppose bank incurs cost c ∼ F (c) to originate loan Will originate loan as long as profits ≥ c∗, where c∗ is cut-off Fall in collateral values reduces loans originated Note, fall still occurs even if secondary markets absent No obvious “multiplier” effect from presence of secondary markets

Chari & Eslami Credit Market Freezes

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Risk versus Illiquidity

B&B use cov (∆pt, ∆pt+1) to measure “illiquidity”

Or use idea prices are mean-reverting

cov (∆pt, ∆pt+1) can be negative if pricing pricing kernel fluctuates, and markets are perfectly liquid Price of a claim that pays off 1 in period 2: p0 = 1, p1 (good) = 1, p1 (bad) = 0.2, and p2 = 1 When ∆p1 < 0, ∆p2 > 0, when ∆p1 = 0, ∆p2 = 0

Chari & Eslami Credit Market Freezes

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Challenges for Links Between Financial Market Distress and Real Outcomes

In data, most investment is “self-financed” Financial market disturbances do not directly reduce “available funds” Financial markets play some role in reallocating funds from cash-rich firms to project-rich firms Geting high “multiplier” effect challenge See Shourideh & Zetlin-Jones for resolution

Chari & Eslami Credit Market Freezes

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Linkage with Macro Outcomes: Challenges

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Big Issue

Financial friction models working through investment channel Pipes get clogged

Chari & Eslami Credit Market Freezes

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Big Issue

Financial friction models working through investment channel Problem: In data, flows go other way

Chari & Eslami Credit Market Freezes

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Does Typical Firm Use External Funds to Finance Investment?

Use data from From Flow of Funds for all non-financial corporations Available Funds, AF = Revenues - Wages - Materials

  • Interest Payments - Taxes

In Flow of Funds, AF = Internal Funds + Dividends Alternatively, AF = Retained Earnings + Dividends + Depreciation In Flow of Funds use Capital Expenditures

Chari & Eslami Credit Market Freezes

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Does Typical Firm Use External Funds to Finance Investment?

Available Funds - Dividends + Net New Debt Issue + New Equity Issue = Capital Expenditures Suppose Net New Debt Issue = 0 and Net New Equity Issue = 0 That is firm loses access to financial markets Can they finance all investment internally?

Chari & Eslami Credit Market Freezes

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Does Typical Firm Use External Funds to Finance Investment?

No, for aggregate of US corporations Financial markets may play a big role in reallocating funds from each cash-rich, project-poor firms to cash-poor, project-rich firms Use disaggregated data to analyze reallocation

Chari & Eslami Credit Market Freezes

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Available Funds and Gross Investment, US Non-Financial Corporations

5 10 15 20 25 30 35 1940 1950 1960 1970 1980 1990 2000 2010 2020 Percent Available Funds / Non-Financial Corporate GDP Capital Expenditures / Non-Financial Corporate GDP

Chari & Eslami Credit Market Freezes

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Big Issue for Alternative Formulations

Financial friction models working through investment channel How important is this channel?

Chari & Eslami Credit Market Freezes

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Do Disaggregated Data Show Different Patern?

Use data from corporate income tax returns Data available by asset size classes

Chari & Eslami Credit Market Freezes

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Available Funds and Gross Investment by Asset Class (under $500k)

  • 1

1 2 3 4 5 6 7 8 9 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 Percent Available Funds / Sales Investment / Sales

Chari & Eslami Credit Market Freezes

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Available Funds and Gross Investment by Asset Class ($500k–1m)

  • 1

1 2 3 4 5 6 7 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 Percent Available Funds / Sales Investment / Sales

Chari & Eslami Credit Market Freezes

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Available Funds and Gross Investment by Asset Class ($1m–5m)

  • 1

1 2 3 4 5 6 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 Percent Available Funds / Sales Investment / Sales

Chari & Eslami Credit Market Freezes

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Available Funds and Gross Investment by Asset Class ($5m–10m)

  • 1

1 2 3 4 5 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 Percent Available Funds / Sales Investment / Sales

Chari & Eslami Credit Market Freezes

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Available Funds and Gross Investment by Asset Class ($10m–25m)

  • 1

1 2 3 4 5 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 Percent Available Funds / Sales Investment / Sales

Chari & Eslami Credit Market Freezes

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Available Funds and Gross Investment by Asset Class ($25m–50m)

  • 1

1 2 3 4 5 6 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 Percent Available Funds / Sales Investment / Sales

Chari & Eslami Credit Market Freezes

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Available Funds and Gross Investment by Asset Class ($50m–100m)

  • 2
  • 1

1 2 3 4 5 6 7 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 Percent Available Funds / Sales Investment / Sales

Chari & Eslami Credit Market Freezes

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Available Funds and Gross Investment by Asset Class ($100m–250m)

  • 2

2 4 6 8 10 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 Percent Available Funds / Sales Investment / Sales

Chari & Eslami Credit Market Freezes

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Available Funds and Gross Investment by Asset Class ($250m or more)

  • 2

2 4 6 8 10 12 14 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 Percent Available Funds / Sales Investment / Sales

Chari & Eslami Credit Market Freezes

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Does Typical Firm Use External Funds to Finance Investment?

Use data from Compustat Compustat available funds for each firm, each time period AFit = Available funds for firm i in period t Iit = Gross investment by firm i in period t How much would Iit fall if no firm can invest more than AFit

Chari & Eslami Credit Market Freezes

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Does Typical Firm Use External Funds to Finance Investment?

Use of external funds to finance investment EF = 1 T

T

  • t=1
  • i [(Iit − AFit) | Iit > AFit]
  • i Iit

In data, financial market contraints = 24.33% of investment financed by external funds Interpretation: If firms had no access to financial markets, investment would have fallen by 24.33% This is exceptionally extreme exercise

Chari & Eslami Credit Market Freezes

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Available Funds and Capital Expenditures (Compustat)

2 4 6 8 10 12 14 16 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 Percent Available Funds / Sales Capital Expenditures / Sales

Chari & Eslami Credit Market Freezes

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Use of External Funds (Compustat)

5 10 15 20 25 30 35 40 45 50 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 Percent

Chari & Eslami Credit Market Freezes

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Does Typical Firm Use External Funds to Finance Investment?

No, for aggregate of US corporations In disaggregated data

Publicly held firms: 75.7% of investment financed internally Privately held firms: only 10% of investment financed internally

Reallocation channel promising for privately held firms Needs models with heterogeneous firms

Chari & Eslami Credit Market Freezes

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How Might Financial Frictions Work?

Financial frictions affect privately held firms Spills over to large firms See Shourideh & Zetlin-Jones for best effort to date

Chari & Eslami Credit Market Freezes