Liquidity, leverage and the impact of sub-prime turbulence.

John Eatwell, Tarik ouakil and Lance Taylor

Centre for Financial Analysis and Policy Judge Business School, Cambridge

The history of financial bubbles !see "indleberger and #liber, $%%&' demonstrates that all bubbles require two components( First, an asset or set of assets that becomes the focus of speculation, in the sense that it is purchased purely as a financial placement, not for its intrinsic characteristics whether they be tulip bulbs, railway shares, dotcom companies or securitised mortgages. )n particular, the price of the financial placement becomes divorced from any likely return from the underlying asset !Eatwell, $%%*'. Second, the rising value of the financial placement requires a continuous e+pansion of purchasing power. This is often a stimulus to financial innovation to provide the wherewithal. The ,utch tulip mania of -./0 is famously associated with the introduction of trading on the margin !1osthumus, -2$2'. The railway bubbles of the early and mid nineteenth century saw the development of the 3oint stock company to something appro+imating its modern form. The relationship between the innovation that enhances liquidity, and the rising value of placements that demand liquidity, is a comple+ one( does the growth of liquidity set off the spirally value of placements, or does the growth of the value of placements stimulate the innovation necessary to the e+pansion of liquidity4 The assets that were the focus of the recent boom in placements were provided by the development of securitisation-, enabling mortgages !and other assets' to be packaged into tradable bundles, allied with the tranching of risks characteristic of credit derivative markets from the mid--22%s onward. The liquidity was provided by the e+pansion of the repo and reverse repo market$.
-

)n the 5nited 6tates mortgage-backed securities began to be significant in the -2/%7s with the creation of 8annie ae. $ # repurchase agreement !or repo' is an agreement between two parties whereby one party sells the other a security at a specified price with a commitment to buy the security back at a later date for another specified price. 9hile a repo is legally the sale and subsequent repurchase of a security, its economic effect is that of a secured loan - the party purchasing the security makes funds available to the seller and holds the security as collateral.

6hin !$%%:' has argued that the interaction of securitisation and the growth of the repo market stimulated and fuelled the growth of liquidity, and led to the development of a ;shadow banking system< that became an ;inflating balloon<. The system comprised an interdependent chain( sub-prime borrower mortgage broker originating bank mortgage pools commercial and investment banks rating agency 61= final investors !see #le+ander, Eatwell, 1ersaud and >eoch, $%%0'. ?ut there remains the question( what was the driving force in this ballooning system4 This is the question that this paper attempts to answer. To do so requires an e+amination not 3ust of the particular market, but of the macro-financial structure within which market is embedded. ?ecause it is within that macro-structure that growth of liquidity takes place. Liquidity is an elusive concept. @n the one hand an asset is liquid if it can be immediately e+changed for money without any significant change in price !a fire-sale is not a manifestation of liquidity'. 8inancial assets command a liquidity premium determined by their market relationship to cash. Liquid markets are markets inhabited by agents with heterogeneous motives and behaviour A when someone wants to sell someone else wants to buy. Bonversely, markets in which agents display relatively homogeneous behaviour are likely to be illiquid as, particularly in the face of e+treme events, all rush to sell, or to buy. 6o liquidity is an ad3ective, not a noun. @n the other hand, aggregate liquidity is often characterised as if it were a measurable quantity. #drian and 6hin !$%%:, p.-' cite popular phrases such as ;a flood of global liquidity< and ;e+cess liquidity< as metaphors embodying this quantitative image. Liquidity is a noun. #drian and 6hin define aggregate liquidity today as ;the growth rate of financial intermediaries7 balance sheet< and relate that growth to the development of the repo market. This amounts to defining liquidity as ;the ability of agents to command purchasing power by acquiring liquid liabilities<, an ability in turn dependent on the willingness of others to supply purchasing power against the issuance of liabilities. #n economy ;awash with liquidity< is then an economy in which the financial system becomes, as 6hin argued in his Blarendon Lectures !$%%:' an ;inflating balloon< looking for assets to fill up its e+panding balance sheets. Bonversely, that balloon may deflate when the ability to issue liabilities disappears and balance sheets shrink. Cistorically, financial innovation has been fundamental to the ability of financial institutions to acquire purchasing power by growing their liabilities and hence growing liquidity. Bhanges to the structure of the financial markets, and the interrelationships between changing financial institutions and monetary policy, have presented a challenge to the development of monetary theory, and have been a fertile source of controversy. The ob3ective of this paper is to e+amine the relationship between financial innovation, the e+pansion of liquidity and the propensity to financial bubbles, and to illustrate these general arguments in the specific case of subprime mortgages. ?y means of a simple model it will be suggested that the sub-prime e+ample is illustrative of the impact of the balance sheet ;inflating balloon< on asset markets.

)n 1art @ne of the paper accounting matrices are used to e+amine the role of liability acquisition in national balance sheets that reflect different stages of the development of financial market structures. )n 1art Two a national balance sheet incorporating securitised mortgages is the starting point for the construction of a simple model of the interaction between the financial sector and the housing market. )n 1art Three the model is used, with some empirical findings on leverage in households and in the financial sector, to attempt an answer to the question of what has been the driving force in the e+pansion of sub-prime mortgage lending.

Part One: Financial structure and the expansion of liquidity.

# very simple monetary structure !perhaps representative of the early stages of the development of market economies, or of some developing countries today' is presented in Table @ne. )n normal times !one historically significant sort of ;abnormality< is considered below', the only private assets are the value of tangible capital pkK with K as the e+isting stock at historical or replacement cost and pk as its asset price. ; oney< !broadly construed' Z is the sole liability of the banking system/. There is no significant market in bonds, so private holdings of government securities are negligible. @n the liability side, private business may borrow p from the banks. Loans from abroad are negligible and both private housing and the value of equity outstanding are effectively non-traded. Table One: Stage One

Sector Assets

Private + pk. K

Banks

Government

RoW

- Real Assets - pk. K

0 0 0 0 0 0 0

Tangible capital Govt Bonds oans !oreign reserves #$one%& - (et )ort*

+ Bb p

-B

0 0 - e. !" 0 0

+ + e. !"

+' - (Wp 0

-' 0 0 ++ 0 + e. !" 0

+ pk. K 0

The system7s assets are loans !at this stage only p to the private sector', bonds Bb which the government has placed with the banks, and international reserves of the central bank eF! with F! as the value of reserves in foreign currency and e as the e+change rate !units of local currency per unit of foreign currency'. The sum of bank assets determines the money supply Z" The government7s total borrowing, which at
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#s is often the case in macroeconomic modelling, bank equity held as an asset by the private sector is omitted from the table. )t is introduced and discussed in connection with financial regulation below.

this stage is only from the banking system, is B # Bb. The corresponding asset is the ;full faith and credit< of the 6tate, D. Table @ne is a matri+ that describes the interlocking system of balance sheets within the economy. 6ymbols with a plus sign describe assets and negative signs indicate liabilities. The sum of each row must be Eero since !a' every financial asset of a given sector is a liability of another one and !b' there is a column allowing every real asset to appear as a double entry. The last row presents the sum of each column A Eero other than the final entry representing national net worth. The entries in this Table @ne represent values of stocks of assets. They change in two ways. @ne is through flow accumulation or decumulation over time. The other is the capital gains and losses consequent upon changes in asset prices pk or e" 8or the private sector, liquidity takes the form of one asset, namely money. Fothing else is at hand*. The accounting framework 3ust sketched puts strict limitations on policy options. 6uppose that money demand is described by the equation of e+change Z$ # P% with P the price level, % output, and $ the velocity of circulation of money. )f % is set by ;full employment< as determined by the 9alrasian equations of e+change, P comes from an inflation forecast or target, and $ is determined ;institutionally<, then money demand must follow. This is in accordance with the basic closed economy monetarist inflation model, set out by 9icksell !-2/&' and developed by 8riedman !-2.:'. # higher fiscal deficit, B, is ;monetised< because the government cannot easily place debt obligations other than with the banks. The resulting increase in Z forces P up. ?ecause liquidity in many economies now comprises a spectrum of financial assets and liabilities far wider than 3ust money, such monetarist inflation models are anachronistic. Cowever, the inflation in Gimbabwe that took off in the mid-$%%%s can be interpreted along these monetarist lines !including money creation was mostly in the form of cash'. Even in this simple structure financial manias can appear. @ne familiar scenario is based on government assets that have been privatiEed and sold through a dealer to the public&. )f the dealer happens to have a captive bank at his disposal, he can lend money to himself to bid up the share price leading to a capital gain !or on-going inflation'. @thers may then start borrowing from the captive and other banks to try to buy shares, setting off a boom that ends inevitably in a crash. 8amous e+amples are the ississippi and 6outh 6ea crises early in the -:th century, in which John Law7s ?anque HInIrale in 1aris and the 6wordblade ?ank in London issued the loans. These e+amples illustrate what was to become a recurring theme in financial instability. Bapital gains are financed by liquidity in the form of liabilities assumed by financial actors to buy the appreciating assets. any possibilities along these lines e+ist in more complicated financial systems.
*

To limit the number of symbols in the balance sheets, government liabilities to the private sector in the form of coin and currency are omitted from the present discussion. They were key components of the rich countries7 financial systems well into the -2th century and remain important in many developing economies today. & The ;assets< might be claims on hypothetical future revenue streams !the 6outh 6ea and ississippi e+amples' or equity of former state enterprises.

Table Two: Stage Two

Sector Assets

Private + pk. K + Bp p

Banks

Government

RoW

- Real Assets - pk. K

0 0 0 0 0 0 0

Tangible capital Govt Bonds oans !oreign reserves #$one%& - (et )ort*

+ Bb + + e. !"

-B

0 0 - e. !" 0 0

+' - (Wp 0

-' 0 0 ++ 0 + e. !" 0

+ pk. K 0

)n Table Two the model is e+tended by incorporating a domestic market in government debt. The banks and the non-bank private sector now have substantial holdings of government bonds !Bb and Bp respectively'. "eynes !-2/.' thought in terms of this sort of financial system, with the significant e+tension of having markets in corporate debt instruments as well. 1rimary liquidity is still money. "eynesian ideas about liquidity preference come into play, with the interest rate mediating portfolio choices between more liquid money and less liquid bonds !with government bonds being more liquid than corporates, which are sub3ect to interest rate spreads associated with both liquidity and solvency risks'. 8inancial instability takes the form of shifts in liquidity preference, mi+ed with over-borrowing !high leverage', such shifts provide the foundation for insky7s ;financial instability hypothesis< ! insky, -20&'. The potential for the use of liabilities as a source of liquidity is e+panded in Table Three. # local market for equity issued by the private sector can provide the dynamic. )n the Table the value of private sector shares outstanding is p$& with p$ as a price inde+ and & a measure of outstanding volume.. The use of liabilities !and derivatives built around them' as sources of liquidity is illustrated in the Table7s ;8inance< sector that holds shares p$&f financed by borrowing from banks and abroad. The sector7s net worth is '(f , held by the private sector as an asset. 9ithin the 8inancial 6ector, there are offsetting asset and liability entries ). )ndividual financial actors such as brokerdealers and hedge funds can borrow from one another but for their ;leveraged< subsystem as a whole many of these transactions will be mutually offsetting0. ?y
.

8or the private non-financial sector, Table 8our follows the accounting convention of the flow of funds by treating equity outstanding as a ;liability< and allowing non-Eero net worth. 6o, for e+ample, in flow of funds terms Hoogle has highly negative net worth because its stock market valuation vastly e+ceeds its tangible capital and financial assets. @n a balance sheet set up to follow accountants7 conventions, Hoogle like all other corporations would have Eero net worth. 0 )n available 56 flow of funds data they do not offset completely A leveraged financial institutions typically have negative net positions in fed funds and security repurchase !repo' agreements !see Table 8ive'. *ross repo asset and liability positions are not reported.

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increasing transactions ), financial institutions can add to cash flow as they build up their leverage ratios +p$&f , )-.'(f. The liabilities + f , ) , e !f - underlying total assets +p$&f , )- can support imposing structures of leverage and liquidity:. 6o long as p$ continues to rise, for e+ample, then growing intra-financial sector claims make it possible to mobiliEe large sums of liquidity to buy stock. This is e+actly how the repo and reverse repo markets have worked to the siEe of balance sheets in the 8inance 6ector.

Table Three: Stage Three

Sector Assets

Private + pk. K + Bp p

Banks

Finance

Government

- Real Assets - pk. K

0 0 0 0 0 0 0 0 0

Tangible capital Govt Bonds oans Repos ,-.ities #$one%& - (et Wort* /0inancial sector1 - (et )ort* /ot*ers1

+ Bb + - Lf +/- R

-B

0 0 0 0 0

- pv . V +' + (W0 - (Wp 0 0 0 -'

+ pv . V f

- (W0 0 0 ++ 0

0 + pk. K 0

The use of repos and reverse repos by financial institutions as a source of liquidity was analysed by insky !-2&0', who demonstrated that the tight 56 monetary policy of the mid-&%7s led government bond houses to develop repurchase agreements in order to finance the e+pansion of their balance sheets, despite the rise in short-term interest rates2. >epos can be depicted as a financial innovation which makes ;idle< liquidity circulate( for instance repos can allow a financial institution to obtain funds from another financial institution whose lending capacity has not reached its regulatory ma+imum. )n addition, repos can result in an increase in the velocity of

)n the 56 at the end of $%%0, leverage for households was around -.$, for commercial banks it was about -%, and for investment banks it was over /%. 2 ;Jif the institutional framework is stable, a tight monetary policy will be effective and the interest rate will rise to whatever e+tent is necessary in order to restrict the demand for financing to the essentially inelastic supply. Cowever, the rise in interest rates feeds back upon the institutional framework. 9ith rising interest rates the incentives to find new ways to finance operations and new substitutes for cash assets increase. J Cence there is a favourable environment for financial innovations. 6ince the significant institutional innovations during a period of monetary policy will be those which tend to increase velocity, they can be represented as shifting the Ksupply of moneyL-interest rate relation to the right< ! insky, -2&0, p.-:$'.

circulation by shortening the time intervals between overlapping transactions and so increases the liquidity of the economy-%. Fowadays, apart from repos, the potential e+pansion of liquidity has been further enhanced by the development of asset securitisation !Table 8our'. 6uppose that as well as capital the private sector holds a tangible asset, residential housing /, with price ph. )t borrows 0 !mortgages' from banks, using ph/ as collateral. The banks in turn bundle the mortgages into a security S with price ps that is then sold on to other financial actors. This makes it possible to borrow large sums and increase leverage by increasing claims on the non-financial sector. )t is also another potential collateral for repo or short-term commercial paper borrowing. Table Four: Securitisation
Sector Assets

Private + pk. K + ph. H + Bp p

Banks

!inance

Government

- Real Assets - pk. K - ph. H

0 0 0 0 0 0 0 0 0 0 0 0

Tangible capital Real estate Govt Bonds oans $ortgages $BS Repos ,-.ities #$one%& - (et Wort* /0inancial sector1 - (et )ort* /ot*ers1

+ Bb + +Mb - ps . S + ps . S +2- R 0

-B

0 0 0 0 0 0 0

-M

- pv . 3 +' + (W0 - (Wp 0 0 0 -'

+ p0 . 30

- (W0 0 0 ++ 0

0 + pk. K + p*. 4 0

The combination of securitisation and the growth of the repo market have greatly e+panded the potential for the growth of liquidity by the e+pansion of the balance sheets of financial intermediaries. )ndeed, #drian and 6hin !$%%:, p.-$' have argued that not only are repos and reverse repos important financing activities for investment banks, but that ;the margin of ad3ustment in the e+pansion and contraction of balance sheets is through repos and reverse repos<.
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6uppose initial repo contracts are for two weeks. Then after receiving liquid funds the issuer can buy a further asset, using that asset as collateral in a second repo to raise the funds to conclude !or roll over' the first contract. The original asset may then be used to raise funds to settle !or roll over' the second contract, and so on. The average length of a repo contract is now one week and the velocity of circulation has doubled, as has the liquidity generated by the repo contracts. #s the average length of repo contracts shortens the velocity of circulation accelerates.

Part Two:

rowth of liquidity: a !odel of securitisation.

The accounting structures of the preceding section provide the foundations of a stockflow consistent macro model, placing the emphasis on the use of stock and flow matrices to model a fully consistent statement of the relationship among the macro sectors of an economy. This approach links the macro-economy to the approach to liquidity presented by #drian and 6hin !$%%0, $%%:' which has at its centre the characterisation of the financial system ;where balance sheets are continuously marked to market, asset prices changes show up immediately in changes in net worth, and elicit responses from financial intermediaries who ad3ust the siEe of their balance sheets. J such behaviour has aggregate consequences. J #ggregate liquidity can be seen as the rate of change of the aggregate balance sheet of the financial intermediaries< !#drian and 6hin, $%%0, p.-'. The model portrays a closed economy with four macro sectors( a central bank, nonfinancial firms, households and the financial sector. The latter includes all the financial institutions involved in the securitisation chain - mortgage brokers, various banks, government sponsored enterprises, special purpose vehicles, money market funds, hedge funds, and so. Table 8ive is the balance sheet matri+ of the proposed economy. 8or the model to be stock-flow consistent initial stocks must be consistent with this matri+. 6tocks in subsequent periods will be consistent as long as flows are also consistent in accounting terms. Table Fi"e: #alance Sheet $atrix
Sector Assets

4o.se*olds + p*. 4d

S*ado) Banking Special P.rpose 5entral bank S%stem 3e*icles

!irms

- Real Assets - p*. 4d

0 0 0 0 0 0 0 0

Real estate
5apital $ortgages

+K -$ + ps . S + +6 -6 +' -R - (W* 0 - (Wb 0 - (Wsp 0 -' +R - (Wcb 0 - (W0 0 +$ - ps . S -

-K 0 0 0 0 0 0

$BS oans 6eposits 4ig* po)ered mone% Repos - (et )ort*

+ p*.4d + K 0 0 0

Table 6i+ is the transactions matri+ describing monetary flows between the four sectors of our postulated economy. Each row represents a monetary transaction between sectors and each column corresponds to a sector account. The columns for Couseholds and 8irms are divided into a current and a capital account. The accounts of the ?anking 6ystem are divided into two accounts( one for special purpose vehicles and one for the other financial institutions !the latter including a current and a capital account'. 6ources of funds appear with plus signs and uses of funds with negative signs--. The sum of every row must be Eero since every transaction corresponds simultaneously to a source and a use of funds. The sum of each column must also be Eero since each account !or sub-account' is balanced. The transactions matri+ can be transcribed into eight accounting identities corresponding to its eight columns. 8or our model to be consistent with this accounting framework it should include seven of these accounting identities-$. Then, according to 9alras7 law, the remaining identity will always be verified in the model - financial flows will be consistent.

--

Cence, in a way, the sign convention on sourcesMuses in Table 6even is opposite to that on #ssetsMLiabilities in Tables 6i+. -$ 8or ease of e+position each accounting identity used in the model is labelled with a lower case >oman numeral.

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Table Six: Transactions $atrix

Sector Transaction
4o.sing p.rc*ases 5ons.mption 8nvestment Wages 8nterests on deposits 8nterests on s.bp. mortgages 8nterests on loans Savings Banks: pro0its !irms: pro0its 7 $ortgages 7 $BS 7 oans 7 6eposits 7 4ig* po)ered mone% 7 Repos

4o.se*olds 5.rrent 5apital -74d.p* -5

Banking S%stem 5.rrent 5apital

Special P.rpose 3e*icles

5entral bank

!irms 5.rrent + 74d.p* +5 + 80 - 80 5apital

0 0 0 0 0 0

+W +rd-9. 6-9 -rm-9. $ -9 - rd-9. 6-9 + rm9. $ -9 + rl-9. -, +, - Pb + Pb

-9

-W

- rl-9.

-9

0 0 0

- P0 +7$ - 7 S. ps -7 -76 + 76 - 7' + 7R 0 /i1 0 /ii1 0 /iii1 0 /iv1 0 /v1 + 7' - 7R 0 /vi1 0 /vii1 - 7$ + 7 S. ps

+ P0

0 0 0

+7

0 0 0 0

0 /viii1

--

The housing !ar%et @ur modelling of the demand for homes is based on the housing economics literature and in particular on the observation that the sign of the effects of various variables on demand depends on whether or not there are any credit restrictions on mortgages. ;)n a market where credit is not restricted, it can be shown that housing is an ;ordinary< good in the sense that housing demand is negatively related to house prices. )n addition, based on theoretical arguments alone, current and future income and e+pected capital gains tend to have an unambiguously positive effect on housing demand when credit is freely available. Bonversely, the demand for housing is a negative function of the interest rate because higher interest rates increase the cost of consuming housing services !mortgage interest costs rise'. )n an economy with binding quantitative restrictions imposed on borrowers, as discussed in iles !-22*', the impact of changes in many of the above variables on the demand for housing is less clear-cut, however. 5nder such conditions, housing is no longer necessarily a decreasing function of the price of housing. )n addition, both income and interest rates can have apparently perverse effects on the stock of housing that will be desired< !"enny, -222, p./2-'. +1- 2/d./d31 # 45 3 41 " ph31 , 46 " 731 8 49 " rm31 8 4: " ;h 31 8 4< " ;b 31 +6- 7 # +2ph " /31- . +ph31 " /31- # 2ph " . ph31 +9- ;h # 0 . '(h +:- ;b # ) . '(b Cere we assume that the rate of growth of the demand for housing depends +anegatively on the price of housing ph +b- positively on the rate of return on housing 7 !the ratio between capital gains 2ph " /31 and the holding of houses ph31 " /31- +cnegatively on the rate of interest on mortgages rm +d- negatively on the leverage ratio of households !the ratio between their stock of mortgages 0 and their net worth '(h' and +e- negatively on the leverage ratio of banks !the ratio between their stock of repos ) and their net worth '(b'. +a-, +b- and +c- correspond to the relationships suggested by economic theory without considering restrictions facing borrowers in the housing market. +d- and +e- aim to describe the effect of credit rationing on the demand for housing-/. +e- is based on 6hin7s !$%%:' analysis of the active management of balance sheets by financial institutions( decreasing leverage ratios induce a ;demand for e+tra assets Kwhich, in turnL entails scouring for borrowers, even sub-prime ones<. #ccording to +d-, the higher the leverage ratio of households, the higher the risks perceived by lenders and thus the smaller the supply of mortgages which allow households to buy new houses. Through +d- the price of housing can have a perverse effect on the demand for housing since, it leads to an increase in the net worth of households( +<- '(h = ph " /d , > 3 0
-/

@ne can consider, for the purpose of simplicity, that +a-, +b- and +c- are related to the ;basic< behaviour of prime borrowers !assuming that they do not face any credit restriction' while +d- and +edescribe the effect of credit rationing on the behaviour of subprime borrowers.

-$

@n the supply side it is assumed, following "enny !-222', that the rate of growth of built homes 2/s./s31 is related positively to the ratio between the price of housing ph and the production cost of housing c !which is assumed to be constant'. This equation is in line of Tobin7s ? analysis of investment-* +@- 2/s./s31 # A5 , A1 " ph31.c The rate of inflation in housing 2ph.ph31 is then determined by the difference between the rates of growth of demand and supply. 6uch a price mechanism allows the model to achieve a steady state when both supply and demand grow at the same rate. )n other words, if the rate of growth of unsold houses remains constant, so does the price of housing units. +B- 2ph.ph31 # C" +2/d./d31 8 2/s./s31The shadow ban%ing syste! The ne+t step is to consider the behaviour of the ;shadow banking system< and its interaction with the housing market. Cere, it is assumed that all purchases of housing units 2/d"ph are financed through mortgages( +D- 20 # 2/d"ph oreover, all mortgages are securitised through the chain of financial institutions presented in 1art @ne. 8rom a macroeconomic point of view securitisation consists of taking sub-prime mortgages 0 off the aggregated balance sheet of the banks, placing them in a separate special purpose vehicle, and receiving in return mortgage-backed securities S whose price ps is correlated with the price of housing !the ultimate collateral'. This is captured in equation !2' in which the price of securities ps is proportional to the price of housing ph. The issue of mortgage-backed securities is derived directly from the amount of new mortgages created !equation -%'. +E- ps # F " ph +153$- 2S = 20.ps # consequence of securitisation is, as shown in !--', that a rise in the price of housingMsecurities now leads to a rise in the net worth of banks and thus to a decrease in their leverage ratio. +11- '(b = ps"S , 8>,Z8)

-*

"enny7s !-222' version is in terms of difference between price and cost( NCMC-- O P% Q P- !ph--- c'. This tends to force price and cost toward equality. The ratio is a more general formulation.

-/

@n the supply side of the housing market, it is assumed that non-financial firms !that build housing units and produce investment and consumption goods' are also financed by the banking system without any restriction. )n other words net borrowing finances whatever part of firms7 investment is not covered by profits( +163$iii- 2 = Gf 8 Pf

The banking system has two sources of liquidity that allow it to finance the housing market. The first source is the savings of households collected by the financial system. )n this model savings can be collected only in the form of bank deposits-& > and banks apply a spread between the various rates of interest on loans !rates on deposits rd, mortgages rm and corporate loans rl' in order to realiEe profits Pb1@( +193iii- Pb = rm31 " 031 , rl31"
31

8 rd31 " >31

This first source of liquidity is not necessarily sufficient to cover the needs of the housing market, especially since banks are forced by the central bank to hold reserves Z in proportion to the amount of deposits( +1:- Z # H " > The second source of liquidity is repurchase agreements, repos. #s e+plained earlier, repos between the various financial institutions enable a global increase in liquidity through a rise in the velocity of circulation. Cowever these intra-sector repos do not appear e+plicitly in the macro model since repos and reverse repos offset each other in the aggregated balance sheet of the shadow banking system. The e+pansion of repos and reverse repos is endorsed by the operations of the Bentral ?ank to sustain liquidity in short-term money markets. #ccordingly, growth of the net repo position in the ?anking 6ystem is balanced by counter-party transactions by the Bentral ?ank clearing the repo market !on mortgage backed securities-0' at the rate of interest of its choice rp, so providing an endogenous demand for repos-:. Thus, through repos, the central bank provides whatever liquidity is required by banks at the rate rr-2 +1<3i$- 2) = 2S " ps , 2 ,2Z 8 2> 3 Pb &ouseholds #side from the housing investment decision, the behaviour of households is straightforward in this model. Cousehold consumption, C is a fi+ed proportion of their net income !wages plus interest on deposits less interest on mortgages' and they hold all their savings I in form of banking deposits >J
-& -.

)n this model financial !as well as non financial' firms do not issue equity. Cere we assume that rm K rl K rr K rd with rr the rate of interest on repurchase agreements between the central bank and private banks. -0 )n this model there is no government and thus no treasury bills or government bonds. -: 8or a description of central bank operations in the repo market see Tucker !$%%*'. -2 )nterest payments on repos from financial institutions to the central bank are ignored in this model in order to avoid dealing with central bank7s profits !in the real world such profits would usually be transferred to the government'.

-*

+1@- C # c " +( , rd31">31 8 rm31"031+1B3i- 2> # I = ( 3 C , rd31">31 3 rm31"031 'on(financial fir!s. The behaviour of non-financial firms is also quite rudimentary. )nvestment consists solely of the number of newly built houses, implying that no investment is necessary for producing consumption or investment goods( +1D- Gf # 2K # L " 2/s )n the same way, wages are a proportion of the cost of newly built houses. +1E- ( # M " +2/s " c1rofits of firms, that appeared in equation !-$', are given by the following accounting identity( +653$ii- Pf = 2/ "ph , C , Gf 8 ( 8 rl31 " )losure of the !odel. The model is now closed. The ;missing identity< is the accounting balance of the central bank( +$i- Z )" This identity reflects the fact that base money Z is supplied to the economy through repos ) to private banks. 9hen the model is solved numerically, identity !vi' is always verified, confirming ;stock-flow consistency<.
31

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Part Three: The sub(pri!e !ortgage crisis.

The behaviour of the model is e+amined by means of simulations using E=iews ..%. 8irst, initial values are assigned to all parameters and e+ogenous variables using ;styliEed facts<. 6econd, numerical simulations are used to solve the model and find a steady state through a process of successive appro+imations. Caving found a steady state, we try to determine which changes are the most likely to make the model ;e+plode<. E+amining the values of parameters that generate unstable regimes provides some insight into the economic conditions that tend to result in instability. 6imulations show that this model is quite sensitive to the siEe of the effects of ;credit rationing< on the demand for housing since it generates stable regimes only for relatively small values of P* and P& in equation !-'. These parameters represent the elasticity of mortgages with respect to the leverage of households P*, and the elasticity of mortgages with respect to the leverage of banks P&. )t might be thought that, in this model, it is the behaviour of lenders that is a potential source of instability. )n fact the unstable regimes obtained with high values of P* and P& fall into two distinct forms of financial instability( ;household-led< financial crises and ;bank-led< crises. * household(led financial crisis Bonsider the unstable regime corresponding to a relatively high value of P*. #s shown in 8igure @ne, simulations tend to show that this unstable regime can be interpreted as a financial crisis arising from the interaction of the price of housing and the leverage ratio of households. )ndeed, when value for 4: is set relatively high, the price of housing tends to have a perverse effect on the demand for housing( the !indirect' positive effect on the demand for housing through the capital gains on houses which increase the net worth of households !and the rate of return R', is stronger than the !direct' negative effect measured by 41 in equation !-'. )n other words, an increase in the price of housing can lead to an increase in the demand for houses which in turn will lead to further rise in pricesJ Figure One: +nstable regi!e for ,- . /.0 1cloc%wise tra2ectory3
>00 ?00 0 P@4 /Baseline1 -?00 ->00 -9<;00 -9<=00 -;<000 ->0 -=0 -?0 -;0 0 ,3@4@0 ;0 ?0 =0 >0

-.

The kind of instability that such a positive feedback in the price of housing may generate may be illustrated in terms of equations describing the interaction between the leverage ratio of households and the price of housing(
N / - # f + p N ; - +61 h # fp + / p p h h d s

# f + 0 -#f +p N; N '( ; ; h h h h

+66-

Equations +61- and +66- correspond to a generic form of differential equation. Cere we do not try to solve the model numerically or to determine the e+act form of these equations$%. >ather our emphasis is on determining which conditions can generate an unstable regime similar as the one observed with simulations. To do so, suppose that 4: is high enough to generate a positive feedback in the price of housing(
h . ph K 5 p

#nd note that equation !-' means that the leverage ratio has a negative impact on the demand for housing and thus on ph(
h . ;h O 5 p

Equation !-' also implies that the leverage ratio behaves in a self-stabiliEing fashion since an increase in the leverage of households reduces the supply of mortgages(
. ; O 5 h h

# 5 with positive critical values p ! K5 and ; ! K5 , the h # )n the steady state p h h h form of the Jacobian matri+ J is(

J +g5!, l!- #

P11 K 5 P61 Q

P16 O 5 P66 O 5 Sr +J- # P11 , P66

with >et +J- # P11RP66 8 P61RP16

6ince the main-diagonal product P11RP66 is negative, the system will only avoid a saddle-point with ,et !J' S % if the off-diagonal product P61RP16 is also negative !and higher than P11RP66 in absolute value', that is, if P61 is positive. Thus, when the price of housing feeds back positively into itself, a ;household-led< financial crisis would . ph K 5. )n this case, if the trace of the Jacobian matri+ is require that h positive$-, the model can generate a divergent tra3ectory similar to the one that appears in the phase diagram of 8igure Two. 6tarting from A, the price of housing will increase and the leverage ratio of households fall !due to capital gains' until the !ph N ;h- tra3ectory crosses the isocline of the leverage ratio in B. Then the leverage ratio
and / and thus, according to h depends on / 5sing equation !0', one can show that p d s equations !-' and !.', on ph and ;h" and thus, according to and '( 5sing equation !/', one could show that ;h depends on 0 h equations !:' and !&', on ph and / , that is on ph and ;h"
$%

$-

)f the trace of is negative the model will still generate a stable tra3ectory, even if P61 is positive.

-0

starts to increase due to the rise in mortgages !allowed by a higher net worth' but the price of houses still increases until C. #t that point the demand and the price of housing begin to fall !due to the negative impact of higher leverage ratios$$' which leads to further increases in the leverage ratio !due to negative capital gains' till ,. #round that point a debt deflation may occur. Figure Two: * households(led financial crisis. ph #5 B , ? # #5

;h )n short, the financial crisis that the model generates for a relatively high value of 4: is caused by both a positive feedback in the price of housing and a pro-cyclical leverage ratio of households. )s this a plausible scenario4 )n particular, is it realistic to assume that the leverage ratio of households can respond positively to a rise in the price of houses4 )ntuitively, the direct effect of a rise in the price of houses seems rather an increase in the net worth of households !due to capital gains' and thus a decrease in the leverage ratio. The only way for the leverage ratio to rise would be that mortgages increase substantially in response to this increase in their net worth !as represented by the high value assigned to 4:'. Cowever, some basic empirical analysis, following of #drian and 6hin !$%%0' would tend to contradict this hypothesis. )n Table 6even are displayed estimates of how the rates of growth of the debt of 56 households and 56 financial institutions responds to
$$

Equation !$-' can be written as follows(

h # C" T341" ph31 84:" ;h31 8 A1"ph31.c , UV p

h to ph, there is a positive effect of @n top of the TnormalT negative demand and supply responses of p ph through ;h which attenuates as ph gets bigger. The attenuation helps e+plain why the solution h # 5 isocline and provokes a crisis in 8igure $. tra3ectory ultimately crosses the p

-:

the rates of growth of their net worth or equity capital. )n the case of households, an increase in net worth has a very limited impact on the rate of growth of debt. Table Se"en: 4e"erage beha"iour 1/556(78863
Source: Federal 9eser"e: Federal ;eposit <nsurance )orporation: 'ational )redit +nion *d!inistration: Securities and =xchange )o!!ission.
T*is table reports regressions o0 -.arterl% 0irst di00erences o0 t*e logarit*m o0 debt on 0irst di00erences o0 t*e logarit*m o0 e-.it%. 6ebt is de0ined as t*e di00erence bet)een assets and e-.it%. T*e Ginvestment banksG col.mn reports a panel regression 0or 0ive investment banksF Bear Sterns< Goldman Sac*s< e*man Brot*ers< $erril %nc*< $organ Stanle%. dlog (deb " 5redit Anions 0.9DD= 0.=;0=0B 0.90=?B; 0.;ED>E;

dlog (equi !"

coe0 s.e coe0 s.e

4o.se*olds 0.0BB=9C 0.0BC?BC 0.0009?E >.9E,-0C -0.00E>=B 0.09=CBB

5ommercial Banks Savings 8ns tit.tions

0.B0?C>9 0.9?DC=C

8nvestment banks 0.;C;DCB 0.0>=9?B

#ons an

coe0 s.e

0.09;=>E 0.00BD>

0.00>EE= 0.00??D;

0.00EBBC 0.00=>0=

0.0;=>D? 0.00C09;

$bse%va ions& S.'. of %eg%ession& R-squa%ed&

So.rceF

?? 0.00=>E9 0.0>E>B
!,6

?B 0.09;90D 0.0D9>C>
!685

?? 0.0;=9D 0.0EE;=D
!685

?B 0.09CD? 0.90E0>=
(5AA

;0> 0.0CE?>? 0.0?09E=

S,5

The relationship between quarterly changes in total household assets and quarterly changes in leverage as measured in the 8low of 8unds account for the 5nited 6tates between -220 and $%%0 is illustrated in 8igure Three. #s shown by #drian and 6hin !$%%0' in a similar chart based on data from -2./ to $%%., there is a strong negative relationship between total assets of households and their leverage$/. Cence it would appear to be unreasonable to impose the parameter values on the model that would be required to generate a ;households-led< financial crisis.

Figure Three: *ssets and le"erage growth rates of &ouseholds

Source: Federal 9eser"e.

$/

)n figure Three, the leverage of households is defined, following #drian and 6hin !$%%0', as the ratio of assets A to net worth '. This leverage ratio is of course interchangeable with the one we used in our model !debt > on net worth ''. )ndeed #MF O # M !# A,' O - Q ,M !# - ,' O - Q ,MF. Thus, when the leverage ratio of 8igure Three decreases, so does the one we used.

-2

.90 .0> .0= dlog/assets1 .0? .0; .00 -.0; -.0? -.090

-.00C

.000

.00C

.090

.09C

dlog/leverage1

* ban%(led financial crisis. ?y contrast with the above case the second type of unstable regime that the model can generate, for high values of P&, provides a plausible representation of the recent subprime mortgage crisis. Figure Four: +nstable regi!e for ,0 . 8.> 1cloc%wise tra2ectory3
9.0> 9.0? 9.00 0.D= 0.D; 0.>> 0.>? -; 0 ; ? = ,3@B@0 > 90 9;

P@S /Baseline1

$%

#s shown in figure 8our, simulations show that unstable regimes obtained for high values of P& can be interpreted, in some cases$*, as arising from the interaction between the price of securities ps and the leverage ratio of the banking system ;b6<(
s # fp +ph- # fp + ps N ;bp

+6@-

#f + ) - # f + p N ; - +6B N '( ; ; s b b b

?ecause the banks7 leverage ratio appears in equation !-', the price of securities tends to feed back positively into itself( an increase in ps leads to capital gains on mortgagebacked securities which increase the net worth of banks and thus lead them to provide more mortgages to borrowers. The resulting increase in house purchases generates a rise in the price of houses !the ultimate collateral for the mortgage backed securities' and thus in ps . s . ps K 5 p oreover equation !-' also implies that the price of securities !and of housing' depends negatively on the leverage of banks and that the latter can behave in a selfstabiliEing fashion$.(
s . ;b O 5 p . ;b O 5 b

6o as far as the steady-state of the model is concerned, the Jacobian matri+ has e+actly the same configuration as the one shown above and the condition for the . model to generate an unstable regime is still a pro-cyclical leverage ratio b psK5" 6o for a crisis to occur, P& needs to be high enough for the supply of mortgages to respond strongly to an increase in bank7s equity and to lead to a large increase in repos to finance the new mortgages. )n this the model generates a financial crisis that corresponds to the ;inflating balloon< view of the sub-prime crisis discussed by 6hin !$%%:'. @nce again this type of financial crisis can be illustrated by the phase diagram of 8igure Two, but with ph being replaced with ps and ;h replaced with ;b. 6tarting from #, an increase in the price of securities leads to capital gains that reduce the leverage ratio of financial institutions till ?. Then the management of balance sheets by banks leads them to increase their leverage ratio by providing more mortgages to !sub-prime' borrowers. These mortgages inflate the bubble in the price of mortgage-backed securities till the point B is reached. #fter that point weaker balance sheets lead to a decrease in the
$*

Cowever, for some different values of P& the model generates unstable regimes with more comple+ dynamics between the price of securities ps and the leverage ratio of the banking system ;b" This tends to show that a high value of P& is not always a sufficient condition for the model to generate a procyclical leverage ratio for banks. $& and / Hiven that ps is proportional to ph !equation !2'', one could show that ps depends on / d s !c.f. equation !$-'' and thus, according to equations !-' and !.', on ps and ;b" and thus, according to and '( 5sing equation !*', one could show that ;b depends on ) b ' equations !--' and !-&', on ps and S , that is on ps and ;b !since S is determined by /
d
$.

The higher the leverage ratio of banks, the less they provide loans and they need repos.

$-

supply of mortgages that depresses the price of securities and leads to even weaker balance sheets and to a possible debt deflation. #s argued by #drian and 6hin !$%%0' this is a plausible scenario for the sub-prime crisis since the data suggest that there is a strongly pro-cyclical leverage ratio for the financial institutions which enter in the securitisation chain, in particular investment banks$0( Figure Fi"e: *ssets and le"erage growth rates of fi"e in"est!ent ban%s
Source: Securities =xchange )o!!ission : *drian and Shin 178863
Bear Sterns
.;0 .9C .0> dlog/assets1 dlog/assets1 dlog/assets1 .90 .0C .00 -.0C -.90 -.0? .9;

Goldman Sac*s
.; .9 .0 -.9 -.; -.B

e*man Brot*ers

.0?

.00

-.;

-.9

.0 dlog/lev erage1

.9

.;

-.B

-.;

-.9 dlog/lev erage1

.0

.9

-.B

-.;

-.9

.0

.9

.;

dlog/lev erage1

$erril %nc*
.; .9C .90 .9 dlog/assets1 dlog/assets1 .0C .00 -.0C -.90 -.; -.9C

$organ Stanle%

.0

-.9

-.B

-.;

-.9

.0

.9

.;

-.;

-.9

.0 dlog/lev erage1

.9

.;

dlog/lev erage1

5sing data from the 8ederal ,eposit )nsurance Borporation it may be shown that commercial banks have a similar behaviour !see 8igure 6i+'$:. oreover the regressions presented in Table 6even suggest that there is a positive relationship between the rates of growth of debt and equity for a number of financial institutions$2.

Figure Six: *ssets and le"erage growth rates of co!!ercial ban%s

Source: Federal ;eposit <nsurance )orporation

$0

@nce again, the definition of the leverage ratio used in this graph !asset on equity' is interchangeable with that used in the model !debt on equity'. $: )n their paper #drian and 6hin !$%%0' observed a fi+ed leverage ratio for commercial banks. Cowever they used data from the 8low of 8unds where the equity of commercial banks is not included. $2 5nfortunately, we did not manage to find good data for the H6Es involved in the securitisation chain.

$$

.0? .0B .0; dlog/assets1 .09 .00

-.09 -.0; -.0B

-.0;

-.09

.00

.09

.0;

.0B

dlog/leverage1

6umming-up
This paper has attempted to throw some light on the question posed at the beginning of this paper, ;what has been the driving force in the e+pansion of sub-prime mortgage lending.<, the development of the ob3ect of the bubble or the financial innovation that the provided the liquidity that drove the bubble4 Hiven the observed behaviour of households and the ;shadow banking system<, our model suggests that it was the latter. @f course, in this case financial innovation took place on both sides of the equation. )t was securitisation and disintermediation that provided the ob3ect, and the repo market that requisite liquidity. The observation that the growth of leverage has been a ;driving force< has important implications for prudential regulation and supervision. Thirty years ago the only significant highly leveraged financial institutions were the commercial banks. Today, leverage is a characteristic of firms throughout the financial system, whether they are deposit taking banks, investment banks, hedge funds, mutual funds, private equity firms or insurance companies. )t is loss of liquidity associated with rapid deleveraging that threatens market gridlock in a disintermediated financial system. 1erhaps it is leverage that should be the target of regulatory intervention, and regulators should change the focus of their analysis and their actions from an institutionally-defined or instrument-sensitive approach to a functionally defined approach.

$/

9eferences
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1osthumus, F.9., -2$2, ;The tulip mania in Colland in the years -./.-/0<, Journal of Iconomic and Business /istory, vol.-, */*-&&. 6hin, Cyun 6., $%%:, ;6ecuritisation and financial stability<, Economic Journal Lecture, Clarendon lectures in Finance, @+ford, June $nd-*th. Tucker, 1aul . 9., $%%*, ; anaging the Bentral ?ank7s ?alance 6heet( 9here onetary 1olicy eets 8inancial 6tability<, Lecture to ark the 8ifteenth

$*

#nniversary of Lombard 6treet >esearch, ?ank of England, 9ednesday $: July. 9icksell, "nut, -2/&, ectures on Political Iconomy, =ol. )), London( acmillan.

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