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E-MailSteven L. Schwarcz is the Stanley A. Star Professor of Law & Business at the Duke University School of Law. This post is based a recent keynote address by Professor Schwarcz at a University of Durham/Newcastle University symposium, “The Untold Stories of the Financial Crisis: the Challenge of Credit Availability.”
Was the global financial crisis the cause of credit unavailability, or was it the effect? The standard story is that the financial crisis resulted in the loss of credit availability. In a keynote address for a University of Durham/Newcastle University symposium (linked here as a more complete and footnoted article), I argue that story is reversed and examine what lessons that can teach us.
To assess cause and effect, consider the timeline of events leading to the financial crisis. As home prices steadily increased, it became common for lenders to make mortgage loans to even risky, or “subprime,” borrowers. Lenders expected that home appreciation would cause collateral values to increase and enable borrowers to repay through refinancing.
This model worked well so long as home prices continued to rise. But when prices began declining, the subprime borrowers could not refinance and, in many cases, defaulted. These mortgage defaults caused substantial amounts of investment-grade-rated mortgage-backed securities to be downgraded or default. As a result, investors started losing confidence in credit ratings and avoiding rated debt securities; and many parties stopped dealing with firms, like Lehman Brothers, holding lots of mortgage-backed securities. Lehman’s subsequent bankruptcy added to the panic. Debt markets, which provide the majority of US corporate credit, shut down, depriving companies of money to expand and pay expenses. The economy collapsed.
In short, although the relationship between credit availability and financial decline leading to the crisis was somewhat interactive, a loss of credit availability appears to have caused the financial crisis more than the reverse. If that non-standard story is true, it suggests at least three lessons about protecting credit availability.
First, because credit availability is dependent on financial markets as well as banks, regulation should be designed to protect the viability of markets as well as banks. Liquidity has traditionally been used by government central banks to help prevent banks from defaulting, but it can also be used to stabilize systemically important financial markets. In response to the post-Lehman collapse of the commercial paper market, for example, the Federal Reserve created a lender of last resort to temporarily stabilize that market. Regulators should consider institutionalizing liquidity to stabilize systemically important financial markets.
Another lesson is that diversifying sources of credit availability might increase financial stability. The EU’s proposed Capital Markets Union has the goal, for example, of building an integrated European financial market to diversify business financing beyond bank lending, which currently dominates European business credit.
A third lesson is that regulators should try to identify and correct system-wide flaws in making credit available. One such flaw is overreliance on credit ratings. Prior to the financial crisis, investors often relied exclusively on credit ratings without performing independent credit examinations. This overreliance continued even as credit ratings were applied to much more complex, highly leveraged, and novel securities that lacked historical performance data. To try to correct this overreliance, regulators might consider trying to demystify credit ratings, thereby reducing the blind faith that can cause overreliance, and also requiring periodic self-awareness and reporting by the financial community on the limitations of credit ratings and their potential for failure.
Another system-wide flaw in making credit available is marking-to-market in crisis conditions. Although marking-to-market generally protects investors against declines in value, it can reduce credit availability in turbulent or panicked markets. Regulators might consider allowing firms to substitute other measures of investor comfort—such as full disclosure of the underlying asset portfolio—when marking-to-market might distort value.
Our inherent human limitations represent yet another system-wide flaw in making credit available. For example, we often implicitly simplify our perception of reality as a coping mechanism, including a tendency to define future events by the recent past. Consider certain parallels between the Great Depression and the financial crisis, which illustrate how the flaw might temporarily increase but ultimately destroy credit availability.
In the years preceding the Great Depression, banks lending “on margin”—a practice in which borrowers use proceeds of a loan to purchase shares of stock and then pledge that stock as collateral to the banks—assumed they were adequately protected, even for margin loans made to risky borrowers. Although these loans were not initially overcollateralized—because the value of the pledged stock initially equaled, but did not exceed, the amount of the loan—banks expected the stock market to continue rising, as it had for decades. That expectation reflects the tendency to define future events by the recent past. An increase in stock prices, and thus a consequent increase in the value of the collateral, would then cause the loans to become overcollateralized. Beginning in October 1929, however, the decline in stock prices caused many of those risky borrowers to default on their now-undercollateralized margin loans. That, in turn, caused margin-lending banks to begin defaulting, triggering a banking collapse that ultimately wiped out credit.
Similarly, prior to the financial crisis, institutions that made mortgage loans to subprime borrowers assumed they were adequately protected because they expected housing prices to continue rising. That expectation again reflects the tendency to define future events by the recent past. In the fall of 2007, however, the decline in housing prices caused many subprime borrowers to begin defaulting on their now-undercollateralized mortgage loans. As discussed, that started the timeline of events that caused the shutdown of debt markets and the resulting financial crisis.
Overreliance on credit ratings and marking-to-market in crisis conditions are system-wide flaws that are part of the design of the financial system; at least in theory, they can be redesigned. But it is harder to correct inherent human limitations. That suggests an ongoing risk for credit availability, and thus an ongoing potential for new financial crises to arise. Although addressing that risk and crisis-potential is a story for another day, Professor Iman Anabtawi and I begin addressing it in Regulating Ex Post: How Law Can Address the Inevitability of Financial Failure, 92 Texas Law Review 75 (2013) (discussed on the Forum here). Taking inspiration from chaos theory, we argue that because financial failure is inevitable, financial regulation should be designed not only to prevent failures but also to work ex post—after a systemic shock has been triggered and is being transmitted—to try to stabilize the afflicted financial system.
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The complete publication is available for download here.
