Credit “Crisis” Looks More Like Market Choice

A decline in new loans does not necessarily imply a “credit crunch” is under way, in which undercapitalized banks are unable to make new loans, nor does it demand government action to save individual banks, said John Cochrane(fac/john.cochrane), Myron S. Scholes Professor of Finance. “Recent data shows the banking system is working well,” Cochrane said.

“The banking system is unwilling, not unable, to make loans, reflecting the preferences of the people who invest in it,” he added. “People have learned that banks and businesses can fail. The risk premium, especially for credit risk, has shot up, so people’s willingness to make risky loans of any sort or hold risky assets is much less. When the supply of risky loans shifts, we make less loans at higher interest rates. That is exactly what we’re seeing.”  In addition, Cochrane pointed out that banks don’t “lend to hold” anymore, then “originate to sell,” and they won’t do that until they can sell securitized debt to us, the ultimate savers.  

Cochrane’s presentation opened a two-day discussion of the unfolding credit crisis at CRSP Forum 2008 hosted by the Center for Research in Security Prices at Gleacher Center in Chicago on November 3.

He pointed out that his view stems from studying capital markets, not banking, whose scholars have diagnosed a “crunch” in the banking system and advocated government “injections” of capital. “We’re all like two-year-olds with hammers, where everything you see looks like a nail,” he said. “But you have to use what you know and look through the binoculars you know how to use, and I hope to offer a different perspective.”

A number of factors suggest Cochrane’s view is a more accurate version of the current economic story than the view that undercapitalized banks are unable to originate loans, he said:

• After a year of crisis, the banking system’s ability to lend has decreased little. “Individual banks may not be able to lend,” Cochrane said. “But the overall banking system’s numbers seem fine, and lots of other lending is going on.”
  
  
• Banks can and do raise equity capital. Since the crisis began, total writedowns, or losses, and capital raised by banks are about the same, he said, and total $400 to $ 500 billion. The “crunch” view states that this can’t happen, so banks must halt lending instead after their assets decline in value.
  
  
• Banks can and do fail and get taken over. Their operations continue under new ownership, able to make new loans.  “The mechanisms that said we were going to get stuck in this credit crisis didn’t happen, quite surprisingly so over the last year,” Cochrane said.
  
  
• Banks represent a smaller fraction of lending than many people assume. Commercial banking provides 17.5 percent and saving institutions three percent of the debt in our economy, he said. Direct lending can continue despite banking problems.
  
  
• The Treasury purchase and debt guarantee did not stop the “crisis” in its tracks. “Banks that got equity and debt guarantee from government are still showing remarkably little inclination to lend to anybody,” Cochrane said. “They’re holding massive reserves and paying dividends. They didn’t ask for the equity capital, are showing all sorts of signs of not wanting more equity, and are capable of getting more. They’re buying other banks. To the consternation of liberal Congressmen, who, now that we own banks, may start to force them to lend, they don’t seem to want to lend.”
  
  
• Very high-risk premiums currently exist for non-financial assets, which do not reflect bank failure and are not intermediated by banks.

Cochrane also passed on some thoughts on how investors should react to stock market turmoil — that is, why not to panic. He pointed out that recent huge declines imply better returns going forward; stocks are a little bit like bonds in that regard, and long-term investors can therefore ignore the current extraordinary short-run volatility. Some investors might even want to buy. “The economics of the situation say that long-horizon investors should be buying because we see panic selling by institutions that have borrowed money and have to de-leverage,” Cochrane said, though he added “I’m back to just holding the market.”

Many dangers lie ahead in financial markets adapting to much higher risk premiums and in the political effects of government bailouts, he said. “You’re supposed to bail things out only when there are systemic effects ─ only when if this institution fails, supply won’t equal demand because this institution won’t be there to do something. The economic principle is, you bail out only as a last resort to stem systemic effects.” He also stressed the great uncertainty engendered by constantly shifting government plans.  

The government’s ownership share of nine banks raises many questions, Cochrane said. “Can those banks ever lose more money or fail?” he said. “Will the government prop them up forever? Now that the government owns banks and Congressmen are certainly aware of it, aren’t they going to get a little mad if the banks start lending to people they don’t like? Who’s next? Ford and GM? Insurance companies? People whose home mortgages are under water? State pension funds?” 

— Phil Rockrohr