Merton, Robert C. →

Systemic Risk and the Refinancing Ratchet Effect

During periods of rising house prices, falling interest rates, and increasingly competitive and efficient refinancing markets, cash-out refinancing is like a ratchet, incrementally increasing homeowner debt as real-estate values appreciate without the ability to symmetrically decrease debt by increments as real-estate values decline. This paper suggests that systemic risk in the housing and mortgage markets can arise quite naturally from the confluence of these three apparently salutary economic trends. Using a numerical simulation of the U.S. mortgage market, the researchers show that the ratchet effect is capable of generating the magnitude of losses suffered by mortgage lenders during the financial crisis of 2007-2008. These observations have important implications for risk management practices and regulatory reform. Key concepts include: Consider the hypothetical scenario in which all homeowners decide to refinance and extract cash from any accumulated house equity so that their loan-to-value ratio is kept the same as the one for a new purchaser of that house. Suppose that the refinancing market is so competitive, i.e., refinancing costs are so low and capital is so plentiful, that homeowners can implement this refinancing each month. In this extreme case, during periods of rising home prices and falling interest rates, cash-out refinancing has the same risk effect "as if" all houses had been purchased and their mortgages originated at the peak of the housing market, thereby creating a large systemic risk exposure. Then, when home prices fall, the refinancing ratchet "locks,'' causing a systemic event with widespread correlated defaults and large losses for mortgage lenders. While excessive risk-taking, overly aggressive lending practices, pro-cyclical regulations, and political pressures surely contributed to the recent problems in the U.S. housing market, the simulations show that even if all homeowners, lenders, investors, insurers, rating agencies, regulators, and policymakers behaved rationally, ethically, and with the purest of motives, financial crises can still occur. The fact that the refinancing ratchet effect arises only when three market conditions are simultaneously satisfied demonstrates that the current financial crisis is subtle, and may not be attributable to a single cause. There may be no easy legislative or regulatory solutions: Lower interest rates, higher home prices, and easier access to mortgage loans have appeared separately in various political platforms and government policy objectives over the years. Their role in fostering economic growth makes it virtually impossible to address the refinancing ratchet effect within the current regulatory framework. We need an independent organization devoted solely to the study, measurement, and public notification of systemic risk, not unlike the role that the National Transportation Safety Board plays with respect to airplane crashes, train wrecks, and highway accidents. The subtle and multifaceted nature of the refinancing ratchet effect is just one example of the much broader challenge of defining, measuring, and managing systemic risk in the financial system. Closed for comment; 0 Comments.

New Framework for Measuring and Managing Macrofinancial Risk and Financial Stability

This paper proposes a set of leading indicators of macrofinancial distress that can be helpful to policymakers and regulators in preparing for, mitigating, and maybe even preventing a credit crisis. These early-warning indicators of crisis are based on modern contingent claims analysis (CCA), which are successfully used today at the level of individual banks by managers, investors, and regulators. The authors' ultimate objective is to provide new tools to help governments and central banks manage financial sector risks. Key concepts include: Traditional approaches have difficulty analyzing how risks can accumulate gradually and then suddenly erupt in a full-blown crisis. The CCA approach is well suited to capturing such "nonlinearities" and to quantifying the effects of asset-liability mismatches within and across institutions. Risk-adjusted CCA balance sheets facilitate simulations and stress testing to evaluate the potential impact of policies to manage systemic risk. Closed for comment; 0 Comments.

A New Framework for Analyzing and Managing Macrofinancial Risks of An Economy

The vulnerability of a national economy to volatility in the global markets for credit, currencies, commodities, and other assets has become a central concern of policymakers, credit analysts, and investors everywhere. This paper describes a new framework for analyzing a country's exposure to macroeconomic risks based on the theory and practice of contingent claims analysis. (A contingent claim is any financial asset for which future payoff depends on the value of another asset.) In this framework, the sectors of a national economy are viewed as interconnected portfolios of assets, liabilities, and guarantees that can be analyzed like puts and calls. The framework makes it transparent how risks are transferred across sectors, and how they can accumulate in the balance sheet of the public sector and ultimately lead to a default by the government. Key concepts include: The high cost of international economic and financial crises highlights the need for a comprehensive framework to assess the robustness of countries' economic and financial systems. Contingent claims analysis provides a natural framework for analysis of mismatches between an entity's assets and liabilities, such as currency and maturity mismatches on balance sheets. Policies or actions that reduce these mismatches will help reduce risk and vulnerability. This framework is useful to both the public and private sectors. Closed for comment; 0 Comments.