This paper summarizes and explains the main events of the liquidity and credit crunch in 2007-08. Starting with the trends leading up to the crisis, I explain how these events unfolded and how four different amplification mechanisms magnified losses in the mortgage market into large dislocations and turmoil in financial markets.

This essay reviews progress in empirical economics since Leamer’s (1983) critique. Leamer highlighted the benefits of sensitivity analysis, a procedure in which researchers show how their results change with changes in specification or functional form. Sensitivity analysis has had a salutary but not a revolutionary effect on econometric practice. As we see it, the credibility revolution in empirical work can be traced to the rise of a design-based approach that emphasizes the identification of causal effects. Design-based studies typically feature either real or natural experiments and are distinguished by their prima facie credibility and by the attention investigators devote to making the case for a causal interpretation of the findings their designs generate. Design-based studies are most often found in the microeconomic fields of Development, Education, Environment, Labor, Health, and Public Finance, but are still rare in Industrial Organization and Macroeconomics. We explain why IO and Macro would do well to embrace a design-based approach. Finally, we respond to the charge that the design-based revolution has overreached.

of Australia, and the Australian Prudential Regulatory Authority for valuable comments. Yian Liu provided

ABSTRACT. A popular explanation for the recent rise in mortgage default is that securitization led to lender moral hazard. According to the story, lending banks that could easily resell loans to (possibly naive) securitizers had little incentive to carefully screen potential borrowers. Some research has supported this view by exploiting what appear to be credit score cutoff rules used by securitizers. In this paper we argue that the cutoff rule evidence has been misinterpreted and is in fact consistent with an equilibrium model where all actors are rational and lender moral hazard is avoided. Even without securitization, cutoff rules emerge endogenously as a rational response of lenders to perapplicant fixed costs in screening. Securitizers ’ response to lender cutoff rules is determined by the degree of information asymmetry between lender and securitizer. Both institutional evidence and findings from a loan-level dataset containing nearly 60 % of active residential mortgages in the United States appear consistent with our model. Discontinuous jumps in mortgage volume and default rate at the FICO credit score of 620 are apparent, implying a change in lender screening behavior at the threshold, but in our main sample of conforming loans there is no corresponding jump in the securitization rate at this score.

We compare the ex ante observable risk characteristics and the default rates of securitized mortgage loans and mortgage loans retained by the original lender. We find that privately securitized loans tend to be riskier and to default at a faster rate than loans securitized with the GSEs and lender-retained loans. However, the differences in default rates across investor types are of secondary importance for explaining mortgage defaults compared to more conventional predictors, such as original loan-to-value ratios and the path for house prices. Privately securitized home mortages have conditionally higher expected returns than retained loans, suggesting the presence of risk factors that are unobservable but nonetheless at least partially acknowledged by the market.

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We study the effect of government assistance on bank risk taking. Using hand-collected data on bank applications for government assistance under the Troubled Asset Relief Program (TARP), we investigate the effect of both application approvals and denials. To distinguish banks ’ risk taking behavior from changes in economic conditions, we control for the volume and quality of credit demand based on micro-level data on home mortgages and corporate loans. Our difference-in-difference analysis indicates that banks make riskier loans and shift investment portfolios toward riskier securities after being approved for government assistance. However, this shift in risk occurs mostly within the same asset class and, therefore, remains undetected by the closely-monitored capitalization levels, which indicate an improved capital position at approved banks. Consequently, these banks

This paper develops a rational expectations framework to analyze how rating agencies’ incentives are altered when ratings are used for regulatory purposes such as bank capital requirements. Regulations of this kind imply that the AAA label of a security is valuable to a regulated investor independent of the information it provides about the riskiness of the security’s underlying cash flows. Our model predicts that a profit maximizing rating agency responds to this regulatory environment by partially inflating the AAA rating class and by reducing information acquisition relative to a (counter-factual) situation without regulation. The equilibrium precision of a rating trades-off two conflicting purposes: (a) the reduction of information asymmetries between issuers and investors, and (b) the support of "regulatory arbitrage". Rating inflation can be related to regulatory changes that increase the sensitivity of regulations to ratings. In our framework, the issuer-pays model does not cause harm to investors. They

We analyze public interventions to alleviate debt overhang among private firms when the government has limited information and limited resources. We compare the efficiency of buying equity, purchasing assets, and providing debt guarantees. With symmetric information, all the interventions are equivalent. With asymmetric information between firms and the government, buying equity dominates the two other interventions. We also solve for the optimal public intervention and show how it can be implemented with preferred stock and warrants.

We present a standard model of financial innovation, in which intermediaries engineer securities with cash flows that investors seek, but modify two assumptions. First, investors (and possibly intermediaries) neglect certain unlikely risks. Second, investors demand securities with safe cash flows. Financial intermediaries cater to these preferences and beliefs by engineering securities perceived to be safe but exposed to neglected risks. Because the risks are neglected, security issuance is excessive. As investors eventually recognize these risks, they fly back to safety of traditional securities and markets become fragile, even without leverage, precisely because the volume of new claims is excessive.