Jeremy C Stein: Overheating in credit markets - origins, measurement,
and policy responses
Speech by Mr Jeremy C Stein, Member of the Board of Governors of the Federal Reserve
System, at the "Restoring household financial stability after the Great Recession - why
household balance sheets matter" research symposium, sponsored by the Federal Reserve
Bank of St. Louis, St. Louis, Missouri, 7 February 2013.
* * *
Clearly detailed accompanying charts to this speech can be found at the end of the pdf document on the US
Federal Reserve website.
Thank you very much. It's a pleasure to be here. The question I'd like to address today is
this: What factors lead to overheating episodes in credit markets?1 In other words, why do we
periodically observe credit booms, times during which lending standards appear to become
lax and which tend to be followed by low returns on credit instruments relative to other asset
classes?2 We have seen how such episodes can sometimes have adverse effects on the
financial system and the broader economy, and the hope would be that a better
understanding of the causes can be helpful both in identifying emerging problems on a timely
basis and in thinking about appropriate policy responses.
Two views of the overheating mechanism
I will start by sketching two views that might be invoked to explain variation in the pricing of
credit risk over time: a "primitive preferences and beliefs" view and an "institutions, agency,
and incentives" view. While the first view is a natural starting point, I will argue that it must be
augmented with the second view if one wants to fully understand the dynamics of
overheating episodes in credit markets.
According to the primitives view, changes in the pricing of credit over time reflect fluctuations
in the preferences and beliefs of end investors such as households, where these beliefs may
or may not be entirely rational. Perhaps credit is cheap when household risk tolerance is high
- say, because of a recent run-up in wealth.3 Or maybe credit is cheap when households
extrapolate current good times into the future and neglect low-probability risks.4
The primitives view is helpful for understanding some aspects of the behavior of the
aggregate stock market, with the 1990s Internet bubble being one illustration. It seems clear
that the sentiment of retail investors played a prominent role in inflating this bubble.5 More
generally, research using survey evidence has shown that when individual investors are
1
The thoughts that follow are my own and do not necessarily reflect the views of my colleagues on the Board of
Governors or the Federal Open Market Committee. I am grateful to Burcu Duygan-Bump, Matt Eichner, Jon
Faust, Michael Kiley, Nellie Liang, Fabio Natalucci, and Bill Nelson for numerous helpful conversations and
suggestions.
2
I am using the term "overheating" in an asset-pricing sense, so when I say that the market for a particular
class of credit instruments is overheated, I mean that forecasted returns on this class of instruments, in excess
of those on riskless Treasury bills, are abnormally low, or even negative, over some horizon. This usage
contrasts with models in the genre pioneered by Bernanke and Gertler (1989), where time-variation in
collateral values can lead to large changes in the supply of certain types of credit but where expected returns
on credit are constant over time.
3
Habit-formation models have this property. See, for example, Campbell and Cochrane (1999).
4
See Gennaioli, Shleifer, and Vishny (2012).
5
For example, Griffin and others (2011) document that during the run-up of the Internet bubble, from January
1997 to March 2000, individual investors were substantial net buyers of tech stocks, via both direct purchases
as well as investments in tech-sector-specific mutual funds.
most optimistic about future stock market returns, the market tends to be overvalued, in the
sense that statistical forecasts of equity returns are abnormally low.6 This finding is consistent
with the importance of primitive investor beliefs.
By contrast, I am skeptical that one can say much about time variation in the pricing of credit
- as opposed to equities - without focusing on the roles of institutions and incentives. The
premise here is that since credit decisions are almost always delegated to agents inside
banks, mutual funds, insurance companies, pension funds, hedge funds, and so forth, any
effort to analyze the pricing of credit has to take into account not only household preferences
and beliefs, but also the incentives facing the agents actually making the decisions. And
these incentives are in turn shaped by the rules of the game, which include regulations,
accounting standards, and a range of performance-measurement, governance, and
compensation structures.
At an abstract level, one can think of the agents making credit decisions and the rulemakers
who shape their incentives as involved in an ongoing evolutionary process, in which each
adapts over time in response to changing conditions. At any point, the agents try to maximize
their own compensation, given the rules of the game. Sometimes they discover
vulnerabilities in these rules, which they then exploit in a way that is not optimal from the
perspective of their own organizations or society. If the damage caused is significant enough,
the rules themselves adapt, driven either by internal governance or by political and regulatory
forces. Still, it is possible that at different times in this process, the rules do a better or worse
job of managing the incentives of the agents.
To be more specific, a fundamental challenge in delegated investment management is that
many quantitative rules are vulnerable to agents who act to boost measured returns by
selling insurance against unlikely events - that is, by writing deep out-of-the-money puts. An
example is that if you hire an agent to manage your equity portfolio, and compensate the
agent based on performance relative to the S&P 500, the agent can beat the benchmark
simply by holding the S&P 500 and stealthily writing puts against it, since this put-writing both
raises the mean and lowers the measured variance of the portfolio.7 Of course, put-writing
also introduces low-probability risks that may make you, as the end investor, worse off, but if
your measurement system doesn't capture these risks adequately - which is often difficult to
do unless one knows what to look for - then the put-writing strategy will create the
appearance of outperformance.
Since credit risk by its nature involves an element of put-writing, it is always going to be
challenging in an agency context, especially to the extent that the risks associated with the
put-writing can be structured to partially evade the relevant measurement scheme. Think of
the AAA-rated tranche of a subprime collateralized debt obligation (CDO), where the
measurement scheme is the credit risk model used by the rating agency. To the extent that
this model is behind the curve and does not fully recognize the additional structural leverage
and correlational complexities embedded in a second-generation securitization like the CDO,
as opposed to a first-generation one, it will be particularly vulnerable to the introduction of a
second-generation product.8
These agency problems may be exacerbated by competitive pressures among
intermediaries and by the associated phenomenon of relative performance evaluation. A
leading example here comes from the money market fund sector, where even small
increases in a money fund's yield relative to its competitors can attract large inflows of new
assets under management.9 And if these yield differentials reflect not managerial skill but
rather additional risk-taking, then competition among funds to attract assets will only make
the underlying put-writing problem worse.
But it is not all that satisfying - either intellectually or from a policy perspective - to simply list
all of the ways that the delegation of credit decisions to agents inside big, complicated
institutions can lead things astray. It must be the case that, on average over long periods of
time, these agency problems are contained tolerably well by the rules of the game - by some
combination of private governance and public policy - or else our credit markets would not
be as large and as well developed as they are. A more interesting set of questions has to do
with time-series dynamics: Why is it that sometimes, things get out of balance, and the
existing set of rules is less successful in containing risk-taking? In other words, what does
the institutions view tell us about why credit markets sometimes overheat?
Let me suggest three factors that can contribute to overheating. The first is financial
innovation. While financial innovation has provided important benefits to society, the
institutions perspective warns of a dark side, which is that innovation can create new ways
for agents to write puts that are not captured by existing rules. For this reason, policymakers
should be on alert any time there is rapid growth in a new product that is not yet fully
understood. Perhaps the best explanation for the existence of second-generation
securitizations like subprime CDOs is that they evolved in response to flaws in prevailing
models and incentive schemes.10 Going back further, a similar story can be told about the
introduction of payment-in-kind (PIK) interest features in the high-yield bonds used in the
leveraged buyouts (LBOs) of the late 1980s. I don't think it was a coincidence that among the
buyers of such PIK bonds were savings and loan associations, at a time when many were
willing to take risks to boost their accounting incomes.
The second closely related factor on my list is changes in regulation. New regulation will tend
to spur further innovation, as market participants attempt to minimize the private costs
created by new rules. And it may also open up new loopholes, some of which may be
exploited by variants on already existing instruments.
The third factor that can lead to overheating is a change in the economic environment that
alters the risk-taking incentives of agents making credit decisions. For example, a prolonged
period of low interest rates, of the sort we are experiencing today, can create incentives for
agents to take on greater duration or credit risks, or to employ additional financial leverage,
in an effort to "reach for yield."11 An insurance company that has offered guaranteed
minimum rates of return on some of its products might find its solvency threatened by a long
stretch of low rates and feel compelled to take on added risk.12 A similar logic applies to a
bank whose net interest margins are under pressure because low rates erode the profitability
of its deposit-taking franchise.
Moreover, these three factors may interact with one another. For example, if low interest
rates increase the demand by agents to engage in below-the-radar forms of risk-taking, this
demand may prompt innovations that facilitate this sort of risk-taking.
Why the distinction matters
To summarize the argument thus far, I have drawn a distinction between two views of
risk-taking in credit markets. According to the primitives view, changes over time in effective
risk appetite reflect the underlying preferences and beliefs of end investors. According to the
institutions view, such changes reflect the imperfectly aligned incentives of the agents in
large financial institutions who do the investing on behalf of these end investors. But why
should anybody care about this distinction?
One reason is that your view of the underlying mechanism shapes how you think about
measurement. Consider this question: Is the high-yield bond market currently overheated, in
the sense that it might be expected to offer disappointing returns to investors? What
variables might one look at to shape such a forecast? In a primitives-driven world, it would be
natural to focus on credit spreads, on the premise that more risk tolerance on the part of
households would lead them to bid down credit spreads; these lower spreads would then be
the leading indicator of low expected returns.
On the other hand, in an institutions-driven world, where agents are trying to exploit various
incentive schemes, it is less obvious that increased risk appetite is as well summarized by
reduced credit spreads. Rather, agents may prefer to accept their lowered returns via various
subtler nonprice terms and subordination features that allow them to maintain a higher stated
yield. Again, the use of PIK bonds in LBOs is instructive. A long time ago, Steve Kaplan and I
did a study of the capital structure of 1980s-era LBOs.13 What was most noteworthy about
the PIK bonds in those deals was not that they had low credit spreads. Rather, it was that
they were subject to an extreme degree of implicit subordination. While these bonds were not
due to get cash interest for several years, they stood behind bank loans with very fast
principal repayment schedules, which in many cases required the newly leveraged firm to
sell a large chunk of its assets just to honor these bank loans. Simply put, much of the action
- and much of the explanatory power for the eventual sorry returns on the PIK bonds - was
in the nonprice terms.
It is interesting to think about recent work by Robin Greenwood and Sam Hanson through
this lens.14 They show that if one is interested in forecasting excess returns on corporate
bonds (relative to Treasury securities) over the next few years, credit spreads are indeed
helpful, but another powerful predictive variable is a nonprice measure: the high-yield share,
defined as issuance by speculative-grade firms divided by total bond issuance. When the
high-yield share is elevated, future returns on corporate credit tend to be low, holding fixed
the credit spread. Exhibit 1 provides an illustration of their finding. One possible
interpretation is that the high-yield share acts as a summary statistic for a variety of nonprice
credit terms and structural features. That is, when agents' risk appetite goes up, they agree
to fewer covenants, accept more-implicit subordination, and so forth, and high-yield issuance
responds accordingly, hence its predictive power.
A second implication of the institutions view is what one might call the "tip of the iceberg"
caveat. Quantifying risk-taking in credit markets is difficult in real time, precisely because
risks are often taken in opaque ways that escape conventional measurement practices. So
we should be humble about our ability to see the whole picture, and should interpret those
clues that we do see accordingly. For example, I have mentioned the junk bond market
several times, but not because this market is necessarily the most important venue for the
sort of risk-taking that is likely to raise systemic concerns. Rather, because it offers a
relatively long history on price and nonprice terms, it is arguably a useful barometer. Thus,
overheating in the junk bond market might not be a major systemic concern in and of itself,
but it might indicate that similar overheating forces were at play in other parts of credit
markets, out of our range of vision.
Recent developments in credit markets
With these remarks as a prelude, what I'd like to do next is take you on a brief tour of recent
developments in a few selected areas of credit markets. This tour draws heavily on work
conducted by the Federal Reserve staff as part of our ongoing quantitative surveillance
efforts, under the auspices of our Office of Financial Stability Policy and Research.
The first stop on the tour is the market for leveraged finance, encompassing both the public
junk bond market and the syndicated leveraged loan market. As can be seen in exhibit 2,
issuance in both of these markets has been very robust of late, with junk bond issuance
setting a new record in 2012. In terms of the variables that could be informative about the
extent of market overheating, the picture is mixed. On the one hand, credit spreads, though
they have tightened in recent months, remain moderate by historical standards. For example,
as shows, the spread on nonfinancial junk bonds, currently at about 400 basis
exhibit 3
points, is just above the median of the pre-financial-crisis distribution, which would seem to
imply that pricing is not particularly aggressive.15
On the other hand, the high-yield share for 2012 was above its historical average, suggesting
- based on the results of Greenwood and Hanson - a somewhat more pessimistic picture of
prospective credit returns.16 This notion is supported by recent trends in the sorts of nonprice
terms I discussed earlier (exhibit 4). The annualized rates of PIK bond issuance and of
covenant-lite loan issuance in the fourth quarter of 2012 were comparable to highs from
2007. The past year also saw a new record in the use of loan proceeds for dividend
recapitalizations, which represents a case in which bondholders move further to the back of
the line while stockholders - often private equity firms - cash out.17 Finally, leverage in large
LBOs rose noticeably, though less dramatically, in the third and fourth quarters of 2012.
Putting it all together, my reading of the evidence is that we are seeing a fairly significant
pattern of reaching-for-yield behavior emerging in corporate credit. However, even if this
conjecture is correct, and even if it does not bode well for the expected returns to junk bond
and leveraged-loan investors, it need not follow that this risk-taking has ominous systemic
implications. That is, even if at some point junk bond investors suffer losses, without
spillovers to other parts of the system, these losses may be confined and therefore less of a
policy concern.
In this regard, one lesson from the crisis is that it is not just bad credit decisions that create
systemic problems, but bad credit decisions combined with excessive maturity
transformation. A badly underwritten subprime loan is one thing, and a badly underwritten
subprime loan that serves as the collateral for asset-backed commercial paper (ABCP) held
by a money market fund is something else - and more dangerous. This observation
suggests an idealized measurement construct. In principle, what we'd really like to know, for
any given asset class - be it subprime mortgages, junk bonds, or leveraged loans - is this:
What fraction of it is ultimately financed by short-term demandable claims held by investors
who are likely to pull back quickly when things start to go bad? It is this short-term financing
share that creates the potential for systemic spillovers in the form of deleveraging and
marketwide fire sales of illiquid assets.
This short-term financing share is difficult to measure comprehensively, but exhibit 5
presents one graph that gives some comfort. The graph shows dealer financing of corporate
debt securities, much of which is done via short-term repurchase agreements (repos). This
financing rose rapidly in the years prior to the crisis, then fell sharply, and remains well below
its pre-crisis levels today. So, on this score, there appears to be only modest short-term
leverage behind corporate credit, which would seem to imply that even if the underlying
securities were aggressively priced, the potential for systemic harm resulting from
deleveraging and fire sales would be relatively limited.
Nevertheless, I want to urge caution here and, again, stress how hard it is to capture
everything we'd like. As I said, ideally we would total all of the ways in which a given asset
class is financed with short-term claims. Repos constitute one example, but there are others.
And, crucially, these short-term claims need not be debt claims. If relatively illiquid junk
bonds or leveraged loans are held by open-end investment vehicles such as mutual funds or
by exchange-traded funds (ETFs), and if investors in these vehicles seek to withdraw at the
first sign of trouble, then this demandable equity will have the same fire-sale-generating
properties as short-term debt.18 One is naturally inclined to look at data on short-term debt
like repo, given its prominence in the recent crisis. But precisely because it is being more
closely monitored, there is the risk that next time around, the short-term claims may take
another form.
With this caveat in mind, it is worth noting the pattern of inflows into mutual funds and ETFs
that hold high-yield bonds, shown in exhibit 6. Interestingly, the picture here is almost the
reverse of that seen with dealer financing of corporate bonds. Assets under management in
these vehicles were essentially flat in the years leading up to the crisis, but they have
increased sharply in the past couple of years.19 This observation suggests, albeit only
loosely, that there may be some substitutability between different forms of demandable
finance. And it underscores the importance of not focusing too narrowly on any one category.
Continuing on with the theme of maturity transformation, the next brief stop on the tour is the
agency mortgage real estate investment trust (REIT) sector. These agency REITs buy
agency mortgage-backed securities (MBS), fund them largely in the short-term repo market
in what is essentially a levered carry trade, and are required to pass through at least
90 percent of the net interest to their investors as dividends. As shown in exhibit 7, they
have grown rapidly in the past few years, from $152 billion at year-end 2010 to $398 billion at
the end of the third quarter of 2012.
One interesting aspect of this business model is that its economic viability is sensitive to
conditions in both the MBS market and the repo market. If MBS yields decline, or the repo
rate rises, the ability of mortgage REITs to generate current income based on the spread
between the two is correspondingly reduced.
Another place where the desire to generate yield can show up is in commercial banks'
securities holdings. In recent work, Sam Hanson and I documented that the duration of
banks' non-trading-account securities holdings tends to increase significantly when the short
rate declines.20 We hypothesized that this pattern was due to a particular form of agency
behavior - namely, that given the conventions of generally accepted accounting principles, a
bank can boost its reported income by replacing low-yielding short-duration securities with
higher-yielding long-duration securities.
Something along these lines seems to be happening today: The maturity of securities in
banks' available-for-sale portfolios is near the upper end of its historical range. This finding is
noteworthy on two counts. First, the added interest rate exposure may itself be a meaningful
source of risk for the banking sector and should be monitored carefully - especially since
existing capital regulation does not explicitly address interest rate risk. And, second, in the
spirit of tips of icebergs, the possibility that banks may be reaching for yield in this manner
suggests that the same pressure to boost income could be affecting behavior in other, less
readily observable parts of their businesses.
The final stop on the tour is something called collateral transformation. This activity has been
around in some form for quite a while and does not currently appear to be of a scale that
would raise serious concerns - though the available data on it are sketchy at this point.
Nevertheless, it deserves to be highlighted because it is exactly the kind of activity where
new regulation could create the potential for rapid growth and where we therefore need to be
especially watchful.
Collateral transformation is best explained with an example. Imagine an insurance company
that wants to engage in a derivatives transaction. To do so, it is required to post collateral
with a clearinghouse, and, because the clearinghouse has high standards, the collateral
must be "pristine" - that is, it has to be in the form of Treasury securities. However, the
insurance company doesn't have any unencumbered Treasury securities available - all it has
in unencumbered form are some junk bonds. Here is where the collateral swap comes in.
The insurance company might approach a broker-dealer and engage in what is effectively a
two-way repo transaction, whereby it gives the dealer its junk bonds as collateral, borrows
the Treasury securities, and agrees to unwind the transaction at some point in the future.
Now the insurance company can go ahead and pledge the borrowed Treasury securities as
collateral for its derivatives trade.
Of course, the dealer may not have the spare Treasury securities on hand, and so, to obtain
them, it may have to engage in the mirror-image transaction with a third party that does -
say, a pension fund. Thus, the dealer would, in a second leg, use the junk bonds as collateral
to borrow Treasury securities from the pension fund. And why would the pension fund see
this transaction as beneficial? Tying back to the theme of reaching for yield, perhaps it is
looking to goose its reported returns with the securities-lending income without changing the
holdings it reports on its balance sheet.
There are two points worth noting about these transactions. First, they reproduce some of
the same unwind risks that would exist had the clearinghouse lowered its own collateral
standards in the first place. To see this point, observe that if the junk bonds fall in value, the
insurance company will face a margin call on its collateral swap with the dealer. It will
therefore have to scale back this swap, which in turn will force it to partially unwind its
derivatives trade - just as would happen if it had posted the junk bonds directly to the
clearinghouse. Second, the transaction creates additional counterparty exposures - the
exposures between the insurance company and the dealer, and between the dealer and the
pension fund.
As I said, we don't have evidence to suggest that the volume of such transactions is currently
large. But with a variety of new regulatory and institutional initiatives on the horizon that will
likely increase the demand for pristine collateral - from the Basel III Liquidity Coverage Ratio,
to centralized clearing, to heightened margin requirements for noncleared swaps - there
appears to be the potential for rapid growth in this area. Some evidence suggestive of this
growth potential is shown in exhibit 8, which is based on responses by a range of dealer
firms to the Federal Reserve's Senior Credit Officer Opinion Survey on Dealer Financing
Terms.21 As can be seen, while only a modest fraction of those surveyed reported that they
were currently engaged in collateral transformation transactions, a much larger share
reported that they had been involved in discussions of prospective transactions with their
clients.
Policy implications
Let me turn now to policy implications. The question of how policymakers should respond to
different manifestations of credit market overheating is a big and difficult one, and I won't
attempt to deliver a set of specific prescriptions here. However, I would like to provoke some
discussion around one specific aspect of the question - namely, what are the respective
roles of traditional supervisory and regulatory tools, on the one hand, versus monetary policy,
on the other, in addressing the sorts of market-overheating phenomena that we have been
talking about? To lend a little concreteness and urgency to this issue, imagine that it is
18 months from now, and that with interest rates still very low, each of the trends that I
identified earlier has continued to build - to the point where we believe that there could be
meaningful systemic implications. What, if any, policy measures should be contemplated?
It is sometimes argued that in such circumstances, policymakers should follow what might be
called a decoupling approach. That is, monetary policy should restrict its attention to the dual
mandate goals of price stability and maximum employment, while the full battery of
supervisory and regulatory tools should be used to safeguard financial stability. There are
several arguments in favor of this approach. First, monetary policy can be a blunt tool for
dealing with financial stability concerns. Even if we stipulate that low interest rates are part of
the reason for, say, a worrisome boom in one segment of credit markets, they are unlikely to
be the whole story. So, would one really want to raise rates, and risk choking off economic
activity, in an effort to rein in that one part of the market? Wouldn't it be better to use a more
narrowly focused supervisory or regulatory approach, with less potential for damage to the
economy?
A related concern is that monetary policy already has its hands full with the dual mandate,
and that if it is also made partially responsible for financial stability, it will have more
objectives than instruments at its disposal and won't do as well with any of its tasks.22 These
are important points to bear in mind. In some cases, supervisory and regulatory tools are
clearly better targeted and more likely to be effective than monetary policy could be. For
example, the Federal Reserve's supervisory responsibilities for the banking sector put it in
the right position to carefully monitor duration risk in banks' securities portfolios and to take
corrective action if necessary.
Nevertheless, as we move forward, I believe it will be important to keep an open mind and
avoid adhering to the decoupling philosophy too rigidly. In spite of the caveats I just
described, I can imagine situations where it might make sense to enlist monetary policy tools
in the pursuit of financial stability. Let me offer three observations in support of this
perspective. First, despite much recent progress, supervisory and regulatory tools remain
imperfect in their ability to promptly address many sorts of financial stability concerns. If the
underlying economic environment creates a strong incentive for financial institutions to, say,
take on more credit risk in a reach for yield, it is unlikely that regulatory tools can completely
contain this behavior. This, of course, is not to say that we should not try to do our best with
these tools - we absolutely should. But we should also be realistic about their limitations.
These limitations arise because of the inherent fallibility of the tools in a world of regulatory
arbitrage; because the scope of our regulatory authority does not extend equally to all parts
of the financial system; and because risk-taking naturally tends to be structured in a
nontransparent way that can make it hard to recognize. In some cases, regulatory tools may
also be difficult to adjust on a timely basis - if, for example, doing so requires extended
interagency negotiation.
Second, while monetary policy may not be quite the right tool for the job, it has one important
advantage relative to supervision and regulation - namely that it gets in all of the cracks. The
one thing that a commercial bank, a broker-dealer, an offshore hedge fund, and a special
purpose ABCP vehicle have in common is that they all face the same set of market interest
rates. To the extent that market rates exert an influence on risk appetite, or on the incentives
to engage in maturity transformation, changes in rates may reach into corners of the market
that supervision and regulation cannot.23
Third, in response to concerns about numbers of instruments, we have seen in recent years
that the monetary policy toolkit consists of more than just a single instrument. We can do
more than adjust the federal funds rate. By changing the composition of our asset holdings,
as in our recently completed maturity extension program (MEP), we can influence not just the
expected path of short rates, but also term premiums and the shape of the yield curve. Once
we move away from the zero lower bound, this second instrument might continue to be
helpful, not simply in providing accommodation, but also as a complement to other efforts on
the financial stability front.
To see why, recall the central role that maturity transformation - the funding of long-term
assets with short-term, run-prone liabilities - can play in propagating systemic instabilities.
Moreover, as illustrated by the mortgage REIT sector that I described earlier, the economic
appeal of maturity transformation hinges on the shape of the yield curve - in that particular
case, on the spread between the yield on agency MBS and the so-called general collateral
(GC) repo rate at which these securities can be funded on a short-term basis. And it would
appear that our policies have at times put pressure on this spread from both sides. Our
purchases