Uncertainty and Liquidity Crises

Arvind Krishnamurthy
Northwestern University

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 Crisis theory
• Liquidation models
– Diamond-Dybvig bank runs
– Balance sheet/asset price feedback effects
– Lender of last resort policy
• Uncertainty and crises
– Current subprime crisis
– Unknowns and immeasurable risk

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 The two issues for any theory
• Why is there “insufficient” liquidity?
– Insufficient in the sense that asset prices reflect liquidity premia
– Or, Difficult to trade assets
– Too few market participants
– Market participants have too few resources to trade
• What are appropriate policy responses?
– Why intervene?
– Channels for policies. Optimal policy.

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 Outline
• Liquidation model
– Bank runs
– Financial markets/capital constraints
• Uncertainty and crises
– Motivation
– Theoretical framework
– Policy insights

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 Liquidity model
• Investors (continuum) A and B own one unit of
an asset at date 0
• Intermediary (bank/market-maker/trading
desk) provides price support at date 1:
– Promises to provide liquidity to sellers at P=1
– But, Bank has only 2 > L > 1 units of liquidity
• Investors may receive shocks that require
them to liquidate:
– qA , qB

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Fundamental equilibrium at date 1
• One of four states
– No shocks: P=1
– A shock: P=1
– B shock: P=1
– A and B shocks: P = L/2
• Date 0 price:
– P0 = 1 – (1 – L/2) qA qB
– Liquidity premium = (1 – L/2) qA qB

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 Bank run a la Diamond-Dybvig
• Bank imposes sequential service constraint:
– If all agents liquidate, first liquidators get 1, until all of
L is used up
– Agents after L get 0 if liquidate, or P<1 if they hold on
past date 1
• Now, liquidation equilibrium is possible even with
no fundamental liquidity shocks
– If an investor conjectures that everyone else will
liquidate, he will try to get in line first …
• LLR policy: Inject (2 – L) into bank if everyone
liquidates
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 Financial market version
• Define the “equity net worth” of an investor as
W = P – D0
• Suppose date 1 holdings are subject to a
capital/collateral constraint
X1 P < m W
• Define Y = 1 – X1 as amount liquidated
• If constraint binds:
Y = 1 – m + D0 / P
• Lower price induces more liquidation … lowers
price further …
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 • P = 1 is equilibrium if Y is small

P = L / 2Y or Y = L/2P • If D0 is large, liquidation curve

shifts right

Y • If fundamental liquidity shock

affects either agent, liquidation
curve shifts

• Either case, multiple equilibria

Y = 1 – m + D0 / P

P=1

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 Liquidation externality
• Familiar liquidity spiral: lower prices induces
liquidations, which lowers prices further
• Amplification mechanism (volatility)
• Multiple equilibria
• Policy response: Increase L in the event of
large liquidations
– Shifts out supply, dampens the liquidity spiral

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 Crisis Policy
• Rule out bad equilibrium via LLR
• Reduce balance sheet pressures by easing
credit

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 Ex-ante Policy
• If we push the model further (I wont here),
there is another policy that pops up:
– Ex-post externalities that agents don’t internalize
ex-ante
– Ex-ante agents will “underinsure” against crises
• In this context, agents will choose too much D0
– Policy aims to correct the underinsurance
problems
• Ex-ante leverage limitation in the model.
• See for example, Caballero-Krishnamurthy on Emerging
Markets

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 Literature
• Bank Run Models: Diamond-Dybvig (JPE 1983), Allen-Gale
(MANY), Morris-Shin (AER 1998), Rochet-Vives (JEEA 2004)
• Financial Markets: Allen-Gale (AER 1994), Kiyotaki-Moore
(JPE 1997), Morris-Shin (ROF 2004), Gromb-Vayanos (JFE
2001), Brunnermeier-Pedersen (RFS 2007)
• Ex-ante Liquidity/Risk Management: Holmstrom-Tirole (JPE
1998), Caballero-Krishnamurthy (JME 2001), Diamond-
Rajan (JF 2005)
• Dynamic GE Models: Xiong (JFE 2001), Vayanos (2007), He-
Krishnamurthy (2007)

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 He-Krishnamurthy
• Asset market:
dD(t) = g dt +  dZ(t)
D(t)

• Asset market investors/intermediaries with CRRA utility:

Can raise outside funds < m w(t)

• Households: lenders, savers, etc. (fill in the gaps)

• Calibrate m to hedge fund data; match average
intermediary leverage; household labor income; g and 
to stock market.
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 Crisis Recovery Experiment
Start model at 20% risk premium state and
simulate until economy reaches:

Transit to Time (yrs) Increment (yrs)

15% 0.23 0.23
12.5% 0.46 0.23
10% 1.02 0.56
7.5% 2.62 1.60
6% 5.91 3.29

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 Recap
• So far, liquidation model

• Next, Uncertainty and Crises

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 Uncertainty
• Subprime crisis:
– Complex CDO products, splitting cash flows in
unfamiliar ways
– Substantial uncertainty about where the losses lie
– But less uncertainty about the direct aggregate
loss (small)

• Knightian uncertainty, ambiguity aversion,

uncertainty aversion, robustness preferences
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 Ellsberg Paradox
• Urn A: 50 red balls and 50 green balls
• Urn B: unknown proportions of red and green balls.
• Subject is offered a gamble:
– Choose either urn A or urn B, and choose a color to bet on.
• If subjective prob(red, B) < ½, then subject should
choose B and green. Or, vice-versa
– But subjects always strictly prefer urn A
• Agents act to reduce ambiguity

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 Ellsberg Paradox (2)
• Urn with 30 red balls and 60 others, which are either
green or black balls
• Gamble A: Choose red or green.
– If P(green|green or black)< ½, choose red
• Gamble B: Choose [red or black] or [green or black]
– If chose red on gamble A, should choose red again
• Subjects choose red in A and [green or black] in B
• Agents act to reduce ambiguity

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 Modeling:
• Standard expected utility
– max{c} EQ u(c)
– P refers to the agent’s subjective probability
distribution
• Modeling ambiguity/uncertainty/robustness:
– max{c} min{Q ϵ Q } EQ u(c)
– Q is the set of probability distributions that the
agent entertains

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 Financial markets context
• Uncertainty kicks-in when Q is large
– Agents don’t know, and have diffuse priors
– Current bout of CDO uncertainty
• The “min” in the objective function
emphasizes the tails of the distribution
– Worst-case decision rules. VAR as an important
input into decisions
• Conjecture: Principal-agent issues become
magnified when there is uncertainty

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 Uncertainty in the baseline model
• Recall, agents may receive liquidity shocks
that makes them sell assets at date 1
– For example, they realize losses on subprime
investments and have to reoptimize portfolios
 Shock probabilities are qA , qB
• Suppose agents are uncertain about the
correlation between their liquidity shocks of A
and B.
• ρ (A,B) ϵ [0, 1]
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 Examples
• Counterparty risk: Will bank have enough
liquidity to deliver on price support?
• How widespread are the subprime losses?
Where are the losses buried?
• Even if A can assess his own risks (qA), what
about other risks (i.e. qB ), that end up
affecting agent A?

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 Worst-case decision rules
• max{c} min{Q ϵ Q } EQ u(c)
Worst-cases for A (and B) is ρ (A,B) = 1
• Agents subjective probs only consider two
states
– No shocks: P=1
– A and B shocks together: P = L/2
• Date 0 price:
– P0 = 1 – (1 – L/2) q
– Liquidity premium = (1 – L/2) q
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 Compare to baseline case
• One of four states
– No shocks: P=1
– A shock: P=1
– B shock: P=1
– A and B shocks: P = L/2
• Date 0 price:
– P0 = 1 – (1 – L/2) qA qB
– Liquidity premium = (1 – L/2) qA qB
• Uncertainty magnifies the importance of the
liquidation event: order(q) versus order(q2)
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 Quantity interpretation
• Suppose the asset was a project that required an
initial outlay from investors and purchase of liquidity
insurance from the bank
– Total cost = 1
• We can interpret the equilibrium as follows:
– Since each agent effectively thinks the world is either (no
shock) or (A and B shocks)
– A requires the bank to put aside L/2 to fully back A
liquidity events. Vice-versa for B
– Overcollateralization eliminates counterparty risk.

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 Quantity interpretation
• Suppose the asset was a project that required an
initial outlay from investors and purchase of liquidity
insurance from the bank
– Total cost = 1
• Each group of agents will require the bank to put
aside L/2 to fully back their own liquidity event.
• Agents undertake only L/2 of the project
• Bank liquidity goes underused in 1 shock
states

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 Policy
• LLR policy again
• Inject liquidity into bank in the event that
both shocks hit.
– Liquidity premium = (1 – L/2) q
– Larger effect on agent’s uncertainty, but CB
delivers only with probability qA qB
– Or, ex-ante quantity response proportional to
injection.

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 Uncertainty and crises literature
• Caballero-Krishnamurthy (JF 2007)
– Collective bias: Individual worst cases cannot simultaneously occur;
yet those are the subjective probabilities underlying each investors’
decisions
– Flight to quality, liquidity hoarding
• Routledge-Zin (working paper): “Model Uncertainty and
Liquidity”
– Uncertainty leads to trading halt, widening of bid-ask spread
• Equity premium puzzle (aggregates versus idiosyncratic):
– Ambiguity/ Uncertainty/ Robustness: Hansen-Sargent, Epstein-
Schneider, Maenhout, Kleshchelski …
– Extreme events: Barro, Weitzman

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 Other Crises
• Claim: This is more general than subprime
– Most important crises have uncertainty at
their core
1.1970 Penn Central Default
2.1993/1994 MBS market meltdown
3.1998 LTCM episode

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 Penn Central Default
• 1970 Penn Central default on $82m of prime rated
commercial paper
– CP market not as mature as today
• “Ratings” were not fine tuned
• Back-up liquidity facilities (standard practice today) did not exist
• Default spooked money-market investors
– Re-evaluate credit models, don’t trust ratings
– Investors stopped buying CP completely
• Fed stepped in to encourage banks to buy CP

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 Mercury Finance in 1997
• Mercury Finance defaults on $500m of CP
– Much larger in real terms than Penn Central
• Surprise at the time, but it quickly became
clear that this was a case of fraudulent
accounting in Mercury Finance
– No effects on the CP market

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 MBS Market in 1993
• MBS securitization in late 1980s, as banks shift
mortgages off balance sheet
MBS Outstanding ($bn)
1600
1400
1200
1000
800
600
400
200
0
1985 1986 1987 1988 1989 1990 1991 1992 1993 1994

• Valuations dependent on assumed consumer

prepayment model
– But, relatively short time series to calibrate

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 Prepayment surprise
• 1993: Large wave of consumer prepayments
– Not predicted by the historical models
OAS% on MBS
1.8
1.6
1.4
1.2
1
0.8
0.6
0.4
GNMA 30 Year FNMA
0.2
0
Mar-91 Jul-91 Nov-91 Mar-92 Jul-92 Nov-92 Mar-93 Jul-93 Nov-93 Mar-94 Jul-94 Nov-94

– Model uncertainty, searching for right model

• “Worst-case” prepayment models and pricing in the interim

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 1998 Hedge Fund Crisis
Total Hedge Funds AUM ($bn)
70

60

50

40

30

20

10

0
1990 1991 1992 1993 1994 1995 1996 1997

• Hedge funds still relatively new in 1998

• Substantial growth over the 1990s

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 Correlations in 1998
• High crisis correlations
– Even sophisticated investors such as LTCM had not
anticipated this in their risk management
• We now know that hedge funds had similar
strategies and had filled up a similar asset space
– Same marginal investors across many asset markets
– Liquidations simultaneous across many markets
• But at the time, hedge funds did not know this and
certainly creditor banks did not understand this
point.

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 Amaranth in 2007
• $5bn loss (>> LTCM loss)
• Liquidations …
• But clearly the result of a specific trading
mistake
• Almost no reaction across the hedge fund
asset space

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 Other uncertainty events
• 1987 Stock market crash
– What was equilibrium with portfolio insurance?
• 9/11
– Was there more? How much would financial
markets be affected

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Financial Innovation is about the New

• Financial innovations are complex even to

sophisticated market participants
• Risk management of an unknown product
– Learning
– Model risk
– Interpreting and acting on outcomes that the
model does not expect
• Mistakes and uncertainty seem inevitable

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 Ex-ante Policy
• In liquidity externality model, it was to reduce
date 0 leverage
• More generally, this is about incentivizing
better ex-ante risk management
• But how does the central bank know what
better risk management is for a new
innovation?

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 1998 Hedge Fund Crisis
• Pre-crisis risk management: Stress testing
based on historical correlations
• Crisis: Liquidity shortages cause unusual
comovement.
• Post-crisis risk management: Stress testing
scenarios include liquidity events

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 1987 Stock Market Crash
• Insurance Strategies: Synthetic Puts/ Portfolio
Insurance
• Pre-1987: Compare implied volatilities on out-
of-the-money put options to at-the money
options (Bates 2000)
– Out-of-the moneys have 3% higher implied vols
• Post-1987: Same comparison
– Out-of-the moneys have 10% higher implied vols
• The crisis led agents to better understand the
true costs of portfolio insurance
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 Ex-ante Policy: Some conjectures
• Policing new innovations, these are the
trouble spots
• Put in place systems that allow for quick
information revelation

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 Summary
• The Uncertainty element
– Can help to understand aspects of crises
– Rationalize LLR, but now due to benefit of
uncertainty reduction
– Need to rethink crisis prevention strategies

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