American Economic Association Nashville, TN 0895-3309 Journal of Economic Perspectives http://www.aeaweb.org/jep/ 23 1 Winter 2009 http://www.aeaweb.org/issue.php?journal=JEP&volume=23&issue=1 Symposia The Economics of Structured Finance JoshuaCovalHarvard U JakubJurekPrinceton U ErikStaffordHarvard U 3 25 This paper investigates the spectacular rise and fall of structured finance. The essence of structured finance activities is the pooling of economic assets like loans, bonds, and mortgages, and the subsequent issuance of a prioritized capital structure of claims, known as tranches, against these collateral pools. As a result of the prioritization scheme used in structuring claims, many of the manufactured tranches are far safer than the average asset in the underlying pool. This ability of structured finance to repackage risks and to create "safe" assets from otherwise risky collateral led to a dramatic expansion in the issuance of structured securities, most of which were viewed by investors to be virtually risk-free and certified as such by the rating agencies. At the core of the recent financial market crisis has been the discovery that these securities are actually far riskier than originally advertised. We examine how the process of securitization allowed trillions of dollars of risky assets to be transformed into securities that were widely considered to be safe. We highlight two features of structured finance products - the extreme fragility of their ratings to modest imprecision in evaluating underlying risks, and their exposure to systematic risks - that go a long way in explaining the spectacular rise and fall of structured finance. We conclude with an assessment of what went wrong and the relative importance of rating agency errors, investor credulity, and perverse incentives and suspect behavior on the part of issuers, rating agencies, and borrowers. http://www.aeaweb.org/articles.php?doi=10.1257/jep.23.1.3 10.1257/jep.23.1.3 American Economic Association Nashville, TN 0895-3309 Journal of Economic Perspectives http://www.aeaweb.org/jep/ 23 1 Winter 2009 http://www.aeaweb.org/issue.php?journal=JEP&volume=23&issue=1 Symposia The Rise in Mortgage Defaults ChristopherMayerColumbia U KarenPenceFederal Reserve Board Shane M.SherlundFederal Reserve Board 27 50 The first hints of trouble in the mortgage market surfaced in mid-2005, and conditions subsequently began to deteriorate rapidly. Mortgage defaults and delinquencies are particularly concentrated among borrowers whose mortgages are classified as "subprime" or "near-prime." The main factors underlying the rise in mortgage defaults appear to be declines in house prices and deteriorated underwriting standards, in particular an increase in loan-to-value ratios and in the share of mortgages with little or no documentation of income. Contrary to popular perception, the growth in unconventional mortgages products, such as those with prepayment penalties, interest-only periods, and teaser interest rates, does not appear to be a significant factor in defaults through mid-2008 because borrowers who had problems with these products could refinance into different mortgages. However, as markets realized the extent of the poor underwriting, underwriting standards tightened and borrowers began to face difficulties refinancing; this dynamic suggests that these unconventional products could pose problems going forward. http://www.aeaweb.org/articles.php?doi=10.1257/jep.23.1.27 10.1257/jep.23.1.27 American Economic Association Nashville, TN 0895-3309 Journal of Economic Perspectives http://www.aeaweb.org/jep/ 23 1 Winter 2009 http://www.aeaweb.org/issue.php?journal=JEP&volume=23&issue=1 Symposia Crisis and Responses: The Federal Reserve in the Early Stages of the Financial Crisis Stephen G.CecchettiBank for International Settlements 51 75 Realizing that their traditional instruments were inadequate for responding to the crisis that began on August 9, 2007, Federal Reserve officials improvised. Beginning in mid-December 2007, they implemented a series of changes directed at ensuring that liquidity would be distributed to those institutions that needed it most. Conceptually, this meant America's central bankers shifted from focusing solely on the size of their balance sheet, which they use to keep the overnight interbank lending rate close to their chosen target, to manipulating the composition of their assets as well. In this paper, I examine the Federal Reserve's conventional and unconventional responses to the financial crisis of 2007-2008. http://www.aeaweb.org/articles.php?doi=10.1257/jep.23.1.51 10.1257/jep.23.1.51 American Economic Association Nashville, TN 0895-3309 Journal of Economic Perspectives http://www.aeaweb.org/jep/ 23 1 Winter 2009 http://www.aeaweb.org/issue.php?journal=JEP&volume=23&issue=1 Symposia Deciphering the Liquidity and Credit Crunch 2007-2008 Markus K.BrunnermeierPrinceton U 77 100 The financial market turmoil in 2007 and 2008 has led to the most severe financial crisis since the Great Depression and threatens to have large repercussions on the real economy. The bursting of the housing bubble forced banks to write down several hundred billion dollars in bad loans caused by mortgage delinquencies. At the same time, the stock market capitalization of the major banks declined by more than twice as much. While the overall mortgage losses are large on an absolute scale, they are still relatively modest compared to the $8 trillion of U.S. stock market wealth lost between October 2007, when the stock market reached an all-time high, and October 2008. This paper attempts to explain the economic mechanisms that caused losses in the mortgage market to amplify into such large dislocations and turmoil in the financial markets, and describes common economic threads that explain the plethora of market declines, liquidity dry-ups, defaults, and bailouts that occurred after the crisis broke in summer 2007. http://www.aeaweb.org/articles.php?doi=10.1257/jep.23.1.77 10.1257/jep.23.1.77 American Economic Association Nashville, TN 0895-3309 Journal of Economic Perspectives http://www.aeaweb.org/jep/ 23 1 Winter 2009 http://www.aeaweb.org/issue.php?journal=JEP&volume=23&issue=1 Symposia Reflections on Northern Rock: The Bank Run That Heralded the Global Financial Crisis Hyun SongShinPrinceton U 101 19 The U.K. bank Northern Rock became the first high-profile casualty of the global financial crisis of 2007-2008 when it suffered its depositor run in September 2007. In spite of the television images of long lines of depositors outside its branch offices, the run on Northern Rock was unlike the textbook retail depositor run caused by coordination failure. Also, contrary to received wisdom, its reliance on securitization was not an immediate factor in its failure. Rather, its problems stemmed from its high leverage coupled with reliance on institutional investors for short-term funding. When the de-leveraging in the credit markets began in August 2007, Northern Rock was uniquely vulnerable to the shrinking of lender balance sheets arising from the tick-up in measured risks. Financial regulation that relies on risk-weighted capital requirements is powerless against such runs. The Northern Rock case also offers lessons concerning the economics of short-term debt. http://www.aeaweb.org/articles.php?doi=10.1257/jep.23.1.101 10.1257/jep.23.1.101 American Economic Association Nashville, TN 0895-3309 Journal of Economic Perspectives http://www.aeaweb.org/jep/ 23 1 Winter 2009 http://www.aeaweb.org/issue.php?journal=JEP&volume=23&issue=1 Symposia Leveraged Buyouts and Private Equity Steven N.KaplanU Chicago PerStrombergStockholm School of Economics and Institute for Financial Research, Stockholm 121 46 In a leveraged buyout, a company is acquired by a specialized investment firm using a relatively small portion of equity and a relatively large portion of outside debt financing. The leveraged buyout investment firms today refer to themselves (and are generally referred to) as private equity firms. We describe and present time series evidence on the private equity industry, considering both firms and transactions. We discuss the existing empirical evidence on the economics of the firms and transactions. We consider similarities and differences between the recent private equity wave and the wave of the 1980s. Finally, we speculate on what the evidence implies for the future of private equity. http://www.aeaweb.org/articles.php?doi=10.1257/jep.23.1.121 10.1257/jep.23.1.121 American Economic Association Nashville, TN 0895-3309 Journal of Economic Perspectives http://www.aeaweb.org/jep/ 23 1 Winter 2009 http://www.aeaweb.org/issue.php?journal=JEP&volume=23&issue=1 Symposia Beware of Venturing into Private Equity LudovicPhalippouU Amsterdam 147 66 As a step towards understanding whether a private equity governance structure reduces overall agency conflicts relative to a public equity governance structure (as is often argued), this paper describes the contracts between private equity funds and investors, and the returns earned by investors. The paper sets the stage with a puzzle: the average performance of private equity funds is above that of the Standard and Poor's 500 - the main public stock market index - before fees are charged, but below that benchmark after fees are charged. Why are the payments to private equity buyout funds so large? Why does the marginal investor invest in buyout funds? I explore one potential answer (and probably the most controversial): that some investors are fooled. I show that the fee contracts for these funds are opaque. Considering this and the way that compensation contracts bury, in details, costly provisions that are difficult to justify on the basis of proper incentive alignment, it would be premature to assert that the agency conflicts are lower in private equity than in public equity. http://www.aeaweb.org/articles.php?doi=10.1257/jep.23.1.147 10.1257/jep.23.1.147 American Economic Association Nashville, TN 0895-3309 Journal of Economic Perspectives http://www.aeaweb.org/jep/ 23 1 Winter 2009 http://www.aeaweb.org/issue.php?journal=JEP&volume=23&issue=1 Articles Microfinance Meets the Market RobertCullWorld Bank AsliDemirguc-KuntWorld Bank JonathanMorduchNYU 167 92 In this paper, we examine the economic logic behind microfinance institutions and consider the movement from socially oriented nonprofit microfinance institutions to for-profit microfinance. Drawing on a large dataset that includes most of the world's leading microfinance institutions, we explore eight questions about the microfinance "industry": Who are the lenders? How widespread is profitability? Are loans in fact repaid at the high rates advertised? Who are the customers? Why are interest rates so high? Are profits high enough to attract profit-maximizing investors? How important are subsidies? The evidence suggests that investors seeking pure profits would have little interest in most of the institutions we see that are now serving poorer customers. We will suggest that the future of microfinance is unlikely to follow a single path. The recent clash between supporters of profit-driven Banco Compartamos and of the Grameen Bank with its "social business" model offers us a false choice. Commercial investment is necessary to fund the continued expansion of microfinance, but institutions with strong social missions, many taking advantage of subsidies, remain best placed to reach and serve the poorest customers, and some are doing so at a massive scale. The market is a powerful force, but it cannot fill all gaps. http://www.aeaweb.org/articles.php?doi=10.1257/jep.23.1.167 10.1257/jep.23.1.167 American Economic Association Nashville, TN 0895-3309 Journal of Economic Perspectives http://www.aeaweb.org/jep/ 23 1 Winter 2009 http://www.aeaweb.org/issue.php?journal=JEP&volume=23&issue=1 Articles The U.S. Equity Return Premium: Past, Present, and Future J. BradfordDeLongU CA, Berkeley KonstantinMaginU CA, Berkeley 193 208 For more than a century, diversified long-horizon investments in America's stock market have consistently received much higher returns than investors in bonds: a return gap averaging 6 percent per year. An enormous amount of creative and ingenious work by a great many economists has gone into seeking explanations for the so-called "equity premium return puzzle," but so far without a fully satisfactory answer. We first review the facts about the equity premium and then discuss a range of explanations that have been proposed. We conclude that the equity premium puzzle has not been solved: it remains a puzzle. And we anticipate that the equity return premium will continue, albeit at a smaller level than in the past - perhaps four percent per year. (The final draft of this paper was written before the recent stock market crash. As of October 2008, we can say that the crash does not fundamentally alter our conclusions and actually strengthens the case for a substantial future equity premium.) http://www.aeaweb.org/articles.php?doi=10.1257/jep.23.1.193 10.1257/jep.23.1.193 American Economic Association Nashville, TN 0895-3309 Journal of Economic Perspectives http://www.aeaweb.org/jep/ 23 1 Winter 2009 http://www.aeaweb.org/issue.php?journal=JEP&volume=23&issue=1 Features Markets: Red Light States: Who Buys Online Adult Entertainment? BenjaminEdelmanHarvard U 209 20 This paper studies the adult online entertainment (Internet pornography) industry, focusing mainly on the consumption side. In particular, it focuses on the demographics and consumption patterns of those who subscribe to adult entertainment websites. On the surface, this business would seem to face a number of obstacles. Regulatory and legal barriers have already been mentioned. In addition, those charging for access to adult entertainment face competition from similar content available without a fee. In the context of adult entertainment, free access offers consumers an extra benefit: online payments tend to create records documenting the fact of a customer's purchase; consumers of free content may feel more confident that their purchases will remain confidential. More broadly, measured levels of religiosity in American are high. On the other hand, social critics often argue that the rise of Internet pornography is contributing to a coarsening of American culture. Do consumption patterns of online adult entertainment reveal two separate Americas? Or is the consumption of online adult entertainment widespread, regardless of legal barriers, potential for embarrassment, and even religious conviction? http://www.aeaweb.org/articles.php?doi=10.1257/jep.23.1.209 10.1257/jep.23.1.209 American Economic Association Nashville, TN 0895-3309 Journal of Economic Perspectives http://www.aeaweb.org/jep/ 23 1 Winter 2009 http://www.aeaweb.org/issue.php?journal=JEP&volume=23&issue=1 Features Retrospectives: On the Definition of Economics Roger E.BackhouseU Birmingham Steven G.MedemaU CO, Denver 221 33 Modern economists do not subscribe to a homogeneous definition of their subject. Surveying definitions of economics from contemporary principles of economics textbooks, we find that economics is the study of the economy, the study of the coordination process, the study of the effects of scarcity, the science of choice, and the study of human behavior. At a time when economists are tackling subjects as diverse as growth, auctions, crime, and religion with a methodological toolkit that includes real analysis, econometrics, laboratory experiments, and historical case studies, and when they are debating the explanatory roles of rationality and behavioral norms, any concise definition of economics is likely to be inadequate. This lack of agreement on a definition does not necessarily pose a problem for the subject. Economists are generally guided by pragmatic considerations of what works or by methodological views emanating from various sources, not by formal definitions: to repeat the comment attributed to Jacob Viner, economics is what economists do. However, the way the definition of economics has evolved is more than a historical curiosity. At times, definitions are used to justify what economists are doing. Definitions can also reflect the direction in which their authors want to see the subject move and can even influence practice. http://www.aeaweb.org/articles.php?doi=10.1257/jep.23.1.221 10.1257/jep.23.1.221 American Economic Association Nashville, TN 0895-3309 Journal of Economic Perspectives http://www.aeaweb.org/jep/ 23 1 Winter 2009 http://www.aeaweb.org/issue.php?journal=JEP&volume=23&issue=1 Features Recommendations for Further Reading TimothyTaylorMacalester College 235 42 http://www.aeaweb.org/articles.php?doi=10.1257/jep.23.1.235 10.1257/jep.23.1.235 American Economic Association Nashville, TN 0895-3309 Journal of Economic Perspectives http://www.aeaweb.org/jep/ 23 1 Winter 2009 http://www.aeaweb.org/issue.php?journal=JEP&volume=23&issue=1 Features Comments: Ramesh Ramankutty; Erik Berglof; and William Easterly and Tobias Pfutze 243 246 http://www.aeaweb.org/articles.php?doi=10.1257/jep.23.1.243 10.1257/jep.23.1.243 American Economic Association Nashville, TN 0895-3309 Journal of Economic Perspectives http://www.aeaweb.org/jep/ 23 1 Winter 2009 http://www.aeaweb.org/issue.php?journal=JEP&volume=23&issue=1 Features Notes 247 247 http://www.aeaweb.org/articles.php?doi=10.1257/jep.23.1.247 10.1257/jep.23.1.247