Jeremy Stein on credit bubbles

Jeremy Stein is a new member of the Board of Governors at the Fed, but he has a long history of good research on credit markets. He presented a very thoughtful speech on credit bubbles last month called "Overheating in credit markets: Origins, Measurement, and Public Response" which should be read in great detail. It calls for deeper analysis of credit markets and the potential for bubbles beyond just looking at spreads.

Stein starts with explaining the two current schools of thought that try to explain the pricing of credit. The first school is the "primitive preferences and beliefs" view while the other is the "institutions, agency, and incentives" view. The primitive preference view states that the changes in pricing for credit are associated with fluctuations in the preferences and beliefs of end users or investors. These beliefs may change in a way that will not always be rational. There can be extrapolation of good times, a change in wealth, or say a low probability weight placed on poor times. These may be a good model at explaining the technology stock bubble or bubbles in markets which have not seen declines for a long time. Here, over optimism can lead to bubbles. There is little control over the process. 

However, credit markets may be different than stock markets or general markets focused on future expectations through discounting of potential cash flow streams. Credit markets expand or contract because those suppliers of credit are willing to provide funds for lending at lower prices. This is not the same as bidding up the price of a stock. 

Put differently, it takes two to tango in the credit markets. There is a demander of credit and there is the supplier. If the supplier does not want to provide funds, credit cannot be obtained. The price of credit is also related to the incentive and behavior of the suppliers who are managers of institutions and not the end saver. Financial institutions are delegated the responsibility to provide credit, monitor the loans and make a return. In this world, the regulatory or institutional structure which create agency problems will have as big an impact on credit availability as the preferences of the buyers. 

Stein argues that changes in structure such as financial innovation, regulation, and economic environment can all impact the supply of credit at a given price;consequently, a more careful analysis has to be done on who is responsible for the creation of credit bubbles. If you believe this school, which I would agree with, the Fed and regulators have an important role in allowing credit bubbles to grow. They can create an environment that is more open to bubbles or an environment that is more controlled and less susceptible to bubbles.  The regulators should take some responsibility for the housing bubble. 

In the current environment, one that is focused on low interest rates and forcing institutions and households to hold risky assets will create a perfect bubble environment. Regulation can be structured to allow for excessive lending in housing and student loans. The demanders of credit can not be solely culpable. Similarly, banks and other financial institutions who have to hit earning targets can be a root cause for excess. Lenders set the terms of credit so even if prices do not change, banks can change terms to create a bubble environment. 

This is a very refreshing and thoughtful view to credit issues and the potential for bubbles. Lets hope that these views have a wide audience.