How Credit Cycles across a Financial Crisis

We study the behavior of credit and output across a financial crisis cycle using information from credit spreads. We show the transition into a crisis occurs with a large increase in credit spreads, indicating that crises involve a dramatic shift in expectations and are a surprise. The severity of the subsequent crisis can be forecast by the size of credit losses (change in spreads) coupled with the fragility of the financial sector (as measured by pre-crisis credit growth). We also find that recessions in the aftermath of financial crises are severe and protracted. Finally, we find that spreads fall pre-crisis and appear too low, even as credit grows ahead of a crisis. This behavior of both prices and quantities suggests that credit supply expansions are a precursor to crises. The 2008 financial crisis cycle is in keeping with these historical patterns surrounding financial crises. ∗emails: [email protected] and [email protected]. We thank Michael Bordo, Gary Gorton, Robin Greenwood, Francis Longstaff, Emil Siriwardane, Chris Telmer, Alan Taylor and seminar/conference participants at the AFA 2015, Chicago Booth Financial Regulation conference, NBER Monetary Economics meeting, FRIC at Copenhagen Business School, Riksbank Macro-Prudential Conference, SITE 2015, Stanford University, University of California-Berkeley, University of California-Davis, and Utah Winter Finance Conference. We thank the International Center for Finance for help with bond data, and many researchers for leads on other bond data.