Anatomy of the global financial crisis

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Anatomy of the global financial crisis

• International Finance - IMB
• Vasja Rant, PhD
• 6 May 2009

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Presentation outline key points about the global
financial crisis

• Origins where and why did the crisis break out?
• Transmission why has the crisis spread so
  rapidly beyond the point of origin and around the
  world?
• Timeline how has the crisis evolved? What were
  the key events?
• Policy response which actions have been taken
  to solve the crisis so far?
• Costs what have been the costs of the crisis so
  far? What are the expected final costs?

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Origins

• Two views of the reasons for the outbreak of the
  crisis in the U.S.
• Narrow view deterioration of the U.S. subprime
  mortgage market
• Broad view factors contributing to the build-up
  of problems in the U.S. housing market

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Origins narrow viewCollapse of the house-price
bubble (1)
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Origins narrow viewCollapse of the house-price
bubble (2)

• The 1997-2006 house-price bubble was in fact the
  largest speculative surge of real housing prices
  in the U.S. since 1950!

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Origins narrow viewRising loan defaults (1)

• Collapse of the house-price bubble coincided with
  a surge in loan defaults in the market for
  residential mortgages.

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Origins narrow viewRising loan defaults (2)

• Rising defaults were the most problematic in the
  recent loan vintages on the subprime market
  segment (2007 is the worst vintage).

of delinquent loans (60 days)
Months from origination
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Origins narrow viewResidential mortgage market
(1)
Government guarantee and GSE securitization
Fannie Mae, Freddie Mac
Private securitization market Countrywide
financial, Bear Stearns, Lehman Brothers, Bank
of America, Wells Fargo, Washington Mutual
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Origins narrow viewResidential mortgage market
(2)

• The share of subprime increased by 130 from 2003
  to 2005!
• The percent of securitized new loans increased
  by 60 from 2001 to 2005!

Share of subprime In total U.S. economy (measured
by GDP) 1 (2001), increasing to 5 (2005)
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Origins narrow viewResidential mortgage
products

• GREATER RISKS
• Flexible payments increase chances of terminal
  default.
• Debt servicing may increase 15-30 upon FRM/ARM
  resetting.

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Origins narrow viewFrom house prices to debt
servicing (1)

• House prices are central to the U.S. subprime
  mortgage market model
• If house prices are rising interest rates are
  low
• Additional home equity due to price appreciation
• Borrowers can repay their loans by refinancing.

• Example of refinancing

Home value 200.000
Mortgage loan 200.000
Repayment of initial loan 200.000
After 1 year
Home value 300.000
Mortgage loan 300.000
Cash remaining 100.000
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Origins narrow viewFrom house prices to debt
servicing (2)

• If house prices are falling interest rates are
  high
• No or negative new home equity
• Repayment of loans by refinancing not possible
• Borrowers faced with increased debt servicing
  difficulties.

• Figure
• Interest rate movements on U.S. mortgage market
  (hybrid ARM rates).

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Origins narrow viewAnd from debt servicing to
house prices

• Mortgage loans have an implicit put option
• In times of increasing house prices
• Home value gt Loan value ? repayment of loan is
  in the interest of the borrower (the borrower
  will service the loan)
• In times of decreasing house prices
• Home value lt Loan value ? repayment of loan is
  not in the interest of the borrower (the borrower
  may default)
• Defaults lead to foreclosures
• Additional supply of the housing stock at forced
  sales prices
• Downward pressure on house prices and increased
  loan delinquencies (feedback loop).

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Origins broad viewReasons for the house-price
bubble

• Macroeconomic factors
• Global and local (U.S.) economic environment in
  the years preceding the crisis
• Microeconomic factors
• Structural characteristics of the mortgage market
  model (originate and distribute)

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Origins broad viewMacroeconomic factors

• Global saving imbalances
• U.S. current account deficit recently as high as
  6 of U.S. GDP! Financing provided by capital
  inflows from Asian countries and oil exporters.
• Implication infusion of liquidity into
  international financial system, searching for
  yield
• Low equity yields
• Substantial declines in stocks after collapse of
  the dot-com bubble (2000).
• Implication incentives to invest into new
  instruments with favorable risk-return profile
• Low interest rates
• Lowest interest rates on 30-year record due to
  agressive U.S. monetary policy
• Implicaton incentives to borrow for those who
  would normally never be able to afford it

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Origins broad viewMacroeconomics saving
imbalances (1)
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Origins broad viewMacroeconomics saving
imbalances (2)
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Origins broad viewMacroeconomics equity
yields
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Origins broad viewMacroeconomics interest
rates
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Origins broad viewMicroeconomic factors (1)

• High risk mortgage products
• Non-classical, flexible mortgage products opened
  access to credit to high risk individuals.
• Failure 1 underestimation of risk in loan
  products risk due to non-classical products not
  fully accounted for
• Predatory lending practices
• Widespread availability of credit fueled demand
  for housing and the house-price boom, which
  attracted additional credit flows
• Failure 2 poor underwriting stanadards in loan
  origination loans made to individuals with poor
  or no credit histories, no documentation, no
  regular income lending based entirely on home
  value!

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Origins broad viewMicroeconomic factors (2)

• Securitization and structured finance
• Transfer of risk (originate and distribute
  model) freed loan potential for new lending
  cycles
• Failure 3 underestimation of risk in structured
  finance products risk-assesment models failed
  due to multi-layer structuring and dispersion of
  risk.
• Failure 4 monitoring of risk in structured
  finance products delegated to credit rating
  agencies with (1) no real value at risk, except
  reputation and (2) conflict of interest with the
  issuer of securities
• Failure 5 poor underwriting standards in loan
  securitization (securities issued despite
  failures 3 and 4)
• Failure 6 intransparent legal design of
  securitization process widespread use of
  off-balance sheet entities

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Transmission

• Two necessary conditions for fast transmission of
  the crisis
• Widespread use of risk transfer mechanisms
  securitization and structured finance
• Strong demand for derivative securities due to
  global macroeconomic environment
• Two sufficient conditions for fast transmission
  of the crisis
• Strong increase in uncertainty (asymmetric
  information) investors unable to determine the
  outcome of their decisions
• Strong increase in risk aversion investors not
  willing to take on new risk
• Two key phases in transmission
• Transmission to institutional investors
• Transmission to banks

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TransmissionSecuritization risk transfer (1)
Mortgage backed securities (MBS)
Mortgage loans Total value 900.000 Mortgage
loan portfolio can be divided into 9.000 bonds
with 100 face falue. Different tranches of
bonds carry different levels of risk depending
on their seniority/subordination in debt
repayment.
1. tranche (low risk) 3.000 bonds at
100 Coupon rate 10
2. tranche (medium risk) 3.000 bonds at
100 Coupon rate 15
Securitization
Supply originators of mortgage loans
Demand financial investors
3. tranche (high risk) 3.000 bonds at
100 Coupon rate 20
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TransmissionThe key to AAA ratings in
securitization

• Credit enhancement facilities
• External
• Bond insurance monoline insurers
• Letter of credit banks.
• Internal
• Overcollateralization assets (underlying
  loans)gtliabilities (issued securities)
• Excess spread lending rate (underlying loans)
  gtborrowing rate (issued securities)
• Reserve account established to absorb losses
• Senior/subordinated debt structure pecking order
  in absorption of loan losses to derivative
  securities (equity tranche first, senior tranches
  last).
• Liquidity facilities sponsor banks provide
  liquidity in case of cash shortages due to
  redemptions

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TransmissionThe players in securitization
Broker places mortgage loans to borrowers for fee
LEGEND KEY OG interest and principal SPV
special purpose vehicle SPE special purpose
enterprise SIV special investment vehicle MBS
mortgage backed securities
End borrowers
Broker

IP ()
Mortgages
Typically a specialized mortgage bank
Originator
Servicer

Insurance company
Can assume part of risks (insurance of mortgage
loans, insurance of MBS returns).
Mortgages
IP ()
Conduit/trust/ SPV/SPE/SIV

Manages the flow of interests and principal
(IP) usually, but not necessarilly the
Originator
MBS
Banks, insurance companies, mutual funds, hedge
funds
Investment bank (underwriter)

Founder loan originator or investment
bank Purpose transfering ownerhship of claims
(loans) and collateral (mortgages) in order to
issue mortgage backed securities
(bonds). Exposure of founder implicit guarantee
in case of large losses.
MBS, IP ()
Rating agency
Institutional investor

Organizes issuing of MBSs and places MBSs to
investors in financial markets.
Financial returns ()
Assigns credit rating to issued MBSs.
End lenders
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TransmissionSecuritization risk transfer (2)
Mortgage backed securities (MBS)
Mortgage bonds Rating AAA/Aaa
Other claims
Collateralized debt obligations (CDO)
Investment grade
CDO Ratings AAA/Aaa BBB/Baa2
Mortgage bonds Rating AA/Aa2
Mortgage bonds Rating A/A2
Investment grade
MBS
Mortgage bonds Rating BBB/Baa2
Mortgage bonds Rating BB/Ba2
Speculative grade
Mortgage bonds Rating B/B2
CDO Ratings less than BBB/Baa2
Equity tranche
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TransmissionSecuritization risk transfer (3)
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TransmissionSecuritization risk transfer (4)

• Credit default swaps (CDS) a form of insurance,
  tied to a reference instrument (a bond or a CDO).
• The CDS buyer agrees to pay periodic payments for
  the right of insurance
• The CDS seller agrees to pay the buyer if the
  reference instrument defaults
• CDS can be bought naked (i.e. without owning
  the underlying reference instrument).
• The buyer and seller can be very different
  institutions (for example, an unregulated hedge
  fund and a regulated bank)
• The market is intransparent (OTC, no centralized
  exchange)
• The market is huge (at peak 60 trillion
  outstanding CDS).

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TransmissionStructured finance instruments
volumes

• RMBS residential mortgage backed securities
• CMBS commercial mortgage backed securities
• MBS mortgage backed securities
• ABS asset backed securities
• CDO collateralized debt obligations
• CDS credit default swaps

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TransmissionStructured finance portfolio ratings
underlying claims
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TransmissionStructured finance funding profile
ABCP underlying claims
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TransmissionPart 1 institutional investors (1)

• Key question
• Why has a crisis in a relatively narrow segment
  of the U.S. financial system send such strong
  shockwaves through the U.S. and international
  financial environment?
• Explanations
• Investor miopia excessive focus on yield and
  insufficient focus on risk due to benign
  international financial environment.
• Difficulties in estimating risks failure of
  risk assessment models for structured finance
  instruments, which are not actively traded in the
  secondary markets (such as CDO, CDO2 and CDS).

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TransmissionPart 1 institutional investors (2)

• Over reliance on credit rating agencies
  systematic large downgrades of MBS credit ratings
  since July 2007 cause panic among investors and
  subsequent flight to quality ? repricing of
  risk!
• Contagion effect a lack of confidence spread
  from the narrow MBS segment to the wider ABS
  segment, which is based on a much broader pool of
  claims, including corporate bonds, student loans,
  car leases, credit card payments etc.
• Deleveraging (unwinding of credit) investors
  lack of condifence ? fire sales of structured
  finance instruments ? forced liquidation of
  SIV/SPV/SPE assets ? falling prices of illiquid
  structured finance instruments ? further lack of
  confidence ? accelerated fire sales of structured
  finance instruments

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TransmissionIncrease in uncertainty unreliable
credit ratings for mortgage derivative securities
35
TransmissionIncrease in risk aversion (1) from
residential to commercial mortgages
36
TransmissionIncrease in risk aversion (2) from
mortgage to other asset derivatives
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TransmissionIncrease in risk aversion (3) from
derivatives to corporate debt market
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TransmissionPart 2 banks (1)

• Key question
• How has the crisis jumped from institutional
  investors to the interbank market?
• Explanations
• Realization of contingent liabilities of banks to
  various investment vehicles
• Important initial role of short-term ABCP (asset
  backed commercial papers) exposed to U.S.
  subprime market in transmission of the crisis.
  They are particularly vulnerable to refinancing
  risk.
• Conduits issuing ABCPs were established
  sponsored by several european banks. As they came
  under pressure due to investors redemptions some
  banks withdrew their liquidity support ? signal
  that banks may have difficulties in meeting their
  obligations!

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TransmissionPart 2 banks (2)

• Non-functioning of the securitization market
  banks can no longer transfer risks off their
  balance sheets (problems with pending LBOs).
  Unwanted claims put pressure on banks capital
  adequacy.
• Hoarding of liquidity by banks due to high
  uncertainty, banks create a dangerous liquidity
  squeeze in the interbank market
• Banks build-up their own precautionary cash
  reserves against realization of unforseen
  contingent liabilities.
• Banks stop lending to each other because of
  adverse selection (lack of confidence)
• Hoarding of liquidity by non-financial companies
  Due to observed liquidity shortages in the
  market, companies try to secure cash (for
  example, by drawing on their credit lines),
  creating further liquidity pressures for the
  banks.

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TransmissionIncrease in banks credit and
liquidity risk
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TimelineThree phases of key crisis events (1)

• Outbreak phase (summer 2007 fall 2007), marked
  by
• First awareness of the crisis in the general
  public
• First period of interbank liquidity squeeze and
  massive central bank interventions
• First isolated bank failures (Northern Rock)
• Deleveraging phase (winter 2007 summer 2008),
  marked by
• Build-up of losses in the financial system
  (banks write-offs and balance sheet clean-ups)
• First significant round of bank recapitalizations
  (large role of sovereign wealth funds due to lack
  of private investors )
• Continued isolated bank failures (Bear Stearns)

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TimelineThree phases of key crisis events (1)

• Escalation phase (fall 2008-now) marked by
• Failures or near failures of large, systemically
  important financial institutions (investment
  banks, insurance companies, commercial banks and
  thrifts) Lehman Brothers, AIG, Washington
  Mutual, Fortis, Hypo Real, Royal Bank of
  Scotland, HBOS, Citigroup
• Second period of interbank liquidity squeeze
• Development of a credit crunch for non-financial
  companies and households (worsening of real
  economy)
• Significant wealth effects (large declines in
  stock prices)
• Unprecedented public interventions by central
  banks and governments around the world
• Balance of payments crises (smaller countries)
  first interventions by the International monetary
  fund

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TimelineOutbreak phase

• First signs of trouble already in the first half
  of 2007
• Mouniting losses due to subprime loans (HSBC)
• Problems of funds involved in the secondary
  market for mortgage securitizations (Bear
  Stearns)
• Problems of institutional investors that invested
  in morgage derivatives (IKB, WestLB).
• Systematic downgrades of credit ratings of
  mortgage derivatives since July 2007
• Result rapid redemptions of derivative
  securities by institutional investors
• Significant outbreak in august 2007
• Problems of three funds of BNP Paribas
• BNP Paribas stops redemptions in funds due to
  difficulties in valuation of funds U.S.
  investments.
• Result investors panic, massive sell-offs create
  the first liquidity squeeze.

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TimelineDeleveraging phase

• Rapid liquidation of positions in mortgage, assed
  based securities CDOs by institutional
  investors
• Losses are absorbed by institutions involved in
  the securitization process significant
  write-downs, particularly among banks
• Write-downs create the need for fresh capital. In
  the absence of sufficient private capital,
  financial institutions resort to sovereign wealth
  funds (SWFs involved in 60 of all
  recapitalizations by decemeber 2007).
• Write-downs, capital raised, and central bank
  liquidity interventions create some transparency
  in the interbank market, easing the liquidity
  squeeze.

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TimelineEscalation phase (1)

• By late summer 2008 deleveraging is endangering
  soundness of large, systemically important
  financial institutions.
• First sign of serious trouble nationalization of
  Fannie Mae and Freddie Mac by the U.S. government
  due to insolvency (7.9.) both GSEs stand behind
  more than 50 of all U.S. mortgages.

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TimelineEscalation phase (2)

• Key event in escalation phase Lehman Brothers
  (investment bank) files for bankruptcy on 15.9.
• Lehman is the underwriter of large volumes of
  derivative securities. Lehmans debt has been
  sold to numerous financial institutions around
  the world.
• Immediate and significant increase in
  counter-party risk
• Events unfold with rapid pace all remaining Wall
  Street investment banks restructured or sold
  within a week, U.S. govenment rescues insurance
  giant AIG (16.9), governments around the world
  scramble to rescue their banks, some prove too
  small for this task (Iceland, Eastern European
  states).
• Inter-bank lending grinds to a halt, bringing
  down credit flow to the real economy along.
• Crisis begins spilling over to the real economy
  (problems with consumptino of durables, i.e. car
  industry)

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Policy response

• Two phases in policy response based on crisis
  timeline
• Outbreak and delevereging phase
• Key feature case-by-case approach and
  involvement of other actors (sovereign wealth
  funds) in addition to national governments
  central banks
• Escalation phase
• Key feature systemic approach and crucial role
  of national governments central banks

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Policy responseOutbreak and deleveraging phases
(1)

• Central banks
• Liquidity measures cash provided in exchange
  for securities that nobody else wants in order
  to ease tensions in the interbank market.
• ECB, Fed and other central banks
• Monetary policy measures reductions of
  reference interest rates with the objective to
  stimulate U.S. growth and to ease conditions in
  the mortgage markets
• Fed

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Policy responseOutbreak and deleveraging phases
(2)

• National governments
• Bailouts of failed banks nationalization in
  case of Northern Rock, government-sponsored
  takeover (by JP Morgan Chase) in case of Bear
  Stearns, with the objective to contain systemic
  risks problem of moral hazard!
• Measures to improve the conditions in the
  mortgage market (U.S.) moratorium on loan
  repayments, increased authority for intervention
  by government sponsored enterprises (GSEs) both
  in granting guarantees and securitization
• Banks and other players
• Balance sheet clean-up and recapitalization of
  large banks substantial role of the so called
  sovereign wealth funds.

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Policy responseEscalation phase (1)

• Central banks
• Liquidity measures cash provided temporarily
  (repo) in exchange for securities that nobody
  else wants in order to ease tensions in the
  interbank market and prevent credit crunch.
• ECB, Fed and other central banks
• Measures extended to non-member countries in case
  of ECB (Hungary, Denmark)
• Monetary policy measures reductions of
  reference interest rates with the objective to
  stimulate growth around the world and prevent
  credit cruch
• Fed, ECB and other central banks
• Non-conventional measures outright purchases of
  securities direct lending to enterprises
  (quantitative easing)
• Fed, Bank of Englad, ECB (under consideration)

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Policy responseEscalation phase (2)

• National governments (1)
• Earmarked rescue packages governments adopt a
  systemic approach rescue packages designed to
  prevent collapse of national banking systems
  sizes of packages
• Recapitalizations and partial nationalizations of
  national banking systems crucial role of
  national government funds (initially ad hoc,
  later based on earmarked rescue packages).
• Government guaranees for interbank loans the
  aim is to help start interbank lending, which
  would unlock the credit crunch (based on
  earmarked rescue packages).
• Unlimited or increased government deposit
  insurance the aim is to build depositors
  confidence in the banking system and prevent bank
  runs (based on earmarked rescue packages).
• Government purchase of toxic assets from banks.

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Policy responseEscalation phase (3)

• National governments (2)
• Rescue packages because of spillover effects of
  the financial crisis into the real economy,
  governments adopt rescue packages, that include
• Spending measures to stimulate demand and growth
  increase in govenrment investment, co-financing
  of private consumption, increased export credit
  and government guarantees, tax cuts (partially)
• Spending measures to cushion the social impact of
  the crisis increase in social support for the
  unemployed, government co-financing of reduced
  working week hours, tax cuts (partially).
• Saving measures reducing the costs of the
  public sector in order to relieve the private
  sector and ensure fiscal sustainability.

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Policy responseEscalation phase (3)

• International level
• Involvement of the International monetary fund
  objective is to help countries facing balance of
  payments difficulties due to financial crisis
  proposals about possible increased role of the
  Fund in this respect.
• Beginning of talks about a substantial reshaping
  of the internatinal financial system so far 2
  meetings of the G-20 forum on 15 November in
  Washington D.C. 2 April in London.