Subprime Crisis: Issues and Lessons for Regulation

1
Tsinghua University Course on Financial
RegulationLecture 08/6

• Subprime Crisis Issues and Lessons for
  Regulation
• Andrew Sheng
• Adjunct Professor,
• Graduate School of Economics and Management
• 11 April 2008

2
IMF Global Financial Stability Report, April
2008 Views on Subprime Crisis

• Collective failure to appreciate extent of
  leverage and risks of disorderly unwinding
• Risk management, disclosure, regulation all
  lagged behind innovation that gave rise to
  excessive risk-taking, weak underwriting,
  maturity mismatches and asset price inflation
• Transfer of risk from banks over-estimated
• Financial markets still under strain, with
  worrisome macro-economic environment, weakly
  capitalized banks and broad-based deleveraging.
• Crisis spreading to prime real estate, consumer
  credit and corporate credit markets.

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Origin of Subprime

• US and EU Banks moved from Lend and Hold Model
  to Originate to Distribute Model
• Asset Securitization innovated into
  Collateralized Debt Obligations (CDOs), then
  backed only by CDOs CDO2.
• Liquidity underwritten by Conduits or buybacks by
  originators and credit rated, plus guarantees by
  monoline insurers
• Mortgage origination lightly regulated
• Credit given to NINJAs (no income, no job assets)
• When subprime defaults increased, liquidity dried
  up in ABS markets, and prime broker/lenders found
  themselves with loss-assets, no liquidity and run
  on their deposits.

4
McKinsey Change of Financial Sector Business
Models

• Buy turn

• Market depth and long term funding
• Facilitate global allocation of capital

• Dynamic

• Mutual funds

• Pension funds - defined contribution

• Buy hold

• Active traders and arbitrators/ proprietary
  trading desks

• Banks

Investors

• Seek high relative returns above benchmark

• Breadth of investment objectives
• Product innovation

• Retail investors

• Depth of investment capacity

• Seek high absolute returns

• Seek safe, predictable, average returns

• Alternative Investors
• Specialized funds
• High net worth individuals
• Investment bank

• Pension funds -defined benefits

• Employ variety of strategies to minimize risks

• Match future liabilities with investment income

• Insurance companies

• Investment objectives

• Examples

• Role

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Box 1.3Balance Sheet Profiles for 10 Large
Publicly Listed Banks
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Bill Gross (PIMCO) Bank Leverage grew from
1987-2007 by securitizing and moving liabilities
off-balance sheet
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Phases of the crisis
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Creation of Asset-Backed Securities from Mortgage
Loans Subprime and Prime Securities
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Layering of Subprime into CDO and CDO2
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Overlap of ABS and CDS Markets (IMF GFSR Box 2.1
chart 2, April 2008)
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Major Net Exporters and Importers of Capital in
2007
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Asian Crisis (97-98) vs Subprime (07-08?)

• Excessive liquidity
• Large capital flows
• Asset bubbles
• Excessive leverage in corporations
• Financial Liberalization
• Lack of transparency
• Inadequate Supervision
• Moral Hazard close banks
• Policy response raise interest rates
• Cut fiscal expenditure

• Yes
• Yen-carry
• Yes
• Yes, in household sector
• CDO and RMBS
• Lack of understanding of complex instruments
• Regulators caught off-guard
• Greenspan Put and Blanket Deposit Guarantee
  rescue Northern Rock
• Lower Interest rates
• Increase fiscal stimulus

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Fig. 1.12. Comparison of Financial Crises
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Figure 1.27. Carry-Trade Index and Currency
Volatility
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Global Leverage (exclude derivatives) moved from
108 of GDP in 1989 to 395 by 2006 US trillion
(IMF Global Financial Stability Report, Oct.
2007 Table 3)
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Global OTC Derivatives Markets Notional and Gross
Market Values, June 2007
(In billions of U.S. dollars)
Source IMF, April 02, 2008
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Table 2.3. Market Participants in Credit
Derivatives, 2004 and 2006
(In percent)
18
Global Leverage and Liquidity the unstable
pyramid source David Roche
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Counterparty Risk Management Group II (July
2005) Ten Fundamental factors of dynamic
financial shocks

• Counterparty Credit Risk is single most important
  variable
• Evaporation of market liquidity is second,
  especially with crowded trades - in periods of
  acute market stress, market liquidity can
  evaporate even in what is normally the most
  liquid of markets.
• Value of complex financial instruments
  (especially those having embedded leverage) can
  change very rapidly even in a matter of hours or
  dates
• Value of many classes of financial instruments is
  very difficult and dependent on complex
  proprietary models (similar analytical tools
  heightens precipitous price changes)
• Most statistically driven models and risk metrics
  such as VaR calculations fail to capture tail
  events.
• Integrity and reliability of financial
  infrastructure are critical risk mitigants.

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CPRGII Fundamental risk issues - in a word,
dynamic complexity

• Many financial institutions now have sizeable
  investments in assets that are highly illiquid
  even in normal market conditions (with very
  difficult valuations)
• Day-to-day costs of comprehensive risk management
  and control-related functions for financial
  intermediaries are very substantial
• Since primary creditors now use the credit
  default swap market to dispose of their credit
  exposure, restructuring in the future may be much
  more difficult
• Since we know that financial disturbances and
  even financial shocks will occur in the future,
  and we know that no approaches to risk management
  or official supervision are fail-safe, we also
  know that we must preserve and strengthen the
  institutional arrangements whereby, at the point
  of crisis, industry groups and industry leaders,
  as well as supervisors, are prepared to work
  together in order to serve the larger and shared
  goal of financial stability.

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Avinash Persaud (2007) Current Risk Management
Analysis add to Risks

• Markowitz Fundamentalism practiced by many
  investors, banks and regulators assumes away
  strategic behaviour by investors. if you use
  industry standard portfolio construction and risk
  management tools that assume risk and return is
  independent of investor behaviour, you will be
  buying with the herd and selling with the herd.
  Far from diversifying risk, these tools will
  concentrate risk.
• No distinction is drawn between markets comprised
  of holders of risk or those comprised of traders
  of risk through securitisation of risks. But
  risk-traders are not risk-absorbers.
• It is assumed that riskiness is a
  characteristic of an instrument than an investor
  may hold. This view that instruments have an
  inherent riskiness, measured by short-term price
  volatility is at the heart of the mantra of
  risk-sensitivity that is often chanted by
  regulators. In fact, riskiness is as much a
  characteristic of the investor, as the
  instrument.
• In other words, those why fly only by black
  boxes, die by black boxes.

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Excess Liquidity due to Market Confidence or
Assumption of Central Bank Put and Lender of Last
Resort

• Why should the banks bother with liquidity
  management when the Central Bank will do all that
  for them? The banks have been taking out a
  liquidity put on the Central Bank they are in
  effect putting the downside of liquidity risk to
  the Central Bank..Goodhart (December 2007).
• One measure of the liquidity of a financial
  instrument is to ask how much a creditor would be
  willing to lend against it. But an instruments
  worth as collateral is intimately tied to its
  current valuation, and to the extent that
  valuation of collateral is incresingly tied to
  market prices, the stability of collateralizing
  financing is brought into question, particularly
  in moments of crisis when market prices are
  either not available or fluctuating wildly
• Forced liquidation in a predator market virtually
  guarantees insolvency.
• It is now empirically clear that when market
  prices go down substantially, volatilities go up.
  How to deal with this double whammy scenario -
  a firms VAR doubling at exactly the moment that
  its capital is halved - continues to baffle firms
  and supervisors alike
• Gumerlock (2000)

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Writedowns of Selected Financial Institutions,
October 15, 2007February 14, 2008
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Estimates of Subprime Potential Losses as of
March 2008 US945 Billion
(In billions of U.S. dollars)
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Figure 1.13. Expected Bank Losses as of March
2008
(In billions of U.S. dollars)
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Total Write-Offs and Capital Injection in Banks
(In billions of U.S. dollars)
Source IMF, April 02, 2008
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Table 2.2. U.S. Subprime Exposures and Losses
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Table 1.2. Typical Haircut or Initial Margin
(In percent)
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Figure 1.18. U.S. Funding Market Liquidity
(In billions of U.S. dollars)
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Table 1.6. Global Bank Losses as of March 2008
(In billions of U.S. dollars)
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Box 2European and U.S. Structured Credit Issuance
(In billions of U.S. dollars)
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Technical Arbitrage increases Volatility
Fundamental Traders Fail to Arbitrage Technical
Pattern
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Figure 3.3. United States Selected Money Market
Spreads
(First difference in basis points)
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Figure 3.4. United States SP 500Stock Market
Returns and Aggregate Bank Credit Default Swap
(CDS) Rate
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Figure 1.15. Systemic Bank Default Risk
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Figure 1.33. Impulse Response of U.S. GDP to
Credit Shocks
(In percent, year-on-year)
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Box 3.5. Central Bank Counterparties
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Implication for Chinese banks

• Chinese banks subprime exposure relatively small
• However, Sub-prime crisis leading to Global real
  economy slowdown
• Overall market risks, including volatility, are
  rising
• Market risk management, credit risk and liquidity
  management cannot be separated
• Issue is total risk management understanding and
  risk management system
• There will be considerable stresses on the IT and
  risk management systems of Chinese banks as they
  manage through a difference phase of the economic
  cycle

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IIF Response

• Global banks acknowledged major points of
  weaknesses in business practices, bankers pay
  and risk management.
• Conflicts of interest in bankers pay
• Over-reliance on models
• Inadequate protection against liquidity shortages
• Failure of rating agencies
• Dangers of mark-to-market accounting in times of
  illiquidity

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• Thank You
• Questions to as_at_andrewsheng.net