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Anatomy of the global financial crisis

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Title: Anatomy of the global financial crisis


1
Anatomy of the global financial crisis
  • International Finance - IMB
  • Vasja Rant, PhD
  • 6 May 2009

2
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?

3
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

4
Origins narrow viewCollapse of the house-price
bubble (1)
5
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!

6
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.

7
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
8
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
9
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)
10
Origins narrow viewResidential mortgage
products
  • GREATER RISKS
  • Flexible payments increase chances of terminal
    default.
  • Debt servicing may increase 15-30 upon FRM/ARM
    resetting.

11
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
12
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).

13
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).

14
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)

15
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

16
Origins broad viewMacroeconomics saving
imbalances (1)
17
Origins broad viewMacroeconomics saving
imbalances (2)
18
Origins broad viewMacroeconomics equity
yields
19
Origins broad viewMacroeconomics interest
rates
20
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!

21
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

22
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

23
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
24
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

25
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
26
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
27
TransmissionSecuritization risk transfer (3)
28
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).

29
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

30
TransmissionStructured finance portfolio ratings
underlying claims
31
TransmissionStructured finance funding profile
ABCP underlying claims
32
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).

33
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

34
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
37
TransmissionIncrease in risk aversion (3) from
derivatives to corporate debt market
38
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!

39
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.

40
TransmissionIncrease in banks credit and
liquidity risk
41
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)

42
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

43
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.

44
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.

45
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.

46
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)

47
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

48
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

49
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.

50
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)

51
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.

52
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.

53
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.
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