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The Role of Financial Innovations in the Current Global Financial Crisis The 2009 Economics Joint Co


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Title: The Role of Financial Innovations in the Current Global Financial Crisis The 2009 Economics Joint Co

The Role of Financial Innovations in the
Current Global Financial Crisis The 2009
Economics Joint ConferenceSeoul, Korea
  • Presented by
  • Yoon-shik Park
  • Professor of International Finance
  • George Washington University
  • February 12, 2009

Conventional Explanation for the Causes of the
Current Crisis
  • Global imbalance between the U.S. and the rest of
    the world, especially East Asian countries such
    as China and Japan.
  • Massive FX reserves accumulated in East Asia were
    promptly recycled back to the U.S., resulting in
    excessive liquidity there. The flood of foreign
    capital into the U.S. lowered interest rates,
    inducing Americans to run down their own savings
    and to keep spending.
  • U.S. FRBs prolonged low interest rate policy
    also contributed to the crisis by encouraging
    banks and investors around the world to search
    for high yields at greater risks.
  • Strong U.S. political pressure for home
    ownership, even in low-income areas, eventually
    leading to widespread subprime mortgage lending.
  • To top it off, Wall Street greed and incompetence
    have also been blamed for the crisis.

Alternative Explanation for the Causes of the
Current Crisis
  • However, the world had lived with global
    imbalances in previous decades without
    necessarily having a massive global crisis.
  • A deeper reason can be found in the phenomenal
    growth of finance in recent decades compared to
    the real sector of the economy. The share of the
    profits of the financial services industry in the
    United States rose from 10 of total corporate
    profits in early 1980s to 40 in 2007, four times
    in less than 3 decades.
  • Such a rapid growth in the financial sector has
    been made possible through revolutionary new
    financial products and techniques. Overall,
    financial innovations have played a constructive
    role in global financial markets, where their
    scale of magnitude can be estimated at (as of mid
  • Daily FX trading volume almost 4 trillion (20
    trillion a week!)
  • Outstanding derivatives (in NPAs) 767 trillion
  • In recent years, there had been an increasing
    abuse of new and sophisticated financial
    innovations. Even if only a small portion of
    such a massive market is misused, it can result
    in catastrophic losses for impacted financial
    institutions and investors.

Explosive Growth of Subprime Mortgage Loans
  • The current global financial crisis began in the
    summer of 2007 as a subprime mortgage crisis in
    the United States.
  • Prior to 2007, there was a phenomenal growth in
    new mortgage loans in the United States,
    including subprime mortgage loans such as no doc
    (documents) loans, liars loans, ninja (no
    income, no job and no assets) loans.
  • 2001 2002 2003 2004
    2005 2006
  • Total mortgage originations (tn) 2.21 2.89
    3.95 2.92 3.12 2.98
  • Subprime mortgage loans (bn) 190 231
    335 540 625 600
  • SM loans as of mortgages () 8.6 8.0
    8.5 18.5 20.0 20.1
  • SM-backed securities (bn) 95 121 202
    401 507 483
  • Meanwhile, the delinquency rate on subprime
    mortgage loans rose from around 11 in 2004 to
    19 in 2008.

? ??????? ? ??? 1 ?? (2007? 8? 2008? 9? 7?)
Subprime Mortgage Crisis
  • 1st half of 2007 The market for subprime
    mortgage-related securities started to crack due
    to the burst of U.S. housing market bubble.
  • 8/07 Subprime mortgage crisis produced its first
    financial casualties when two German banks (IKB
    and SachsenLB), that had invested heavily in
    subprime mortgage-related securities through
    their off-balance sheet vehicles and suffered
    huge losses, had to be bailed out by the German
  • 9/07 Northern Rock, Britains 5th largest
    mortgage lender, experienced liquidity crisis,
    triggering the first British bank run in 150
  • 3/08 Bear Sterns had to be merged with JPMorgan
    Chase and, since then, other financial
    institutions had to announce huge write-downs of
    their subprime mortgage-related investments.
  • At this first stage of the crisis, however,
    mostly long-term bonds were affected including
    MBS, CMOs, CDOs and the 330 billion auction-rate
  • Subprime mortgage crisis appeared to reach its
    climax with the U.S. government rescue of Fannie
    Mae and Freddie Mac on 9/7/08.

? 2 ?? (9? 15? ??) Global Financial Market
  • 9/15/08 New financial crisis started with the
    bankruptcy of Lehman Brothers, which had 700
    billion assets and 740 billion in derivatives
    contracts with over 5,000 counterparties around
    the world.
  • On the same day, September 15, Merrill Lynch was
    merged into BOA through stock swap worth 50
    billion. On the next day, September 16, the
    worlds largest insurance company AIG was bailed
    out by the U.S. government with 2-year 85
    billion loan from the FRB at the punitive
    interest rate of 3-month LIBOR plus 8.5. (AIG
    received 152 billion so far from the
  • Eurodollar inter-bank market frozen (3-month
    LIBOR doubled) 3.5 trillion MMFs, 1.3 trillion
    CP market, and 58 trillion CDS market also
  • On 9/21, both Goldman Sachs and Morgan Stanley
    were turned into BHCs, thus ending the 75-year
    history of U.S. mono-line investment banks.
  • On Friday, October 3 (after initial failure on
    9/29), Congress passed 700 billion bank bailout
    package, but the U.S. stock market experienced
    the worst weekly decline of 18 the following

???? (Too-Big-To-Fail) ?? ??? ? ????
  • The crisis was born in excess liquidity due to
    easy monetary policy (especially during the
    Greenspan era) and the government policy to make
    mortgage loans easily available to low-income
    areas (the first cause of subprime mortgage
  • But much of the blame for the current global
    financial crisis should be placed on both the
    abuse of financial innovations by Wall Street and
    the regulatory failure in the U.S. as the
    government ignored the too-big-to-fail (TBTF)
  • 1984 Continental Illinois Bank (7th largest with
    45 billion assets) was saved by the government.
  • 1998 LTCM (Long Term Capital Management) hedge
    fund (with 120 billion assets) was bailed out.
  • 2008 Lehman Brothers (4th largest investment
    bank with 700 billion assets and 740 billion
    derivative contracts outstanding) was allowed to
    fail, even though BOA was willing to take over
    with 65 billion cover for losses (as in the Bear
    Stearns takeover by JPMorgan Chase with 29
    billion cover by the U.S. for possible losses).
  • ?? ?? ?? Lame-duck ?? ?? 3? Bear Stearns, 9? 7?
    Fannie Mae? Freddie Mac? ????? ?? ??? ?? ??? ????.

U.S. Regulatory Problems in the Financial Crisis
  • Unlike the unified regulatory framework in other
    advanced countries (FSA in UK, FSA in Japan, FSC
    in Korea, etc.), the US financial regulatory
    system is antiquated.
  • 6 Federal regulatory agencies (OCC, FRB, FDIC,
    OTS, CFTC, SEC) for commercial and investment
    banks, plus 50 state regulators.
  • No Federal regulator for the insurance industry,
    with only 50 state regulators for insurance
  • Regulatory asymmetry Commercial banks have been
    more tightly regulated than investment banks,
    encouraging the latter to higher and riskier
    leverage and trading in esoteric financial
  • US regulators such as SEC were more relaxed
    towards investment banks in terms of capital
    ratios and others, unlike commercial banks
    accepting deposits from the public.

Fair Value Accounting in the Current Financial
  • In the aftermath of the U.S. SL crisis in the
    1980s and the Japanese banking crisis in the
    1990s, both FASB and IASB adopted fair value (or
    mark-to-market) accounting. In late 2007, SEC
    required all U.S. companies to adopt the
    mark-to-market accounting standards.
  • When there are no normal market activities during
    a financial crisis, M-T-M accounting is
    pro-cyclical, as some assets are disposed at
    fire sale prices to raise cash and thus forcing
    all the similar asset classes in the industry to
    be written down.
  • As asset write-downs reached hundreds of billions
    dollars, banks have been forced to further
    liquidate other assets to raise cash and to meet
    the BIS capital adequacy ratios.
  • For example, 1 billion write-down due to the
    M-T-M accounting rule leads to 10 billion
    reduction in loans due to a typical 10-to-1
    leverage ratio maintained by banks.
  • US regulators such as SEC should have suspended
    the fair value accounting at the beginning of the
    current crisis, thus preventing the further
    deterioration of financial markets.

Major Financial Market Liberalization
  • In addition to the macroeconomic missteps
    mentioned earlier, series of global financial
    deregulations also played a part.
  • U.S. May Day in 1975 removed fixed brokerage
  • U.K. Big Bang in 1986
  • Abolition of fixed brokerage commissions.
  • Opening up U.K. exchanges to outsiders.
  • Replacement of trading floor by computers.
  • New competition in gilts trading.
  • Easier to have MAs among financial firms.
  • Japanese Big Bang in 1996 Gradual deregulation
    of Japanese financial markets.

Transformation of the U.S. Financial System
  • 1933 Glass-Steagall Act was passed, separating
    commercial banks from investment banks. For
    example, in 1934 J. P. Morgan Co. was split
    into Morgan Guaranty Trust commercial bank
    (todays JPMorgan Chase) and Morgan Stanley
    investment bank (IB).
  • Commercial banks relied on deposits to fund loans
    and earned interest income, while investment
    banks depended on stock brokerage commission
  • 1975 The May Day financial deregulation in the
    U.S. removed fixed stock brokerage commission
    rates, pushing IBs to look for alternative
    revenue sources. IBs leveraged their capital up
    to 30 or more times to engage in proprietary
    trading and private equity investments , and they
    also developed and traded esoteric financial
    products for a high risk-high return strategy.
    Their strategy worked until 2006, when the total
    bonuses at Wall Street firms amounted to 62
  • 1999 Glass-Steagall Act was repealed, allowing
    commercial banks to merge with investment banks
    and even insurance companies to form universal
    banks (Citigroup model). Since 1999, many Wall
    Street investment banks disappeared. By the early
    2008, only five investment banks were left in
    Wall Street Bear Stearns, Lehman Brothers,
    Merrill Lynch, Morgan Stanley, and Goldman Sachs.
  • Universal banks are more competitive than
    investment banks due to their stable deposit base
    and, with less leverage, less prone to liquidity

Problem with Credit Rating Agencies
  • Rating agencies are paid by underwriters of the
    asset-backed securities such as MBS and CDOs
    after the issue.
  • Rating agencies play an active role in
    structuring securitization before the issue so
    that the rated securities can obtain the highest
    possible ratings. (As in the case of Arthur
    Andersens conflict of interests between auditing
    and consulting in the Enron scandal, conflict of
    interests between rating and consulting for the
    rating agencies.)
  • Grade inflation therefore is likely to take
    place. Investment-grade securitized products
    experienced 10 times the default rate of the
    same-grade regular bonds over 1983-2005.
  • Banks, pension funds and insurance companies
    require minimum ratings for their eligible
    investment securities, thereby increasing the
    demand for highly rated securities.

Assets-backed Commercial Paper (ABCP)
  • ABCP first emerged in the 1980s and it became a
    significant source of funding in the 1990s. The
    outstanding volume of ABCP was under 50 billion
    in 1992, but it reached 1.3 trillion by 2007.
  • ABCP is short-term CP issued by an SPV (special
    purpose vehicle) backed by assets, and it trades
    like conventional commercial paper.
  • The SPV used in ABCP is known as a conduit or
    SIV, which is usually sponsored by a commercial
    bank to issue ABCP.
  • ABCP became popular with many money market funds,
    one of which, Reserve Primary Fund established by
    pioneer Henry Brown, started to invest in CP in
    early 2006. This fund broke the buck due to
    its loss on Lehman Brothers CP and triggered a
    crisis in the 3.5 trillion money market funds.

Liquidity Squeeze in the ABCP Market
  • Many financial institutions set up structured
    investment vehicles (SIVs) or conduits to issue
  • SIVs and conduits raised short-term funds through
    ABCP in order to invest in long-term and
    higher-yield securitized products such as CMOs,
    MBS or CDOs backed by subprime mortgage loans.
  • SIVs and conduits were not shown on the balance
    sheet of the sponsor banks.
  • Citigroup, for example, set up many SIVs with
    combined total assets of over 100 billion.
  • German Landesbanks lost state guarantees in 2005,
    thus becoming active in SIVs and conduits in
    order to enhance their earnings, resulting in
    SachsenLB and IKB fiascos.

Asset Securitization Origin of the Crisis
  • Securitization packaging illiquid assets into
    marketable securities. It can take place in two
  • Pass-through securities (certificates of
    ownership or participation certificates)
    Investors have ownership interest in the
    collateralized assets. Examples are MBS
    (mortgage-backed securities), ABS (asset-backed
    securities), CARs (certificates for automobile
    receivables) and CARDs (certificates for
    amortizing revolving debts).
  • Pay-through securities (collateralized debt
    obligations) Investors do not have any ownership
    interest in the collateralized assets but their
    securities are serviced by the cash flows
    generated by the assets. Examples are CMOs
    (collateralized mortgage obligations) and CDOs
    (collateralized debt obligations).

History of Mortgage Loan Securitization
  • Mortgage-related securitization MBS and CMOs
  • Non-mortgage securitization ABS
  • 1970 GNMA (Ginnie Mae) pioneered MBS, which are
    pass-through securities on mortgage loans.
  • 1983 FNMA (Fannie Mae) marketed the first CMOs,
    which are pay-through securities on mortgage
  • 1985 first ABS was marketed by Sperry Lease
    Finance Corp. backed by its computer lease

Volume of Securitization
  • By 2007, over half of non-financial debt in the
    U.S. was securitized, compared to just 28 in
  • As of end-2007, compared to 7 trillion of
    government debt securities held by the public and
    international investors, 10 trillion of
    securitized instruments outstanding (8.3
    trillion of MBS and CMOs, and 1.8 trillion of
  • New issue of mortgage-related securitization (in
  • 1996 2000 2005 2006 2007
  • Total issues 508 708 1,966 2,003 1,351
  • Non-agency issues 52 102 646 773

CDOs (Collateralized Debt Obligations)(The Real
Villain of the Current Crisis)
  • CDOs are called structured finance products and
    packaged as pay-through securities.
  • CDOs first emerged in the 1990s due to banks
    desire to off-load high risk loans such as
    leveraged loans used in MAs.
  • Wall Street firms acting as CDO underwriters
    earned fees of 2.5 3.5.
  • Merrill Lynch alone launched about 150 billion
    CDOs during 2004-07, earning fee income of over
    5 billion. Citibank, Bear Stearns and other U.S.
    banks made tons of money the same way.
  • Wall Street investment banks were eager to create
    and market more CMOs but their new volume was
    constrained by the availability of mortgage loans
    which are used as the collaterals for CMOs.
  • Wall Street had un-satiable appetite for more
    collaterals, thus resulting in an increasing
    demand for even subprime mortgage loans, and then
    Wall Street finally proceeded to create CDOs
    which do not need mortgage loans as collaterals.

CDOs and Subprime Mortgage Crisis
  • Collaterals for CDOs are three types
  • Mortgage loans plain vanilla CDOs
  • MBS, CMOs, and other ABS CDOs squared
  • Derivatives such as credit default swaps (CDS)
    related to mortgage loans synthetic CDOs
  • Thus, CDOs allowed Wall Street firms to issue new
    class of bonds without waiting for supplies of
    new mortgage loans.
  • CDOs were able to pay higher interest rates than
    comparably rated regular bonds due to their
    unique tranching (or layering) feature.
  • CDO issue volume ( billions)
  • 2004 2005 2006 2007 2008 (1st half)
  • 158 272 552 503 37

A Case Study of CDOs called Norma (1)
  • CDOs the key to understanding the origin of the
    current global financial crisis.
  • 3/07 Merrill Lynch launched 1.5 billion CDOs
    known as Norma. Normas collaterals carried an
    average of BBB ratings generating a yield of
    6.5, but Norma CDOs had 5 tranches
  • 75 (1,125 million) AAA
  • 9 (136 million) AA
  • 5 (74 million) A
  • 7.7 (115 million) BBB
  • 3.3 (50 million) un-rated
  • A modern alchemy performed by the wizards of Wall
    Street BBB-rated assets turned into 89 AAA, AA,
    and A-rated assets. (Similar to a class of 100
    students with average B grades magically turned
    into almost 90 students getting A grades!)

A Case Study of CDOs called Norma (2)
  • At that time, the actual bond market yields (and
    the differences from the 6.5 average yields of
    the Norma collaterals in and s for respective
    tranches) were
  • AAA bonds 5.3 (1.2, or 13.5 million)
  • AA bonds 5.66 (0.84, or 1.14 million)
  • A bonds 5.84 (0.66, or 0.49 million)
  • BBB bonds 6.27 (0.23, or 0.26 million)
  • Total additional interest income 15.4 million
    per year.
  • Even if the unrated 3.3 (50 million) tranche is
    paid 15 or 7.5 million per year, the remaining
    7.9 million can be distributed to the remaining
    upper tranches (1,450 million) for an extra
    yield of 0.54 or 54 basis points above the
    comparably rated bonds.

Reasons for CDOs Popularity among Investors
  • Too much liquidity in the financial market pushed
    asset managers around the world into intense
    competition for extra yield.
  • Higher investment returns led to more success for
    the investment manager in 2006, a Credit Suisse
    money market fund achieved an investment yield
    just 31 basis points higher than the industry
    average. The fund size increased from 1 billion
    to 26 billion in just 6 months in early 2007.
  • CDOs were the perfect investments of choice among
    asset managers hungry for higher yields to stay
  • Wall Street underwriters of CDOs such as Merrill
    Lynch and Citibank sold liquidity puts, which
    allow buyers to return CDOs later at the purchase
    price. (25 billion puts were exercised on
    Citibank alone.) They along with other firms
    such as UBS and HSBC also invested in CDOs for
    their own portfolios due to their high yields.
  • CDOs were able to provide higher yields through
    the magic of tranching in securitization and
    rating inflation due to willing cooperation of
    rating agencies eager for extra fee income.

Conduits and Structured Investment Vehicles
  • Both conduits and SIVs are established as
    separate legal entities by sponsoring banks in
    order to create off-balance sheet investment
    vehicles, as they are not consolidated into
    sponsor bank financial statements.
  • Conduits full credit back-up facilities from
    sponsor banks.
  • SIVs only partial or even no credit back-up from
    sponsor banks.
  • Conduits and SIVs issued ABCP at low short-term
    interest rates and used the proceeds to invest in
    high-yield long-term CDOs.
  • The first sign of the current financial crisis
    involved conduits set up by two small German
    banks, IKB and SachsenLB, which had to be bailed
  • Many conduits and SIVs were closed down, with
    their assets put on the balance sheets of sponsor
    banks which are thus further weakened financially.

Lessons from the Current Financial Crisis (Longer
  • High leverage ratios for investment banks should
    have been lowered by SEC to that of commercial
    banks (from 30 times to about 10 times equity
  • As securitization became wildly popular in the
    US, the regulator should have introduced the
    European-style covered bonds in lieu of the
    American-style securitization. In this way, the
    subprime mortgage loans would still be on the
    balance sheet of originating banks, motivating
    them to be selective in credit quality.
  • SIVs and conduits should have been required to be
    consolidated with the sponsor banks, thus
    injecting transparency in this murky area. In
    this way, the financial crises of IKB and
    SachsenLB would have been avoided, along with
    many other banks.

Lessons from the Current Financial Crisis (During
the Crisis)
  • From September 2007, when Northern Rock triggered
    the first British bank run in 150 years, or at
    least from October 2007 when mortgage-related
    securities were massively downgraded by major
    credit rating agencies, the U.S. SEC should have
    suspended the mark-to-market accounting rules
  • Banks could thus avoid massive write-downs which
    required further fire sale of securities in order
    to raise cash and to meet capital requirements
    and then still more write-downs at the new lower
    fire sale prices and so on in a vicious circle.
  • Lehman Brothers should have been bailed out like
    Bear Stearns. The government mistake here turned
    the original subprime mortgage crisis into the
    current global financial and economic crisis.
  • Regulatory dilemma choosing among the spectrum
    from lightly-regulated but highly innovative
    financial system to heavily-regulated but stodgy
    financial system a tradeoff between the costs
    and benefits.

Regulatory Failure in the AIG Case
  • There is no Federal-level insurance regulator
    instead the insurance companies are regulated by
    50 state governments in the U.S.
  • AIGs Financial Products subsidiary in London
    acted like an investment bank but without any SEC
    supervision since it is part of an insurance
  • From 1998, AIG sold more than 500 billion of CDS
    (credit default swaps) to hundreds of
    counterparties such as Merrill Lynch, Goldman
    Sachs, and others earning additional profits for
    AIG. Including CDS, AIG had outstanding total
    swap contracts worth 2.7 trillion with about
    2,000 counterparties as of 2008.
  • AIG simulation model predicted 99.9 probability
    of never paying out any money on its CDS
    contracts, which were bought by many banks who
    could save on their BIS capital ratio by turning
    their CDOs and other investments into AAA-rated
  • Furthermore, CDS was not considered an insurance
    product, so the New York State Insurance
    Commissioner did not exercise any supervision of
    AIGs CDS operations, which were run by a unit
    located in London as part of AIGs small French

????? ?? ???? ??
  • ?? ? ???? ??? ?? ????? ?? ???.
  • 2??? ?? ?? 60?? ????? 10?? Recession ??
    (excluding the current recession).
  • ?? ?? 10?? (??? 1973? ? 1981? recession? 16
  • ?? peak ??? 7.6 (?? 1981-82? peak 10.8)
  • ?? Recession? 2007? 12? ???? ?? 15?? ?? ?? ??
    ???? 1? ?? 7.6.
  • 2009 ???? ??? ????? ?? ?? 2??? ?? ???? 2?? 20???
    ???? Recession?? ??? ??.

Proactive Role of U.S. Federal Reserve
  • Between September and December of 2008, FRB
    injected 900 billion into the U.S. financial
    system (500 billion for banks, 270 billion for
    CP market, 70 billion for MMFs, 50 billion for
    investment firms)
  • FRB also lowered the Fed fund rate from 5.25 in
    the summer of 2007 to near zero (0 0.25) now.
  • FRB announced to inject another 800 billion
    (600 billion for mortgage-backed securities and
    Fannie Mae and Freddie Mac securities, and 200
    billion for student and car loans, etc.)
  • FRB has moved from LLR (Lender of Last Resort) to
    commercial banks to LLR to other financial firms
    (such as AIG) and even industrial companies
    (through its purchase of CP), as banks now
    account for a much smaller share of all lending
    in the U.S. Some even call FRB now as Lender of
    First Resort.
  • FRB has also become Investor of Last Resort (ILR)
    by directly buying shares of banks and insurance

Proactive Role of US Administration
  • U.S. Treasury Department has administered its
    700 billion TARP (Troubled Asset Relief Program)
    appropriation by injecting capital into banks and
    other financial institutions.
  • Congress and the new Obama Administration are now
    working on an economic stimulus package of about
    800 billion (almost 6 of GDP).
  • The Obama Administration just announced 2.5
    trillion bailout package for the U.S. financial
    system, including 350 billion TARP fund not yet
  • 2??? ?? ???? ??, EU ? G-20 ???? Synchronized ????
    ?? ??. (1930?? ?? ?? ? ???? ??.?? ??? ???? ?? ???
    ? ???? ?? ??? ?? ??).
  • ?? FRB, ?? ?? ? ? Obama ??? 3?? ???? ??? ??????
    ????? ?? ??? U-? ?? ?? ?? (2009 ??? ?? ????? ???
    ??? ??? ???? ?).

  • Thank You!
  • ?? ???!