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Understanding the Financial Crisis 20072009

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Title: Understanding the Financial Crisis 20072009


1
Understanding the Financial Crisis 2007-2009
  • Professor Paul Mizen
  • Centre for Finance and Credit Markets, University
    of Nottingham

2
Background
  • Low short-term and long term interest rates
    occurred for several reasons
  • - inflation was low and stable
  • - the action by FOMC in response to the dotcom
    bubble, 9/11 and the 2001-2 recession reduced
    short rates
  • - the long term rates were low because there was
    a global savings glut (Asia, Oil economies)

3
Great Moderation in Inflation and Short-term
Interest Rates
Source Bank of England
4
Background
  • Low interest rates encouraged several trends in
    financial markets driven by affordable borrowing
    for financial and non-financial sector.
  • growth of mortgage lending, and esp new segments
    such as subprime, Alt-A, Jumbo.
  • expansion of banks balance sheets using borrowed
    funds from wholesale markets rather than deposit
    base.
  • new market for securitised financial products
    such as RMBS, ABS, ABCP and move to originate
    and distribute model.

5
Three-Phase Crisis Phase 1
  • The first phase of the crisis occurred from Aug
    2007 February 2008, with difficulties at
    overstretched financial intermediaries
    Countrywide, Dillon Reed (US), IKB (Germany),
    Paribas (France), Northern Rock (UK)
  • Interbank spreads widened,
  • asset backed financial products faced dramatic
    reduction in traded volumes.

6
Three-Phase Crisis Phase 2
  • The second phase of the crisis occurred from
    March 2008 October 2008, following the near
    collapse of Bear Stearns
  • US Treasury engineered a rescue by JP Morgan,
    taking 29bn of assets onto its books
  • Interbank spreads which had moderated widened
    again
  • Insurance costs in the CDS market increased.

7
Three-Phase Crisis Phase 3
  • The third phase of the crisis occurred from Oct
    2008 present, beginning with bankruptcy at
    Lehman Brothers. This was more severe than
    earlier phases because
  • All investment banks were seen as vulnerable and
    took steps to merge with stronger partners or
    become bank holding companies
  • Of the top financial companies in the SP 500 by
    asset holdings, 47 hold 95 of the assets, 22
    required capital injections under the TARP, 33
    sought assistance through this or other means.
  • Interbank spreads widened much further as LIBOR
    spiked and official rates were cut very sharply.

8
Special Features
  • I would like to discuss some special features of
    the financial crisis relating to
  • Securitisation
  • Leverage
  • Transmission

9
Feature 1 Securitisation
  • Securitisation allows originators of loans,
    mortgages etc to re-package the assets and sell
    them to investors.
  • It is not new but it has become much more
    extensive in the last decade.
  • The process was engineered by Special Purpose
    Vehicles (SPVs) which were off-balance sheet
    entities of banks.
  • By pooling assets it was thought risk could be
    diversified.
  • Investors could select tranches with preferred
    return-risk combinations.

10
Securitisation
  • Yields on conventional assets were low, but
    returns to investors in structured financial
    products were high. Banks bought them through
    conduits and Special Investment Vehicles (SIVs).
  • Demand for ABS, RMBS etc drove arrangers/issuers
    to demand more financial assets to securitise.
  • Brokers and originators sought to expand the
    number of mortgages by lowering the thresholds
    for loan agreements this caused rapid growth in
    sub-prime, Alt-A and jumbo mortgages.

11
Subprime mortgage growth
12
Securitisation
  • The originate and distribute model meant
    originators/arrangers did not hold these assets
    on their balance sheets
  • Provided they could re-package the assets in
    securitised form, and ratings agencies rated them
    at appropriate attachment points investors
    would purchase.
  • Rating agencies drew additional fees to advise
    arrangers how to meet attachment points.
  • If securitised products were rated below these
    points they could be combined with other low
    rated ABSs to form CDOs or CDOs-squared.

13
Securitisation
  • Subprime mortgages are more risky than prime
    mortgages, and eventually the extent of the risks
    behind securitised products became apparent.
  • Sub-prime mortgages had higher default rates
    because borrowers were often given low teaser
    rates that would re-set after a period of time.
  • While house prices were rising, borrowers could
    remortgage and attach to a new teaser rate, but
    when prices stagnated and then fell, they could
    not and defaults increased.

14
Delinquency rates on US mortgages
15
Sub-prime Mortgage Delinquency Rates by Originator
Source Bank of England, Bloomberg. (a) 60
days delinquent, including foreclosures for loans
originated in 2005 H2.
16
Securitisation
  • Originate and distribute model did not eliminate
    the risks, if anything it concealed them.
  • There are many places where information can be
    lost in the securitisation process.
  • Incentives of brokers/originators/arrangers are
    distorted.
  • The modelling of risk by ratings agencies that
    labelled the products was faulty, assuming house
    prices would continue to rise.

17
Information Asymmetries
18
Securitisation
  • Conduits and SIVs funded their purchase of ABSs
    with short term paper such as Asset Backed
    Commercial Paper (ABCP).
  • Funding for these products was rolled over
    regularly, often weekly or monthly.
  • When it was know that the collateral assets
    behind the ABSs was falling in value, and risks
    were increasing, ABCP and ABS issuance dropped.

19
Commercial Paper Issuance in the US
20
Global Issuance of ABSs
Sources Bank of England, Dealogic and Sifma.
21
Securitisation
  • In the first phase, it was largely for this
    reason that BNP Paribas (France), IKB (Germany),
    and Bear Stearns (US) failed to find short-term
    funding and needed to be rescued.
  • Banks used their own funds to finance their
    SIVs/Conduits in the short-term but this meant
    lending to other banks on the inter-bank market
    dried up. LIBOR rose sharply.
  • Markets providing insurance against default also
    showed signs of strain as CDS premia jumped.

22
LIBOR-OIS spreads
23
Feature 2 Leverage
  • A defining feature of the crisis has been the
    extent of leverage and its management in the
    financial sector
  • Consider a comparison between the largely passive
    household investors and active investors e.g.
    investment banks, hedge funds etc

24
Passive household investors
  • Leverage and asset values are inversely related.
  • Take a balance sheet as follows

25
Evidence from US
26
Active Investors
  • Financial institutions actively manage balance
    sheets so as to
  • meet performance measures such as return on
    equity for shareholders
  • ensure they obtain good credit ratings
  • meet regulatory requirements
  • meet their own value at risk or capital targets

27
Active Investors
  • Suppose we start with a balance sheet such as
  • If asset values rise by 1
  • In the first case leverage is 10, but in the
    second case leverage falls to 9.18
  • If the active investor is seeking to maintain
    leverage at 10 then it must increase debt by 9
    and purchase securities worth 9

28
Active Investors
  • In an effort to maintain high leverage active
    investors in the financial sector continue to
    purchase assets using debt as asset values rise
  • Provided house prices rise, mortgage backed
    assets will also rise in value and if mortgage
    backed assets comprise a large share of the
    portfolio this will expand the balance sheet on
    both sides.

29
Active Investors
30
Active Investors
31
Leverage
  • In an effort to maintain high leverage, financial
    institutions bought asset backed securities
    composed of subprime mortgages, credit card debt,
    uncollateralised loans etc
  • They funded this activity using short-term debt
    using the assets as collateral in ABCP markets
  • 49 of sub-prime mortgages were held by the
    leveraged financial sector
  • This explains how 1.2tr sub-prime mortgages
    could exert such a large effect in a 12tr
    mortgage market.

32
Deleveraging the costs
  • Leverage for investment banks was in the region
    of 30 at the start of the crisis de-leveraging
    has since become a major objective
  • Greenlaw et al illustrate how deleveraging
    affects the available credit in the economy
  • They begin by creating a balance sheet for
    individual banks and aggregating up.

33
Greenlaw et al. (2008)
  • Individual banks borrow and lend from each other,
    but in aggregate (capitals) these cancel
  • Aggregate debt and equity equal total assets, and
    by accounting identities are related to leverage
    (H/A), deposit/asset ratio (A/E) and equity
    values E.

34
Greenlaw et al. (2008)
  • Estimated contraction in credit based on losses
    covered by a capital injection (k) and decline
    in leverage.
  • Top panel total contraction including to fin.
    intermed. (tr) bottom panel contraction for
    end-borrowers (tr)

35
Feature 3 - Transmission
  • Functioning of financial markets has been
    impaired by the crisis
  • Banks that relied on wholesale funding were
    unable to obtain it, except at much higher rates
  • Uncertainty about the value of assets was
    largely responsible for illiquidity in inter-bank
    markets
  • Banks sought to conserve cash both to meet needs
    of SIVs/conduits and to meet their own funding
    needs
  • Mortgage defaults continued to rise and house
    prices fell and the real economic situation
    worsened.
  • Insurers that would have provided cover against
    default could not deal with the scale of the
    problem.

36
Financial Accelerators and Decelerators
  • The credit channel is critical to the story.
  • In good times, rising asset markets raise balance
    sheet valuations supporting new borrowing backed
    by collateral. Financial accelerator.
  • In bad times, this goes into reverse. Falling
    asset valuations undermine collateral value and
    confidence, reducing access to credit as
    suppliers limit lending. Financial decelerator.

37
Two Other Factors
  • Two other factors compound the problem in the
    present crisis
  • Banks face a funding problem as a) interbank
    markets have re-priced the cost of short term
    liquidity, b) they attempt to deleverage, and c)
    they seek true valuations of their assets.
  • A deterioration in the real economy reduces other
    indicators of creditworthiness such as
    profitability, buoyant order book, etc

38
A Vicious Circle
  • There is a vicious circle
  • - Lending cannot be supported due to combination
    of liquidity constraints, uncertainty and
    economic conditions
  • Lack of lending adversely affects economic
    conditions and uncertainty
  • CB provisions to increase liquidity and reduce
    uncertainty break the cycle but take time.
  • the depth and length of a world recession
    increases uncertainty.

39
Policy Responses
  • Central Banks
  • Very quickly central banks converged on a common
    short-term approach to the crisis through
  • the rapid adjustment of short term interest rates
  • co-ordinated activity to provide liquidity to the
    markets (c.f. swap arrangements between US
    Federal Reserve and ECB, SNB, BoE and more
    recently Asian central banks).
  • innovation in liquidity provision to the markets.

40
Policy Responses
  • Innovation in liquidity provision in the United
    States (beginning with relatively conventional
    and becoming more innovative)
  • Primary Dealer Credit Facility liquidity
    directly to PDs
  • Term Securities Lending Facility weekly term
    lending to offer Treasuries on 1-month loan
  • TAF (term auction facility) term lending in
    fixed amounts via auctions against a wide range
    of collateral

41
Policy Responses
  • ABCP-MMMF-LF (ABCP Money Market Mutual Fund
    Liquidity Facility) funding to U.S. banks to
    finance high-quality ABCP from MMMFs.
  • CPFF (Commercial Paper Funding Facility)
    purchase of highly rated unsecured and ABCP as a
    liquidity backstop to US CP issuers.
  • MMIFF (Money Market Investor Funding Facility)
    provide liquidity to U.S. money market investors
  • TALF (term asset-based security lending facility)
    direct lending facility to holders of ABS
    backed by car loans, credit cards, student loans
    etc.

42
Policy Responses
  • Purpose?
  • - To provide liquidity at appropriate maturities
    to reduce LIBOR-OIS spreads
  • - To facilitate price discovery in markets that
    were not functioning i.e. markets for structured
    products ABCP, ABS, RMBS.
  • Success? Limited.

43
Policy Responses
  • LIBOR-OIS spreads
  • Provided liquidity but did not raise interbank
    lending (much) 3m LIBOR-OIS spread peaked at 300
    basis points in October 2008 and is currently
    still over 150 basis points. Note prior to July
    2007 it was 10 basis points.
  • The challenge for central banks is to determine
    why wide spreads have persisted.

44
Policy Responses
  • Pass through of interest rates
  • Governments and central banks have urged lenders
    to pass on rate cuts, but in the UK and the
    euroarea where we can measure pass through more
    easily than in the US, there is little evidence
    of pass through occurring.
  • Why the need for direct action? Why have
    liquidity operations not been sufficient?
  • Near zero rates compress loan-deposit spreads
    reducing banks ability to recapitalise.

45
Policy Responses
  • Price discovery.
  • FRB Governor, Randy Kroszner suggests price
    discovery will be improved with more data on
    risks, better models, better understanding of
    model properties and more transparency.
  • It is hard to disagree given that failure of
    these aspects has been central in the recent
    crisis.
  • Will they be sufficient or are these markets
    unlikely to revive? And how long will it take?

46
Issues
  • The financial crisis has raised a number of
    issues that need to be reconsidered over the
    longer term
  • Asymmetric information
  • Regulatory environment
  • Standards for ratings agencies
  • Accounting standards

47
Information Provision
  • As Randy Kroszner has said more information is
    required. Not just more information structured
    products were issued with 300 page prospectuses
    full of information. Two issues
  • recognition that there were information gaps
    where the vital details about the risk
    characteristics of products, their structure etc
    were not passed up the chain
  • need for regulation of the format of information
    to ensure information is accessible and easily
    digested. This should cover all kinds of
    financial instruments not just structure products.

48
Regulation of Banks
  • - Competition between financial centres prompted
    a move to a regulation-lite (principles-based
    regulation) environment which will probably be
    revisited
  • - Banks were not just moving to low regulation
    environments by relocating their activities, they
    were taking business into areas of low regulation
    through use of off-balance sheet entities (SIVs
    and conduits).
  • - There needs to be a review of the treatment of
    capital requirements for off-balance sheet
    entities as well as commercial and investment
    banks

49
International Co-ordination
  • The Financial Stability Forum (BIS) has mooted
    rule changes to capital requirements for
  • structured products
  • warehoused assets awaiting sale
  • liquidity provisions for off-balance sheet
    entities
  • This is welcome, but need also to keep informed
    of the market innovations to ensure rules
    continue to adapt and do this without stifling
    innovation. Better regulation, not just more.

50
Ratings Agencies
  • - Rating agencies will probably face regulatory
    changes in the US. At present they defend their
    activities as published opinions.
  • - The SEC in the US confers a nationally
    recognised status, but stops short of setting
    standards the FSF issues a code of conduct, but
    we need more than this.
  • - In asymmetric information environment
    provision of information and its interpretation
    is key needs a framework and standards.
  • - Improvements in the modelling process needed
    for rating structured products.

51
Fair-Value Accounting
  • The FASB standard requires fair value accounting
    for derivatives, similarly EU since 2005
  • market measure of asset values are current not
    historical.
  • true prices are hard to discover when markets
    have impaired function.
  • when prices fall, realised asset values can
    trigger sales creating a downward spiral.
  • As a result
  • FASB proposed 3-levels approach level-1 market
    inputs level-2 some market inputs level-3 none.
  • Alternative is intents approach if intention is
    to sell then they should be marked to market, if
    for investment then they need not be.
  • Consider the economic consequences of decisions
    on accounting standards, and research their
    impact.

52
Conclusions
  • The crisis has had three distinct phases Aug
    07-Feb 08 Mar 08-Sept 08 and Oct 08 present.
  • There have been three unique features of this
    crisis securitisation, leverage and
    transmission that have altered the dynamics
    compared to previous crises.
  • Policy has needed to respond quickly to unfolding
    events, but some long term issues need to be
    addressed at an international level.
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