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)

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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.

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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.

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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.

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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.

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Special Features

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

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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.

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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.

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Subprime mortgage growth
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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.

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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.
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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.

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Information Asymmetries
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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

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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.

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Active Investors
30
Active Investors
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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.

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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)

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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.

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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.

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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

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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.

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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.
  

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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.

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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.

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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.

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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.

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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?

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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

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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.

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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

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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.

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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.

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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.

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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.