The 20072008 crisis

1
The 2007-2008 crisis

• Notes for Macrorisks course Università di Milano
  Bicocca
• Based on Brunnermeier 2009 - JEP

2
Introduction

• The paper tries to explain the mechanisms that
  caused losses in the mortgage market and the
  threads that can explain the generalised market
  decline
• The US were experiencing low interest rates,
  large capital inflows (especially from Asia)
• The FED did not counteract the build-up of the
  housing bubble, while the banking system went
  through an important evolution towards the
  originate to distribute model
• The creation of new securities (new asset types)
  facilitated the large capital inflows from abroad
  (remember Caballero?).

3
Banking industry trends

• Instead of holding loans on their balance sheets,
  banks moved to an originate and distribute
  model, packaging loans and selling these packages
  to other financial investors, offloading risks
• Banks increasingly financed their assets with
  short maturity instruments, exposing themselves
  to maturity mismatch and liquidity risk
• To offload risks structured products were created
  (typically CDOs)
• CDOs were sliced into different tranches and sold
  to investors with different risk appetite (super
  senior, senior, mezzanine, equity or toxic)
• Buyers of these tranchescould protect themselves
  through CDS (also on indexes, e.g. CDX or Itraxx).

4
Maturity mismatch

• Investors prefer assets with short maturity
  (focussing on short term performance), but
  mortgages and other investment projects have long
  maturities (years)
• Often (unfortunately) this time mismatch was
  transferred to a shadow banking system, such as
  off-balance sheet vehicles and conduits, which
  raise funds by issuing 90-days notes backed by
  long term assets, which can be seized and sold by
  owners in case of default
• This practice exposes vehicles to funding
  liquidity risk, that is solved by banks
  granting credit lines to their sponsored
  vehicles
• At the end of the day, it is always banks which
  bear the risk which, however, is hidden away from
  the balance sheet of banks
• Regulatory advantages and infrequent portfolio
  revaluation.

5
The unfolding of the crisis

• The trigger for the liquidity crisis was an
  increase in subprime mortgage defaults, first
  noted in February 2007

6
ABCP vs. non-ABCP

• Initially, only the asset backed commercial paper
  market was affected by the unfolding of the
  crisis

7
LIBOR, Repo and TED

• In addition to commercial paper, banks use repo
  markets, the Fed funds market and the interbank
  market to finance themselves
• Repurchase agreements (Repos) allow collateral
  funding, Fed funds rate is the overnight rate at
  which banks lend reserves to each other to meet
  the central banks reserve requirement and LIBOR
  is the interbank rate at which commercial banks
  lend to each other which is the highest rate?
• TED is the difference (spread) between the risky
  LIBOR (counterparty risk) and the risk free US
  Treasury bill rate in times of liquidity crisis
  this spread widens for two reasons. Which
  reasons? Why?
• The wider the TED, the worse the liquidity crisis.

8
The TED spread
9
The unfolding of the crisis

• As the default rates on mortgages started to
  increase and banks started to refrain from
  trusting each other, the crisis became extremely
  serious
• Various interventions of the Fed through rates
  cuts and rescue packages did not prevent the
  crisis from fully unfolding and causing various
  important defaults such as that of Bear Sterns,
  Lehman Brothers, etc
• Banks, and their vehicles and conduits, could not
  finance themselves any more and the liquidity
  mismatch described above became unsustainable.

10
The risks at work

• Funding liquidity risk can take three forms
• Margin or haircut funding risk
• Rollover risk
• Redemption risk (bank runs and funds withdrawals)
• Low market liquidity
• Wide bid-ask spread
• Shallow markets
• Market resiliency
• Network risk (all banks and financial
  institutions are lender and borrower at the same
  time)

11
The liquidity spiral
12
Conclusions and policy implications

• An increase in mortgage delinquency precipitated
  the crisis
• The crisis, which is still going on, was
  exacerbated by the extensive use of
  securitization and interconnected obligations
• The issue of a new financial architecture and a
  new regulatory framework is a good starting point
  to address these problems of fire-sale
  externalities, network and domino effects.