Credit Crunch 101 by LSE faculty and students

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Credit Crunch 101by LSE faculty and students

• Part 1 Financial Market Developments

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Overview of today

1. Subprime mortgages
2. Mortgage-Backed Securities
3. CDOs and CDSs
4. Banks

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Subprime Mortgages
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Subprime Mortgages

• The federal objective of an ownership society
  through indirect and off-budget activities
  (mortgage insurance and guarantee programs
  through Fannie Mae and Freddie Mac ).
• Subprime mortgage
• loans to high risk borrowers with low or
  uncertain incomes and poor credit histories.
• Most are adjustable-rate mortgages (ARMs) such as
  2/28 or 3/27. Initial low interest rate, then
  rise to significant premium over the prime rates.
• Since 2000, the subprime grew at the expense of
  Fannie and Freddie (prime mortgages).

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Subprime Mortgages
Source Jaffee and Quigley (2007)
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Subprime Mortgages

• Essentially zero in 1993, grew to 20 by 2005.
• Regulations and deregulations (i) subprime
  became legal in 1980 (ii) securitization enabled
  lenders to spread risks more efficiently (iii)
  gave banks an incentive to make low- and
  moderate-income mortgages. (iv) tax reform
  prohibited interest deductions on consumer loans
  but allowed those on mortgages.
• Borrowers usually refinance (usually after two or
  three years) when they have to face higher
  interest rates. It works when house price is
  rising fast (1997-2006).

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Subprime Mortgages
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Subprime Mortgages

• Subprime Residential Mortgage-Backed Securities
  (RMBS)
• Different from traditional securitizations
  because subprime mortgages are expected to
  refinance after 2 or 3 years. So the risk
  inherent in the securitization of subprime
  mortgages depends on the refinancing of the
  mortgages, which depends on house prices.
• The ABX.HE index (linked to a basket of subprime
  cash bonds) was launched in January 2006,
  allowing trading of subprime risk.

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Subprime Mortgages
Source Gorton (2008)
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Mortgage-Backed Securities
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Securitization
Investor

• 1. Rating Agency (e.g. Standard Poors)
• Insurance Agency
• Servicer

Asset Manager
Issuer
Originator
Borrower (hhold)
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SOURCE NyFed Staff Report 318
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Changing mix and increasing securitization
SOURCE NyFed Staff Report 318
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Frictions in Securitization
Investor
MH

• 1. Rating Agency (e.g. Standard Poors)
• Insurance Agency
• Servicer

Asset Manager
MH/Errors
AS
Issuer
MH
MH/Errors
AS
Originator
Errors, MH
MH
Borrower (hhold)
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Question

• How much does it have to do with vertical
  disintegration? Are incentive problems same
  in-house?
• E.g. Merryl Lynch purchase of its own originator
• .
• Eager to build its own money machine, Merrill
  went on a buying spree. From January 2005 to
  January 2007, it made 12 major purchases of
  residential or commercial mortgage-related
  companies or assets. It bought commercial
  properties in South Korea, Germany and Britain, a
  loan servicing operation in Italy and a mortgage
  lender in Britain. The biggest acquisition was
  First Franklin, a domestic subprime lender.
• The firms goal, according to people who met with
  Merrill executives about possible deals, was to
  generate in-house mortgages that it could package
  into C.D.O.s. This allowed Merrill to avoid
  relying entirely on other companies for
  mortgages. NYT

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Lending standards Collapse
Source IMF financial stability report, Oct 08.
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Loan values
Source IMF financial stability report, Oct 08.
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CDOs and CDSs
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Banks

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Leverage Amplification
decrease in asset prices
Decrease in the demand for assets

• Equity difference between value of assets and
  value of the debts.
• Leverage Assets/Equity (A/E).
• ? asset prices ? ? value of assets ? ? equity ?
  ? leverage.
• To restore the original level of leverage sell
  assets to pay down debt
• Asset sell-off lowers asset prices, further
  lowering the value of assets.
• Marking-to-market synchronizes the actions of
  market participants ?
• a shock requires a quick adjustment.

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Summary

• Since 2000, Increase in leverage (good
  expectations, asset prices increasing)
• Summer 2007 Asset values down/worsening
  expectations (leads to need to deleverage)
• We have assumed that to restore the original
  leverage ratio the bank could not raise extra
  equity to pay down debt.
• Why is that a reasonable assumption?
• Asymmetric information problem.
• Need for adjustment (reducing balance sheet size)
• Government intervention bank re-capitalization.

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Investment banks leverage is pro-cyclical

• Upper bound on leverage increases in good times.
• Leverage is limited by the rate at which the bank
  can borrow .
• Higher leverage and more risky assets induce
  lower ratings.
• Rating influences the rate at which the
  investment bank can borrow.
• In good times, default probabilities and
  volatility are perceived to be lower, ratings are
  higher.
• So the upper bound on leverage that allows for
  low cost of borrowing (maximum rating) is higher
  in good times.

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Debt Outstanding
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• Commercial Banks

• Investment Banks

• 12Tn assets, leverage 10
• Funded by deposits and debt
• Leverage limited by capital reserve ratios
• Access to Discount Window

• 6Tn assets, leverage 25
• Funded just by debt
• Leverage limited by debt ratings
• No access to discount window

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Basel Capital Requirements on Banks

• To meet Basel I standards, or to qualify as
  adequately capitalized in in the US
• Tier I capital (book equity) must be at least 4
  of risk-adjusted assets
• Tier I Tier II capital (reserves, long-term
  debt) must be at least 8 of risk-adjusted
  assets.
• MBSs typically weighted at 20 or 50

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Structured Investment Vehicles

• Banks set up an SIVs that issue short-term Asset
  Backed Commercial Papers (ABCPs) and invest in
  risky and long-term assets.
• Liquidity risk ABCP market might dry up.
• Sponsoring banks get all the risk of the ABCP's
  via derivative contracts (liquidity facility,
  credit facility, swap agreement)
• If the SIV's fail to refinance the ABCP's, the
  sponsoring banks buy the SIV's assets at a price
  that ensures full payment of the ABCP investors.
• Usual tenure of this derivative contracts less
  than a year (often 364 days), often renewed. So,
  they get preferential regulatory treatment.
• But banks are not required to hold capital
  against that risk.
• However, when banks buy the SIV's assets,
  capital requirements might bind. That may lead to
  fire-sale of the assets.
• In a stress scenario, that may damage the bank's
  balance sheet
• Coordination issue if nobody buys the ABCP's,
  they become risky.

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Writedowns Recapitalisation
Source http//ftalphaville.ft.com/blog/2008/10/23
/17369/losing-control/
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Credit Crunch 101

• Part II The Crisis, Policy Response, and Macro
  Outlook

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Overview of Today

1. The crisis, and the policy response
2. Historical comparisons
3. The macro outlook
4. Discussion

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Brief History of the Crisis
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Financial markets some key events

• June-August 2007 Losses associated with subprime
  related assets forced Bear Stearns ad Goldman
  Sachs to inject capital in their own hedge-funds.
  IKB (German lender) issued unexpected profit
  warning. BNP Paribas froze redemption on three
  hedge funds. Quasi-closure of CDOs market.
• October-November 2007 further write-downs by
  major international banks partly covered by
  Sovereign Wealth Funds. Estimates from subprime
  losses revised upward.
• January 2008 stock market sell-off likely
  related to monoline insurers downgrade and BNP
  Paribas unwinding position of rogue trader.
• March 2008 liquidity problem lead to Bearn
  Stearns bail-out via J.P. Morgan.
• July 2008 Fannie Freddie obtain potential
  unlimited support from government.
• September 2008 Fannie Freddie conservatorship,
  Lehmann Brothers collapse, and AIG bail-out

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Stress indicators in money and equity markets

• LIBOR-OIS spread (measure of risk and liquidity
  in the money market)
• What is LIBOR? London Interbank Offered Rate
  (LIBOR) is the interest rate at which banks
  borrow unsecured funds from other banks in the
  London wholesale money market for a period of 3
  months.  
• What is OIS? Overnight Index Swap (OIS) is an
  interest rate swap where the floating rate of
  the swap is equal to the (compounded) average of
  an overnight index (i.e., a published interest
  rate) over every day of the payment period. In
  the U.S., OIS reflects the compounded Fed Funds
  rate over the payment period.
• TED spread is the gap between 3-month LIBOR and
  the 3-month Treasury bill rate. Measure of flight
  to quality rising TED spread often presages a
  downturn in the U.S. stock market, as it
  indicates that liquidity is being withdrawn.
• VIX index fear index measures expected
  volatility in the SP 500 index over the next
  month.

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Policy response I official policy rate

• Roles of official policy rate
• macroeconomic stabilization
• liquidity.
• Different monetary policies pursued until August
  2008 (aggressive cuts by the Fed, minor cuts by
  Bank of England and rates increase by ECB).
• From August 2008 coordinated policy cuts among
  major central banks.
• Has policy been effective? (i.e., transmitted to
  the rest of the economy?)
• Liquidity What has been the pass-through to
• Mortgage rates
• Commercial paper rates
• Interbank rate
• Macroeconomic Stabilization Has the market led
  the policy rate? Policy surprise?

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Policy response II liquidity management(i.e.
the alphabet soup of new facilities)

• General aim to inject liquidity into markets by
  increasing volume and Maturity of liquidity
  management operations and by allowing for wider
  range of collaterals.
• Discount window changes reduced penalty rate and
  extended terms of loans (FED) no changes for ECB
  and BOE.
• TAF (term auction facility) commercial banks
  could borrow anonymously against broad range of
  collateral. Designed to avoid stigma of discount
  window (December 2007) FED, ECB, BOE, BOC, SNB
• TSLF (term securities lending facility) allowing
  investment banks to swap agency and other
  mortgage-related bonds for Treasury bonds
  (Difference with TAF investment banks and range
  of collateral, March 2008.
• PDCF (primary dealer credit facility) discount
  window for investment bank. Overnight horizon and
  same penalty as discount window (March 2008)
• International Currency Swap aim is to address
  dollar funding needs of international financial
  institution that have short maturity foreign
  currency liabilities and illiquid foreign assets
• Guarantees of money market funds and commercial
  paper facility

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Historical Comparisons
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1929 not primarily a banking crisis

• Banking crisis only late during depression,
  1931-33
• Triggered by exogenous events (Banking scandal
  1930, German reparations, Gold Std breakdown)
• Effects of banking crisis on U.S. output in doubt
• Monetary policy not that restrictive
• Fed slashed interest rates, policy lost traction
• Bad news about resurrection of unions in 1929
• Political deals for later New Deal all concluded
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• Real wage rigidity (pressure by Hoover admin.)
• Lax antitrust unions to cut into monopoly rents

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Comparison to Japan
Japan (1/3 of US GDP) Japan (1/3 of US GDP) US US
91 Land prices peak out 1/2 by 95, 1/3 by 05 origin 06 House prices peak out Decreased by 20 by now
94 98 Tokyo-Kyowa (94) Jusen (96) Sanyo, Yamaichi etc (97) Case-by-case bailout / bankruptcy 08 Bear Sterns (March) Fannie-Mae, Freddie-Mac Lehman, AIG (Sep), etc
97 Default in inter-bank market (Sanyo) Banking crisis 08 Lehman (MMF below par)
98 500 bn (12 of GDP) Bailout plan 08 700 bn
93 Established in 93, 99, 03 Purchase of NPL 08 Not yet implemented
98- 98-99 (93bn) 03 (20 bn) Capital injection 08 350bn
10 in 95, 18 in 98 NPL/GDP
-1.5 (1998) Min. GDP growth
17.6 Output loss
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The Macro Outlook
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United States
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Eurozone
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Wealth effect

• Falling prices of houses and financial assets
  reduce wealth and hence consumption.
• But theoretically, house price change need not
  generate a wealth effect
• Families could internalize opposite wealth effect
  on their children (analogous to Ricardian
  equivalence argument)
• Heterogeneity in marginal propensity to consume
  out of wealth between those long and short in
  housing
• Collateral constraints
• Empirical evidence
• Case, Quigley Shiller (2005), macro data, US
  states, 1982-99 Elasticity of consumption w.r.t.
  house price 0.04-0.06 (using retail sales data
  as proxy for consumption)
• Campbell Cocco (2007), micro data, UK FES,
  1988-2000 High elasticity of consumption w.r.t.
  house price - approx 0.65

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Credit channel and financial accelerator

• Theory (Bernanke, Gertler Gilchrist, 1999)
• Falling asset prices reduce ability of borrowers
  to post collateral or inject equity into
  investment projects
• With imperfect monitoring by lenders, when net
  worth falls, the external finance premium
  increases.
• Fall in investment has knock-on effect on demand
  and asset prices, with further falls in net worth
  (financial accelerator).
• Empirical evidence
• Levin, Natalucci Zakrajsek (2004) Micro data
  support link between leverage and external
  finance premium, but time-variation in financial
  frictions (bankruptcy costs in model) needed to
  fit macro data.
• Christensen Dib (2008) Build financial
  accelerator into DSGE model Boosts output
  fluctuations by around 10-20.

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Bank Capital Channel

• Theory (van den Heuvel, 2007)Suppose
• Capital requirement
• Banks cannot readily issue new equity
• Then decrease in bank capital results in decrease
  in lending
• Evidences in Japan (Watanabe, JMCB, 2007) In
  1997 MOF required banks rigorous self-assessment
  of banks assets and adequate write-offs. ? banks
  cut back lending to meet capital requirement

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Other mechanism

• Balance-sheet contagion
• If sectors use similar assets as collateral,
  sector-specific shocks spread out across sectors
  through changes in asset prices
• Equity prices and bank capital channels in Japan

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Monetary policy under the zero bound

• Commitment to zero interest rate

• OMO of illiquid assets

Nominal rate
recession
policy rate
commitment
Traditional MP
benchmark
New MP
time
boom
pre-emptive
Nominal rate
benchmark
illiquidity
commitment
Tangible assets
money
T bills
MBS ABS
equity
maturity
Simple quantitative easing did not work in Japan
Was effective in Japan
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Fiscal policy

• How useful is discretionary fiscal policy if
  monetary policy proves ineffective?
• Issues
• Tax cut or direct increase in govt. spending?
• Ricardian equivalence
• Lags (implementation, effectiveness)
• Tax changes to increase disposable income or
  affect relative prices? e.g. mimic a fall in
  real interest rate by announcing a future
  consumption tax increase (or temporary tax cut) ?
  credibility problem.
• Empirical evidence
• Fiscal policy multipliers - Blanchard Perotti
  (2002)
• 1 govt. spending shock ? approx 1 higher output
  (peak time uncertain, between 1 -16 qtrs.)
• 1 tax shock ? approx 1 higher output (peak
  after 5-7 qtrs.)

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End
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Central Bank Balance Sheet

• Simple structure as of August 2007
• Assets Treasury securities of about 800 billion
  plus its discount loans (an insignificant number
  at that time).
• Liabilities cash held by the public (about 800
  billion a year ago) plus the reserve deposits
  held by banks (also a small number)
• How to expand Feds balance sheet in order to
  support those facilities?
• Two phases
• Composition phase keeping the total asset
  value constant by essentially exchanging
  treasuries for riskier assets (August 2007 -
  August 2008)
• Expansion phase (September 2008 -)
• Usual way would be to credit reserve deposit
  account (printing more money)
• Instead the Fed asked the Treasury to implement a
  Supplementary Financing Program whereby the
  Treasury sells securities directly to the public
  but keeps the funds in an account with the Fed.
• Another way is by paying interest on reserves
  (October 6) way of encouraging banks to sit on
  their excess reserve deposits.

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Policy response III fiscal policy

• TARP legislation initial program 700bn to buy
  MBSs
• Main features Treasury will purchase, guarantee
  and later sell MBSs on a continuous basis for 2
  yrs up to 700bn (only) at a 'given' time 250
  bn will be provided first, next 100bn when new
  President reports to Congress and additional
  350bn only on Congress approval institutions
  limited to banks, broker dealers, insurance
  firms, US subsidiaries of foreign firms but not
  hedge funds
• Valuation and pricing issues are challenges -
  Buying assets at lower prices will reduce risks
  to taxpayers but might reduce banks' incentive to
  participate in the program and writedowns might
  be too large to bear
• On October 11 Treasury Department announced
  standardized plan to take ownership stakes in
  many US banks to try to restore confidence in the
  financial system.
• UK authorities decided to inject capital
  directly Oct 12, 39bn into three of the
  countrys largest banks in a broad-based
  recapitalisation

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Risks ahead?

• Financial risk hedge funds redemptions, further
  downgrades and increasing margin call might
  prompt further deleveraging.
• Losses could easily exceed current fiscal plans
  there might be a need for further government
  interventions.