Financial Crisis in detail

Created by: Parshwadeep Lahane Financial crisis 2008

Disclaimer
I am no financial expert. Made solely out of interest generated after seeing the debacle on wall street
All content is based on research, readings on internet, newspapers and my understanding from it.
Free to use. I hope people can take it as base and improve/update it over time as crisis evolves

Let’s start with Basics

Bank
Operation
Take money as deposits on which they pay interests
Lend it to borrowers who use if for investment or consumption
Borrow money from other banks (inter bank market)
Make profit on the difference between interest paid and received
Source: The Economist: Making Sense of Modern Economy

Potential problems in Bank
Most of bank liabilities have shorter maturity period than assets
This can be a potential cause of bank failure incase all depositors take out money at once (bank run)
Credit risk
Possibility that borrowers will be unable to repay their loans
More risk in prosperity period as lending terms tends to be relaxed
Interest rate risk
Most deposits at floating rate
Loans at fixed rate
If floating rate is more than fixed rate bank loses ( S&LI ,America 1979)

Criticality of Banking system
As bank provide credit and operate payments- failure can have a more damaging effect on the economy than the collapse of other businesses
Hence need for more regulation by government
Reserve requirement – holding a proportion of bank deposits at the central bank (CRR)
Match a proportion of risky assets (i.e loans) with capital in form of equity or retained earnings
Capital of internationally active banks should amount to at least 8% of the value of risky assets. (Basel Accord)

Investment Banks
Help firms raise money in the capital markets (equity and bonds market)
Advise firms whether to finance themselves with debt or equity
Underwrite such issues by agreeing often with other banks in syndicate, to buy any unsold securities
Paid a commission for this service
Advice on mergers and acquisitions
(most lucrative work- not during
sub-prime crisis though!!)
Glass-Steagall act – prevented
commercial banks from giving Investment
banks services

At most basic , they are simply vast pools of money
Institutional investors are
Pension funds
Mutual funds
Insurance companies
Dominate the securities( stocks, bonds) market
Control a huge chunk of most rich countries retirement savings and other wealth
These have been growing at the expense of banking system
As biggest owners of stocks and bonds they have growing influence in corporate finance and hence corporate governance
Institutional investors Source: The Economist: Making Sense of Modern Economy

Pension funds
Designed for employees of companies or governments
Common form –Trust- overseen by trustees for the benefit plan members
In traditional pension plan, the employer guarantees a fixed pension in old age. The company and employee both pay monhtly contributions into pension fund, where the money is invested.
Trustee is responsible to make sure that the fund’s asset cover its liabilities. Usually actuaries hired to carry this out.
401K plans – allow for choosing from a menu of mutual funds. Blurring the distinction between mutual and pension funds

Hedge funds
Try explicitly to make money whether markets are going up or down
Mostly private partnerships instead of public companies
Most regulators allow only rich to invest in them
Over the years shifted from being largely private funds for rich families to being larger institutions whose investors are pension funds, hospitals, endowments and foundations.

Insurance companies
Oldest type of institutional investor
From protection to savings + protection
Law of large numbers – risk can be managed by pooling individual exposures in large portfolios
Catch1- law works if risk are not correlated
Catch2- losses in any 1 year may differ hugely from the long run trend

Central Bank-US FED
Primary purpose is to address banking panics
To strike a balance between private interests of banks and the centralized responsibility of government
To supervise and regulate banking institutions
To protect the credit rights of consumers
To manage the nation's money supply through monetary policy to achieve the sometimes conflicting goals of
maximum employment
stable prices
moderate long-term interest rates
To maintain the stability of the financial system and contain systemic risk in financial markets
To provide financial services to depository institutions, the U.S. government, and foreign official institutions, including playing a major role in operating the nation’s payments system
To facilitate the exchange of payments among regions
To respond to local liquidity needs
Source: Wikipedia

Government securities/bonds
Governments usually borrow by issuing securities, government bonds and bills to make up for the expenses and revenue (tax collected) differential
One can treat it as commercial paper
Least risky investment in US
Source: Wikipedia

Credit Rating Agency (CRA)
Company that assigns credit ratings for issuers of certain types of debt obligations as well as the debt instruments themselves
A credit rating for an issuer takes into consideration the issuer's credit worthiness (i.e., its ability to pay back a loan), and affects the interest rate applied to the particular security being issued
Ex: Moody's (U.S.), Standard & Poor's (U.S.)
Credit ratings are used by investors, issuers, investment banks, broker-dealers, and governments.
For investors, credit rating agencies increase the range of investment alternatives and provide independent, easy-to-use measurements of relative credit risk.
Source: Wikipedia

Mortgage Broker
Mainly found in developed economies like US, Western Europe
Professionals who are paid a fee to bring together lenders and borrowers
Sells mortgage loans on behalf of businesses (ex. Banks)
Tasks undertaken:
Marketing to attract clients
Assessment of the borrowers circumstances (Mortgage fact find forms interview). This may include assessment of credit history (normally obtained via a credit report) and affordability (verified by income documentation)
Assessing the market to find a mortgage product that fits the clients needs (Mortgage presentation/recommendations)
Applying for a lenders agreement in principle (pre-approval)
Gathering all needed documents (paystubs / payslips, bank statements, etc.),
Completing a lender application form
Explaining the legal disclosures
Submitting all material to the lender
Source: Wikipedia

Sub-prime mortgage – What’s that?
Home loans made to borrowers with poor credit ratings — a group generally defined by FICO scores below 620 on a scale that ranges from 300 to 850
FICO - a number that is based on a statistical analysis of a person's credit report, and is used to represent the creditworthiness of that person.
(FICO is the acronym for Fair Isaac Corporation, a publicly-traded corporation (under the symbol "FIC") that created the best-known and most widely used credit score model in the US.)
Creditworthiness —the likelihood that the person will pay his or her debts. Calculated by credit reporting agencies.
Ex. Equifax, Experian, and TransUnion in US
Source: Wikipedia

Secondary Mortgage markets
The secondary mortgage market allows banks to sell mortgages, giving them new funds to offer more mortgages to new borrowers.
If banks had to keep these mortgages the full 15 or 30 years, they would soon use up all their funds, and potential homebuyers would have a more difficult time to find mortgage lenders.
Many of the mortgages on the secondary market are bought by Fannie Mae.
Other are packaged into mortgage-backed securities, and sold to investors.
Source: http://www.urbandigs.com/2007/08/how_mortgage_backed_securities.html

Mortgage Backed Security (MBS) Source: http://www.urbandigs.com/2007/08/how_mortgage_backed_securities.html STEP 1 - A pool of mortgages are owned by a bank or lender. They are grouped into categories by credit risk including subprime, alt-a (between subprime and prime), and prime. STEP 2 - The pool of mortgages are packaged into a mortgage backed security. STEP 3 - The mortgage backed security is then sliced and diced into different classes with varying maturities (called tranches). Each tranche offers varying degrees of risk to the investor. The first loan to default will be placed into the Junk tranche while the strongest loans receive the highest credit rating of 'AAA' and are placed at the top of the tranche division. As with any asset associated with risk, the highest risk tranche receives the highest rate of return or yield while the lowest risk (AAA rated) will receive the lowest yield. STEP 4 - The tranches are then resold to investors who are willing to take on the varying degrees of risk and maturities.

Collateralized Debt Obligation (CDO) simplified MBS CDO MBS
Created in 1987 by now defunct investment firm Drexel Burnham Lambert
Not traded on exchange but OTC market

OTC market
A decentralized market of securities not listed on an exchange where market participants trade over the telephone, facsimile or electronic network instead of a physical trading floor. There is no central exchange or meeting place for this market.
In the OTC market, trading occurs via a network of middlemen, called dealers, who carry inventories of securities to facilitate the buy and sell orders of investors
Trading is private and prices and
volumes are not disclosed
Price discovery non transparent
Source : http://www.investopedia.com/terms/o/over-the-countermarket.asp

Now we are ready to look into the mess !

Evolution of home mortgage Source : http://www.imf.org/external/pubs/ft/fandd/2007/12/dodd.htm ,Subprime Mortgage Market Turmoil, Christopher L. Peterson, Asst Prof of Law, Univ of Florida 1930s Lender-Banks Borrower-Individuals Home loan funding Principal + interest payable over long term
Owning a house was not affordable to many
Great Depression brought industry to a halt. Large scale defaulters and lenders could not recover by reselling
To simulate the industry again Government as part of New Deal policy created the Federal National Mortgage Association (Fannie Mae) in 1938. This created a secondary market for mortgages
Lender-Banks Borrower-Individuals Home loan funding Principal + interest payable over long term Bought loan Cash Transfer of credit risk, market risk Had Access to long term borrowing Bought only those which conformed to certain underwriting standard ( called Prime Mortgages)

Evolution continued…
Fannie Mae proved very successful . But by 1960s , borrowing done by it constituted a significant share of the debt owed by US government.
1968- Government National Mortgage Association (Ginnie Mae) was created to handle government guaranteed mortgages.
Fannie Mae became federally chartered, privately held
1970- Ginnie Mae developed MBS -- shifted the market risk to investors -- eliminated debt incurred to fund government housing program
1970-Federal National Mortgage Corporation (Freddie Mac) created
To securitize conventional mortgages
Provide competition to Fannie Mae
Over time Fannie Mae and Freddie Mac together provided enormous amount of funding for US mortgage
Since Fannie Mae and Freddie Mac guaranteed loans, much of credit risk stayed with them. Size and diversification allowed them to handle it.
Source : http://www.imf.org/external/pubs/ft/fandd/2007/12/dodd.htm ,

New Model of mortgage lending Lender-Banks Home loan funding Principal + interest payable over long term Bought loan Cash Transfer of credit & market risk MBS Cash Transfer of market risk
Advantages
More liquidity in market
Risk spread out
Long term funding for mortgage lending
MBS- allows originators to earn fee income from underwriting activities without exposure to credit, market or liquidity risks as they see the loans they make
SPV Securitization fees

Further evolution..
1977- Private label securitization started first done by BOA and Salomon Brothers
1980s- pricing, liquidity and tax hurdles were resolved in same
Unlike 2-3 party , private label securitization has 10 or more different parties playing independent role
Big private players in this field were
Wells Frago
Lehman Brothers
Bear Stearns
JP Morgan
Goldman Sachs
Bank Of America
Indymac
Washington Mutual
Countrywide

Details : Private Sub-prime mortgage process 1. Brokers identify borrowers 2. Originator and broker identify a loan for borrower after looking at his credit rating 3. Formal application for loan by borrower 4. Originator transfers the loan to the subsidiary of an investment banking firm ( Seller) 5. Seller(Investment bank) collects a pool of loans and call it as SPE/SIV/SPV. Off balance sheet instrument 6. SPV can be a corporation, partnership or limited liability company. Most often a Trust. It has nothing else except mortgage loans 7. Underwriter purchases all the securities (derivative income streams) 8. In designing SPV and its tranches underwriter works with credit rating agencies 9. Underwriter then sells the securities to the investors 10. High rated tranches might be guaranteed by a 3rd party insurance company 11. Seller also arranges to sell the rights to service the loan pool to a company or sometimes Originator takes these rights 12. MERS – document custodian. Company to keep track of mountains of paper work on loans in the pool. At National level. Source : Subprime Mortgage Market Turmoil , testimony by Christopher L. Peterson

Possible inter linkage in the US subprime mortgage market Source: http://www.norges-bank.no/templates/article____66901.aspx

Reasons for forming of Subprime mess
Giant pool of money available for investment through savings of Oil exporters , economic development in BRIC countries.
Private share in mortgage market growth in large part through origination and securitization of high risk sub-prime and Alt-A mortgages.
Building up of the housing bubble
Private Banks made use of CDOs to sell to investors
Lax regulations which did not keep pace with the innovations happening in financial engineering
US kept interest rates too low for too long in post dotcom bust period
Hedge funds, Wall street firms and instructional investors found lower tranches in MBS and CDO attractive which were highly risky
Hedge funds leverage ratio of the order of 500%.
To sum up in 3 words as noted by Harvard dean: Leverage(high) , Transparency (low) and Liquidity (abundant)

Big assumptions
Belief that modern capital markets had become so much more advanced than their predecessors that banks would always be able to trade debt securities. This encouraged banks to keep lowering lending standards , since they assumed they could sell the risk on.
Many investors assumed that the credit rating agencies offered an easy and cost-effective compass with which to navigate this ever more complex world. Thus many continued to purchase complex securities throughout the first half of 2007 – even though most investors barely understood these products.
Most crucially, there was a widespread assumption that the process of “slicing and dicing” debt had made the financial system more stable . Policymakers thought that because the pain of any potential credit defaults was spread among millions of investors, rather than concentrated in particular banks, it would be much easier for the system to absorb shocks than in the past.
Housing prices will keep going up all time
Source :http://www.ft.com/cms/s/0/a09f751e-6187-11dd-af94-000077b07658,dwp_uuid=698e638e-e39a-11dc-8799-0000779fd2ac.html

Misaligned incentives & pitfalls
“ churning” of capital “allows even an institution without a great amount of fixed capital to make a huge amount of loans, lending in a year much more money than it has
If an individual or class of victims obtains a large judgment, the lender’s management can simply declare bankruptcy, liquidate whatever limited assets are left, and possibly reform a new company a short time later.
Securitization conduit divides various lending tasks into multiple corporate entities—a broker, an originator, a servicer, a document custodian, etc.—the conduit tends to prevent the accumulation of a large enough pool of at risk assets to attract the attention of class action attorneys, which tend to be the only actors capable of obtaining system-impacting judgments.
Source : Subprime Mortgage Market Turmoil , testimony by Christopher L. Peterson

Good days turn bad. Crisis at the door (mid 2006 onwards):
Through financial innovations loans issued to borrowers at minimal rate, adjusted rate. By mid 2006 time to pay bigger amounts comes
Household income did not increase in same proportion as house prices
Subprime mortgage owners start defaulting
Rating agencies revise ratings of MBS/CDO as expected number of defaults turn out higher. Many ratings are lowered
Bewildered investors lost faith in ratings, many stop buying MBS/CDO altogether
Alarm bell at SIV/SPVs
Banks find themselves in non-comfortable position , stop making loans
Housing prices plummet owing to increase in foreclosure , delinquency and stoppage of loans

what a mess….
More frenzy in market and more defaults, again revised ratings, again further stoppage of funding and further stoppage of loans, further fall in house prices as demand and supply mismatch....problem feeding itself in circular fashion.
As MBS/CDO market is shaken….investors start debating other derivatives true worth…panic spreads across and people start getting out….further hurting the banks
The crisis unfolded as silent Tsunami on Wall Street where by the time people realized the graveness of the mess they were in , it had gone beyond control.
Since, most of the player in the market, mortgage brokers, investment banks were running in debts. They are suddenly caught unaware and are in insolvency and start tumbling down….many are saved by nationalization as their fall would spread the contagion way far .
Central government start pumping in money as last resort but one thing is surely not returning soon and which is very vital in financial industry -FAITH.

In Short
When homeowners default, the amount of cash flowing into MBS declines and becomes uncertain.
Investors and businesses holding MBS have been significantly affected.
The effect is magnified by the high debt levels maintained by individuals and corporations, sometimes called financial leverage.
Source : http://www.imf.org/external/pubs/ft/fandd/2007/12/dodd.htm ,

Those good old days were gone now!!

How Subprime became Global Financial Crisis?
Lets look into it from start again:
Industry data suggest that between 2000 and 2006, nominal global issuance of credit instruments(MBS/CDO) rose twelvefold, to $3,000bn a year from $250bn
Became intense from 2004, partly because investors were searching for ways to boost returns after a long period in which central banks had kept interest rates low.
“ slicing and dicing” was fuelling a credit bubble, leading to artificially low borrowing costs, spiraling leverage and a collapse in lending standards
Source: Financial Times , http://www.ft.com/cms/s/0/a09f751e-6187-11dd-af94-000077b07658,dwp_uuid=698e638e-e39a-11dc-8799-0000779fd2ac.html In billion US $ How could problems with subprime mortgages, being such a small sector of global financial markets, provoke such dislocation?

Build up into a financial crisis…
In 2003, Bank of International Settlements(BIS) repeatedly warned that risk dispersion might not always be benign. But US Federal Reserve was convinced that financial innovation had changed the system in a fundamentally beneficial way.
No efforts made to correct debt to equity ratios of bank
Huge trust in the intellectual capital of Wall Street –supported by the fact that banks were making big money.
When high rates of subprime default emerged in late 2006, market players assumed that the system would absorb the pain.
Initial estimate of subprime loss put to $50bn-$100bn by US FED
Subprime losses started to hit the financial system in the early summer of 2007 in unexpected ways. As the surprise spread, the pillars of faith that had supported the credit boom started to crumble.
Investors woke up to the fact that it was dangerous to use the ratings agencies as a guide for complex debt securities.
In the summer of 2007, the agencies started downgrading billions of dollars of supposedly “ultra-safe” debt – causing prices to crumble.
Source: Financial Times , http://www.ft.com/cms/s/0/a09f751e-6187-11dd-af94-000077b07658,dwp_uuid=698e638e-e39a-11dc-8799-0000779fd2ac.html

Poor Investors….
Shocked investors (sitting in all parts of the world) lost faith in ratings, many stopped buying complex instruments altogether
That created an immediate funding crisis at many investment vehicles ( remember SIV), since most had funded themselves by issuing notes in the asset-backed commercial paper market.
Many banks had not yet passed on the risk to others. Many were holding asset-backed securities in “warehouses” and were working on splicing them up into CDOs, getting them rated by a credit agency such as Moody’s or Standard & Poor’s. Several banks were caught out not only because it took time to structure the securities but because they deliberately held on to what they regarded as “safe” tranches of loans. Ex. UBS was badly damaged by retaining “super-senior” CDO debt.
It also meant that banks were no longer able to turn assets such as mortgages into subprime bonds and sell these on.
That in turn meant the key assumption that the capital markets would always stay liquid – was overturned.
Assumption that banks would be better protected from a crisis because of risk dispersion – also cracked.
As investment vehicles lost their ability to raise finance, they turned to their banks for help. That squeezed the banks’ balance sheets at the very moment that they were facing their own losses on debt securities and finding it impossible to sell on loans.

Desperate banks….
As a result, western banks found themselves running out of capital
Banks started hoarding cash and stopped lending to each other as financiers lost faith in their ability to judge the health of other institutions – or even their own.
The London interbank offered rate(LIBOR) , the main measure of interbank lending rates, rose sharply
Firms became reluctant to participate in money markets ... as a result subprime credit problems turned into a systemic liquidity crunch.
Vicious deleveraging spiral got under way. As banks scurried to improve their balance sheets, they began selling assets and cutting loans to hedge funds.
But that hit asset prices, hurting those balance sheets once again.
Mark-to-market accounting forced banks to readjust their books after every panicky price drop

Lessons learned & Action plans ….
lesson of the CDO collapse is that technology does not obviate the need to assess a borrower carefully. Neither banks nor credit agencies did this well enough on behalf of investors and it proved a painful experience for everyone
In the medium term, regulators are preparing reforms that aim to make the system look credible
These would force banks to hold more capital and ensure that the securitization process is more transparent
Separately, groups such as the IIF are trying to introduce measures that could rebuild confidence in complex financial instruments
More immediately, the banks are trying to rekindle investor trust by replenishing their capital bases

Subprime losses by Big Banks Worldwide :US$ 586.2 billion and still counting Source: Financial Times

Finance & Economy
The collapse of an enormous financial institution stirs uncertainty, and uncertainty rattles Wall Street. Lenders are happiest when they are confident they will be repaid. If they think there's a chance that borrowers will default, they simply don't make loans. Their refusal, in turn, can shut down the economy and the financial system.
Financial system is what provides the funding for all the other sectors of the economy, and if you have a broken financial system, you have a broken economy

Investments devalued across the Globe Source: BBC News, http://news.bbc.co.uk/2/hi/talking_point/7644574.stm

Subprime impact across globe Source: Financial Times

Impact of Financial crisis-felt across the globe Source: Reuters, http://www.reuters.com/news/globalcoverage/creditcrisis

Thanks

Market share shifted from 2003 to mid 2006
Government share fell by 43% where as private share rose sharply by 138% over a period of 3 years
Between sub-prime and prime
Subprime lending increased by massive 205% over 3 years
Alternative–A similarly expanded by 384%
Increase in Prime was mere 16.7%

Global pool of money Source: http://www.rbnz.govt.nz/speeches/2968727.html
After 1997/98 financial crisis – Developing countries focus on export-driven growth and the associated accumulation of foreign exchange reserves
The strength of exports relative to domestic demand has seen saving outstrip investment in most of these economies
Accordingly, we have the ironic situation whereby a range of developing countries are (in net terms) the providers of capital to some of the world’s most developed economies.
This rapidly rising “savings glut” has been a principal source of increased global liquidity .

Rise of Global Liquidity (1998 onwards) Source: http://www.rbnz.govt.nz/speeches/2968727.html
The flow of increased global liquidity through markets has provided the impetus for many changes
To generate a return on this liquidity has spurred massive growth in securitization of debt and the development of a vast array of derivatives . The propagation of these instruments can itself be seen as a source of liquidity growth. From a monetary policy perspective, this implies a very big increase in the liquidity that is not directly controlled by central banks .
Bank for International Settlements, highlighted a number of important new features:
the unbundling and re-pricing of risk through major advances in financial engineering, resulting in improved ability to lever lending via new markets such as for credit transfer products;
the emergence of new financial players such as hedge funds and private equity firms that have not been traditional intermediaries;
more reliance of financial firms on markets to handle growing complexity;
a reliance on market liquidity even in stress situations; and
a surge in volume and value of transactions.

FED interest rate
To catch up with dot com boom FED kept interest rate low for long
This indirectly resulted in investors looking for other safe heavens
They got attracted to housing market

High Banks leverage ratio’s to fund MBS/CDO

Building up of the housing bubble

Housing prices and Income Source: http://varbuzz.com/meltdown/
Housing prices were increasing
Income slope was almost flat

Starting 2006 housing bubble busted

LIBOR rate

Credit rating of complex financial instruments Source: IMF and WSJ

Speedy Foreclosures

Top 10 Bankruptcies

The American way of debt Source: http://www.nytimes.com/interactive/2008/07/20/business/20debt-trap.html?ei=5070

Average debt of American in 2004 Source: http://www.nytimes.com/interactive/2008/07/20/business/20debt-trap.html?ei=5070

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Financial Crisis in detail

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