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Deciphering the 2007/8 Liquidity and Credit Crunch
 

Deciphering the 2007/8 Liquidity and Credit Crunch

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    Deciphering the 2007/8 Liquidity and Credit Crunch Deciphering the 2007/8 Liquidity and Credit Crunch Presentation Transcript

    • Deciphering the 2007/8 Liquidity and Credit Crunch Markus K. Brunnermeier Princeton University Written notes will be available at http://www.princeton.edu/~markus 1
    • Overview of Talk Run-up 1. Creation of structured products Demand for structured products Consequences: Buy-out bonanza, house price frenzy Unfolding of crisis 2. Subprime, ABCP, banking crisis Quant crisis Mechanisms at work 3. Difference to previous crises 4. 2
    • 1.1 Creation of Structured Products Bond Thickness “Loss Securitization I Tranches Support” Insuring CDS AAA 80% 20% US$ ≈45tr (corporate debt ≈5tr) Pooling AA 5% 15% Tranching CDOs A 5% 10% Catering BBB+ 2% 8% Opaqueness BBB 1% 7% Securitization II BBB- 2% 5% Shortening maturity SIVs et al. BB 1% 4% Traditional business of banks “Ride yield curve” Overcollateralization 4% 0% (Equity) Buy long-term assets Sell and roll over short-term assets (ABCP) Opaqueness in off-balance sheet vehicles 3
    • 1.2 Shortening Maturity - SIVs et al. Conduits SIVs SIV-lites US$ ≈1,400bn US$ ≈400bn US$ ≈12bn assets not tradable loans assets are traded assets are traded less risky less risky risky RMBS 43% fin. Inst. Debt >95% US RMBS •≈11% •≈ • •≈11% ABS/CDOs •≈ 23% RMBS •≈ 11% CDOs 26% ABCP liabilities 68% MTN 7% capital/mez.notes non-structured structured structured (aggressively) capital structure open closed dynamic (change size/financing) static (like CDOs) Some No (but overcollateralized) No Credit (sponsoring bank) enhancement Contractual Contractual Contractual Liquidity enhanc. 100% < outstanding ABCP credit line is subject (credit line) 4 to market value tests Reputational
    • 1.3 Why Structured Products? Good reasons Catering – transfer risk who can best bear it – stayed mostly within banking system (complete markets) Bad reasons Supply: Rating Arbitrage – Diluting existing bond holders Transfer highly rated asset to SIV and issue AAA papers Instead of issuing A- minus rated papers + banks’ rating was unaffected by this practice Regulatory Arbitrage: Outmaneuver Basel I accord (SIVs) esp. reputational liquidity enhancements Demand: Creative way to enhance portfolio returns searching for yield track record building - picking up nickels before the steamroller Attraction of illiquidity (no price exists) + difficulty to value CDOs (correlation risk) “mark-to-model”: Mark “up”, but not “down” smooth volatility and increase Sharpe ratio fraction of “level 3 assets” went up a lot 5
    • 1.4 Consequences of “originate and distribute banking model” Banks focus only on “pipeline risk” Distance between borrowers and lenders Opaqueness - obfuscation Deterioration of lending standards Mortgages Mortgage brokers Piggyback mortgages, NINJA loans, … Housing Frenzy Corporate bonds Pik bonds Covenant-lite bonds Private equity bonanza – LBO acquisition spree 6
    • 2. Unfolding of Crisis Subprime 1. ABCP, banking crisis 2. Spillover to corporate credit 3. Quant crisis 4. 7
    • 2.1 Subprime crisis – envelope calculation Subprime mortgage: 15% of US$ 10tr = US$ 1.5tr Say: 50 % default, only recoup 50% Total loss: US$ 375bn, incl. Alt-A say, US$ 500bn 2% change in stock market > US$ 500bn Amplifying mechanism needed 8
    • 2.2 ABCP – Banking Crisis Rates Outstanding ABCP 6.5 1300 6 1200 1100 5.5 1000 5 900 4.5 800 4 ABCP 700 3.5 A B CP LIBOR 3 months FinCP T-Bill 3 months FedFund 600 3 7 7 7 7 7 7 7 7 /0 /0 /0 /0 /0 /0 0 0 8/ 5/ 27 11 25 22 19 /3 07 07 07 07 07 7 7 7 7 7 7 7 7 7 7 /0 /0 /0 /0 /0 /0 /0 /0 /0 /0 8/ 9/ 10 1/ 8/ 5/ 2/ 9/ 6/ 7/ 7/ 8/ 9/ 15 22 29 12 19 26 16 23 30 /7 7/ 7/ 8/ 9/ 9/ 10 7/ 7/ 7/ 8/ 8/ 8/ 9/ 9/ 9/ ABCP dries up – no rollover SIVs draw on credit lines of sponsoring bank LIBOR and flight to quality Banking Crisis: IKB, SachenLB, Northern Rock 9
    • 2.3 Spillover to Corporate Credit 600 3000 500 2500 400 2000 300 1500 200 1000 Note difference in scale! 100 500 CDX.HY.5y On the Run ABX.HE.BBB- On the Run 0 0 07 07 07 07 7 07 07 07 07 07 /0 1/ 1/ 1/ 1/ 1/ 1/ 1/ 1/ 1/ 1 0/ 1/ 2/ 3/ 4/ 5/ 6/ 7/ 8/ 9/ 1 Novelty effect Learning about structured products 10
    • 2.4 Quant Crisis High frequency stat arbs 1. High frequency, IT driven, short-term reversal strategies Aug 1st to Aug 9th - price declines seven days in a row e.g. Renaissance’s Medallion fund Low frequency quant funds 2. Value-growth (HML) strategy, momentum strategy FX carry trades e.g. Goldman Sachs’ Global Alpha, AQR, … 11
    • 2.4 Quant Crisis Funds’ assets in general (Knowledge) Market Order of Acquisition Cost Liquidity Liquidation High fixed costs Low/High 3 Proprietary trading strategy (incl. credit) Low cost High 2 Standard trading strategy (incl. carry trade, HML) No cost 1 ∞ Cash holding 12
    • 2.4 Quant Crisis HML Accumulative Returns Deutsche Bank Carry Trade ETF 1.02 1.18 1 1.16 1.14 0.98 1.12 0.96 1.1 1.08 0.94 1.06 0.92 1.04 1.02 0.9 1 0.88 0.98 07 07 07 07 07 07 07 07 07 07 07 07 07 07 07 07 07 07 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 1/ 1/ 1/ 1/ 1/ 1/ 1/ 1/ 1/ 1/ 1/ 1/ 1/ 1/ 1/ 1/ 1/ 1/ 3/ 4/ 5/ 6/ 7/ 8/ 9/ 1/ 2/ Date 1/ 2/ 3/ 4/ 5/ 6/ 7/ 8/ 9/ Date Why? Many (not only quant) funds liquidate “relatively” liquid positions first Quant funds are particularly loaded on these factors 13
    • Cumulative Return 6/ 1/ 20 85 90 95 100 105 07 6/ 8/ 20 07 6/ 15 /2 00 7 6/ 22 /2 00 7 6/ 29 /2 00 7 7/ 6/ 20 07 Daily HFR indexes 7/ 13 /2 2.4 Quant Crisis 00 7 7/ Equity Market Neutral Index Stat arb crisis 20 /2 00 7 7/ 27 /2 00 7 8/ 3/ 20 07 8/ 10 Macro Index /2 00 7 8/ 17 /2 00 7 8/ 24 /2 00 7 8/ 31 /2 Global Index 00 7 HFR indexes 14
    • 3. Mechanisms Market liquidity Ease with which one can raise money by selling the asset Funding liquidity Ease with which one can raise money by borrowing using the asset as collateral Each asset has two values/prices 1. price 2. collateral value 15
    • 3. The 3 Flavors of (the same) Funding Liquidity Risk Margin funding risk Prime broker Margin has to be covered by HF’s own capital Margins increase at times of crisis Rollover risk CP Inability to roll over short-term commercial paper Redemption risk Depositors, HF-investors Outflow of funds for HFs and banks Essentially the same! Maturity mismatch: Long-term assets but short-term borrowing 16
    • 3. Mechanism 1 Collateral Crisis due to Increased Vol. + Losses Permanent price shock is Rating Jan-May 2007 July-Aug 2007 accompanied by higher Bond Investment grade 0-3 3-7 future volatility (e.g. ARCH) High yield 0-5 10+ Realization how difficult it is Leveraged Loan to value structured products Senior 10-12 15-20 2nd lien 15-20 20-30 estimate default Mezzanine 18-25 30+ correlations ABS and CDO Value-at-Risk shoots up AAA 2-4 8-10 AA 4-7 20 Margins/haircuts increase A 8-15 30 Collateral value declines BBB 10-20 50 Funding liquidity dries up Equity 50 100 Source: Citigroup, IMF Stability report 2007 Liquidity/Margin Spiral 17
    • 3. Mechanism 1 - Margins for S&P 500 Futures Collateral Crisis due to Increased Vol. + Losses 14% 12% Black Monday US/Iraq war LTCM 10/19/87 10% 8% 6% 4% 2% 1989 mini crash Asian crisis 18 0% Jan-82 Jan-84 Jan-86 Jan-88 Jan-90 Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06
    • 3. Mechanism 1 – Why ARCH? Collateral Crisis due to Increased Vol. + Losses vt = vt-1 + Δvt = vt-1 + σt εt p1 σt+1= σ + θ |Δvt | 120 100 Λ Λ m1 80 m1 2 1 t 19
    • 3. Mechanism 1 – Hyperbolic Star Collateral Crisis due to Increased Vol. + Losses customers’ supply _ x1 < W1/m1 = W1/(σ + θ|Δp1|) 20
    • 3. Mechanism 1 Collateral Crisis due to Increased Vol. + Losses Liquidity spiral Margin spiral (Redemption/roll-over spiral) Loss spiral Source: Brunnermeier & Pedersen (2007) Both spirals reinforce each other 21
    • 3. Mechanism 2 Collateral Crisis due to Lemon’s Problem Financiers are concerned Collateral is more risky + Receive a particular bad selection of collateral Issuer knows best what’s in the pool of assets Recall CDOs are particularly difficult to price As margins/ABCP rate increase, selection of collateral worsens Leads to a further increase and hence worse selection ultimately leads to a market breakdown. 22
    • 3. Mechanism 3 Expertise, Complexity and Discreteness CP stops to be viewed as “cash substitute” Buyers of ABCP do not conduct a credit analysis. No expertise in credit quality evaluation Deterioration in fundamentals makes credit evaluation necessary Withdrawal from ABCP market Expertise is only slowly build up again 23
    • 3. Mechanism 4 Run on Financial Institutions Run before others run – DYNAMIC Financial Institutions On Banks: Demand depositors, by withdrawing On HFs: Prime brokers, by increasing margins Investors, by redeeming funds On SIVs: Investors, by not rolling over ABCP Note: “Liquidation policy” of SIVs favors early withdrawals! 24
    • 3. Mechanism 5 Gridlock Risk Interweaved network of financial obligations Lender and borrower at the same time Example: B 30m 50m A 40m 60m 40m C 30m Gridlock, if A loses 30m – Deadlock, if A loses 55m Opaqueness makes matters worse Regulator can’t intervene 25 Warren Buffett is less likely to help out
    • 3. Mechanism 6 Precautionary Hoarding “Funding cushion” for adverse events increases for 3 reasons SIVs might draw on credit lines 1. Borrowing at interbank lending market is more 2. volatile (since other banks might have SIV exposure) Increased credit counterparty risk 3. 26
    • 3. Mechanism 7 Knightian Uncertainty Market freezes up, since Investors focus on worst-case analysis if it is difficult to assign probabilities to different outcomes (like value of CDOs) Investors/banks hoard because they fear the worst 27
    • 4. Differences to Previous Crisis Common theme: interaction between funding and market liquidity. 1987 crash: culprit was portfolio insurance trading 1994 mortgage crisis: primarily prepayment risk 1998 LTCM crisis: specific convergence spread arbitrage trades were well known e.g. on-the run and off-run spread (not much in 2007) known main player which needed to be bailed out 2000 Internet bubble – role of analysts 2007 culprit: rating agencies housing market correction maturity mismatch 28
    • 5. Conclusion Crisis with traditional elements: due to mismatch of maturities Interaction between funding and market liquidity New level of opaqueness Structured products are difficult to value off-balance sheet vehicles (SIVs) (Basel accord) Several mechanism/“liquidity spirals” are at work Collateral crisis due to increased volatility Run on financial institutions (dynamic) Gridlock risk Hoarding 29