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U.S. residential mortgage market “ Prime” Loan to value < 80% Good credit score “ Non-prime” “ Conforming” Small principal (< conforming limit) “ Jumbo” Large principal (> conforming limit) “ Near-prime (Alt-A)” Loan to value ~ 80-90% Intermed. credit score “ Subprime” Loan to value > 90% Bad credit score
Non-classical, flexible mortgage products opened access to credit to high risk individuals.
Failure #1 : underestimation of risk in loan products; risk due to non-classical products not fully accounted for;
Predatory lending practices
Widespread availability of credit fueled demand for housing and the house-price boom
Failure #2 : poor underwriting stanadards in loan origination; loans made to individuals with poor or no credit histories, no documentation, no regular income ; lending based entirely on home value !
Origins – broad view Microeconomic factors (1)
Securitization and structured finance
Transfer of risk (“originate and distribute” model) freed loan potential for new lending cycles
Failure #3 : underestimation of risk in structured finance products; risk-assesment models failed due to multi-layer structuring and dispersion of risk.
Failure #4 : monitoring of risk in structured finance products delegated to credit rating agencies with (1) no real “value at risk”, except reputation and (2) conflict of interest with the issuer of securities
Failure #5 : poor underwriting standards in loan securitization (securities issued despite failures #3 and #4)
Failure #6 : intransparent legal design of securitization process; widespread use of off-balance sheet entities
Origins – broad view Microeconomic factors (2)
Two necessary conditions for fast transmission of the crisis
Widespread use of risk transfer mechanisms – securitization and structured finance
Strong demand for derivative securities – due to global macroeconomic environment
Two sufficient conditions for fast transmission of the crisis
Strong increase in uncertainty (asymmetric information) – investors unable to determine the outcome of their decisions
Strong increase in risk aversion – investors not willing to take on new risk
Two key phases in transmission
Transmission to institutional investors
Transmission to banks
Transmission Securitization & risk transfer (1)
Mortgage loans Total value: $900.000 Mortgage loan portfolio can be divided into 9.000 bonds with $100 face falue. Different tranches of bonds carry different levels of risk depending on their seniority/subordination in debt repayment. 1. tranche (low risk) 3.000 bonds at $100 Coupon rate: 10 % 2. tranche (medium risk) 3.000 bonds at $100 Coupon rate: 15 % 3. tranche (high risk) 3.000 bonds at $100 Coupon rate: 20 % Securitization Mortgage backed securities (MBS) Demand: financial investors Supply: originators of mortgage loans
Senior/subordinated debt structure: pecking order in absorption of loan losses to derivative securities (equity tranche first, senior tranches last).
Liquidity facilities – sponsor banks provide liquidity in case of cash shortages due to redemptions
Transmission The key to AAA ratings in securitization
Transmission The players in securitization
Originator End borrowers Conduit/trust/ SPV/SPE/SIV Investment bank (underwriter) Rating agency Institutional investor End lenders Insurance company Broker Servicer $ $ $ $ $ Mortgages Mortgages MBS I&P ($) I&P ($) MBS, I&P ($) Financial returns ($) LEGEND KEY O&G – interest and principal SPV – special purpose vehicle SPE – special purpose enterprise SIV – special investment vehicle MBS – mortgage backed securities Founder: loan originator or investment bank Purpose: transfering ownerhship of claims (loans) and collateral (mortgages) in order to issue mortgage backed securities (bonds). Exposure of founder: implicit guarantee in case of large losses. Assigns credit rating to issued MBSs. Organizes issuing of MBSs and places MBSs to investors in financial markets. Broker places mortgage loans to borrowers for fee Manages the flow of interests and principal (I&P); usually, but not necessarilly the Originator Typically a specialized mortgage bank Banks, insurance companies, mutual funds, hedge funds… Can assume part of risks (insurance of mortgage loans, insurance of MBS returns).
Why has a crisis in a relatively narrow segment of the U.S. financial system send such strong shockwaves through the U.S. and international financial environment?
Investor miopia – excessive focus on yield and insufficient focus on risk due to benign international financial environment.
Difficulties in estimating risks – failure of risk assessment models for structured finance instruments, which are not actively traded in the secondary markets (such as CDO and CDO2).
Transmission Part 1: institutional investors (1)
Over reliance on credit rating agencies – systematic large downgrades of MBS credit ratings since July 2007 cause panic among investors and subsequent “flight to quality” repricing of risk!
Contagion effect – a lack of confidence spread from the narrow MBS segment to the wider ABS segment, which is based on a much broader pool of claims, including corporate bonds, student loans, car leases, credit card payments etc.
Deleveraging (unwinding of credit) – investors’ lack of condifence fire sales of structured finance instruments forced liquidation of SIV/SPV/SPE assets falling prices of illiquid structured finance instruments further lack of confidence accelerated fire sales of structured finance instruments…
Transmission Part 1: institutional investors (2)
Transmission Increase in uncertainty: unreliable credit ratings for mortgage derivative securities
Transmission Increase in risk aversion (1): from residential to commercial mortgages
Record drops in prices Record increases in risk premiums
Transmission Increase in risk aversion (2): from mortgage to other asset derivatives
Transmission Increase in risk aversion (3): from derivatives to corporate debt market
How has the crisis jumped from institutional investors to the interbank market?
Realization of contingent liabilities of banks to various investment vehicles
Important initial role of short-term ABCP (asset backed commercial papers) exposed to U.S. subprime market in transmission of the crisis. They are particularly vulnerable to refinancing risk.
Conduits issuing ABCPs were established & sponsored by several european banks. As they came under pressure due to investors’ redemptions some banks withdrew their support signal that banks may have difficulties in meeting their obligations!
Transmission Part 2: banks (1)
Non-functioning of the securitization market – banks can no longer transfer risks off their balance sheets (problems with pending LBOs). Unwanted claims put pressure on banks’ capital adequacy.
Hoarding of liquidity by banks – due to high uncertainty, banks create a dangerous liquidity crunch in the interbank market
Banks build-up their own precautionary cash reserves against realization of unforseen contingent liabilities.
Banks stop lending to each other because of adverse selection (lack of confidence)
Hoarding of liquidity by non-financial companies – Due to observed liquidity shortages in the market, companies try to secure cash (for example, by drawing on their credit lines), creating further liquidity pressures for banks.
Transmission Part 2: banks (2)
Transmission Increase in banks’ credit and liquidity risk
Outbreak phase (summer 2007 – fall 2007), marked by:
First awareness of the crisis in the general public
First period of interbank liquidity crunch and massive central bank interventions
Build-up of losses in the financial system (banks’ write-offs and balance sheet clean-ups)
First significant round of bank recapitalizations (large role of sovereign wealth funds due to lack of private investors )
Continued isolated bank failures (Bear Stearns)
Timeline Three phases of key crisis events (1)
Escalation phase (fall 2008-now) – marked by:
Failures or near failures of large, systemically important financial institutions (investment banks, insurance companies, commercial banks and thrifts) – Lehman Brothers, AIG, Washington Mutual, Fortis, Hypo Real, Royal Bank of Scotland, HBOS, Bradford & Bingley…
Second period of interbank liquidity crunch
Development of a credit crunch for non-financial companies and households (worsening of real economy)
Significant wealth effects (large declines in stock prices)
Unprecedented public interventions by central banks and governments around the world
Balance of payments crises (smaller countries) & first interventions by the International monetary fund
Timeline Three phases of key crisis events (1)
Timeline Outbreak phase
First signs of trouble already in the first half of 2007
Mouniting losses due to subprime loans (HSBC)
Problems of funds involved in the secondary market for mortgage securitizations (Bear Stearns)
Problems of institutional investors that invested in morgage derivatives (IKB, WestLB).
Systematic downgrades of credit ratings of mortgage derivatives since July 2007
Result: rapid redemptions of derivative securities by institutional investors
Significant outbreak in august 2007
Problems of three funds of BNP Paribas
BNP Paribas stops redemptions in funds due to “difficulties in valuation of funds’ U.S. investments”.
Result: investors panic, massive sell-offs create the first liquidity crunch.
Timeline Deleveraging phase
Rapid liquidation of positions in mortgage and assed based securities by institutional investors
Losses are absorbed by institutions involved in the securitization process – significant write-offs, particularly among banks
Write-offs of losses create need for fresh capital . In the absence of sufficient private capital, financial institutions resort to sovereign wealth funds (SWFs involved in 60% of all recapitalizations by decemeber 2007).
Write-offs, capital raised, and central bank liquidity interventions create some transparency in the interbank market, easing the liquidity crunch .
Timeline Escalation phase (1)
By late summer 2008 deleveraging is endangering soundness of large, systemically important financial institutions .
First sign of serious trouble : nationalization of Fannie Mae and Freddie Mac by the U.S. government due to insolvency (7.9.) – both GSEs stand behind more than 50% of all U.S. mortgages.
Key event in escalation phase: Lehman Brothers (investment bank) files for bankruptcy on 15.9.
Lehman is the underwriter of large volumes of derivative securities
Immediate and significant increase in counter-party risk
Events unfold with rapid pace : all remaining Wall Street investment banks restructured or sold within a week, U.S. govenment rescues insurance giant AIG (16.9), governments around the world scramble to rescue their banks, some prove too small for this task (Iceland, Hungary, also other smaller nations).
Inter-bank lending grinds to a halt , bringing down credit flow to the real economy along.
Crisis begins spilling over to the real economy (problems with consumptino of durables, i.e. car industry)
Timeline Escalation phase (2)
Two phases in policy response based on crisis timeline
Outbreak and delevereging phase
Key feature: case-by-case approach and involvement of other actors (sovereign wealth funds) in addition to national governments & central banks
Key feature: systemic approach and crucial role of national governments & central banks
Liquidity measures – cash provided in exchange for securities that “nobody else wants” in order to ease tensions in the interbank market .
ECB, Fed and other central banks
Monetary policy measures – reductions of reference interest rates with the objective to stimulate U.S. growth and to ease conditions in the mortgage markets
Policy response Outbreak and deleveraging phases (1)
Bailouts of failed banks – nationalization in case of Northern Rock, government-sponsored takeover (by JP Morgan Chase) in case of Bear Stearns, with the objective to contain systemic risks – problem of moral hazard!
Measures to improve the conditions in the mortgage market (U.S.) – moratorium on loan repayments, increased authority for intervention by government sponsored enterprises (GSEs) both in granting guarantees and securitization
Banks and other players
Balance sheet clean-up and recapitalization of large banks – substantial role of the so called sovereign wealth funds.
Policy response Outbreak and deleveraging phases (2)
Liquidity measures – cash provided in exchange for securities that “nobody else wants” in order to ease tensions in the interbank market and prevent credit crunch.
ECB, Fed and other central banks
Measures extended to non-member countries in case of ECB (Hungary, Denmark…)
Monetary policy measures – reductions of reference interest rates with the objective to stimulate growth around the world and prevent credit cruch
Fed, ECB and other central banks
Policy response Escalation phase (1)
National governments (1)
Earmarked rescue packages – governments adopt a systemic approach; rescue packages designed to prevent collapse of national banking systems – sizes of packages:
U.S. – 700 bn USD
EU – 1.300 bn EUR (1.800 bn USD); of this Germany (500 bn EUR), France (360 bn EUR), UK (300 bn GBP)
Recapitalizations and partial nationalizations of national banking systems – crucial role of national government funds (initially ad hoc, later based on earmarked rescue packages).
Government guaranees for interbank loans – the aim is to help start interbank lending, which would unlock the credit crunch (based on earmarked rescue packages).
Unlimited or increased government deposit insurance – the aim is to build depositors’ confidence in the banking system and prevent bank runs (based on earmarked rescue packages).
Policy response Escalation phase (2)
National governments (2)
Direct central bank lending channel to non-financial companies – the aim is to circumvent non-performing banking system and prevent real effects of the credit crunch (only Fed adopted this measure).
Involvement of the International monetary fund – objective is to help countries facing balance of payments difficulties due to financial crisis; proposals about possible increased role of the Fund in this respect.
Beginning of talks about a substantial remaking of the internatinal financial system – talks will be launched at presidential/prime minister level in the G-20 forum on 15 November in Washington D.C.