LUMS Research Forum on the Credit Crunch
The Credit Crunch and Policy Responses to it
29 November 2008
Traditional vs. ‘new’ banking model
Traditional model ‘New’ model
The new banking model
a.k.a. vehicular finance
a.k.a. originate and distribute model
a.k.a. shadow banking system
a.k.a. structured off-balance-sheet vehicle model
Mortgages collected into a portfolio, sold via a ‘true sale’ to a legally
separate entity, called a Special Purpose Vehicle
(SPV, SIV, conduit), funded by sale of Collateralised Mortgage Obligations
(CMOs) − claims on different ‘slices’ of the revenue from the portfolio of
mortgages, which are structured into different risk classes ranging from AAA
Not only mortgages but also Collateralised Debt Obligations (CDOs)
• loans • Collat. Mort. Obl. (CMOs)
• corporate bonds • Collat. Loan Obl. (CLOs)
• credit card receivables
• aircraft lease portfolios
CDOs, CMOs, CLOs, SIVs, conduits
Take the mortgages/loans off of the bank’s balance sheet
This means that the usual regulatory capital charge for
such loans (money set aside to ensure bank remains
solvent in the case of borrowers defaulting) is not required
i.e. regulatory arbitrage − response to e.g. Basel I
other motivation: rating arbitrage, in that top-rated CDO tranches
Basel I Accord
• Enforced by law in G10rating while the sponsoring bank itself may have
may achieve AAA countries from 1992 onward
• Risk ‘weightings’ rating!
a lower credit
structured products passed through conduits off-balance sheet
• Sponsoring bank usually govt securities, i.e. a on to the lowest-rated
Insured assets treated like (not always) holds zero risk weight
‘toxic waste’ explosion of Credit Default Swap (CDS) use
Superseded bybank extends a ‘reputational’ credit line (‘liquidity backstop’)
Sponsoring Basel II Accord
• to SIVs/conduits.
published 2004, implemented in US in Nov 2007
• closed loopholes for regulatory arbitrage
This doesn’t attract a regulatory capital charge
But it rapidly multiplies the bank’s obligations when defaults multiply
Shortened maturity structure
From 2000 onward, investment banks started to finance an increasing
fraction of their balance sheets with short-term collateralised lending
called repurchase agreements or ‘repos’.
Mostly ‘overnight’ repos (data from US):
• 2000: overnight & 3-month repos 12.5% each
• 2007: overnight repos up to 25%, 3-month repos stable 12.5%
Investment banks have had to roll over 25% of their balance sheet daily
Any disturbance to operation of the repo market immediately affects
investment bank balance sheets.
Importance of ‘liquidity’ in these repo markets. A vulnerability!
Similar importance of liquidity in inter-bank unsecured lending.
Mortgage markets and sub-prime crisis
Securitization of mortgages began in the early 1980s and grew
Rating agencies:creating a vast new market that catered to heterogeneous
domestic and foreign investors, greatly enhancing liquidity, and
• Changed management culture − toward ‘deal chasing’
Moody’s was spun off into a lenders to originate residential
thereby making it attractive forpublic corporation in Sept 2000
• Were making between 8 and 11 basis points on every CMO structure rated
this equated to $ 250,000−$300,000+ each
Specialisation and information technology compressed the mortgage
in the heyday, at 20 ratings per month ≥ $5million per month
cycle down to 6-8months.
these structures would work only if the bulk of the tranches received AAA
At every ‘link’ in the mortgage market chain, the specialised
firms received transactions-based fees. Yes, including the rating
conflict of interest between ‘rating’ and ‘advisory’ functions
Market failure in the provision of information & advice esp. to low-
income households (who get no inf./advice or worse, biased inf./advice).
Explosion of demand for CDOs from the ‘shadow banking system’. Why?
A ‘liquidity bubble’ or ‘credit bubble’?
US Fed pursued loose monetary policy (low interest rates) 2001−
following the stock bubbles 1998-2000. (n.b. 9/11 and war also)
In UK, BoE mirrored this policy.
Capital outflows from Asian manufacturing nations, with surplus US$,
seeking US assets after Asian crisis.
US tax cuts; low US saving rate.
Sovereign wealth funds begin to bulge with US$ as oil price begins
to rise 2001−
massive (‘insatiable’) appetite for CDOs, CMOs, because this
asset class appeared to be delivering high returns
(ah, but with what risk of loss?!!!)
shadow banking system responsible for 50% of US mortgage lending
Unrelenting demand for more mortgages to create more CDOs.
Combined with transaction-based fees (at every link of the chain),
led to deteriorating credit quality, predatory lending, NINA loans, etc.
Prior to the rise of securitisation, sub-prime lenders had strong incentive to monitor
US policymakers did nothing to curb this bubble
• because historically housing bubbles in the US had always been
In the securitization era up to 2004, two classes of agents actively ‘disciplined’ the market.
local/regional, and therefore not national systematic phenomena.
Both had their own independent expertise basis for evaluating sub-prime-based products.
• because of govt’s intensifying commitment to promote home
• bond insurers
•ownership for all AmericansMBS area − would take on subordinate
sophisticated investors from the
tranches from deals not insured by bond insurers
UK policymakers did nothing to curb this bubble
From 2004 onward, CDOs and their investors, by their number and purchasing activity,
• because of the myth that ↑ population + growth persistent upward
became the dominant sub-prime credit risk ‘pricers’ − without specific sub-prime expertise.
trend in real estate prices
Expertise • in reality mort borrowingexpertise left ‘democratized’, earnings ratings.
‘left the market’. No-one with had been to scrutinize the risks and the multi-
ples had soared upward from 3.5, buy-to-let lending grew to >10%,
With no effective curbs, sub-prime lending activity was ramped up: a fall in credit quality.
and initial 2-year fixed-rate offers were extended to people who
Unsustainably risky lending practices from late 2005 to 2007.
could not afford to refinance if interest rates increased at all.
Information economics: market for lemons, winner’s curse with experts & non-experts
As mortgage defaults began to increase (e.g. after 2-year teaser rates
ended), CDOs began defaulting.
First, flight to quality in the repo market, then closure of repo market.
Inter-bank unsecured lending dried up.
Asset-Backed Commercial Paper market dried up.
Remember! Banks have shortened maturity structure!
Daily/monthly/quarterly ‘roll-over’ requirements!
Funding liquidity: margin funding risk, roll-over risk, redemption risk
Market liquidity: high when it is easy to raise money by selling the asset
(and the price isn’t depressed by the act of selling)
Loss Spirals − as asset values fall, borrowing capacity falls,
necessitating asset sales to cover the loans, which depresses
asset price, which reduces borrowing capacity, etc.
Marking-to-market feeds the loss spiral.
Margin Spirals − increased ‘margin calls’ force ‘deleveraging’,
which lowers the price, which forces more sales, which causes
margins to be increased, and so on.
Margin Spirals and Loss Spirals reinforce each other.
Precautionary hoarding − the response of most banks to the
large injections of liquidity and cash!
• two kinds !
A background of systemic deleveraging.
Overall, we observe
Deleveraging and falling asset values.
Low liquidity (zero?) among various interbank markets.
Many institutions are getting caught out, pushed to the brink (and over).
The real economy is increasingly being affected.
Immediately: CRISIS MANAGEMENT
Longer term: INSTITUTIONAL REFORM