Financial Crises and financial interdependence
F.SERGIANI May 2015
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Prequel - the stock market
The general situation of economy was healthy. The market
reacted to the 2002-03 tech bubble and the money market
showed low signs of “counterparty risk”.
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Prequel (2) - the banking sector
The spread between the LIBOR rate (at which banks borrow from each other) and the
Treasury-bill rate (at which the U.S. government borrows), a common measure of
credit risk in the banking sector (often referred to as the TED spread), was only around
0.25%. TED is the treasury-eurodollar spread. This means also low counterparty risk.
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First Problem: low interest rates
US interest rate, source: FED
As an answer to the 2001 tech bubble and to the 9/11,
monetary policy brought down interest rates, even below
the 1%. As a result, people begun to invest in the housing
sector, exploiting the easy credit that banks begun to sell.
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The housing bubble
The massive investments from prime and non prime investors led
to an housing bubble, and prices went up immediately. In ten years
beginning 1997, US house prices tripled. Anyway, most of these
borrowers were not only non prime but NINJA: No Income No Job
or Assets.
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Before the storm
“On the one hand, the Fed’s policy of reducing interest
rates had resulted in low yields on a wide variety of
investments, and investors were hungry for higher yielding
alternatives. On the other hand, low volatility and growing
complacency about risk encouraged greater tolerance for
risk in the search for these higher yielding investments.
Nowhere was this more evident than in the exploding
market for securitized mortgages. The U.S. housing and
mortgage finance markets were at the center of a gathering
storm.”
Bodie, Kane, Marcus, “Investments” 2011
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The storm.
In 2004 interest rates begun to rise. It suddenly begun more difficult to pay mortgages,
especially from non prime (sub-prime) customers. Prices fell immediately and banks
begun to lose money. The cash flow at the base of the securitization process ended rising
volatility on markets and spreading uncertainty.
US interest rates, FED
Case-Shiller index, US house prices
The crisis suddenly become widespread because
of securitization. This process, that let banks
hedge financial risk and spread it all around the
world, is the core of 2008 crisis.
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Securitization
Securitization allows borrowers to enter in the market directly.In this procedure, pools of
loans are aggregated into pass trough securities such as MBS. The transformation of
these pools into standardized securities enables issuers to deal in a volume large enough
that they can bypass intermediaries. We have already discussed this phenomenon in the
context of the securitization of the mortgage market. Today, most conventional mortgages
are securitized by government mortgage agencies. Securitization works thanks to Special
Purpouse Vehicles or SPVs, created by banks or other intermediaries that sells
instruments on markets.
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Securitization (2)
Moreover, banks create the so called SIVs and SPVs
(Special Investment Vehicles and Special Purpose Vehicles)
in order to sell the mortgages, transferring the risk and
putting it out of the balance sheet, evading capital and
reserve requirements. In this way SPVs “securitized”
mortgages and emitted ABS and MBS for secondary
market. Basically, loans must be paid from SPV to the bank
before securitization, and the SPV emits debt in the short
term to pay this service, normally in the form of commercial
paper.
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Mortgages and mortgages backed securities
Mortgages are long-term loans secured by real estate. They are the largest segment in the capital markets in terms
of the amount outstanding. Mortgages by themselves do not have good secondary markets. However, a large
number of mortgages are often pooled together to form new securities called mortgage backed securities, which
have an active secondary market that was hit by financial crisis in 2008.
Specifically, they sell their claim to the cash inflows from the mortgages as those loans are paid off. The mortgage
originator continues to service the loan, collecting principal and interest payments, and passes these payments
along to the purchaser of the mortgage. For this reason, these mortgage-backed securities are called passthroughs. By 2009, about $5.1 trillion of outstanding mortgages were securitized into Freddie or Fannie passthroughs, making this market larger than the $4.0 trillion corporate bond market and comparable to the size of the
$7.1 trillion market in Treasury securities.
The great majority of MBS was issued by Fannie MAE and Freddie Mac, the two government sponsored
enterprises.
source: IMF 2008 - price of mortgage backed securities
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CDOs or Collateralized Debt Obligation
One might ask: Who was willing to buy all of these risky subprime mortgages?
Securitization, restructuring, and credit enhancement provide a big part of the answer.
New risk-shifting tools enabled investment banks to carve out AAA-rated securities from
original-issue “junk” loans. CDOs were designed to concentrate the credit (i.e., default)
risk of a bundle of loans on one class of investors, leaving the other investors in the pool
relatively protected from that risk. The idea was to prioritize claims on loan repayments by
dividing the pool into senior versus junior slices, called tranches. The senior tranches had
first claim on repayments from the entire pool. Junior tranches would be paid only after
the senior ones had received their cut.
Bodie, Kane, Marcus, “Investments” 2011
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The crisis of 2008 - money market and commercial
papers
Large companies often issue their unsecured short term bond notes rather than borrowing from banks. These claims
are called “commercial papers”, often backed by a line of credit from banks in order to let the firm pay off the paper at
maturity (if needed).
Since the maturity is less than 270 days (thus avoiding registration from the SEC) and papers are issued in multiple of
100000 $, small investors can invest only with large MMFs. They are considered almost secure, due to the nature of
issuing firms.
Today, even financial enterprises have begun to issue the so called Asset Backed Commercial Papers, short term notes
issued to raise funds. This kind of engagement from large banks hit the commercial paper market in 2008, as Lehman
Brother collapsed.
Several funds suffered large losses, and this led to a wave of investor redemptions similar to a run on a bank, MMF had
become afraid to commit funds even over short periods and their demand for commercial paper had dried up. The
money market was shocked.
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From Subprime crisis to the global crisis
During 2008 banks were
under stress and they
stopped to trust one
another, shrinking liquidity
in all markets. Financial
commercial papers
collapsed, the money
market went under stress,
and even consumer credit
begun to be reduced. But
another market was
severely hit by the crisis:
the CDS market.
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- invisible hand? -
The CDS market. The crisis goes global.
Another factor of contagion is the CDS (Credit Default
Swap) market. CDS are derivative contracts sold
mainly by banks and insurance companies in order to
protect the customer against the risk of default,
hence the “credit default swap”. Many CDS were sold
to protect against the risk of mortgages and other
risky assets. When trust collapsed even the CDS
market lost most of its value.
CDS are sold on the over the counter market, so it is
very difficult to track the life of these contracts.
Anyway, we can assume that the total amount of
CDS outstanding passed from 2.000 billion dollars to
55 000 billion during the period 2000-2007.
Moreover, in a context of solvency uncertainty and
confidence crisis, “for all OTC derivatives, the
moment a bank does not have sufficient cash buffer
of short-term securities of sufficient quality to be able
to meet collateral calls it is essentially, in the absence
of direct official support, going to go rapidly into a
failure situation.”. The increased fear of bankruptcy
moved into a sovereign crisis via bank and sovereign
CDS interaction. This unregulated niche (since all the
contracts are traded over-the-counter) raised
investors worries over State solvency and offered an
interesting occasion for speculation.
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From private to public sector
As we may see from graph, bank cds and sovereign
cds moved accordingly both in 2009 and 2011,
when sovereign cds spread reached the peak of
1200bp. Moreover, as we may see from table, the
DTCC does not distinguish between reference
entities: State and banks are on the same level in the
global cds market and many investors want to be
protected from Italy or Spain or Greece more than
private companies.
Basically, the crisis, reflected and well represented by
the cds market shifted from a crisis of the private
sector to a crisis of the public sector, since the banks
were too intertwined with eurozone public debt or
other forms of financial instruments. In 2010 Greece
owes 53 billion to French banks and 19 billion to
German banks. Moreover, in 2011, Deutsche Bank
had 39,1% of its balance dedicated to derivatives
while the exposure of Soc. Générale was 17,9%
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As a result... recession.
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Finance and Territory
The crisis showed systemic interconnection between
financial system and territory. There are micro and
macro economic channels that let crises spread to
the so called real economy and thus to the territory.
States manage their debt with finance, monetary
authorities act on markets via money market. Firm
borrow and lend exploiting money and capital
markets, being tied to financial risks and
vulnerabilities. Commodities are directly priced on
financial markets.
This system is at the basis of what we call
“geofinance”.
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What’s next?
Financial Interconnection and systemic risk
In finance, we have to distinguish between
systemic and systematic risk. The former is
based on macro prudential approach and is
a relatively new field of analysis while the
latter is the β of securities and is based on
microeconomic fundamentals of firms.
This definition has been introduced by the De
Larosiére report of 2009 and translated into
an European regulation establishing the
European Systemic Risk Board. The
European Union defines “systemic risk” as “a
risk of disruption in the financial system with
the potential to have serious negative
consequences for the internal market and the
real economy. All types of financial
intermediaries, markets and infrastructure
may be potentially systemically important to
some degree.”. This is a macro-prudential
approach that follows the Vrolijk approach
and that is behind the overall functioning of
the new ESFS, the European network of
financial authorities
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source: Vitali, Glattfelder, Battiston 2011 - Politi 2012
Interconnected world
the global banking network, 1978
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Systemic Risk
The global banking system, today
Sources: Minoiu C. Reyes J. A Network Analysis of Global Banking , WP December 2011 ; OECD, Outlook for the Securisation Market, Paris 2011
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Its all connected - The Eurocrisis
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