Credit Crunch 101
by LSE faculty and students
Part 1: Financial Market
Developments
Overview of today
1.
2.
3.
4.
Subprime mortgages
Mortgage-Backed Securities
CDOs and CDSs
Banks
Subprime Mortgages
Subprime Mortgages
• The federal objective of “an ownership society” through
indirect and off-budget activities (mortgage insurance and
guarantee programs through Fannie Mae and Freddie Mac ).
• Subprime mortgage
– loans to high risk borrowers with low or uncertain incomes
and poor credit histories.
– Most are adjustable-rate mortgages (ARMs) such as 2/28 or
3/27. Initial low interest rate, then rise to significant
premium over the prime rates.
• Since 2000, the subprime grew at the expense of Fannie and
Freddie (prime mortgages).
Subprime Mortgages
Source: Jaffee and Quigley (2007)
Subprime Mortgages
Essentially zero in 1993, grew to 20% by 2005.
• Regulations and deregulations– (i) subprime became
legal in 1980 (ii) securitization enabled lenders to
spread risks more efficiently (iii) gave banks an
incentive to make low- and moderate-income
mortgages. (iv) tax reform prohibited interest
deductions on consumer loans but allowed those on
mortgages.
• Borrowers usually refinance (usually after two or
three years) when they have to face higher interest
rates. It works when house price is rising fast (19972006).
Subprime Mortgages
Real House Price Index, United States
1980-2007, Shiller
1.8
1.6
1.4
1.2
1
0.8
1980
1985
1990
1995
2000
2005
Subprime Mortgages
Subprime Residential Mortgage-Backed Securities
(RMBS)
• Different from traditional securitizations because
subprime mortgages are expected to refinance after 2
or 3 years. So the risk inherent in the securitization of
subprime mortgages depends on the refinancing of
the mortgages, which depends on house prices.
• The ABX.HE index (linked to a basket of subprime cash
bonds) was launched in January 2006, allowing
trading of subprime risk.
Subprime Mortgages
Source: Gorton (2008)
Mortgage-Backed Securities
Securitization
Investor
1. Rating Agency
(e.g. Standard &
Poor’s)
2. Insurance
Agency
3. Servicer
Asset Manager
Issuer
Originator
Borrower (hhold)
SOURCE: NyFed
Staff Report 318
Changing mix and
increasing securitization
SOURCE: NyFed
Staff Report 318
Frictions in Securitization
Investor
MH
1. Rating Agency
(e.g. Standard &
Poor’s)
MH/Errors
Asset Manager
AS
Issuer
2. Insurance
Agency
MH/Errors
MH
AS
Originator
3. Servicer
MH
Errors, MH
Borrower (hhold)
Question
• How much does it have to do with vertical
disintegration? Are incentive problems same inhouse?
– E.g. Merryl Lynch purchase of its own originator
–.
• “Eager to build its own money machine, Merrill went on a buying
spree. From January 2005 to January 2007, it made 12 major
purchases of residential or commercial mortgage-related
companies or assets. It bought commercial properties in South
Korea, Germany and Britain, a loan servicing operation in Italy and
a mortgage lender in Britain. The biggest acquisition was First
Franklin, a domestic subprime lender.
• The firm’s goal, according to people who met with Merrill
executives about possible deals, was to generate in-house
mortgages that it could package into C.D.O.’s. This allowed Merrill
to avoid relying entirely on other companies for mortgages.” NYT
Lending standards Collapse
Source: IMF financial
stability report, Oct 08.
Loan values
Source: IMF financial
stability report, Oct 08.
CDOs and CDSs
Banks
Leverage Amplification
E
decrease in
asset prices
A
E’
A’
D
D’
Decrease in the demand for
assets
• Equity: difference between value of assets and value of the debts.
• Leverage: Assets/Equity (A/E).
•  asset prices   value of assets   equity   leverage.
• To restore the original level of leverage: sell assets to pay down debt
• Asset sell-off lowers asset prices, further lowering the value of assets.
• Marking-to-market synchronizes the actions of market participants 
• a shock requires a quick adjustment.
Global Economic Crisis: Global
Imbalance
D. Quah
28
Summary







Since 2000, Increase in leverage (good expectations,
asset prices increasing)
Summer 2007: Asset values down/worsening
expectations (leads to need to deleverage)
We have assumed that to restore the original leverage
ratio the bank could not raise extra equity to pay down
debt.
Why is that a reasonable assumption?
Asymmetric information problem.
Need for adjustment (reducing balance sheet size)
Government intervention: bank re-capitalization.
Global Economic Crisis: Global
Imbalance
D. Quah
29
Investment banks: leverage is pro-cyclical
Upper bound on leverage increases in good times.

Leverage is limited by the rate at which the bank can
borrow .
◦ Higher leverage and more risky assets induce lower ratings.
◦ Rating influences the rate at which the investment bank can
borrow.


In good times, default probabilities and volatility are
perceived to be lower, ratings are higher.
So the upper bound on leverage that allows for low cost
of borrowing (maximum rating) is higher in good times.
Global Economic Crisis: Global
Imbalance
D. Quah
30
199001
199003
199101
199103
199201
199203
199301
199303
199401
199403
199501
199503
199601
199603
199701
199703
199801
199803
199901
199903
200001
200003
200101
200103
200201
200203
200301
200303
200401
200403
200501
200503
200601
200603
200701
200703
200801
Debt Outstanding
25000000
20000000
home mortgages
15000000
consumer credit
bank loans nec
10000000
bonds + CP
5000000
0

Commercial Banks
• $12Tn assets, leverage
10
• Funded by deposits
and debt
• Leverage limited by
capital reserve ratios
• Access to Discount
Window

Investment Banks
• $6Tn assets, leverage
25
• Funded just by debt
• Leverage limited by
debt ratings
• No access to discount
window
Basel: Capital Requirements on Banks
To meet Basel I standards, or to qualify as adequately capitalized in in the
US:
•Tier I capital (book equity) must be at least 4% of risk-adjusted assets
• Tier I + Tier II capital (reserves, long-term debt) must be at least 8 % of
risk-adjusted assets.
• MBSs typically weighted at 20% or 50%
ASSET
S
0%
RISKWEIGHTED
ASSETS
LIABILITIES
& EQUITY
Liabilities
20 %
50 %
100 %
TIER 2: Debt
Equity
200 %
TIER 2:
Reserves
TIER 1
Structured Investment Vehicles
• Banks set up an SIVs that issue short-term Asset Backed Commercial
Papers (ABCP’s) and invest in risky and long-term assets.
• Liquidity risk: ABCP market might dry up.
• Sponsoring banks get all the risk of the ABCP's via derivative contracts
(liquidity facility, credit facility, swap agreement)
• If the SIV's fail to refinance the ABCP's, the sponsoring banks buy
the SIV's assets at a price that ensures full payment of the ABCP
investors.
• Usual tenure of this derivative contracts: less than a year (often
364 days), often renewed. So, they get preferential regulatory
treatment. ∙
• But banks are not required to hold capital against that risk.
• However, when banks buy the SIV's assets, capital requirements might
bind. That may lead to fire-sale of the assets.
• In a stress scenario, that may damage the bank's balance sheet
• Coordination issue: if nobody buys the ABCP's, they become risky.
Writedowns & Recapitalisation
Source: http://ftalphaville.ft.com/blog/2008/10/23/17369/losing-control/
Credit Crunch 101
Part II: The Crisis, Policy Response,
and Macro Outlook
Overview of Today
1.
2.
3.
4.
The crisis, and the policy response
Historical comparisons
The macro outlook
Discussion
Brief History of the Crisis
Financial markets: some key events
•
June-August 2007: Losses associated with subprime related assets forced Bear
Stearns ad Goldman Sachs to inject capital in their own hedge-funds. IKB
(German lender) issued unexpected profit warning. BNP Paribas froze
redemption on three hedge funds. Quasi-closure of CDOs market.
•
October-November 2007: further write-downs by major international banks
partly covered by Sovereign Wealth Funds. Estimates from subprime losses
revised upward.
•
January 2008: stock market sell-off likely related to monoline insurers
downgrade and BNP Paribas unwinding position of rogue trader.
•
March 2008: liquidity problem lead to Bearn Stearns bail-out via J.P. Morgan.
•
July 2008: Fannie & Freddie obtain potential unlimited support from
government.
•
September 2008: Fannie & Freddie conservatorship, Lehmann Brothers
collapse, and AIG bail-out
Stress indicators in money and equity markets
• LIBOR-OIS spread: (measure of risk and liquidity in the money market)
– What is LIBOR? London Interbank Offered Rate (LIBOR) is the interest rate at
which banks borrow unsecured funds from other banks in the London
wholesale money market for a period of 3 months.
– What is OIS? Overnight Index Swap (OIS) is an interest rate swap where the
floating rate of the swap is equal to the (compounded) average of an overnight
index (i.e., a published interest rate) over every day of the payment period. In
the U.S., OIS reflects the compounded Fed Funds rate over the payment period.
• TED spread: is the gap between 3-month LIBOR and the 3-month Treasury bill
rate. Measure of flight to quality; rising TED spread often presages a downturn in
the U.S. stock market, as it indicates that liquidity is being withdrawn.
• VIX index: “fear index” measures expected volatility in the S&P 500 index over
the next month.
3-month LIBOR-OIS SPREAD (2-year horizon)
4.00
3.50
3.00
2.50
US LIBOR OIS SPREAD
EUR LIBOR OIS SPREAD
UK LIBOR OIS SPREAD
2.00
1.50
1.00
0.50
13/11/08
13/09/08
13/07/08
13/05/08
13/03/08
13/01/08
13/11/07
13/09/07
13/07/07
13/05/07
13/03/07
13/01/07
13/11/06
0.00
13/11/08
13/09/08
13/07/08
6
13/05/08
13/03/08
13/01/08
13/11/07
13/09/07
13/07/07
13/05/07
13/03/07
13/01/07
13/11/06
TED SPREAD-US
7
TED SPREAD US
GB3 Govt
US0003M Index
5
4
3
2
1
0
14/10/08
14/08/08
14/06/08
14/04/08
14/02/08
14/12/07
14/10/07
14/08/07
14/06/07
14/04/07
14/02/07
14/12/06
14/10/06
14/08/06
14/06/06
14/04/06
14/02/06
14/12/05
14/10/05
14/08/05
14/06/05
14/04/05
14/02/05
14/12/04
14/10/04
VIX (4-year horizon)
90
80
70
60
50
40
30
20
10
0
Policy response I: official policy rate
• Roles of official policy rate:
– macroeconomic stabilization
– liquidity.
• Different monetary policies pursued until August 2008 (aggressive cuts by
the Fed, minor cuts by Bank of England and rates increase by ECB).
• From August 2008 coordinated policy cuts among major central banks.
• Has policy been effective? (i.e., transmitted to the rest of the economy?)
– Liquidity: What has been the pass-through to:
• Mortgage rates
• Commercial paper rates
• Interbank rate
– Macroeconomic Stabilization: Has the market led the policy rate? Policy
surprise?
15/08/08
15/05/08
15/02/08
15/11/07
15/08/07
15/05/07
15/02/07
15/11/06
15/08/06
15/05/06
15/02/06
1
15/11/05
2
15/08/05
15/05/05
15/02/05
15/11/04
7
US Policy Rate, OIS and LIBOR (4-year horizon)
6
5
4
3
FED Funds Rate
OIS-US
LIBOR-US
0
15/08/08
15/05/08
15/02/08
15/11/07
15/08/07
15/05/07
15/02/07
15/11/06
15/08/06
15/05/06
15/02/06
15/11/05
2
15/08/05
3
15/05/05
15/02/05
15/11/04
UK Policy Rate and OIS (4-year Horizon)
8
7
6
5
4
BOE Official Rate
OIS-UK
LIBOR-UK
1
0
15/08/08
15/05/08
15/02/08
15/11/07
15/08/07
15/05/07
15/02/07
15/11/06
15/08/06
15/05/06
15/02/06
15/11/05
15/08/05
15/05/05
1
15/02/05
15/11/04
ECB Policy Rate and OIS (4-year horizon)
6
5
4
3
2
ECB Official Rate
OIS-EUR
LIBOR-EUR
0
18/10/08
18/07/08
18/04/08
18/01/08
18/10/07
18/07/07
18/04/07
18/01/07
18/10/06
18/07/06
18/04/06
18/01/06
18/10/05
1
18/07/05
18/04/05
18/01/05
18/10/04
US Policy Rate and Commercial Paper Rate
(4-year horizon)
6
5
4
3
2
FED Funds Rate
Commercial Paper Rate
0
14/10/08
14/07/08
14/04/08
14/01/08
14/10/07
14/07/07
14/04/07
14/01/07
14/10/06
14/07/06
14/04/06
14/01/06
14/10/05
14/07/05
1
14/04/05
14/01/05
14/10/04
US Policy Rate and Mortgage Rates
(4-year horizon)
7
6
5
4
3
2
FED Funds Rate
Mortgage-Fannie Mae Commitment Rates
0
Policy response II: liquidity management
(i.e. the alphabet soup of new facilities)
General aim: to inject liquidity into markets by increasing volume and
Maturity of liquidity management operations and by allowing for wider
range of collaterals.
•
•
•
•
•
•
Discount window changes: reduced penalty rate and extended terms of loans (FED); no changes
for ECB and BOE.
TAF (term auction facility): commercial banks could borrow anonymously against broad range of
collateral. Designed to avoid stigma of discount window (December 2007) [FED, ECB, BOE,
BOC, SNB]
TSLF (term securities lending facility): allowing investment banks to swap agency and other
mortgage-related bonds for Treasury bonds (Difference with TAF: investment banks and range of
collateral, March 2008.
PDCF (primary dealer credit facility): discount window for investment bank. Overnight horizon
and same penalty as discount window (March 2008)
International Currency Swap: aim is to address dollar funding needs of international financial
institution that have short maturity foreign currency liabilities and illiquid foreign assets
Guarantees of money market funds and commercial paper facility
Historical Comparisons
1929+ not primarily a banking crisis
• Banking crisis only late during depression, 1931-33
– Triggered by exogenous events
(Banking scandal
1930, German reparations, Gold Std breakdown)
– Effects of banking crisis on U.S. output in doubt
• Monetary policy not that restrictive
– Fed slashed interest rates, policy lost traction
• Bad news about resurrection of unions in 1929
– Political deals for later New Deal all concluded in ’29
– Real wage rigidity (pressure by Hoover admin.)
– Lax antitrust– unions to cut into monopoly rents
Comparison to Japan
Japan (1/3 of US GDP)
91 Land prices peak out
1/2 by 95, 1/3 by 05
US
origin
06
House prices peak out
Decreased by 20% by now
94 Tokyo-Kyowa (94)
Case-by-case
bailout /
~ ``Jusen’’ (96)
98 Sanyo, Yamaichi etc (97) bankruptcy
08
Bear Sterns (March)
Fannie-Mae, Freddie-Mac
Lehman, AIG (Sep), etc
97 Default in inter-bank
market (Sanyo)
Banking crisis
08
Lehman
(MMF below par)
98 $500 bn (12% of GDP)
Bailout plan
08
$700 bn
93 Established in 93, 99, 03 Purchase of NPL
08
Not yet implemented
98 98-99 ($93bn)
03 ($20 bn)
08
$350bn
Capital injection
10% in 95, 18% in 98
NPL/GDP
-1.5% (1998)
Min. GDP growth
17.6%
Output loss
The Macro Outlook
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United States
Real GDP
Industrial production
Unemployment rate
7.0
112
110
6.5
108
6.0
106
5.5
104
5.0
102
4.5
100
98
4.0
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n0
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M 4
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4
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S 4
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-0
4
N
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4
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n05
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ar
-0
M 5
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5
Ju
l-0
5
S
ep
-0
5
N
ov
-0
5
Ja
n06
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ar
-0
M 6
ay
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6
Ju
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6
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6
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M 8
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8
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8
Eurozone
Real GDP
Industrial production
Unemployment rate
9.5
112
110
104
98
9.0
108
8.5
106
8.0
102
7.5
100
7.0
Wealth effect
• Falling prices of houses and financial assets reduce wealth and
hence consumption.
• But theoretically, house price change need not generate a
wealth effect:
– Families could internalize opposite wealth effect on their children
(analogous to Ricardian equivalence argument)
– Heterogeneity in marginal propensity to consume out of wealth
between those “long” and “short” in housing
– Collateral constraints
• Empirical evidence:
– Case, Quigley & Shiller (2005), macro data, US states, 1982-99:
Elasticity of consumption w.r.t. house price = 0.04-0.06 (using retail
sales data as proxy for consumption)
– Campbell & Cocco (2007), micro data, UK FES, 1988-2000: High
elasticity of consumption w.r.t. house price - approx 0.65
Credit channel and financial accelerator
• Theory (Bernanke, Gertler & Gilchrist, 1999)
• Falling asset prices reduce ability of borrowers to post collateral or inject
equity into investment projects
• With imperfect monitoring by lenders, when net worth falls, the external
finance premium increases.
• Fall in investment has knock-on effect on demand and asset prices, with
further falls in net worth (financial accelerator).
• Empirical evidence:
– Levin, Natalucci & Zakrajsek (2004): Micro data support link between leverage
and external finance premium, but time-variation in financial frictions
(bankruptcy costs in model) needed to fit macro data.
– Christensen & Dib (2008): Build financial accelerator into DSGE model: Boosts
output fluctuations by around 10-20%.
Ja
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nJa 9 2
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n08
Corporate bond spreads over Treasuries (30 yr)
NBER recession
Baa spread
Aaa spread
5
4.5
4
3.5
3
2.5
2
1.5
1
0.5
0
Commercial paper spreads over Treasuries (3 mon)
NBER recession
Financial CP spread
Non-financial CP spread
5
4.5
4
3.5
3
2.5
2
1.5
1
0.5
Ja
n07
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n05
Ja
n03
Ja
n01
Ja
n99
Ja
n97
Ja
n95
Ja
n93
Ja
n91
Ja
n89
Ja
n87
Ja
n85
Ja
n83
Ja
n81
Ja
n79
Ja
n77
Ja
n75
Ja
n73
Ja
n71
0
Bank Capital Channel
• Theory (van den Heuvel, 2007):
Suppose:
– Capital requirement
– Banks cannot readily issue new equity
Then decrease in bank capital results in decrease in
lending
• Evidences in Japan (Watanabe, JMCB, 2007):
In 1997 MOF required banks rigorous self-assessment of
banks assets and adequate write-offs.
 banks cut back lending to meet capital requirement
Other mechanism
• Balance-sheet contagion
– If sectors use similar assets as collateral, sector-specific
shocks spread out across sectors through changes in
asset prices
– Equity prices and bank capital channels in Japan
Monetary policy under the zero bound
• Commitment to zero
interest rate
• OMO of illiquid assets
Nominal rate
recession
policy rate
commitment
Traditional MP
benchmark
New MP
time
boom
pre-emptive
Nominal rate
benchmark
illiquidity
commitment
money T bills
maturity
Was effective in Japan
MBS
ABS
equity
Tangible
assets
Simple quantitative easing
did not work in Japan
Fiscal policy
• How useful is discretionary fiscal policy if monetary policy
proves ineffective?
• Issues:
–
–
–
–
Tax cut or direct increase in govt. spending?
Ricardian equivalence
Lags (implementation, effectiveness)
Tax changes to increase disposable income or affect relative prices? –
e.g. mimic a fall in real interest rate by announcing a future
consumption tax increase (or temporary tax cut)  credibility
problem.
• Empirical evidence:
– Fiscal policy multipliers - Blanchard & Perotti (2002)
• 1% govt. spending shock  approx 1% higher output (peak time
uncertain, between 1 -16 qtrs.)
• 1% tax shock  approx 1% higher output (peak after 5-7 qtrs.)
End
Central Bank Balance Sheet
•
Simple structure as of August 2007
– Assets: Treasury securities of about $800 billion plus its discount loans (an
insignificant number at that time).
– Liabilities: cash held by the public (about $800 billion a year ago) plus the
reserve deposits held by banks (also a small number)
•
How to expand Fed’s balance sheet in order to support those facilities?
Two phases:
1. “Composition” phase: keeping the total asset value constant by essentially
exchanging treasuries for riskier assets (August 2007 - August 2008)
2. “Expansion phase” (September 2008 -)



Usual way would be to credit reserve deposit account (“printing more money”)
Instead the Fed asked the Treasury to implement a Supplementary Financing Program
whereby the Treasury sells securities directly to the public but keeps the funds in an
account with the Fed.
Another way is by paying interest on reserves (October 6): way of encouraging banks to
sit on their excess reserve deposits.
Policy response III: fiscal policy
•
•
•
•
•
TARP legislation: initial program $700bn to buy MBSs
Main features: Treasury will purchase, guarantee and later sell MBSs on a
continuous basis for 2 yrs up to $700bn (only) at a 'given' time; $250 bn will be
provided first, next $100bn when new President reports to Congress and additional
$350bn only on Congress approval; institutions limited to banks, broker dealers,
insurance firms, US subsidiaries of foreign firms but not hedge funds;
Valuation and pricing issues are challenges - Buying assets at lower prices will
reduce risks to taxpayers but might reduce banks' incentive to participate in the
program and writedowns might be too large to bear;
On October 11 Treasury Department announced standardized plan to take
ownership stakes in many US banks to try to restore confidence in the financial
system.
UK authorities decided to inject capital directly: Oct 12, £39bn into three of the
country’s largest banks in a broad-based recapitalisation
Risks ahead?
• Financial risk: hedge funds’ redemptions, further downgrades and
increasing margin call might prompt further deleveraging.
• Losses could easily exceed current fiscal plans: there might be a need for
further government interventions.