THE SUB PRIME CRISIS –
EVENTS AND APPLICATION
OF THEORY
Course on Financial Instability at the Estonian Central Bank,
9-11 December 2009 – Lecture 4
E Philip Davis
NIESR and Brunel University
West London
e_philip_davis@msn.com
www.ephilipdavis.com
groups.yahoo.com/group/financial_stability
1 The build up to the crisis –
global background
• Low real interest rates stimulated borrowing and
financial innovation
– Long rates were low because of high saving especially
by Asian economies
– Short rates were held low in the US
• Buildup of debt and asset price boom
• New features of the market were not stress tested
for downturns
– New asset backed securities hid risk rather than shared
or reduced it
– Reliance on wholesale markets was unwise
Real interest rates
6
5
4
3
2
1
0
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
-1
-2
UK long real rate
US long real rate
UK short rreal rate
US short real rate
France
Germany
Spain
UK
US
20
07
20
05
20
03
20
01
19
99
19
97
19
95
19
93
19
91
19
89
19
87
19
85
19
83
19
81
19
79
19
77
19
75
ratio to personal disposable incomes
Personal sector borrowing
1.8
1.6
1.4
1.2
1
0.8
0.6
0.4
0.2
0
France House prices
UK House prices
Germany House prices
US House prices
Spain House prices
2006Q4
2005Q1
2003Q2
2001Q3
1999Q4
1998Q1
1996Q2
1994Q3
1992Q4
1991Q1
1989Q2
1987Q3
1985Q4
1984Q1
1982Q2
1980Q3
1978Q4
1977Q1
1975Q2
1973Q3
1971Q4
1970Q1
Log scale 2000q1 = 1
Real house prices
1.4
1.3
1.2
1.1
1
0.9
0.8
0.7
0.6
0.5
The build up to the US crisis
• Structural background:
– Rush to sub prime lending in US, encouraged by government
and compensation schemes for bankers
– Accelerating shift to securitisation, credit assessment neglected
for CDOs and other ABS
– Low levels of liquidity and aggressive liability management by
banks
– Some ABS held in SIVs and conduits, ABCP financed (Basel 1)
– Context of global liquidity glut and search for yield (sub-prime
and ABS)
– Suspicion of “disaster myopia”
• The non systemic period (August 2007-August 2008)
• Market liquidity risk
– Realisation of risks of sub-prime plus uncertainty about
valuation of ABS…
– …led to ABS sales, leading to market liquidity failure, with
price falls due to liquidity risk and lower risk appetite, not
just credit risk
– Aggravated by margin requirements and credit limits on
arbitrageurs, and restriction on risk appetite of market
makers
– Rush to sell worsened by mark to market’s impact on
capital of institutions and solvency – contrast to banking
crises of past with book values
– Contagion spread via market collapse of ABCP financing
conduits and SIVs
– And via traders attempts to hedge, meet margin calls and
realise gains in more liquid markets
• Funding risk
– Effect on interbank via inability of banks to
securitise, backup calls from conduits and SIVs,
and suspicion of other banks’ solvency due to price
of ABS
– Hence hoarding of liquidity, and wide spreads in
interbank market, also quantity rationing of funds,
especially at longer maturities
– Collapse of Northern Rock due heavy dependence
on wholesale funds, and later of Bear Stearns and
Lehman Brothers
– Close relation of funding risk to market liquidity
risk revealed overall
• The Systemic period (September 2008-)
– Failure of Lehmans leading to complete drying-up
of wholesale markets, including commercial paper
– Problems for money market funds breaking the
dollar – also mutual funds and hedge funds
– Massive redemptions of such funds leading to
sales in illiquid markets
– Flight to quality in government bonds
– Bank failures and government recapitalisations
– Crisis spreading to real economy – risk of adverse
feedback loop (Bernanke)
– Major recession has ensued
US problems
• Losses in the US on sub prime loans perhaps $1.4
trillion
– Sold on as asset backed securities
– Over half to European banks
• Sub prime loans may have defaults of over $1
trillion because of US bankruptcy law
– unwise lending masked by ‘originate and distribute’
model
– Evaluation of securities based on individual not group
default rates
• Lehman was a US bank
US
Euro Area
UK
05 June 2009
05 March 2009
05 December 2008
05 September 2008
05 June 2008
05 March 2008
05 December 2007
05 September 2007
05 June 2007
05 March 2007
05 December 2006
05 September 2006
05 June 2006
05 March 2006
05 December 2005
05 September 2005
05 June 2005
05 March 2005
05 December 2004
05 September 2004
05 June 2004
05 March 2004
05 December 2003
05 September 2003
05 June 2003
05 March 2003
05 December 2002
05 September 2002
05 June 2002
05 March 2002
05 December 2001
05 September 2001
05 June 2001
05 March 2001
05 December 2000
05 September 2000
05 June 2000
05 March 2000
US, UK, EU credit spreads
Spread between BAA corporate and government bonds
10
9
8
7
6
5
4
3
2
1
0
2
Application of theory
• Financial fragility: crisis linked to asset price bubble
fuelled by underpriced credit. Time of realisation that
situation unsustainable (“Minsky moment”), leading in
turn to tightening of credit, asset price falls and bank
failures.
• Monetarist: highlight policy regime shift to laxity from
2000 onwards, warranted tightening from 2004-6 which
nevertheless exposed the weaknesses of the US housing
market and overleveraged borrowers. Regime shift from
open to closed wholesale (including interbank) markets
that began in August 2007 almost wholly unexpected
even by central banks.
• Uncertainty: financial innovations that were highly
opaque and wholly untested in a downturn.
• Disaster myopia: pervaded both financial institutions
and most policy makers in boom period, sharpening
incidence of credit rationing after August 2007 as risk
loving changed sharply to risk aversion. 2 key points:
– announcement by BNP Paribas in August 2007 that their funds
investing in ABS could not be valued, which brought on the
initial interbank market failure.
– failure of Lehmans in September 2008, which changed agents’
views of what institutions are “too big to fail”, unleashing
immense systemic risks.
• Agency costs: incentives to underprice credit from
transfer of risk in securitisation. Asymmetric
information worsened by opacity of structured credit
products and helps to explain failure of wholesale
funding markets, since banks were uncertain about
“toxic assets” on others’ balance sheets.
• Industrial: securitization enabled a wide range of new
players to enter markets for origination of loans and
also investment. Former worsened adverse selection of
loans, heart of crisis. The latter include hedge funds,
SIVs and conduits; heightened risks to banks that were
either providing credit directly or had backup lines to
them. Hedge funds’ short selling, and later forced sales
of assets central to falling asset prices in securities
markets.
• Standard indicators of financial instability (“generic
sources of crisis”) – applied to US subprime crisis
– Regime shift to laxity or other favourable shock (US
monetary policy in early 2000s)
– New entry to financial markets (subprime lenders)
– Debt accumulation (US subprime)
– Asset price booms (US housing)
– Innovation in financial markets (CDOs/SIVs)
– Underpricing of risk, risk concentration and lower
capital adequacy for banks (use of SIVS, incorrect
ratings)
– Regime shift to rigour – possibly as previous policy
unsustainable - or other adverse shock (house price
weakening, French bank BNP Paribas suspends three
investment funds worth 2bn euros, later Lehmans
failure)
– Heightened rationing of credit (interbank market and
wholesale money markets, also mortgage market and
later all private credit)
– Operation of safety net and/or severe economic crisis (
LOLR in money markets, Northern Rock, indirectly
Bear Stearns – but not Lehmans – bank recapitalisation
and guarantees - now worst recession since 1930s)
3
Incentive problems
• Adverse selection - inadequate corporate governance of
loan officers in banks which allowed credit risk to
accumulate, passed on via securitisation; adverse
selection feared in interbank market
• Moral hazard - incentive of banks to avoid capital
adequacy by setting up SIVs/SPVs and thus holding
loans indirectly – implicitly passing on risk to the safety
net where “too big to fail”, also incentive of originators
of subprime loans not to monitor loans if securitised
• Incentive of rating agencies to give top ratings to paper
containing low quality loans (as payment by issuer)
• Incentives of UK retail depositors to run on Northern
Rock due to low level of deposit insurance
• Incentives of lenders in the wholesale market to
avoid counterparty risk and hoard liquidity for
themselves, thus entailing runs on Northern Rock
and Bear Stearns, and later Lehmans.
• Regulators failed to inform central banks early
enough of potential liquidity problems, showing
institutional problem of separating supervision and
central bank functions.
• Adverse selection and moral hazard incentives for
credit rationing in the interbank market from 2007
and in the real economy from 2008
• Financial crisis triggered by loss of confidence in
“too big to fail”, as authorities did not rescue
Lehmans for fear of moral hazard
4 Liquidity management
• We assess how the sub-prime crisis has changed the
situation for LOLR:
– New forms of liquidity risk – interaction of funding
liquidity and market liquidity
– New responses of LOLR such as supporting non-banks,
lower quality collateral, longer maturities
– New challenges for LOLR such as confidentiality, “stigma”
and deposit insurance interaction
– Coping with the systemic crisis since September 2008
• Overall understanding requires to supplement bank
funding risk with market liquidity risk, and bank
policies of mark to market and balance sheet
management
Relevant liquidity risk paradigms
• Some standard elements
– asset price fall leading to liquidity shock
– Deterioration of loan quality
– Fire sales and runs
• Market liquidity risk and liquidity insurance
(Davis, Bernardo and Welch)
– Reconsider Diamond-Dybvig for markets
– Rationality of selling if fear liquidity will collapse
– Externalities similar to bank failures – fire sales,
funding problems, contagion to other markets, as
with ABS, ABCP, interbank
– Role of market makers in uncertainty or asymmetric
information – uncertainty regarding ABS valuation
and on counterparties
– Dynamics relating to dealers’ capital
– Becomes impossible to sell assets, e.g. primary
securitisation markets
• Contagion via market price changes in context of
mark to market (Adrian and Shin)
– Financial institutions’ active balance sheet
management, positive relation of leverage and balance
sheet size
– Desired expansion in upturn, boosting liquidity
– Shock to prices led to desired contraction, but stopped
by obligations (e.g. backup lines) – so cut back on
discretionary lending - interbank
• Interbank funding liquidity (Freixas et al)
– Imperfect information or market tension can lead
to shortages of funds even for solvent banks
– “Bank runs” in market occur as banks hoard
liquidity
• Amplifying mechanisms of liquidity shocks
(Brunnermeier)
– Borrowers balance sheet effects – loss spiral and
margin spiral
– Lending channel effect – hoarding liquidity
– Runs on institutions and markets
– Network effects – Goldman Sachs and Bear
Stearns
4 LOLR and the sub-prime
crisis – non systemic period
• Needed to evolve to cope with new conditions
• Nature of LOLR
– Open market operations more than direct lending expansion to longer maturities
– Protracted crisis – fear NCBs lacked instruments?
– Investment banks covered – Bear Stearns and
liquidity facilities – reflect central role in financial
system but not regulated by Fed
• Costs of LOLR
– Ambiguity of lending to reliquify markets – impact
on solvency of institutions
– Conflicts with other policies, need to maintain
monetary stance and difficulty of interpreting
stance given LIBOR spread
– How much moral hazard generated by “new”
LOLR?
• Minimising costs of LOLR
– Reduction in collateral standards…
– …even ABS, reliquified by non market means –
market maker of last resort – or even first
– Inversion of traditional NCB role, adverse
selection and moral hazard
– Private sector solutions sought but not found for Northern Rock,
only with guarantee for Bear Stearns – wide scale of problem
and uncertainty on valuation
– Adequate information for LOLR, not the case for Bank of
England in Northern Rock case
– Loss of reputation to banks receiving LOLR notably Northern
Rock – decision to be overt in lending and leakage of
information – need for new facilities instead of discount window
– Conflict with a partial deposit insurance scheme in the UK –
reason for rescue?
– Domestic LOLR insufficient – cross currency swap arrangement.
Need for cooperation and risk of “gaming”. Fortunate no major
cross border failure?
– Challenge for exit strategies to prevent moral hazard to reactivate
markets
LOLR and the sub-prime crisis –
systemic period
• Response of fiscal authorities to crisis
–
–
–
–
–
–
–
Recapitalisation
Overriding of merger policy
Extension of deposit insurance
Purchase of illiquid or impaired assets
Guarantees
US guarantee of money market funds
initial outlays 6% of GDP but total support in North
America and Europe $14 tn., 50% of GDP
• LOLR activity
– Growth in central bank balance sheets, to 15% of GDP
in UK and US
– Mainly developing from earlier innovations
• Types of collateral
• Expansion of cross border activity
• Central bank swap lines
• Some innovations – UK standing facilities
• UK later revealed massive clandestine support for
major banks in October 2008
• Changes initially in US
– Providing funds direct to borrowers and investors in markets rather
than via intermediaries, acting as “market maker of last resort” or
even “investor of last resort”,
– Market support for commercial paper, MBS…
– Purchasing GSE obligations
– Further support for money funds
– Institution support for Citicorp, AIG….
– Would Lehmans have been rescued had the law been changed
earlier?
• Market support later emulated in UK, Eurozone
• UK shift to quantitative easing – monetary policy not LOLR
• On balance, classic response to systemic crisis except for
further extension of LOLR role
Conclusion
• Sub prime crisis is most serious financial crisis
since 1930s at global level
• A number of novel features
• Nevertheless validates much of traditional theory
as well as incentive mechanisms, underlining the
need to look for patterns of crisis buildup
• Sub prime showed that liquidity risk assessment
needs rethinking to allow for interaction of market
liquidity risk and funding risk
• LOLR challenges include:
–
–
–
–
–
longer term provision
variety of lower quality collateral
including investment banks in the safety net
confidentiality of bank support
interaction with deposit insurance
• Has the net effect of these changes been to
increase moral hazard?
• Innovation mainly in non systemic period
• Issue of exit strategies, not least given size of
central bank balance sheets, QE
• And need for reform of liquidity regulation –
FSA model?
References
Banque de France (2008), “Liquidity”, Financial Stability
Review
Barrell, R. and E. P. Davis (2008), “The Evolution of the
Financial Market Crisis in 2008”, National Institute
Economic Review, No. 206.
BBC (2008) “Timeline – subprime losses”
news.bbc.co.uk/2/hi/business/7096845.stm
Davis, E P (2009), "The lender of last resort and liquidity
provision- how much of a departure is the sub-prime
crisis?", paper presented at the LSE Financial Markets
Group conference on the Regulatory Response to the
Financial Crisis, 19th January 2009