Title: Anatomy of the global financial crisis
1Anatomy of the global financial crisis
- International Finance - IMB
- Vasja Rant, PhD
- 6 May 2009
2Presentation outline key points about the global
financial crisis
- Origins where and why did the crisis break out?
- Transmission why has the crisis spread so
rapidly beyond the point of origin and around the
world? - Timeline how has the crisis evolved? What were
the key events? - Policy response which actions have been taken
to solve the crisis so far? - Costs what have been the costs of the crisis so
far? What are the expected final costs?
3Origins
- Two views of the reasons for the outbreak of the
crisis in the U.S. - Narrow view deterioration of the U.S. subprime
mortgage market - Broad view factors contributing to the build-up
of problems in the U.S. housing market
4Origins narrow viewCollapse of the house-price
bubble (1)
5Origins narrow viewCollapse of the house-price
bubble (2)
- The 1997-2006 house-price bubble was in fact the
largest speculative surge of real housing prices
in the U.S. since 1950!
6Origins narrow viewRising loan defaults (1)
- Collapse of the house-price bubble coincided with
a surge in loan defaults in the market for
residential mortgages.
7Origins narrow viewRising loan defaults (2)
- Rising defaults were the most problematic in the
recent loan vintages on the subprime market
segment (2007 is the worst vintage).
of delinquent loans (60 days)
Months from origination
8Origins narrow viewResidential mortgage market
(1)
Government guarantee and GSE securitization
Fannie Mae, Freddie Mac
Private securitization market Countrywide
financial, Bear Stearns, Lehman Brothers, Bank
of America, Wells Fargo, Washington Mutual
9Origins narrow viewResidential mortgage market
(2)
- The share of subprime increased by 130 from 2003
to 2005! - The percent of securitized new loans increased
by 60 from 2001 to 2005!
Share of subprime In total U.S. economy (measured
by GDP) 1 (2001), increasing to 5 (2005)
10Origins narrow viewResidential mortgage
products
- GREATER RISKS
- Flexible payments increase chances of terminal
default. - Debt servicing may increase 15-30 upon FRM/ARM
resetting.
11Origins narrow viewFrom house prices to debt
servicing (1)
- House prices are central to the U.S. subprime
mortgage market model - If house prices are rising interest rates are
low - Additional home equity due to price appreciation
- Borrowers can repay their loans by refinancing.
Home value 200.000
Mortgage loan 200.000
Repayment of initial loan 200.000
After 1 year
Home value 300.000
Mortgage loan 300.000
Cash remaining 100.000
12Origins narrow viewFrom house prices to debt
servicing (2)
- If house prices are falling interest rates are
high - No or negative new home equity
- Repayment of loans by refinancing not possible
- Borrowers faced with increased debt servicing
difficulties.
- Figure
- Interest rate movements on U.S. mortgage market
(hybrid ARM rates).
13Origins narrow viewAnd from debt servicing to
house prices
- Mortgage loans have an implicit put option
- In times of increasing house prices
- Home value gt Loan value ? repayment of loan is
in the interest of the borrower (the borrower
will service the loan) - In times of decreasing house prices
- Home value lt Loan value ? repayment of loan is
not in the interest of the borrower (the borrower
may default) - Defaults lead to foreclosures
- Additional supply of the housing stock at forced
sales prices - Downward pressure on house prices and increased
loan delinquencies (feedback loop).
14Origins broad viewReasons for the house-price
bubble
- Macroeconomic factors
- Global and local (U.S.) economic environment in
the years preceding the crisis - Microeconomic factors
- Structural characteristics of the mortgage market
model (originate and distribute)
15Origins broad viewMacroeconomic factors
- Global saving imbalances
- U.S. current account deficit recently as high as
6 of U.S. GDP! Financing provided by capital
inflows from Asian countries and oil exporters. - Implication infusion of liquidity into
international financial system, searching for
yield - Low equity yields
- Substantial declines in stocks after collapse of
the dot-com bubble (2000). - Implication incentives to invest into new
instruments with favorable risk-return profile - Low interest rates
- Lowest interest rates on 30-year record due to
agressive U.S. monetary policy - Implicaton incentives to borrow for those who
would normally never be able to afford it
16Origins broad viewMacroeconomics saving
imbalances (1)
17Origins broad viewMacroeconomics saving
imbalances (2)
18Origins broad viewMacroeconomics equity
yields
19Origins broad viewMacroeconomics interest
rates
20Origins broad viewMicroeconomic factors (1)
- High risk mortgage products
- 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, which
attracted additional credit flows - 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!
21Origins broad viewMicroeconomic factors (2)
- 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
22Transmission
- 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
23TransmissionSecuritization risk transfer (1)
Mortgage backed securities (MBS)
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
Securitization
Supply originators of mortgage loans
Demand financial investors
3. tranche (high risk) 3.000 bonds at
100 Coupon rate 20
24TransmissionThe key to AAA ratings in
securitization
- Credit enhancement facilities
- External
- Bond insurance monoline insurers
- Letter of credit banks.
- Internal
- Overcollateralization assets (underlying
loans)gtliabilities (issued securities) - Excess spread lending rate (underlying loans)
gtborrowing rate (issued securities) - Reserve account established to absorb losses
- 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
25TransmissionThe players in securitization
Broker places mortgage loans to borrowers for fee
LEGEND KEY OG interest and principal SPV
special purpose vehicle SPE special purpose
enterprise SIV special investment vehicle MBS
mortgage backed securities
End borrowers
Broker
IP ()
Mortgages
Typically a specialized mortgage bank
Originator
Servicer
Insurance company
Can assume part of risks (insurance of mortgage
loans, insurance of MBS returns).
Mortgages
IP ()
Conduit/trust/ SPV/SPE/SIV
Manages the flow of interests and principal
(IP) usually, but not necessarilly the
Originator
MBS
Banks, insurance companies, mutual funds, hedge
funds
Investment bank (underwriter)
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.
MBS, IP ()
Rating agency
Institutional investor
Organizes issuing of MBSs and places MBSs to
investors in financial markets.
Financial returns ()
Assigns credit rating to issued MBSs.
End lenders
26TransmissionSecuritization risk transfer (2)
Mortgage backed securities (MBS)
Mortgage bonds Rating AAA/Aaa
Other claims
Collateralized debt obligations (CDO)
Investment grade
CDO Ratings AAA/Aaa BBB/Baa2
Mortgage bonds Rating AA/Aa2
Mortgage bonds Rating A/A2
Investment grade
MBS
Mortgage bonds Rating BBB/Baa2
Mortgage bonds Rating BB/Ba2
Speculative grade
Mortgage bonds Rating B/B2
CDO Ratings less than BBB/Baa2
Equity tranche
27TransmissionSecuritization risk transfer (3)
28TransmissionSecuritization risk transfer (4)
- Credit default swaps (CDS) a form of insurance,
tied to a reference instrument (a bond or a CDO). - The CDS buyer agrees to pay periodic payments for
the right of insurance - The CDS seller agrees to pay the buyer if the
reference instrument defaults - CDS can be bought naked (i.e. without owning
the underlying reference instrument). - The buyer and seller can be very different
institutions (for example, an unregulated hedge
fund and a regulated bank) - The market is intransparent (OTC, no centralized
exchange) - The market is huge (at peak 60 trillion
outstanding CDS).
29TransmissionStructured finance instruments
volumes
- RMBS residential mortgage backed securities
- CMBS commercial mortgage backed securities
- MBS mortgage backed securities
- ABS asset backed securities
- CDO collateralized debt obligations
- CDS credit default swaps
30TransmissionStructured finance portfolio ratings
underlying claims
31TransmissionStructured finance funding profile
ABCP underlying claims
32TransmissionPart 1 institutional investors (1)
- Key question
- 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? - Explanations
- 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, CDO2 and CDS).
33TransmissionPart 1 institutional investors (2)
- 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
34TransmissionIncrease in uncertainty unreliable
credit ratings for mortgage derivative securities
35TransmissionIncrease in risk aversion (1) from
residential to commercial mortgages
36TransmissionIncrease in risk aversion (2) from
mortgage to other asset derivatives
37TransmissionIncrease in risk aversion (3) from
derivatives to corporate debt market
38TransmissionPart 2 banks (1)
- Key question
- How has the crisis jumped from institutional
investors to the interbank market? - Explanations
- 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 liquidity support ? signal
that banks may have difficulties in meeting their
obligations!
39TransmissionPart 2 banks (2)
- 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
squeeze 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 the
banks.
40TransmissionIncrease in banks credit and
liquidity risk
41TimelineThree phases of key crisis events (1)
- Outbreak phase (summer 2007 fall 2007), marked
by - First awareness of the crisis in the general
public - First period of interbank liquidity squeeze and
massive central bank interventions - First isolated bank failures (Northern Rock)
- Deleveraging phase (winter 2007 summer 2008),
marked by - 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)
42TimelineThree 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, Citigroup - Second period of interbank liquidity squeeze
- 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
43TimelineOutbreak 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 squeeze.
44TimelineDeleveraging phase
- Rapid liquidation of positions in mortgage, assed
based securities CDOs by institutional
investors - Losses are absorbed by institutions involved in
the securitization process significant
write-downs, particularly among banks - Write-downs create the 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-downs, capital raised, and central bank
liquidity interventions create some transparency
in the interbank market, easing the liquidity
squeeze.
45TimelineEscalation 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.
46TimelineEscalation phase (2)
- 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. Lehmans debt has been
sold to numerous financial institutions around
the world. - 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, Eastern European
states). - 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)
47Policy response
- 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 - Escalation phase
- Key feature systemic approach and crucial role
of national governments central banks
48Policy responseOutbreak and deleveraging phases
(1)
- 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 - Fed
49Policy responseOutbreak and deleveraging phases
(2)
- National governments
- 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.
50Policy responseEscalation phase (1)
- Central banks
- Liquidity measures cash provided temporarily
(repo) 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
- Non-conventional measures outright purchases of
securities direct lending to enterprises
(quantitative easing) - Fed, Bank of Englad, ECB (under consideration)
51Policy responseEscalation phase (2)
- National governments (1)
- Earmarked rescue packages governments adopt a
systemic approach rescue packages designed to
prevent collapse of national banking systems
sizes of packages - 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). - Government purchase of toxic assets from banks.
52Policy responseEscalation phase (3)
- National governments (2)
- Rescue packages because of spillover effects of
the financial crisis into the real economy,
governments adopt rescue packages, that include - Spending measures to stimulate demand and growth
increase in govenrment investment, co-financing
of private consumption, increased export credit
and government guarantees, tax cuts (partially) - Spending measures to cushion the social impact of
the crisis increase in social support for the
unemployed, government co-financing of reduced
working week hours, tax cuts (partially). - Saving measures reducing the costs of the
public sector in order to relieve the private
sector and ensure fiscal sustainability.
53Policy responseEscalation phase (3)
- International level
- 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 reshaping
of the internatinal financial system so far 2
meetings of the G-20 forum on 15 November in
Washington D.C. 2 April in London.