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Balance Sheet Adjustments in the 2008 Crisis

Balance Sheet Adjustments in the 2008 Crisis. Zhiguo He, In Gu Khang, and Arvind Krishnamurthy University of Chicago and Northwestern University April 1, 2010. Objectives. Fact-finding: Understand how securitized mortgage/credit assets have shifted across the financial sector

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Balance Sheet Adjustments in the 2008 Crisis

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  1. Balance Sheet Adjustments in the 2008 Crisis Zhiguo He, In Gu Khang, and Arvind Krishnamurthy University of Chicago and Northwestern University April 1, 2010

  2. Objectives • Fact-finding: Understand how securitized mortgage/credit assets have shifted across the financial sector • Who has sold? How much? • Buyers? How have they financed? • We measure mortgage/credit assets because it is a large asset class, and probably the source of the biggest problems. • Why is this interesting? • Theories about link between asset trading decisions and financing conditions • Try to understand how theories fit together in the big picture

  3. Data • Assets: • Hedge funds, • Broker/dealers, • Insurance companies, • Commercial banks • Government support • Fed, Treasury, GSEs • Liabilities: • Repo financing, • Bank debt • Equity capital

  4. Theory: Leverage Constraints • E = equity capital (cant raise more) • L = maximum leverage provided by lenders • For example, L = 1/repo haircut • Total funds = E L • Asset demand increasing function of E L • Sellers in a crisis: Gromb and Vayanos (2003), Geanokoplos and Fostel (2008), Brunnermeier and Pedersen (2009), Adrian and Shin (2009), … • Buyers in a crisis: Allen and Gale (many), Shleifer and Vishny (1995),…

  5. Theory: Equity Risk Capital • E = equity capital (cant raise more) • Manager/trader makes portfolio choices, doesn’t want to lose wealth (go bankrupt, lose job, lose wages, etc.) • Cost of financial distress • Endogenous risk aversion • More E means lower risk of distress, less risk averse in portfolio choices • Risky asset demand increasing in E. • Managerial risk aversion: • Sellers: Xiong (2001), Brunnermeier and Sannikov (2010) • Buyers: He and Krishnamurthy (2009) • Risk-based capital requirements: Kashyap and Stein (2004)

  6. Financial Sector

  7. Money Market Table 14: Source: Flow of Funds of Federal Reserve ($ Billions)

  8. Computations • Suppose we measure assets at time as At At+1 – At = Purchases – Losses – Maturity • We roughly see if purchases balance out, • SUM (purchases) =0 • t is Q4 2007 and t+1 is Q1 2009

  9. Maturing Assets • Suppose assets mature between t and t+1 • Then assets will shrink, but not because the assets were sold. • Maturity rate: • We compute aggregate repayment rate in 2008 across all ABS and MBS from Bloomberg = 17% • We compute aggregate new issuance = 10% • Assume shrinkage rates of 7%, 12%

  10. Measurement Issues (1) • Double counting • Suppose bank makes a $100 repo loan to a hedge fund, that uses the $100 to buy an MBS • Hedge fund liquidates the MBS back to the back • i.e. Hedge fund assets fall by $100 • Total bank assets (MBS + Repo Loan) remains the same • SUM may not be zero • This problem is most pronounced for repo and we will try to exclude repo from our computations

  11. Measurement Issues (2) • Suppose banks improperly value assets. • For example suppose banks mark books at t+1 at $100 too high a value • But also report $100 smaller losses than true 100+ At+1 – At = Purchases – (Losses – 100)

  12. Measurement Issues (3) • Sum = 0 applies only for a specific asset measured (i.e. single class of MBS) • The data is only available at higher levels of aggregation. • We measure across a broad class • Agency MBS, non-Agency MBS, ABS • Large (supply is $10tn to $15tn) • We have data on non-Agency MBS, ABS for commercial banks

  13. Debt Market Table 1: Mortgage and Credit Securities ($ billions) Source: SIFMA (2007 Q1) • There is an additional $12tn of mortgage/credit loans in financial institutions’ portfolios.

  14. Financial Institutions Table 2: Financial Institution Assets ($ billions) Sources: Flow of Funds of Federal Reserve 2007, Barclays Hedge Fund Report

  15. Losses • Table 3: Financial Institution Losses ($ billions) • Sources: Bloomberg WDCI (2009), Hedge Fund Flow Report by Barclay Hedge (2009) • Note: losses are as reported by institutions

  16. Hedge Funds Table 4: Equity Capital (or Assets under Management) of Hedge Fund Industry ($ billions) Sources: Hedge Fund Flow Report by Barclay Hedge (2008, 2009)

  17. Mortgage/Credit Capital • Main source of error: what are the relevant strategies? • Three scenarios • Fixed Income • Fixed Income and Macro • Fixed Income, Macro, Distressed, proportion of Multi-strategy and sector specific

  18. Leverage Ratios • Leverage ratios by strategy in 2006 from TASS • e.g., Fixed Income = 4.5 • Gives us initial assets • Industry average leverage ratio in 2008 = 2.3 • But haircuts rose most in fall 2008 • AAA CMOS: 10% in 2007 and 30% in fall 08 • Assume haircuts double over 08, but average leverage is 2.3, where is final leverage? • Answer: 1.7

  19. Haircuts Table 3: Repo Haircuts in the Crisis Source: Krishnamurthy (2009)

  20. Net Trade • Scenario 1: $-492bn • Scenario 2: $-546bn • Scenario 3: $-754bn • Caveats • There is more than just MBS/ABS in these figures.

  21. Brokers and Dealers Table 5: Trading Assets of Broker/Dealers Source: SEC Filings

  22. Pure Broker/Dealers Table 6: Trading Assets of Investment Banks($ billions) Source: SEC Filings of the above-listed Broker/Dealers

  23. Scaling • We scale up to the industry based on the three firms we measure. • Main error: How representative are the firms • Three scenarios • Goldman Sachs (lowest shrinkage rate of assets) • $-205bn • All firms • $-254bn • Merrill Lynch (highest shrinkage) • $-307bn

  24. Caveats • We have not accounted for derivative hedges • For example, AIG sold CDS to broker/dealers to hedge ABS exposure. • We have included all credit assets, some of which may not be ABS

  25. Insurance Companies Table 7: Mortgage and ABS Holdings of Top 8 Insurance Companies ($ billions) Source: SEC Filings

  26. Computation • Scenario 1: Scale all to the rest of the insurance industry (34% of total assets by Flow of Funds) • $-247bn • Scenario 2: Scale, excluding AIG • $-50bn • Scenario 3: Scale using 3 lowest growth firms • $36bn

  27. Commercial Banks Table 9: Assets of Commercial Banks ($ billions) Source: Flow of Funds of Federal Reserve (L109 minus L112) • Note: Data is from Flow of Funds, which is back-filled to reflect the effect of mergers.

  28. Securities Table 10: Holdings of Securities by Commercial Banks ($ billions) Sources: Flow of Funds of Federal Reserve, FDIC Statistics on Depository Institutions Report

  29. Securities Table 10: Holdings of Securities by Commercial Banks ($ billions) Sources: Flow of Funds of Federal Reserve, FDIC Statistics on Depository Institutions Report

  30. Changes • Main issue is assigning reported losses of $500bn • Scenario 1: Assign all to securities. • $731bn • Scenario 2: Assign fraction (secs/loan+secs) • $313bn • Scenario 3: Assign losses to ABS and Agency MBS • $176bn

  31. Did banks buy the sold assets? • We have no idea. • We know they grow.

  32. Bank Mergers • WaMu and Countrywide mergers • Will not affect Flow of Funds data, because of back-filling • Merrill Lynch and Bear Stearns • No immediate effect on bank assets • Slow effect: Transfer of assets from broker/dealer to commercial bank • Reflective of buying power among commercial banks

  33. ABCP • ABCP (including SIVs) outstanding fall from • Summer 07: 1250bn • December 07: 833bn • December 08: 650bn • Most of this is taken back on to bank balance sheets • ABCP investors lose 1.7% (Acharya,Schnabl, Suarez, 2009) • Banks did not take back the assets and sell them (as other sectors likely would have).

  34. JP Morgan Chase Source: SEC Quarterly and Annual Filings.

  35. Did banks buy the sold assets? • We have no idea. • We know they grow when other sectors shrink. • What makes them different?

  36. Commercial Bank MBS Figure 2: MBS Holdings of US Commercial Banks ($ Billions) Source: FDIC Call Reports

  37. Foreign Holdings of MBS/ABS Table 12: Foreign Holdings of Asset Backed Securities ($ billions) Source: U.S. Treasury Report on Foreign Portfolio Holdings of U.S. Securities • Net sales of corporate bonds (including non-Agency Asset backed Securities), over the six-month period from October 2008 to March 2009 totaled $24.4bn • Total purchase: $45bn

  38. Other Private Buyers • BlackRock Assets under Management in Fixed Income Funds • Q4 07: $513 bn • Q1 09: $474 bn • Pension funds • The increase in holdings of GSE securities (which includes both MBS and straight Agency debt) plus all corporate and foreign bonds over the relevant period is about $70bn

  39. Other Repayment Scenarios

  40. Next • Government intervention • Bank and non-bank funding

  41. Government Purchase of MBS • As of 3/25/09 Fed owned $236bn of GSE-backed mortgage debt in secondary market • No purchases of non-agency debt • Part of Fed initiative to purchase up to $1.25tn of GSE-backed MBS.

  42. GSEs Table 14: Government-Sponsored Enterprises ($ billions) Source: Monthly Volume Summaries from Fannie Mae and Freddie Mac (2007 and 2009) Total Increase: $112bn

  43. Direct Government Purchase • Agency MBS • $348 bn from Fed and GSEs • Can resolve the “hole” in our computation • Although the picture on Agency and non-Agency securities, separately is not clear to us.

  44. Fed/Treasury Table 13: Federal Reserve/Treasury Source: Caballero and Kurlat (2009) On January 16, 2009, Chief Executive Ken Lewis announced Bank of America has received the federal guarantee for $118 billion of toxic assets, most of which were accrued in its acquisition of Merrill Lynch. However, on May 7, 2009, after the “stress test” Bank of America tried to terminate this deal unilaterally, and in the end this facility failed. The data is included because at the end of Q1 2009, markets operated under the assumption that the deal was still in force.

  45. Money Market Table 14: Source: Flow of Funds of Federal Reserve ($ Billions)

  46. FDIC Guarantee Program (TLGP) • As of March 31, 2009 • $336bn of FDIC guaranteed senior unsecured debt issued by banks • Mostly issued 4Q08 and 1Q09 • Banks pay a fee for guarantee (25 - 50 bps) • Maximum 3 year bond issue • Limits • Total program capped at $769 bn • Only 44% of total used

  47. Federal Home Loan Bank • Lending only to commercial banks • 2006: $640bn • 2007: $800bn • 2008: $900bn • Peak: $1011bn on 9/30/08 • 9/30/09: $677bn • Lending to largest 20 banks rises by $60bn from Q407 to Q109

  48. Bank Capital and Book Leverage Table 20: Top 19 Commercial Banks ($ billions) Source: FDIC

  49. Bank Leverage • IMF loss estimates as of Oct 2008: >$1.5tn (banks say $500bn) • Level 3 assets (a subset of securities carried at fair value): $225bn

  50. Fact Summary • Repo market tightening hits hedge fund and broker/dealer sector • Substantial shrinkage • Commercial banking sector grows • Government guaranteed financing • Leverage increases • Banks do not saturate debt guarantees • Government • Significant amount of “ring-fenced” asset purchase by government (stays on bank books) • Government has been active in purchasing Agency MBS

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