Structured Finance and the Global Financial Crisis

1. Structured Finance and the Global Financial Crisis

2. Which Crisis? • During the second half of the war, there was an explosion of easy credit, driven by capital from abroad. • This resulted in lavish displays of wealth — and opulent living was seen, especially in New York. • Housing prices soared during the war. • But when credit tightened afterward– collapse of real estate bubble and generalized crisis Arjun Jayadev Assumption College

3. Arjun Jayadev Assumption College

4. Structural Adjustment in the US after 1970 Intermediate Patterns Proximate Causes Increasing Household Indebtedness Global Savings Glut (Lower Long Term Rates Decline in Real Wages ‘Market Keynesianism’ Collapse in Personal Savings Hollowing out of Manufacturing Increasing Global Imbalances Financial Innovation Growth of Shadow Banking Finance and Market Ideology Reign Supreme Financial Deregulation Accommodative Monetary Policy (Low Short Term Rate Monetary Policy alone = Housing Bubble Arjun Jayadev Assumption College

5. Collapsed Real Wages

6. Destruction in Household Balance Sheets (Personal Savings Rates)

7. Growing Indebtedness of Households

8. Finance and Manufacturing as Percentage of National Income

9. Global Financial Imbalances • U.S. borrows 50 % of the worlds capital that is exported

10. Deficits and Debt

11. Ideology “You mean to tell me that the success of the economic program and my re-election hinges on the Federal Reserve and a bunch of f***g bond traders?”Bill Clinton- 1994From Woodward “ The Agenda” We’re Eisenhower Republicans here…We stand for lower deficits, free trade and the bond market. Isn’t that great? Bill Clinton-1998

12. Financial Deregulation • Gramm-Leach Bliley replaces Glass Steagall in 1998 • Commodities Futures Modernization Act (1999) • Sarbanes Oxley Rule (2002) • SEC deregulation of brokers (2004) • ‘Self Regulation’ and Trust in Ratings Agencies Arjun Jayadev Assumption College

13. Proximate Causes • Easy Credit • Search for Yield • Regulatory Loopholes (particularly CFMA 1999, SOX,2002 and Leverage Rule, 2004) • Shadow Banking/Securitization of Loan Chain • Discovery of Enormous (Hidden) Leveraging • Inadequate capitalization leading to Liquidity and then Solvency Crises

14. Easy Credit

15. Mortgage bubble took off in the aftermath of declining yield from shares Equity markets and the Search for Yield

16. Structured finance: The players in securitization Broker places mortgage loans to borrowers for fee LEGEND KEY O&G – interest and principal SPV – special purpose vehicle SPE – special purpose enterprise SIV – special investment vehicle MBS – mortgage backed securities End borrowers Broker $ I&P ($) Mortgages Typically a specialized mortgage bank Servicer Originator $ Insurance company Can assume part of risks (insurance of mortgage loans, insurance of MBS returns). Mortgages I&P ($) Conduit/trust/ SPV/SPE/SIV $ Manages the flow of interests and principal (I&P); usually, but not necessarilly the Originator MBS Mutual funds, pension 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. CDOs, I&P ($) 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 (wholesale)

17. Assets Loans Liabilities Deposits Capital A bank balance sheet Arjun Jayadev Assumption College

18. Assets Asset Backed Securities Mortgage Backed Securities Credit Default Swaps Interest Rate Swaps Liabilities Collateralized Debt Obligations Asset Backed Commercial Paper A shadow banking balance sheet Arjun Jayadev Assumption College

19. Banking FDIC Risk Adjusted Capital Adequacy Ratios Interbank Market sets price of liquidity (money) (LIBOR) Monetary Policy affects price, interest rates, macro balance No Equivalent of FDIC No Capital Adequacy Ratios No state control over liquidity creation Banking versus Shadow Banking Shadow Banking Arjun Jayadev Assumption College

20. IB Leverage

21. The ‘Magic’ of Securitization and Structured Finance

22. The CDS Market

23. “Subprime” Growth • Subprime growth shot up in 2003-2005 • By 2006, most Subprime mortgages were securitized Share of subprime In total U.S. economy (measured by GDP): 1% (2001), increasing to 5% (2005)

25. Bubble in Housing Prices

26. The Crisis Begins... • In August 2007, Crisis begins with first wave of sub prime Failures • Overleveraged shadow banks (easy credit) were invested in very  bad bets (subprime), at scale, with no  liquidity backstop (unregulated credit markets). • Counterparty Risk was perceived as much larger. • Liquidity starts freezing (Interbank markets start to experience wild shifts in ability to borrow and lend and much higher rates for borrowing)

27. Residential Real Estate Prices Crash

28. Crisis in Subprime Lending Crisis in Subprime Lending % of delinquent loans (60+ days) Months from origination

29. MBS’s lose value

30. Total Predicted Losses 2.2-3.6 Trillion Dollars! (Oct 08)

31. TED-Spread: Liquidity Crisis Arjun Jayadev Assumption College

32. LIBOR-Overnight Interest Swaps spread (Measure of Interbank liquidity) Arjun Jayadev Assumption College

33. Global Declines in Stock Markets

34. Famous Last Words • "We have a good deal of comfort about the capital cushions at these firms at the moment." • - Christopher Cox, chairman of the U.S. Securities and Exchange Commission, March 11, 2008.

35. The Crisis of 2008--? • Bailout of Fannie and Freddie, • Collapse of Lehman, Bailout of AIG…. • The Paulson Plan -- $700 bn. rescue • Contagion to UK and EU…. • The Paulson $200 bn. • TARP, Citi takeover • Recapitalization (still unclear) • Collapse of Aggregate Demand • Worldwide Crisis, Fiscal Stimulus?