Money Markets Freeze: Causes and Developments since August 2007

1. Money Markets Freeze:Causes and Developments since August 2007 Gerald P. Dwyer Federal Reserve Bank of Atlanta University of Carlos III, Madrid

2. Disclaimer • These views are mine and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System.

7. Size of Financial Markets Source: Bank of England Stability Report, 10/2007

8. Story • A tiny part of securities markets has put asset markets around the world in a state of turmoil? • How can that be?

9. Summary of Developments • Prelude until August 9, 2007 • Main Act from August 9, 2007 to September 16, 2008 • Climax from September 16, 2008 to early 2009 • Financial crisis • Denouement from early 2009 to ????

10. Structured Finance • Mortgages are securitized • Residential Mortgage Backed Securities (RMBS) • Mortgages are pooled together and sold on the open market • Agency securities • Others • Can be divided into tranches • Tranching • Typical bond has all holders suffering losses proportionately • Structured financial instruments structure receipts of payments

11. Two Securities from One AAA rated security Subprime mortgages Equity trancheof security

12. Collateralized Debt Obligations • Take set of securities and restructure their payments • Corporate bonds • Residential mortgage backed securities (RMBS)

13. CDO Deals Idiosyncratic andTraded over the Counter • A trust, generally in the Cayman Islands owns the assets backing the CDOs and distributes payments • Not standardized contracts • Over-collateralization and triggers • Can build up a reserve account for possible losses • Can be contingent on delinquencies and losses • Manager can be passive or active • Traded over the counter

15. Securities and “Risk Sharing” • CDOs were purchased by entities all over the world • AAA rating made them seem like a fine purchase • AAA CDO is not a AAA corporate bond • CDO is based on a portfolio of loans • Behavior of cash flows in default is different • Ratings were conditioned on rising house prices • Mispricing of CDOs may partly explain the earnings from creating so-called arbitrage CDOs

17. Run on money market funds End of year Northern Rock

18. Run on money market funds End of year Kindergarten day Northern Rock

19. This Is Not All the Story • House prices rose in many other places than parts of U.S. • House prices have fallen substantially in Ireland, Spain and other countries • Nothing directly to do with subprime mortgages or CDOs • Widespread increases of leverage • Widespread increases of maturity transformation

20. One Cause Source: http://library.thinkquest.org

21. Another Possible Cause

22. Who’s to Blame? • My personal estimate of proximate causes in order of importance • Fannie and Freddie’s purchases of subprime securities spurred on by Congress • Financial innovations – CDOs • Reduced the cost of risky activities • Not clear how much this is due to increased issuance of subprime loans • Private institutions took on more risk • Increased leverage • Increased maturity transformation

23. Regulators to Blame? • Federal Reserve and low Fed Funds rate • Would have to establish that short rates were relatively low around the world, not just dollar rates • John Taylor claims this in talks and in his book • Would have to establish that low rates induced people to buy houses even though long rates were unaffected • Regulators • The combination of the developments caused the crisis • It’s easy to see this after the fact

24. Financial Difficulties • It’s the truck you don’t see that runs you down

25. Stability Source: http://img2.travelblog.org/Photos2/