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Global financial and economic crisis Dr. Vasja Rant 14 December 2009 Origins of the crisis Origins of the real estate price bubble Residential mortgage market Debt  Prices  Structured finance market (MBS, CDO) Real estate market

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global financial and economic crisis

Global financial and economic crisis

Dr. Vasja Rant

14 December 2009

origins of the crisis origins of the real estate price bubble
Origins of the crisisOrigins of the real estate price bubble

Residential mortgage

market

Debt

Prices

Structured finance market

(MBS, CDO)

Real estate market

origins of the crisis rising mortgage defaults
Rising defaults were the most problematic in the recent loan vintages on the “subprime” market segment. Origins of the crisisRising mortgage defaults

% of delinquent loans (60+ days)

Months from origination

origins of the crisis residential mortgage market 1
Origins of the crisisResidential 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…

origins of the crisis residential mortgage market 2
Origins of the crisisResidential 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)

origins of the crisis residential mortgage products
Origins of the crisisResidential mortgage products
  • GREATER RISKS:
  • Flexible payments increase chances of terminal default.
  • Debt servicing may increase 15-30% upon FRM/ARM resetting.
origins of the crisis relation of real estate prices to debt servicing 1
House prices are central to the U.S. subprime mortgage market model

If house prices arerising & interest ratesare low:

Additional home equity

Borrowers can repay their loans by refinancing.

Example of refinancing:

Origins of the crisisRelation of real estate prices to debt servicing (1)

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

origins of the crisis relation of real estate prices to debt servicing 19
If house prices arefalling & interest rates are high:

No or negative new home equity

Repayment of loans by refinancing not possible

Borrowers faced with increased debt servicing difficulties.

Origins of the crisisRelation of real estate prices to debt servicing (1)
  • Figure:
    • Interest rate movements on U.S. mortgage market (hybrid ARM rates).
origins of the crisis feedback loop between debt defaults and real estate prices
Origins of the crisisFeedback loop between debt defaults and real estate prices
  • Most U.S. mortgages were non-recourse (i.e. limited liability of the borrower) implicit “put” option
    • In times of increasing house prices

Home value > Loan value  borrowers servicing debt

    • In times of decreasing house prices

Home value < Loan value  borrowers defaulting

  • Defaults = foreclosures
    • Additional supply of the housing stock  prices  defaults (feedback loop).
origins of the crisis pre crisis macro environment
Origins of the crisisPre-crisis macro environment
  • Global saving imbalances  infusion of liquidity into international financial system, searching for yield
  • Low equity yields  search for new high yielding financial instruments
  • Low interest rates incentives to borrow for those who would normally never be able to afford it
origins of the crisis m ortgage markets structured finance
Origins of the crisisMortgage markets & structured finance

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

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, 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

origins of the crisis securitization risk transfer 1
Origins of the crisisSecuritization & risk transfer (1)

Mortgage backed securities (MBS)

1. tranche

(low risk)

3.000 bonds at $100

Coupon rate: 10 %

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.

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 %

origins of the crisis securitization risk transfer 2
Origins of the crisisSecuritization & 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

origins of the crisis securitization risk transfer 3

A mil. $ question:

if I am a sponsor bank

of the SIV that issued

CDO2, what is my

risk exposure?

Origins of the crisisSecuritization & risk transfer (3)
origins of the crisis securitization risk transfer 4
Origins of the crisisSecuritization & risk transfer (4)
  • Credit default swaps (CDS) - a form of insurance, tied to a reference instrument (a bond or a CDO) where:
    • 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).
transmission of the crisis transmission in the financial system
Transmission of the crisisTransmission in the financial system

Residential mortgage

market

Debt

Debt

Prices

Prices

Structured finance market

(MBS, CDO)

Real estate market

Asset writedowns &

insolvency problems of FI

Prices

Uncertainty and

deleveraging

Uncertainty and

deleveraging

Interbank lending freeze &

liquidity problems of FI

Prices

Structured finance and credit

derivatives (ABS, ABCP, CDS)

Sponsor financial institutions,

investors

slide23
Transmission of the crisisIncrease in uncertainty: unreliable credit ratings for mortgage derivative securities
transmission of the crisis increase in risk aversion 1 from residential to commercial mortgages

Record increases

in risk premiums

Record drops

in prices

Transmission of the crisisIncrease in risk aversion (1): from residential to commercial mortgages
transmission of the crisis increase in risk aversion 2 from mortgage to other asset derivatives
Transmission of the crisisIncrease in risk aversion (2): from mortgage to other asset derivatives
transmission of the crisis increase in risk aversion 3 from derivatives to corporate debt market
Transmission of the crisisIncrease in risk aversion (3): from derivatives to corporate debt market
transmission of the crisis interbank market freeze
Transmission of the crisisInterbank market freeze

Key question

  • Why did the banks experience such an increase in credit and liquidity risk from the onset of the crisis?

Explanations

  • Realization of contingent liabilities of banks to various investment vehicles – some banks withdraw their liquidity support  signal that banks may have difficulties in meeting their obligations!
  • 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.
transmission part 2 banks 2
TransmissionPart 2: banks (2)
  • 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.
transmission of the crisis transmission to the real economy
Transmission of the crisisTransmission to the real economy

Initial

shock

Financial economy

Uncertainty and

deleveraging

Wealth

effect

Expectation

effect

Credit

crunch

Reduced liquidity &

solvency

Working

capital finance

problems

Reduction of

new orders

Investment

finance

problems

Real economy

Adjustments

in capital

structure

Adjustments

in capital

budgeting

Adj. in work.

capital

management

Adjustments

in

employment

transmission transmission between countries
TransmissionTransmission between countries

Global financial environment

Global real environment

Global

wealth effect

Global

credit crunch

Global

demand

Commodity

prices

Local financial environment

Local real environment

Local

wealth effect

Local

wealth effect

policy response
Policy 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
policy response outbreak and deleveraging phases 1
Policy 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
policy response outbreak and deleveraging phases 2
Policy 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.
policy response escalation phase 1
Policy 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)
policy response escalation phase 2
Policy responseEscalation phase (2)
  • National governments (1)
    • Rescue packages for the financial system – 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.
policy response escalation phase 3
Policy responseEscalation phase (3)
  • National governments (2)
    • Rescue packages for the real economy – 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.
policy response escalation phase 349
Policy 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.
future prospects based on past experience real estate prices
Future prospects based on past experience: real estate prices

6 years

35,5 %

Vir: Reinhart C. in Rogoff K. (2009): The Aftermath of Financial Crises

future prospects based on past experience equity prices
Future prospects based on past experience: equity prices

3,4 years

55,9 %

Source: Reinhart C. in Rogoff K. (2009): The Aftermath of Financial Crises

future prospects based on past experience unemployment
Future prospects based on past experience: unemployment

7 percentage points

4,8 years

Source: Reinhart C. in Rogoff K. (2009): The Aftermath of Financial Crises

future prospects based on past experience economic growth
Future prospects based on past experience: economic growth

9,3%

1,9 years

Source: Reinhart C. in Rogoff K. (2009): The Aftermath of Financial Crises

future prospects based on past experience public finance
Future prospects based on past experience: public finance

Index = 100 in the crisis

186,3 (86 % increase)

Source: Reinhart C. in Rogoff K. (2009): The Aftermath of Financial Crises