Transcript Money Markets Freeze: Causes and Developments since August

The Crisis of 2008 and
the Future of Regulation
Gerald P. Dwyer
Federal Reserve Bank of Atlanta
University of Carlos III, Madrid
Disclaimer
• These views are mine and not necessarily
those of the Federal Reserve Bank of Atlanta
or the Federal Reserve System.
H o u sin g P rice In d ice s
J a n u a ry 2 0 0 0 to F e b ru a ry 2 0 0 9
200
In d e x v a lu e
C a s e S h ille r in d e x
O F H E O in d e x
160
120
80
1 /1 /2 0 0 0
4 /9 /2 0 0 2
7 /1 7 /2 0 0 4
D a te
1 0 /2 5 /2 0 0 6
2 /1 /2 0 0 9
U .S . M ortgage O rigin ation s b y T y p e
2 0 0 1 th ro u g h 2 0 0 7
FHA / VA
C onventional
P rim e J um bo
A lt A
S ubprim e
H om e E quity L ines
T rillio n D o lla rs (U .S .)
4
3
2
1
0
2001
2002
2003
2004
Y ea r
S ource: Inside M ortgage Finance
2005
2006
2007
U .S . D e lin q u e n cie s b y L o a n T yp e
F irs t Q u a rte r 1 9 9 8 th ro u g h F o u rth Q u a rte r 2 0 0 8
30
P rim e F R M
P rim e A R M
S u b p rim e F R M
S u b p rim e A R M
20
10
0
1 /1 /1 9 9 8
1 0 /1 /2 0 0 0
N ote: D elinquent 90 days or m ore
S ource: M ortgage B ankers A ssociation
7 /2 /2 0 0 3
D a te
4 /1 /2 0 0 6
1 2 /3 1 /2 0 0 8
Size of Financial Markets
Source: Bank of England Stability Report, 10/2007
Story
• A tiny part of securities markets has put asset
markets around the world in a state of
turmoil?
• How can that be?
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
Two Securities from One
AAA
rated
security
Subprime
mortgages
Equity
tranche
of
security
Collateralized Debt Obligations
• Take set of securities and restructure their
payments
– Corporate bonds
– Residential mortgage backed securities (RMBS)
CDO Deals Idiosyncratic and
Traded 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
A B X In d ice s b y V in ta g e
110
110
70
70
0 6 -1 v in ta g e
0 6 -2 v in ta g e
30
30
1 /1 /2 0 0 6
8 /3 1 /2 0 0 7
4 /3 0 /2 0 0 9
AAA
AA
A
BBB
BBB-
80
1 /1 /2 0 0 6
0 7 -2 v in ta g e
50
50
20
20
8 /3 1 /2 0 0 7
D a te
4 /3 0 /2 0 0 9
80
0 7 -1 v in ta g e
1 /1 /2 0 0 6
8 /3 1 /2 0 0 7
4 /3 0 /2 0 0 9
1 /1 /2 0 0 6
8 /3 1 /2 0 0 7
D a te
4 /3 0 /2 0 0 9
Securities and “Risk Sharing”
• CDOs of ABS 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 these CDOs may partly explain the
earnings from creating so-called arbitrage CDOs
L IB O R le ss O IS - 3 0 d a ys
J a n u a ry 1 , 2 0 0 6 to A p ril 3 0 , 2 0 0 9
s p re a d
300
200
100
0
1 /2 /2 0 0 6
1 1 /1 /2 0 0 6
9 /1 /2 0 0 7
D a te
6 /3 0 /2 0 0 8
4 /3 0 /2 0 0 9
L IB O R le ss O IS - 3 0 d a ys
J a n u a ry 1 , 2 0 0 6 to A p ril 3 0 , 2 0 0 9
Run on money
market funds
s p re a d
300
200
End of year
100
Northern Rock
0
1 /2 /2 0 0 6
1 1 /1 /2 0 0 6
9 /1 /2 0 0 7
D a te
6 /3 0 /2 0 0 8
4 /3 0 /2 0 0 9
L IB O R le ss O IS - 3 0 d a ys
J a n u a ry 1 , 2 0 0 6 to A p ril 3 0 , 2 0 0 9
Run on money
market funds
s p re a d
300
200
End of year
Kindergarten
day
100
Northern Rock
0
1 /2 /2 0 0 6
1 1 /1 /2 0 0 6
9 /1 /2 0 0 7
D a te
6 /3 0 /2 0 0 8
4 /3 0 /2 0 0 9
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
One Cause
Source: http://library.thinkquest.org
Another Possible Cause
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
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
Financial Difficulties
• It’s the truck you don’t see that runs you
down
Stability
Source: http://img2.travelblog.org/Photos2/