Transcript Slide 1

LUMS Research Forum on the Credit Crunch
Introduction:
The Credit Crunch and Policy Responses to it
by
Kim Kaivanto
29 November 2008
Traditional vs. ‘new’ banking model
‘New’ model
Traditional model
a simplification
Bank checks
‘Independent’ checks
The new banking model
Roughly:
a.k.a.
a.k.a.
a.k.a.
a.k.a.
a.k.a.
vehicular finance
originate and distribute model
securitization
shadow banking system
structured off-balance-sheet vehicle model
Mortgages collected into a portfolio, sold via a ‘true sale’ to a legally
separate entity, called a Special Purpose Vehicle (SPV, SIV, conduit),
funded by sale of Collateralised Mortgage Obligations (CMOs) − claims on
different ‘slices’ of the revenue from the portfolio of mortgages, which are
structured into different risk classes ranging from AAA downwards.
Not only mortgages but also
• loans
• corporate bonds
• credit card receivables
• aircraft lease portfolios
• etc.
Collateralised Debt Obligations (CDOs)
• Collat. Mort. Obl. (CMOs)
• Collat. Loan Obl. (CLOs)
CDOs, CMOs, CLOs, SIVs, conduits
Take the mortgages/loans off of the bank’s balance sheet
 This means that the usual regulatory capital charge for
such loans (money set aside to ensure bank remains
solvent in the case of borrowers defaulting) is not required
 i.e. regulatory arbitrage − response to e.g. Basel I
 other
motivation: rating arbitrage, in that top-rated CDO tranches
Basel
I Accord
may achieve
while
the1992
sponsoring
• Enforced
by law inAAA
G10rating
countries
from
onward bank itself may have
lower credit rating!
• Riska ‘weightings’
 structured products passed through conduits off-balance sheet
bank
usually
(not securities,
always) holds
theweight
lowest-rated
• Sponsoring
Insured assets
treated
like govt
i.e. a on
zerotorisk
‘toxic waste’
tranches.of Credit Default Swap (CDS) use
 an explosion
Sponsoring
Superseded
bybank
Baselextends
II Accorda ‘reputational’ credit line (‘liquidity backstop’)
SIVs/conduits.
• to
published
2004, implemented in US in Nov 2007
• closed loopholes for regulatory arbitrage
 This doesn’t attract a regulatory capital charge
 But it rapidly multiplies the bank’s obligations when defaults multiply
Shortened maturity structure
From 2000 onward, investment banks started to finance an increasing
fraction of their balance sheets with short-term collateralised lending
called repurchase agreements or ‘repos’.
Mostly ‘overnight’ repos (data from US):
• 2000: overnight & 3-month repos 12.5% each
• 2007: overnight repos up to 25%, 3-month repos stable 12.5%
Investment banks have had to roll over 25% of their balance sheet daily
Any disturbance to operation of the repo market immediately affects
investment bank balance sheets.
Importance of ‘liquidity’ in these repo markets. A vulnerability!
Similar importance of liquidity in inter-bank unsecured lending.
Mortgage markets and sub-prime crisis
Securitization of mortgages began in the early 1980s and grew
Rating agencies:
rapidly, creating a vast new market that catered to heterogeneous
domestic
and foreign
greatly
enhancing liquidity, and
• Changed
management
cultureinvestors,
− toward ‘deal
chasing’
thereby
making
attractive
lenders
to originate
residential
 Moody’s
was itspun
off intofor
a public
corporation
in Sept
2000
mortgages.
• Were making between 8 and 11 basis points on every CMO structure rated
 this equated to $ 250,000−$300,000+ each
Specialisation and information technology compressed the mortgage
 in the heyday, at 20 ratings per month ≥ $5million per month
cycle down to 6-8months.
 these structures would work only if the bulk of the tranches received AAA
At every ‘link’ in the mortgage market chain, the specialised
firms received transactions-based fees. Yes, including the rating
agencies.
 conflict of interest between ‘rating’ and ‘advisory’ functions
Market failure in the provision of information & advice esp. to lowincome households (who get no inf./advice or worse, biased inf./advice).
Explosion of demand for CDOs from the ‘shadow banking system’. Why?
A ‘liquidity bubble’ or ‘credit bubble’?
US Fed pursued loose monetary policy (low interest rates) 2001−
following the stock bubbles 1998-2000. (n.b. 9/11 and war also)
In UK, BoE mirrored this policy.
Capital outflows from Asian manufacturing nations, with surplus US$,
seeking US assets after Asian crisis.
US tax cuts; low US saving rate.
Sovereign wealth funds begin to bulge with US$ as oil price begins
to rise 2001−
 massive (‘insatiable’) appetite for CDOs, CMOs, because this
asset class appeared to be delivering high returns
(ah, but with what risk of loss?!!!)
 shadow banking system responsible for 50% of US mortgage lending
2005−2007.
Housing bubble
Unrelenting demand for more mortgages to create more CDOs.
Combined with transaction-based fees (at every link of the chain),
led to deteriorating credit quality, predatory lending, NINA loans, etc.
Prior to the rise of securitisation, sub-prime lenders had strong incentive to monitor
creditUS
quality.
policymakers did nothing to curb this bubble
• because historically housing bubbles in the US had always been
In the securitization era up to 2004, two classes of agents actively ‘disciplined’ the market.
local/regional,
and expertise
thereforebasis
notfor
national
systematic
phenomena.
Both had their
own independent
evaluating
sub-prime-based
products.
•• because
of govt’s intensifying commitment to promote home
bond insurers
all Americans
•ownership
sophisticatedfor
investors
from the MBS area − would take on subordinate
tranches from deals not insured by bond insurers
UK policymakers did nothing to curb this bubble
From 2004 onward, CDOs and their investors, by their number and purchasing activity,
• because of the myth that ↑ population + growth  persistent upward
became the dominant sub-prime credit risk ‘pricers’ − without specific sub-prime expertise.
trend in real estate prices
Expertise •‘left
the market’.
with expertise
left ‘democratized’,
to scrutinize the risks
and the ratings.
in reality
mortNo-one
borrowing
had been
earnings
multiples had soared upward from 3.5, buy-to-let lending grew to >10%,
With no effective curbs, sub-prime lending activity was ramped up: a fall in credit quality.
and initial
2-yearpractices
fixed-rate
were
extended to people who
 Unsustainably
risky lending
fromoffers
late 2005
to 2007.
could not afford to refinance if interest rates increased at all.
Information economics: market for lemons, winner’s curse with experts & non-experts
Sub-prime crisis
As mortgage defaults began to increase (e.g. after 2-year teaser rates
ended), CDOs began defaulting.
First, flight to quality in the repo market, then closure of repo market.
Inter-bank unsecured lending dried up.
Asset-Backed Commercial Paper market dried up.
Remember! Banks have shortened maturity structure!
Daily/monthly/quarterly ‘roll-over’ requirements!
Funding liquidity: margin funding risk, roll-over risk, redemption risk
Market liquidity: high when it is easy to raise money by selling the asset
(and the price isn’t depressed by the act of selling)
Vicious spirals
Loss Spirals − as asset values fall, borrowing capacity falls,
necessitating asset sales to cover the loans, which depresses
asset price, which reduces borrowing capacity, etc.
Marking-to-market feeds the loss spiral.
Margin Spirals − increased ‘margin calls’ force ‘deleveraging’,
which lowers the price, which forces more sales, which causes
margins to be increased, and so on.
Margin Spirals and Loss Spirals reinforce each other.
Precautionary hoarding − the response of most banks to the
large injections of liquidity and cash!
• two kinds !
A background of systemic deleveraging.
Overall, we observe
Deleveraging and falling asset values.
Low liquidity (zero?) among various interbank markets.
Many institutions are getting caught out, pushed to the brink (and over).
The real economy is increasingly being affected.
Immediately:
CRISIS MANAGEMENT
Longer term:
INSTITUTIONAL REFORM