Transcript Why are financial intermediaries special? What is a bank?

Thoughts on
the Current Financial Turmoil
presentation by Richard Rosen,
Federal Reserve Bank of Chicago
April 18, 2008
The views expressed here are those of the author and may not represent those of the Federal
Reserve Bank of Chicago or the Federal Reserve System.
1
Outline
• What caused the recent financial turmoil?
• What do we mean by turmoil?
• What does this mean for the broader economy?
– What did the Fed do?
2
Causes of the turmoil.
• Financial markets seemed strong going into 2007.
– Equity markets had at least partially recovered from the 2001
declines.
• The IPO market was healthy.
• Measures of expected equity market volatility were at historically
low levels.
– Bond markets were growing, with bond spreads at low levels.
• But housing markets were beginning to show signs of weakness.
– Home prices had stopped their rapid increase.
3
The period of rising home prices comes to an end.
Home price index change
(percent change over prior year)
20
Case-Shiller Home Price Index
15
10
5
OFHEO price index
0
-5
'75
'80
'85
'90
'95
2000
'05
4
MBS total outstanding compared to total mortgage debt
12.0
10.0
$ trillions
8.0
Total single-family
residential mortgages
6.0
4.0
Total
MBS
2.0
0.0
1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006
• MBS outstanding are a growing share of total mortgage debt.
Source: Inside Mortgage Finance, “The 2007 Mortgage Market Statistical Annual”
5
The share of non-agency securities
in total MBS issuance
60%
50%
40%
30%
20%
10%
0%
1995
1997
1999
2001
2003
2005
• Privately-issued MBS have grown in importance, especially in the last few
years through 2005.
Source: Inside Mortgage Finance, “The 2007 Mortgage Market Statistical Annual”
6
The share of non-agency securities
in total MBS issuance by type of mortgage
25%
20%
15%
Prime
Subprime
Alt A
10%
5%
0%
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
• Subprime and Alt-A mortgages have grown in share in the last few years,
both overall and as a fraction of non-agency MBS through 2006.
7
Source: Inside Mortgage Finance, “The 2007 Mortgage Market Statistical Annual”
Causes of the turmoil.
• Then, in 2007, there were a series of problems related to subprime
mortgage investments that spooked the markets.
– In addition, home prices started to decrease in some markets
and homes became more difficult to sell.
8
Housing prices decelerate . . .
Home price index change
(percent change over prior year)
20
Case-Shiller Home Price Index
15
10
5
OFHEO price index
0
-5
'75
'80
'85
'90
'95
2000
'05
9
with larger declines in some markets
Case-Shiller Home Price Index
(percent change over prior year)
50
40
30
Miami
20
Phoenix
10
San Diego
National
0
'88
'90
'92
'94
'96
'98
'00
'02
'04
'06
-10
-20
10
Housing sales decline and inventories rise
Inventory of Unsold Homes
Single-family Home Sales
(months supply)
(thousands)
1600
6400
Existing 
10
Existing homes
9
1400
5600
8
1200
1000
4800
New
4000
7
6
New homes
5
800
3200
4
600
2003
2400
'04
'05
'06
'07
3
2003
'04
'05
'06
'07
'08
11
The share of non-agency securities
in total MBS issuance
60%
50%
40%
30%
20%
10%
0%
1995
1997
1999
2001
2003
2005
2007
• Private issuance of MBS fell off sharply in 2007.
Source: Inside Mortgage Finance, “The 2007 Mortgage Market Statistical Annual”
12
Credit quality in subprime markets erodes . . .
Loans 90+ Days Past Due Plus Foreclosures Started
(percent of loans outstanding)
9
Subprime-FRM
Subprime-ARM
6
3
Prime-FRM
Prime-ARM
0
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
13
especially among recently-issued loans
From Demyanyk and Van Hemert, “Understanding the Subprime Mortgage Crisis,” 2007
14
even those with full documentation
From Demyanyk and Van Hemert, “Understanding the Subprime Mortgage Crisis,” 2007
15
What do we mean by turmoil?
• The problems in subprime mortgage markets sparked a general
reconsideration of, and repricing of, risk in many markets.
16
Financial markets stress in August indicated a new view
of future risk
CBOE Volatility Index
50
45
40
August spike
35
30
25
20
15
10
5
0
3 4
6 7
7
0
1 1
1
2
3
3
4
4
5 5
6
6
0
0
2 2
5
7
00 200 200 200 200 200 200 200 200 200 200 200 200 200 200 200 200 200 200 200 200 200 200 200
2
3/ 8/ 1/ 5/ 1/ 4/ 8/ 3/ 7/ 0/ 6/ 0/ 3/ 8/ 1/ 7/ 1/ 4/ 0/ 4/ 7/ 2/ 6/ 1/
1/ 5/ 9/1 1/1 5/2 9/2 1/2 6/ 10/ 2/1 6/1 0/2 2/2 6/2 11/ 3/ 7/1 1/1 3/2 7/2 1/2 4/ 8/ 2/1
1
1
1
1
17
Financial market stress was widespread
Spreads on Commercial Paper Yields
Corporate Bond Spreads
(basis points)
(basis points relative to 10-year Treasury)
180
160
30 Day Asset-Backed
less AA financial
1000
140
120
30 Day A2/P2
less AA nonfinancial
800
High Yield
less 10 year Treasury
100
600
80
60
400
40
20
200
0
il
y
p
g
e
ly
pr Ma un Ju Au Se
A
J
v
ct
O No
D
ec
Ja
Aaa less
10 Year Treasury
n
0
'02
'03
'04
'05
'06
'07
'08
18
4/
2/
4/ 200
16 7
4/ /20
30 07
5/ /200
14 7
5/ /20
28 07
6/ /200
11 7
6/ /20
25 07
/2
7/ 00
9/ 7
7/ 200
23 7
/2
8/ 00
6/ 7
8/ 200
20 7
/2
9/ 00
3/ 7
9/ 200
17 7
10 /20
/ 0
10 1/2 7
/1 00
10 5/2 7
/2 00
7
11 9/20
/1 07
11 2/2
/2 00
7
12 6/20
/1 07
12 0/2
/2 00
4/ 7
2
1/ 007
7/
20
08
There was a flight to quality
LIBOR-Overnight Index Swap Spread
(basis points; three month maturity)
1.10
1.00
0.90
0.80
0.70
0.60
0.50
0.40
0.30
0.20
0.10
0.00
19
What do we mean by turmoil?
• Some markets essentially or largely shut down.
– Examples include the asset-backed commercial paper market
and auction-rate securities.
– The examples may not seem directly related to credit concerns.
20
What happened to the broader economy and financial
markets during this time?
Heading into the subprime problems:
• Economic activity was expanding at a moderate pace.
– Unemployment continued to be low.
– However, the threat of increased inflation was present.
• Financial markets were strong, with market indicators suggesting low
risk.
• But, . . .
21
Are the changes in credit markets related to the problems
in subprime mortgage markets?
• The subprime and Alt-A mortgage market is somewhat small.
– In total, subprime and Alt-A mortgage debt outstanding is
estimated at about $1.5 trillion, which is 20% of all mortgage debt
(Credit Suisse estimates).
– This compares to the U.S. GDP of $14 trillion per year and U.S.
equity market valuation of about $20 trillion.
 So, losses of 20% equate to a 1.5% drop in equity valuations (180
points on the Dow, if the Dow is at 12,000).
22
Are the changes in credit markets related to the problems
in subprime mortgage markets?
• But, claims on subprime mortgages are spread more widely.
– There are derivative securities such as structured investment
vehicles (SIVs) that are based on subprime mortgages.
• Perhaps more importantly, the problems in subprime mortgages and
derivative products with claims on subprime mortgages may have led
the markets to reassess how they calculate risk and risk premia.
– This is reflected in the higher risk spreads noted above.
23
What does this mean for the broader economy?
The problems in subprime housing can have three types of
effects:
• Direct effect: Residential construction.
• Semi-direct effect: Consumer spending.
• Indirect effect: Tightness in credit markets.
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What does this mean for the broader economy?
Where does this leave us?
• Overall, economic growth has started to weaken.
– There are also indications of inflationary pressures.
• The weakness in housing continues and there are fears it may
negatively affect consumer spending.
 This led to the decision to cut the federal funds target rate at the
recent FOMC meetings (and once between meetings), and to
recent statements by senior Fed officials including Chairman
Bernanke.
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What does this mean for the broader economy?
What about the financial sector?
• The Fed has taken a series of actions designed to add liquidity to credit
markets.
– Lengthening the maturity of Discount Window loans.
– Allowing more collateral for these loans.
– Term Auction Facility.
– Primary Dealer Credit Facility and Term Securities Lending Facility: loans
to investment banks (technically, primary dealers).
• And then there was the Bear Stearns situation . . .
26
Bear Stearns and systemic risk
• “Our financial system is extremely complex and interconnected, and
Bear Stearns participated extensively in a range of critical markets.
The sudden failure of Bear Stearns likely would have led to a chaotic
unwinding of positions in those markets and could have severely
shaken confidence. The company's failure could also have cast doubt
on the financial positions of some of Bear Stearns' thousands of
counterparties and perhaps of companies with similar businesses.
Given the exceptional pressures on the global economy and financial
system, the damage caused by a default by Bear Stearns could have
been severe and extremely difficult to contain. Moreover, the adverse
impact of a default would not have been confined to the financial
system but would have been felt broadly in the real economy through
its effects on asset values and credit availability.”
Fed Chairman Ben Bernanke before the Senate Banking Committee, April
3, 2008
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Bear Stearns and systemic risk
• The Fed initially agreed to lend money to Bear Stearns through JP
Morgan Chase Bank. Then, over the following weekend, JP Morgan
Chase agreed to acquire Bear Stearns.
– The Bear Stearns resolution immediately preceded the opening of the
Term Securities Lending Facility, although the NY Fed president said that
Bear Stearns would not have qualified for it.
– JP Morgan offered $2 per share, later upped to $10 per share. On the prior
Friday, Bear Stearns shares closed at $30 (down from a high of $170).
• As the quote on the previous page suggests, the Fed, along with the
Treasury Department, felt that it was too dangerous to allow Bear
Stearns to fail.
– Since the failure of Continental Illinois in 1984, regulators have been
reluctant to let large, systemically important banks close. Some have
argued that this extends this “too big to fail” policy to investment banks.
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Appendix: Simple pass-through MBS
Payments (principal and interest) on a group of home mortgages are passed
through to MBS security holders.
Financial intermediary (originator)
Issuer – government agency or non-agency
(private) firm – packages mortgages
For subprime,
this is a private firm
Investors in MBS
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Appendix: Bankruptcy-remote master trust
The following gives a little more detail on how a MBS structure works.
Countrywide
Countrywide owns CWMBS. Home mortgages are
sold by Countrywide to CWMBS before being put in
the trust. The reason AmSouth Auto Receivables is set
up is to prevent AmSouth’s creditors from claiming the
receivables in bankruptcy.
CWMBS
Master trust
CWMBS transfers the mortgages to the trust.
The trust obtains what is known as the “first
perfected security interest,” basically giving
the trust a claim on the mortgages that protects
the bondholders’ interests in bankruptcy. Note
that the trust is a corporate legal structure set
up to isolate the ABS activities.
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Appendix: Bankruptcy-remote master trust
The following gives a little more detail on how a MBS structure works.
Master trust
The trust issues claims on the mortgages. However, the
total claims issued are less than the total loans
transferred. The difference is the overcollateralization.
When the bondholders are repaid, any remaining funds
are transferred upstream (to Countrywide). Thus, in
effect, overcollateralization functions as investment in a
junior security held by Countrywide.
Investors’
interest
The trust issues multiple classes of bonds
including A, B, and R. Class A bonds are senior
to Classes B and R. All the bonds bear a fixed
(but different) interest rate. The classes have
different order of repayment and priority in
bankruptcy.
Class A
bonds
Class B
bonds
Class R
bonds
31
Appendix: Why did subprime mortgages increase?
The role of securitization
• Somewhat a ‘chicken and egg problem’ – that is, there are a number
of factors, but it is not clear which came first:
– Rising home prices.
– “Excess liquidity”
– Increases in securitization.
• Securitization refers to the packaging and resale of assets as securities.
• Mortgage-backed securities (MBS) are bonds with payments based on
and backed by the payments on pools of home mortgages.
32
Appendix: The share of non-agency securities
in total MBS issuance by type of mortgage
25%
20%
15%
Prime
Subprime
10%
Alt A
5%
07
20
06
20
05
20
04
20
03
20
02
20
01
20
00
20
99
19
98
19
97
19
96
19
19
95
0%
• Especially hard hit were subprime and Alt-A mortgages.
33
Source: Inside Mortgage Finance, “The 2007 Mortgage Market Statistical Annual”
Appendix: MBS: Use of Tranches
• Issuers structure MBS with multiple tranches (or classes) to allocate prepayment
and default risk across different investors.
• In the simplest type of tranche structure (referred to as a sequential pay
structure), payments are as follows:
– Separate bonds are issued for each tranche.
– Senior classes have less default risk than junior classes, and generally have
less prepayment risk.
– Overcollateralization (OC) serves as an equity tranche, absorbing initial
default risk.
– Payments to the tranches are as follows:
• Interest payments: All classes are paid interest if possible. In a
shortfall, tranches are paid by seniority.
• Principal repayment: The classes are repaid in order of seniority
(including cases where there is bankruptcy or prepayment).
34
Appendix: Multitranche payment flows
Principal payments
2.00
1.50
Senior tranche
1.00
0.50
Junior tranche
20
25
20
25
15
10
5
1
0.00
Years
Interest payments
1.00
0.80
Senior tranche
0.60
0.40
Junior tranche
0.20
15
10
5
1
0.00
Years
35
Note: This assumes some prepayments.
Appendix: Non-agency MBS: typical structures
100%
AAA: 79.3%
AAA: 92.9%
AA: 2.4%
A: 1.8%
BBB: 1.2%
BB: 1.0%
OC: 0.8%
AA: 6.6%
A: 5.4%
BBB: 4.3%
BB: 2.6%
OC: 1.9%
0%
Subprime1structure
Alt-A structure
2
AAA: 95.6%
AA: 2.0%
A: 0.9%
BBB: 0.5%
BB: 0.4%
OC: 0.6%
Prime jumbo
3 structure
• Excess spread varies by deal, but averaged 2.5% in 2006.
(OC refers to overcollateralization.)
Source: Bear Stearns.
36
Appendix: But MBS aren’t always the end of the line:
CDOs and SIVs
Homeowner
Financial intermediary
Third-party intermediary
Securities with payments based on
MBS and/or other securities:
Mortgage-backed security
Collateralized debt obligation or
structured investment vehicle
Other MBS,
other ABS, or
just “other”
37
Appendix: Resecuritization: CDOs and SIVs
• There are also bonds that backed by the payments on mortgage-backed
securities rather than the payments on the mortgages themselves.
– Collateralized debt obligations (CDOs) are a general class of derivative
securities backed by a pool of bonds (or loans).
– CDOs backed by bonds issued as part of a mortgage-backed securitization
or a derivative MBS security issue are called collateralized mortgage
obligations (CMOs).
– CMOs typically have complicated tranche structures.
• Structured investment vehicles (SIVs) can be considered a type of CDO, but
they generally refer to investment vehicles with a specific structure:
– SIVs generally issued shorter-term debt than CDOs.
– They issue a mix of asset-backed commercial paper (roughly 30% of a
typical SIV) and medium-term notes (roughly 70% of a typical SIV).
38
Appendix: MBS: agency and non-agency issuers
• Mortgage-backed securities are issued by agency and non-agency
issuers.
– Agency issuers are the GSEs (Fannie Mae and Freddie Mac) and
Ginnie Mae.
– Non-agency issuers are private firms. They include depository
institutions and other financial intermediaries.
39
Appendix: Non-agency issuers
• The largest private issuers include thrifts, investment banks, finance companies,
and some commercial banks. Top issuers include (2006 rankings in parentheses):
– Thrifts: Countrywide (1), Washington Mutual (2), and IndyMac (8)
– Investment banks: Lehman (3), Bear Stearns (5), and Goldman Sachs (6).
– Finance companies: GMAC (4) and New Century (9)
– Commercial banks: Wells Fargo (6) JPMorgan Chase (10), DeustcheBank
(17), and Bank of America (20)
• Many of the largest issuers in 2006 were also large issuers in 2000, but:
– Investment banks are bigger players today (Lehman and Bear Stearns
ranked 12th and 20th, respectively, in 2000; and Goldman Sachs was not a
major player.).
– The market was more diffuse in 2006 than in 2000 (the market share of
the top 10 issuers declined from 93.6% in 2000 to 56.0% in 2006.).
Source: Inside Mortgage Finance, “The 2007 Mortgage Market Statistical Annual”
40