Global Financial Crisis

 Hand in the homework that is due today

 What caused the Global Financial Crisis?
 We’ll focus today on
• Financial Innovation and Regulatory Issues
• Other issues have been cited, including monetary policy errors,
capital inflows from abroad.

 Prof. Bonham has placed several short pieces about

todays material online.
 Housing boom and bust

 2000-06 surge in
home prices 650!
569!
• Why?
488!
 Housing prices began 406!
325!
to fall in 2007
244!
 Delinquencies and 163!
81!
foreclosures surged
0!
 20% failure rate on
1!

1!

1!

1!

1!

1!
Q

Q
80

85

90

95

00

05
sub-prime mortgages
19

19

19

19

20

20
San Diego! Los Angeles! Sacramento! Stockton!
 Financial Market Fallout

 2007: Crisis in markets for mortgage-related assets

• Large losses at hedge funds from credit default swaps
» mortgage bond guaranteeing
• Credit rating downgrades of subprime products
• Prices of mortgage-backed securities fell and demand dried up
• Banks began to write down mortgage-related assets
• Some institutions were unable to raise needed funds
 Two key crisis events were outside the U.S.:
• In August 2007, French bank BNP Paribas froze redemptions
saying couldn’t value underlying securities
• UK bank Northern Rock bailed out in Sep 2007
 Fed and other central banks began aggressive response
 Financial Market Fallout

 2008: Credit conditions continued to worsen

• March: Bear Sterns
• Sep: Fannie Mae and Freddie Mac
• Sep. 15: Lehman Bros.
• Sep. 16: AIG
• Sep. 25: WAMU
 Credit markets froze up
 US and world entered most severe recession since
1930s
 How did the structure and operation of financial
markets and institutions cause this?
 Mortgage lending

 What is the traditional model for mortgage lending?

• Banks make loans and hold loans as income-earning assets
 How is most of it done now?
• A bank or loan originating company (e.g. Countrywide) makes
a loan and then sells it
» In U.S. Fannie Mae and Freddie Mac or private financial institution
• They securitize the loans and sell them to investors
• The “originate-to-distribute” model
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Originate-to-Distribute Model
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Creating asset backed securities
 Collateralized Debt Obligations

 This is a form of collateralized debt obligation (CDO)

 What are the benefits of such “structured finance”?
• Pooling lowers risk through diversification
• Subordination allows some highly-rated securities
» Credit default swaps can be used to reduce risk further
» Some investors can only hold highly-rated securities
• Security sales can tap large pool of funds
• This all means lower interest rates, greater access to credit
• And risk is channeled to investors who are willing to bear it
 Growth of CDO Market

 Why did it grow so

fast?
• financial innovation
• growth of non-bank
financial
institutions
• low interest rate
environment
• rapid home price
appreciation
 Mortgage meltdown
Figure 1
Decline in Mortgage Credit Default Swap ABX Indices
 (the ABX 7-1 series initiated in January 1, 2007)
Prices of mortgage credit default swaps
100

80

60
ABX price

40
AAA
AA
20 A
BBB
BBB-
0
M

N
M

Se
M

Se
M

Ja
Ja

Ju
Ja

Ju

ov
ov

ar

ay
ar

ay

n0
n0

p0
n0

l
p0
l0

08

08
08

08
07
07

07

9
8

8
7

Source: LehmanLive.
Note: Each ABX index is based on a basket of 20 credit default swaps referencing asset-backed securities
 What went wrong?

 Exposure to losses was much larger than believed

• Underestimation of potential home price decline
• Correlation of losses
• Some securitized asset structures magnified losses
» CDO-squared
• MarketPlace video

• Lack of transparency made it harder for investors to assess risk

• Incentive problems in structured finance
» Loan originators have no skin in the game
• Poor monitoring
FIGURE 2:
Poor monitoring led to falling credit quality
Total Mortgage Originations by Type: with share of each product; billions, percent

Total= 2,215 2,885 3,945 2,920 3,120 2,980 2,430 1,800

(annualized)

FHA/VA HEL
Conforming Alt-A
Jumbo Subprime

2001 2002 2003 2004 2005 2006 2007 2007Q4

(annualized)

Source: Inside Mortgage Finance. HEL is Home Equity Loan.

 What went wrong?

 Incentive problems in structured finance (continued)

• The rating agencies
• What do the rating agencies do?
» Why have the grown in importance over the years?
• What is their particular role in structured finance?
» What are the potential problems with reliance on rating
agencies?
• Incentives for issuing investment bank?
• Incentives for rating agencies?
» What went wrong?
» How might we fix it?
• See Lowenstein, Roger, “Triple-A Failure: The Ratings Game,” New York Times,
April 27, 2008. http://www.nytimes.com/2008/04/27/magazine/27Credit-t.html .
 What went wrong?

 Little or no regulation of non-bank financial institutions

• Severe maturity mismatches
• Very high leverage ratios, facilitated by regulatory changes and
regulatory arbitrage
» Why is high leverage attractive? Dangerous?
• Banks set up structured investment vehicles (SIVs) to hold asset
backed securities (also called more generally special purpose
vehicles
» But banks were still threatened. Why?
• Liquidity backstops
Leverage at U.S. Investment Banks
 Why did it spread beyond mortgages?

 Why did a crisis in a relatively limited part of the

markets turn into a full-blown financial crisis?
• Borrower balance sheet effects
» Loss spiral
• asset price falls -> must sell assets to correct balance sheet -> asset sales
cause further asset price declines -> etc.
» Margin / haircut spiral. With increased assessments of risk,
• larger margins are required -> must reduce leverage -> asset sales -> as in
loss spiral.
• Lending channel
» Precautionary hoarding by banks and nonbanks.
• Runs on nonbank financial institutions
» E.g. hedge funds pulling money out of Bear Sterns; AIG forced to post
more collateral
 Why did it spread beyond mortgages?

• Network effects
» Counterparty risk. The argument for saving AIG.

• See Brunnermeier, Markus K. “Deciphering the Liquidity and Credit Crunch 2007–
2008,” Journal of Economic Perspectives 23:1, Winter 2009, 77–100.