Global financial and economic crisis

Global financial and economic crisis Dr. Vasja Rant 14 December 2009

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 crisisCollapse of the real estate price bubble

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 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 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 crisisResidential mortgage products • GREATER RISKS: • Flexible payments increase chances of terminal default. • Debt servicing may increase 15-30% upon FRM/ARM resetting.

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

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 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 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 crisisPre-crisis macro environment – saving imbalances (1)

Origins of the crisis Pre-crisis macro environment – saving imbalances (2)

Origins of the crisis Pre-crisis macro environment – equity prices

Origins of the crisis Pre-crisis macro environment – interest rates

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 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 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

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 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).

Origins of the crisisThe world of structured finance

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

Transmission of the crisisIncrease in uncertainty: unreliable credit ratings for mortgage derivative securities

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 crisisIncrease in risk aversion (2): from mortgage to other asset derivatives

Transmission of the crisisIncrease in risk aversion (3): from derivatives to corporate debt market

Transmission of the crisisIncrease in banks’ credit and liquidity risk

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.

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 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

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

Transmission of the crisisReal economy – GDP

Transmission of the crisisReal economy – consumption

Transmission of the crisisReal economy – investment

Transmission of the crisisReal economy – trade

Transmission of the crisisReal economy – employment and unemployment

Transmission of the crisisPublic finance

Transmission of the crisisReal economy – credit & interest rates

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 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 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 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 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 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 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 6 years 35,5 % Vir: Reinhart C. in Rogoff K. (2009): The Aftermath of Financial Crises

Global financial and economic crisis