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Posts tagged “Bear Stearns

Remember The Global Financial Crisis?! – Panic

Repo – A New Type of Banking

  • A sale and repurchase agreement (“repo”) is a deposit of cash at a “bank” which is short-term, receives interest, and is backed by collateral. Depositor takes legal ownership of the collateral.
  • Carved out of Bankruptcy Code; unilateral termination by non-defaulting party.
  • Two types of repo: bilateral and tri-party. Both types caused trouble in the crisis.
  • Collateral may be “rehypothecated”.
  • Collateral value typically exceeds the amount of cash deposited, this is called a haircut For example, deposit $98, receive a bond worth $100—a 2% haircut.

 

Lehman Brothers

  • As of March 2008, the situation at Lehman Brothers was just as precarious as it was at Bear Stearns, and perhaps Lehman only survived longer than Bear because some shady accounting made them look better than reality.
  • After the government-supported rescue of Bear Stearns in March 2008, the Federal Reserve created the Primary Dealer Credit Facility (PDCF) to provide liquidity to non-bank dealers like Lehman.
  • The PDCF was critical to Lehman’s survival over the next six months, as they tried to get rid of their worst assets and improve their capital and liquidity position.

 

Lehman Weekend – September 2008

  • On September 10, 2008, Lehman reported $28 billion in shareholder equity, $4 billion higher than a year earlier. But it was simply impossible to know if this equity cushion was accurate.
  • For one thing, Lehman reported $54 billion in real estate assets. Some market participants thought the true value was closer to half of that, which would effectively wipe out Lehman’s equity.
  • At the same time, Lehman’s counterparties in derivatives, commercial paper, and repo were pulling back, shortening terms, and demanding more collateral.
  • Most notably, JP Morgan, Lehman’s clearing bank in the tri-party repo market, demanded $5 billion and received $3.6 billion on 9/9, and demanded and received $5 billion on 9/12.

 

Lehman Weekend – September 12-14, 2008

  • Over the weekend of 9/12 – 9/14, the U.S. government tried unsuccessfully to arrange a private rescue for Lehman.
  • The government insisted there would be no public money spent on the rescue.
  • Bank of America chose to buy Merrill Lynch instead of Lehman.
  • On Saturday, Barclays agreed to buy Lehman, but by Sunday the deal was effectively blocked by UK regulators.
  • Without sufficient liquidity to operate the next day, and otherwise out of options, Lehman filed for bankruptcy early in the morning on September 15.

 

MMMFs

  • Money-Market Mutual Funds (MMMFs) are a specific type of investment company that is only permitted to own a narrow range of securities. In return for accepting this narrow investment range, they had the right (at this time) to report “stable values” for their share prices.
  • On September 16, 2008, Reserve Primary Fund “broke the buck” due to exposure to Lehman Brothers commercial paper. This led to a run on many MMMFs – mostly by institutional investors – and then quickly to an explicit guarantee from the U.S. government.
  • We really should have seen this coming – but we did not. Because MMMFs had significant problems in August 2007 as a result of the Asset-Backed Commercial Paper (ABCP) runs.
  • McCabe (2010) shows that MMMFs assets under management grew during the ABCP runs of 2007, but that is because the implicit promises of many sponsors were honored: 43 MMMFs were bailed out by their sponsors/fund-families. This level of support was unprecedented.
  • In September 2008, this support was not possible, and the resulting runs transferred more than $400 billion from prime MMMFs (which support many components of private finance) to government-only MMMFs (which do not).

 

AIG

Main weaknesses:

  • Credit-default-swap (CDS) mark-to-market losses and collateral calls.
  • Cash collateral investment losses in securities lending business.
  • Funding pressure in CP and repo.
  • Ratings downgrade triggers additional collateral calls.
  • Liquidity puts on CDOs.

After Lehman, markets are in turmoil and no private rescue is possible.

Fed led rescue of $85 billion, later supplemented by more from Fed and TARP.

 

The Run on Repo

  • $350 billion of short-term funding ran away from ABCP.
  • From MMMFs, about the same amount.
  • Combine these drains with uncertainty about the subprime exposure on balance sheets, and there is massive pressure on repo markets.
  • This pressure manifests in spreads (on underlying ABS), repo rates, and haircuts.
  • The statistical evidence in Gorton and Metrick (2012) confirms a significant relationship between LIBOR-OIS and ABS spreads.
  • Regression evidence also suggests that the main driver of haircuts was uncertainty about future spreads on the ABS collateral.

 

Special thanks to Timothy F. Geithner (Lecturer in Management, Yale SOM, Former U.S. Secretary of the Treasury, Yale School of Management) and Andrew Metrick (Michael H. Jordan Professor of Finance and Management, Yale School of Management)

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Remember The Global Financial Crissis?! – Anxiety

Some Notable Events in 2007

April 2007

New Century: 4/2/07 (REIT with market cap of $1.75 billion on 1/1/07, delisted 3/13, filed for bankruptcy 4/2)

June 2007

S&P/Moody’s significant downgrades beginning in June 2007 Bear Stearns suspends redemptions: 6/7/07

July 2007

Bear Stearns liquidates funds: 7/31/07

August 2007

BNP Paribas funds: 8/9/07

 

ABX

The ABX-HE (or just “ABX”), is an index of credit default swaps (CDS) written on subprime mortgage securitizations. The price of the ABX index is essentially a measure of perceived value of subprime securities with various ratings; the return (or spread) on the ABX is essentially a risk premium for subprime.

The index was created by the firm Markit, and first released in January 2006 covering the 20 largest subprime securitizations that closed in the last six months of 2005. These indices were denoted as ABX-HE 2006-1. Subsequent releases were denoted 2006-2, 2007- 1, and 2007-2 before subprime activity became too small for index construction.

The launch of ABX in 2006 was a notable event, as it allowed everyone to see, speculate, and hedge – for the first time – market expectations about subprime.

 

How Could We Be So Wrong?

“… given the fundamental factors in place that should support the demand for housing, we believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system.” – Chairman Bernanke in a speech on May 17, 2007

 

Anxiety Spreads

The bad news in subprime was well-known by the time of Chairman Bernanke’s speech. Indeed, the news events in the spring of 2007 seem uncorrelated with the movements in the ABX.

Instead, the problem became the uncertainty about the location of subprime risk. Which securitized bonds were exposed to subprime? Which financial institutions would need to support their investment vehicles?

The financial system is not equipped to analyze “safe” investments. The resources for deep analysis of information are not there.

Consider what you would do if you had uninsured deposits at a bank, and you became nervous about the bank’s solvency. Is it rational to analyze the bank’s balance sheet, or to just take your money out?

 

LIBOR-OIS

The London Interbank Offered Rate (LIBOR) is a measure of the interest rates that banks charge each other for unsecured dollar funding over various time periods (overnight, one-month, threemonth etc.)

The Overnight Index Swap (OIS) is a fixed-floating interest-rate swap for various time periods. Because the amounts owed daily are small and counterparties must continuously post collateral for expected payments, the fixed leg of this swap is considered to be a good proxy for risk-free interest rates.

The LIBOR-OIS spread is thus a good measure for the riskiness of banks’ unsecured borrowing. Historically, this spread was very small (around ten basis points).

 

Asset-Backed Commercial Paper

Asset-backed commercial paper (ABCP) is primarily a method of maturity transformation – funding a pool of long-term assets with short-term liabilities.

ABCP is designed to meet specific needs of investors (often money-market mutual funds), and includes credit enhancement and liquidity support to achieve this goal.

 

ABCP vs. Securitization

ABCP may appear similar to securitization, but there are many differences:

  • Investments can be revolving and fluctuate in size
  • Conduits may invest in various asset types
  • Typically engage in maturity transformation, with backup liquidity support
  • No scheduled amortization of assets and liabilities

 

ABCP Data

ABCP programs grew rapidly in the 1990s, and then again in the crucial 2003-2007 period.

As of 2007, ABCP programs took many forms, and were not dominated by any particular type of sponsor.

 

ABCP “Runs”

Covitz, Liang and Suarez define an ABCP “run” as a week when the program does not issue new CP despite having at least 10% of outstanding CP mature.

Runs became endemic in August 2007, and once a program experienced a run it was unlikely to ever leave that state. By December 2007 more than 40% of programs were in a run state.

 

Summary

The problems in subprime were clear to all market participants in early 2007.

These problems were not expected to infect the whole financial system, but uncertainty about the location of risks led to a spread of anxiety beginning in the middle of 2007.

The anxiety is driven by a financial system ill-equipped to analyze risks in seemingly “safe” assets. This sets the stage for a good oldfashioned bank run, but now taking place in the shadow banking markets.

 

Special thanks to Timothy F. Geithner (Lecturer in Management, Yale SOM, Former U.S. Secretary of the Treasury, Yale School of Management) and Andrew Metrick (Michael H. Jordan Professor of Finance and Management, Yale School of Management)