Some Notable Events in 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)
S&P/Moody’s significant downgrades beginning in June 2007 Bear Stearns suspends redemptions: 6/7/07
Bear Stearns liquidates funds: 7/31/07
BNP Paribas funds: 8/9/07
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
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?
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 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.
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.
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)
The Swiss franc rose against all of its 16 most-traded peers, reaching a record against the euro, as investors sought safety on concern an austerity plan to stabilize Greece won’t resolve Europe’s sovereign-debt crisis.
The dollar gained for a third week against the euro, the longest since February, on speculation Greece’s parliament may reject Prime Minister George Papandreou’s plan to cut the budget deficit, win more aid and avoid default. The pound slid for a fourth week against the dollar after U.K. policy makers discussed more monetary stimulus. Growth in U.S. manufacturing cooled in June, a report next week may show.
“All these headlines continue to add to uncertainty and nervousness amongst investors and continue to create the choppy price action that we’ve been seeing,” said Paresh Upadhyaya, head of Americas G-10 currency strategy at Bank of America Corp. in New York. “Just as you feel you’re on top of the Greek situation, you get thrown a curve ball.”
The franc touched 1.1806 versus the euro yesterday, the strongest level since the shared currency’s 1999 debut. It gained 2.6 percent for the week to 1.1826 per euro, from 1.2142 on June 17. The franc gained 1.8 percent to 83.31 centimes per dollar, from 84.82 centimes a week earlier.
The greenback appreciated 0.8 percent to $1.4188 against the euro, from $1.4306. The U.S. currency rose 0.5 percent against the yen to 80.43, from 80.05, gaining for the first time in five weeks. The euro fell 0.3 percent to 114.13 yen in its third week of losses, the longest losing streak since January.
No New Purchases
IntercontinentalExchange Inc.’s Dollar Index, which tracks the greenback against the currencies of six trading partners, rose for a third week as Federal Reserve Chairman Ben S. Bernankedashed expectations policy makers would expand stimulus measures. That eased concern Fed policies would further debase the currency. The index rose 0.8 percent to 75.583.
The central bank said June 22 after a two-day meeting it will maintain monetary stimulus to support a flagging economic recovery while letting a $600 billion bond-purchase program end on schedule this month. Bernanke told reporters policy makers are in a “different position” now than last August, when deflation posed a “nontrivial risk” and he first hinted the Fed might undertake the debt buys.
Sterling fell for a fourth week against the greenback, the longest since September, as minutes of the latest Bank of England meeting showed some policy makers saw a risk that more bond purchases may be required.
The pound weakened 1.5 percent to $1.5959, from $1.6194 on June 17. It touched $1.5939 on June 23, a three-month low.
Greece’s Papandreou may struggle to pass austerity measures even after winning a confidence vote by 155-143 on June 22, which sent the euro to a one-week high against the dollar. The prime minister will seek parliament’s approval next week for a 78 billion-euro ($111 billion) package of budget cuts and asset sales, a condition for more aid the European Union and theInternational Monetary Fund.
“Anything that starts with a “G” I’ll be paying attention to,” said Carl Forcheski, a director on the corporate currency sales desk at Societe Generale SA in New York.
Finance Minister Evangelos Venizelos said he’ll speak to dissenters from the ruling Pasok party in a bid to persuade them to back the austerity measures in a vote that’s due by June 30.
Thomas Robopoulos, a lawmaker from the party, said he hadn’t decided whether he’ll vote for the plan. He said yesterday by telephone he was leaning toward voting against it.
“The majority that they had for the confidence on Tuesday of 155 seems to be dwindling away,” said Mark McCormick, a New York-based currency strategist at Brown Brothers Harriman & Co.
The euro fell 1.5 percent over the past three months, according to Bloomberg Correlation-Weighted Currency Indexes, which track the currencies of 10 developed nations. The Swiss franc was the best performer, gaining 8.4 percent.
The 17-nation currency fell against most major counterparts yesterday as Italy’s two largest banks, UniCredit SpA and Intesa Sanpaolo SpA, led a drop in bank stocks in Milan. Trading in both firms’ shares was briefly suspended after breaching limits on intraday swings.
Moody’s Investors Service said June 23 it may downgrade 13 Italian banks because they would be vulnerable to a cut in the government’s credit rating. The firm said last week Italy’s ratings may be cut because of slowing economic growth and the potential for Europe’s debt crisis to drive up borrowing costs.
“Adding to unexpected risk to the euro, the market now has to concentrate on risks to Spain and Italy, which were long considered safe in this go-around,” said Bank of America’s Upadhyaya.
Canada’s dollar dropped against the greenback as crude oil, the nation’s biggest export, fell. TheInternational Energy Agency said its members will release 60 million barrels of oil from emergency stockpiles to alleviate possible shortages following the loss of Libyan crude.
The Canadian currency depreciated 0.9 percent to 98.86 cents per U.S. dollar, from 97.94 cents a week earlier. It touched 98.87, yesterday, within one cent of the weakest since March 17. Crude fell 2.3 percent to $91.16 a barrel in New York, dropping below $90 on June 23 for the first time since February.
The Institute of Supply Management’s manufacturing index slipped to 51.8 in June from 53.5 in May, according to a Bloomberg News survey of economists before the data is released on July 1. Readings above 50 signal growth.