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)
Global regulators may expand the definition of a too-big-to-fail financial firm, signing up domestic lenders, clearing houses and insurers to capital rules designed for the world’s biggest banks.
The “framework should be in place for domestically systemically important banks by the end of the year,” Mark Carney, chairman of the Financial Stability Board, said yesterday after a meeting of the group inBasel, Switzerland.
Deutsche Bank AG (DBK), BNP Paribas SA (BNP) and Goldman Sachs Group Inc. (GS) were among 29 banks subject to the so-called capital surcharge on globally systemic financial institutions drawn up by the FSB in November. Banks will have to boost reserves by 1 to 2.5 percentage points above minimum levels agreed on by international regulators.
“The world contains a whole slew of institutions like that which are not systemic on a global level but are on a national level,” Simon Gleeson, regulatory lawyer at Clifford Chance LLP, said in a telephone interview. “The institution most interesting in this regard is Erste Bank,” he said. “The more you look at it the more you think it’s systemically important to Hungary.”
Carney said that the FSB was considering putting in place tougher rules for so-called shadow banks whose failure could harm the global financial system. This work was less advanced than rules for systemic insurers, he said, adding that requirements would vary for different types of institutions.
“Despite the important steps that have been taken over the last couple of years, we are all aware that, in the short term, vulnerabilities remain,” Carney said.
The European Central Bank warned last year that shadow- banks require more scrutiny from regulators on the risks they pose to the financial system, while Michel Barnier, the European Union’s financial services commissioner, said that he will “go as fast as we can” in considering possible rules for them.
The FSB will review its work on shadow banks by March, the board said yesterday in a statement issued following its meeting.
Global regulators will also work on rules to ensure the robustness of clearing houses, the FSB said in the statement. Regulators should be able to take decisions by June on the “appropriate form” of central clearers dealing with derivatives, it said.
The FSB will also set up a group to examine cross-border disputes over rules governing banker pay, Carney said, acknowledging an “enduring mistrust” between banks over how lenders set their pay.
Regulators will together “address specific level playing field concerns” raised by their respective banks, the board said.
“This will be another tough year for the FSB,” Richard Reid, research director for the International Centre for Financial Regulation, said in an e-mail. “Although much of the regulatory agenda has been put in place, there remains a huge amount of work to be done on implementation.”
Carney said that the board may not replace former Swiss National Bank Governor and FSB Deputy Chairman Philipp Hildebrand, following his resignation this week over a currency trade made by his wife.
The decision will be taken “in the fullness of time and in consultation with G20,” he said.
European regulators have demanded the regions’ banks raise 114.7 billion euros ($146.6 billion) in new capital as part of measures designed to boost their resilience during the euro area’s sovereign-debt crisis.
German banks need to raise an additional 13.1 billion euros, Italian banks 15.4 billion euros, and Spanish lenders 26.2 billion euros in core tier 1 capital, the European Banking Authority in London said in December.
The capital shortfalls include 15.3 billion euros for Spain’s Banco Santander SA (SAN) and 7.97 billion euros for Italy’s UniCredit SpA. (UCG) Lenders in the region have until the end of June to raise the money.
(Reuters) – Technology company Apple is now worth as much as the 32 biggest euro zone banks.
That’s the stark result from a steep fall in the share price of banks including Spain’s Santander, France’s BNP Paribas, Germany’s Deutsche Bank and Italy’s Unicredit, compared to a steady rise in Apple’s valuation, according to Thomson Reuters data.
Earlier on Friday the DJ STOXX euro zone banks index fell 4 percent, valuing its 32 members at $340 billion. That’s based on the market capitalization of their free-float shares, which for some French banks in particular is less than 100 percent.
The index has crashed by a third since the start of July, hammered by fears banks will lose billions from their holdings of euro zone government bonds and a failure of policymakers to stop a euro zone debt crisis from spreading.
The euro zone banks have lost three-quarters of their value since peaking in May 2007.
In contrast, Apple’s market capitalization has soared to $340 billion on the back of the success of innovative technology products like iPods, iPhones and iPads.