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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)


Remember The Global Financial Crissis?! – Anxiety (2)

Northern Rock: Narrative

Northern Rock – History

  • Northern Rock began in the nineteenth century as a mutually owned “building society”, with a business focused on serving its local community.
  • The bank went public in 1997 and grew at an annual rate over 20 percent for the next ten years, with total assets of 113.5 billion pounds, the fifth largest U.K. bank by mortgage assets, as of June 2007.
  • Northern Rock focused on prime lending, had minimal subprime exposure, and the U.K. housing market remained strong in the summer of 2007.
  • But rapid growth starting in 1997 outstripped the traditional deposit base, and the bank had to rely on non-traditional funding sources.

 

Repo – 2007

  • Over the summer of 2007, some of these nontraditional funding sources began to dry up, and efforts to organize a private rescue for the bank failed.
  • On 9/13/07, the BBC broke the news that Northern Rock had sought assistance from the Bank of England; the BoE granted that assistance the next morning. The run on retail-branch deposits began that day.
  • At the time of the run, full deposit insurance in the U.K. was capped at 2000 pounds, and then 90 percent up to 35,000 pounds.
  • Despite the public nature of the retail-branch run, the real story was a wholesale run that had intensified in the previous month.

 

Northern Rock – The Puzzle

“The real question raised by the Northern Rock episode is not so much why retail depositors are so prone to loss of confidence that lead to bank runs, but instead …

why sophisticated lenders who operate in the capital markets chose suddenly to deny lending to a bank that had an apparently solid asset book and virtually no subprime lending.”

(Shin, p.102)

Northern Rock and the Global Financial Crisis

The “Monolines” – Background

  • Since they began in the 1970s, bond insurers main business was to provide credit enhancement to municipal bond offerings.
  • This insurance was provided by specialized companies that do not sell other types of insurance products – hence the name “monolines”.
  • In the roaring 2000s, they expanded into insurance provision for structured products (securitizations and CDOs).
  • January 2008, MBIA and Ambac (the two largest insurers), had a combined $265 billion in structured-product guarantees.
  • Starting in mid-2007, the markets became worried about these insurers.

 Source: FCIC, p. 276

Auction Rate Securities – Background

  • The traditional way to sell securities is with a primary offering, followed by the management of a secondary market. For some types of securities, the secondary markets are so illiquid that investors are scared away.
  • Auction rate securities (ARS) are a solution to this illiquidity, with a broker-dealer holding periodic auctions of long-term bonds to reset the interest rates based on demand.
  • Historically, broker-dealers reputational concerns meant that they provided a backstop to the market, holding paper to manage shortterm liquidity disruptions.
  • ARS are used for a very quiet type of securities: mostly studentloan pools and municipals.
  • The municipal securities were given credit enhancement by the monolines … uh-oh.

Bear Stearns

  • In mid-2007, Bear Stearns was the fifth-largest investment bank in the United States, with assets of about $400 billion.
  • The firm was a significant player in all parts of the subprime space, from loan origination to trading.
  • The first problem occurred in June 2007, with a suspension of redemptions in two Bear-managed hedge funds.
  • For reputational reasons, Bear bailed out these funds after liquidation on 7/31 by paying off their lenders and taking the collateral onto its own balance sheet.
  • This action, and the losses from other asset holdings, were not nearly enough to drive Bear Stearns into insolvency. So what happened?

What happened? A remarkable combination of liquidity pressures that took virtually everyone by surprise.

  • Prime brokerage withdrawals
  • “Novations” of derivatives
  • Collateral calls
  • Maturity shortening on secured “repo” loans
  • And, finally, a run on repo

 

Aftermath

  • The Federal Reserve supported a JP Morgan buyout of Bear Stearns, initially set at $2 per share, later raised to $10.
  • After Bear Stearns policymakers introduced several new tools to support liquidity in interbank markets.
  • The markets did not learn their lesson. The failure of Lehman Brothers six months later followed a similar script.
  • Some argue that Fed actions during the Bear Stearns crisis created a false sense of complacency and belief that there would always be support for other “too-big-to-fail” institutions – a belief that proved false and damaging before Lehman.
  • An alternative explanation is that these wholesale banking operations were inherently fragile – in ways that were simply not understood at the time – and our regulatory system was not equipped to handle their rapid failure.

 

Summary

  1. Institutions with subprime exposures began to fail in early to mid 2007.
  2. These failures were not expected to be a problem for broader economy, but led to stresses in wholesale funding markets, notably the ABCP market.
  3. These tensions would contribute to failures of seemingly unrelated or sufficiently insulted firms and markets: Northern Rock, auction rate securities and Bear Stearns.
  4. The vulnerabilities were not fixed, and there would be worse problems to come.

 

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)