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Remember The Financial Crisis?! – What have we learned?

The economic costs of the crisis were brutal

  • Real GDP fell more than 4% and took more than 3 years to return to the pre-crisis peak
  • Public debt has increased by more than 30% of GDP, mostly due to cyclical forces
  • At market bottom, $15 trillion in household wealth had disappeared

But these costs would have been much greater in the absence of an effective financial rescue

 

Policy Failures – Before and During the Crisis

Failures Ex Ante

  • Home equity was too thin
  • Capital cushions were too thin—and, more importantly, too narrow in scope
  • Too much issuance of shortterm, deposit-like liabilities, without regulatory constraints on leverage and without access to the safety net

Failures In the Crisis

  • We escalated too late, mostly because of limitations of authority
  • Fiscal policy turned too tight too soon
  • Mortgage restructuring authority, resources, and incentives were too weak

 

“Too big to fail” is less of a problem

  • The largest institutions are subject to a systemic capital surcharge
  • The FDIC has resolution authority to manage the failure of systemic institutions
  • We imposed tougher concentration limits on the financial system
  • The Fed’s emergency lending authority has been curtailed, and the FDIC’s emergency guarantee authority has been eliminated

 

Unfinished Business

  • Lots of economic damage remains from the crisis
  • The housing finance system is still broken
  • Our firefighting tools are too weak
  • The regulatory oversight structure is a mess

 

Tough questions on housing finance

  • How do we balance the imperatives of mortgage accessibility and market stability?
  • Should we have mandatory down payment requirements? And how high should those down payments be?
  • What should the government’s role be in the new system? Guarantee should be explicit, limited in scope, more expensive—with greater role for private capital But government needs authority to step in during crisis
  • How do we transition to the new system?

 

Firefighting authorities are too weak

  • Our shock absorbers are thicker and broader than they were
  • But we will always need firefighting authorities
  • Guarantee authority is essential for breaking panics and for recapitalizing the system
  • The scope of the standing lender of last resort authority is still too narrow
  • We need more “break-the-glass” authority for the President

 

The costs of regulatory balkanization

  • There’s too much opportunity for regulatory arbitrage
  • Regulators and regulations are too slow to adapt to changing markets and institutions
  • The rules are too complex
  • There’s little accountability
  • There’s too much regulatory capture

 

Principles to govern a streamlined system

  • Functional specialization
  • More budgetary independence from Congress
  • Stronger enforcement
  • Better firefighting authority

 

Rule 01  – If you want peace, prepare for war

  • The extreme crisis is unimaginable ex ante
  • Manias are not preventable, and there’s no over-the-horizon radar for preempting panics and crashes
  • So design the system not to prevent failure, but to be safe for failure
  • This means you need strong shock absorbers

 

Rule 02 – Design the shock absorbers for the extreme crisis and apply them broadly

  • Impose capital, leverage, and funding requirements on bank-like institutions; systemic surcharge on the biggest
  • Place margin requirements on repo and derivatives
  • Design for the migration problem: Use the regulated system to impose limits on the shadow system Build in the ability to expand the perimeter of prudential regulation
  • Require thick down payments for home mortgages
  • Have clear accountability for the design and enforcement of these limits

 

Rule 03 – The supplemental arsenal of ex ante tools

  • Don’t let your banking system get too large relative to the size of your economy (size and concentration limits)
  • Don’t let your “banks” borrow too much in foreign currency
  • Transparency
  • Deterrence and enforcement

 

Rule 04 – Maintain strong financial capacity and a powerful firefighting arsenal

  • Shock absorbers will not save you from the risk of the extreme crisis, so you need firefighting tools and the capacity to use them
  • The key sources of financial strength are: Relatively low public debt levels A credible central bank, with a strong record on inflation
  • Your firefighting arsenal must include: Liquidity for vulnerable parts of the system Guarantee authority for banks and banklike institutions Capital and resolution authority

 

Rule 05 – When the fire starts, let it burn—but build a firebreak around the core

  • At the beginning of a crisis, there is a fog of diagnosis—idiosyncratic or systemic?
  • To get it right, let the fire burn—and let the system adjust
  • Escalate slowly at the beginning, but accelerate quickly when necessary
  • And set the perimeter of protection so that you capture the solvent and the systemic, but not the insolvent and the peripheral

 

Rule 06 – When it’s time to escalate, apply the Powell Doctrine

  • Use overwhelming force—fiscal, monetary, and financial Fiscal: as much as you can get Monetary: expansive throughout crisis and deleveraging Financial: liquidity, guarantees, capital, resolution
  • None of these are powerful enough to work in isolation
  • Together they must be powerful enough to remove risk of depression

 

Rule 07 – Plan for the long war

  • Crises that follow booms entail long periods of deleveraging
  • That makes growth weak and fragile
  • Need sustained period of monetary policy accommodation to keep real rates negative
  • And sustained fiscal support
  • Avoid applying the brakes too early

 

Rule 08 – Impose conditions on the rescue

  • Bagehot: Lend freely at a penalty rate
  • Ideally, limit the scope of the rescue to the core of the financial system
  • Price it to be valuable in the panic, but expensive when the panic breaks
  • No naked, unconditional guarantees
  • The guarantees should cover catastrophic risk, but not all risk
  • Put the non-viable firms into resolution
  • Accelerate restructuring and recapitalization of the core of the system to fuel the recovery
  • Do the hard stuff early and quickly

 

Rule 09 – Distinguish the systemic from the idiosyncratic

  • Faced with a systemic panic, do the opposite of what makes sense in a typical crisis
  • Rather than imposing haircuts, you have to guarantee liabilities
  • Rather than worrying about the potential costs of each specific intervention, you must try to limit the risk of broader failures and the greater costs they will entail
  • You have to be prepared to take more potential risk if you want to limit actual risk to the taxpayer
  • If you misdiagnose the systemic crisis as a normal crisis, then you will end up having to nationalize everything and socialize more risk

 

Rule 10 – Keep some perspective on moral hazard

  • You can’t design a financial system or an effective financial rescue that eliminates moral hazard risk—you can wound moral hazard but you can’t kill it
  • You can’t break a panic without creating moral hazard
  • In a systemic crisis, the failure of small firms can jeopardize the stability of the system
  • Without a firewall of guarantees around the core of the system, you won’t be able to get private capital to come in, and you won’t be able to allow failure and facilitate restructuring
  • Preserving ambiguity around when you escalate and how broad to extend liquidity support buys you some market discipline
  • Systemic capital surcharge and limits on size and/or consolidation are necessary

 

Conclusion – Accept the central paradox of financial crises

  • It cannot be morally responsible to allow depression in the hopes of deterring future risk-taking
  • What seems politically compelling in the moment is perilous and irresponsible
  • What seems unjust is just; what seems risky is prudent
  • You can’t solve the crisis by trying to fix the problems that caused the crisis; you have to solve the crisis first

 

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 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)


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)