4 - Subprime Crisis

8/2/2019 4 - Subprime Crisis

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THE SUB PRIME CRISIS EVENTS AND

APPLICATION OF THEORY

E Philip Davis

NIESR and Brunel UniversityWest London

[email protected]

groups.yahoo.com/group/financial_stability

Course on Financial Instability at the Estonian Central Bank,9-11 December 2009 Lecture 4


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1 The build up to the crisis

global background Low real interest rates stimulated borrowing and

financial innovation Long rates were low because of high saving especially

by Asian economies Short rates were held low in the US

Buildup of debt and asset price boom

New features of the market were not stress testedfor downturns New asset backed securities hid risk rather than shared

or reduced it Reliance on wholesale markets was unwise


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Real interest rates

-2

-1

0

1

2

3

4

5

6

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

UK long real rate US long real rate UK short rreal rate US short real rate


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Personal sector borrowing

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

1.8

1 9 7 5

1 9 7 7

1 9 7 9

1 9 8 1

1 9 8 3

1 9 8 5

1 9 8 7

1 9 8 9

1 9 9 1

1 9 9 3

1 9 9 5

1 9 9 7

1 9 9 9

2 0 0 1

2 0 0 3

2 0 0 5

2 0 0 7

r a t i o

t o

p e r s o n a

l d i s p o s a

b l e

i n c o m e s

France Germany Spain UK US


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Real house prices

0.5

0.6

0.7

0.8

0.9

1

1.1

1.2

1.3

1.4

1 9 7 0 Q 1

1 9 7 1 Q 4

1 9 7 3 Q 3

1 9 7 5 Q 2

1 9 7 7 Q 1

1 9 7 8 Q 4

1 9 8 0 Q 3

1 9 8 2 Q 2

1 9 8 4 Q 1

1 9 8 5 Q 4

1 9 8 7 Q 3

1 9 8 9 Q 2

1 9 9 1 Q 1

1 9 9 2 Q 4

1 9 9 4 Q 3

1 9 9 6 Q 2

1 9 9 8 Q 1

1 9 9 9 Q 4

2 0 0 1 Q 3

2 0 0 3 Q 2

2 0 0 5 Q 1

2 0 0 6 Q 4

L o g s c a

l e 2 0 0 0 q

1 =

1

France House prices Germany House prices Spain House prices

UK House prices US House prices


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The build up to the US crisis Structural background:

Rush to sub prime lending in US, encouraged by governmentand compensation schemes for bankers

Accelerating shift to securitisation, credit assessment neglectedfor CDOs and other ABS

Low levels of liquidity and aggressive liability management bybanks

Some ABS held in SIVs and conduits, ABCP financed (Basel 1) Context of global liquidity glut and search for yield (sub-prime

and ABS) Suspicion of disaster myopia


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The non systemic period (August 2007-August 2008) Market liquidity risk

Realisation of risks of sub-prime plus uncertainty aboutvaluation of ABS

led to ABS sales, leading to market liquidity failure, withprice falls due to liquidity risk and lower risk appetite, not

just credit risk

Aggravated by margin requirements and credit limits onarbitrageurs, and restriction on risk appetite of marketmakers

Rush to sell worsened by mark to markets impact oncapital of institutions and solvency contrast to bankingcrises of past with book values

Contagion spread via market collapse of ABCP financingconduits and SIVs

And via traders attempts to hedge, meet margin calls and

realise gains in more liquid markets


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Funding risk Effect on interbank via inability of banks to

securitise, backup calls from conduits and SIVs,and suspicion of other banks solvency due to priceof ABS

Hence hoarding of liquidity, and wide spreads ininterbank market, also quantity rationing of funds,especially at longer maturities

Collapse of Northern Rock due heavy dependenceon wholesale funds, and later of Bear Stearns andLehman Brothers

Close relation of funding risk to market liquidityrisk revealed overall


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The Systemic period (September 2008-) Failure of Lehmans leading to complete drying-up

of wholesale markets, including commercial paper Problems for money market funds breaking the

dollar also mutual funds and hedge funds Massive redemptions of such funds leading to

sales in illiquid markets Flight to quality in government bonds Bank failures and government recapitalisations

Crisis spreading to real economy risk of adversefeedback loop (Bernanke)

Major recession has ensued


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US problems

Losses in the US on sub prime loans perhaps $1.4trillion Sold on as asset backed securities Over half to European banks

Sub prime loans may have defaults of over $1trillion because of US bankruptcy law

unwise lending masked by originate and distributemodel Evaluation of securities based on individual not group

default rates Lehman was a US bank


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US, UK, EU credit spreadsSpread between BAA corporate and government bonds

0

1

2

3

4

5

6

7

8

9

10

0 5 M a r c h 2 0 0 0

0 5 J u n e 2 0 0 0

0 5 S e p t e m b e r 2 0 0 0

0 5 D e c e m b e r 2 0 0 0

0 5 M a r c h 2 0 0 1

0 5 J u n e 2 0 0 1

0 5 S e p t e m b e r 2 0 0 1

0 5 D e c e m b e r 2 0 0 1

0 5 M a r c h 2 0 0 2

0 5 J u n e 2 0 0 2

0 5 S e p t e m b e r 2 0 0 2

0 5 D e c e m b e r 2 0 0 2

0 5 M a r c h 2 0 0 3

0 5 J u n e 2 0 0 3

0 5 S e p t e m b e r 2 0 0 3

0 5 D e c e m b e r 2 0 0 3

0 5 M a r c h 2 0 0 4

0 5 J u n e 2 0 0 4

0 5 S e p t e m b e r 2 0 0 4

0 5 D e c e m b e r 2 0 0 4

0 5 M a r c h 2 0 0 5

0 5 J u n e 2 0 0 5

0 5 S e p t e m b e r 2 0 0 5

0 5 D e c e m b e r 2 0 0 5

0 5 M a r c h 2 0 0 6

0 5 J u n e 2 0 0 6

0 5 S e p t e m b e r 2 0 0 6

0 5 D e c e m b e r 2 0 0 6

0 5 M a r c h 2 0 0 7

0 5 J u n e 2 0 0 7

0 5 S e p t e m b e r 2 0 0 7

0 5 D e c e m b e r 2 0 0 7

0 5 M a r c h 2 0 0 8

0 5 J u n e 2 0 0 8

0 5 S e p t e m b e r 2 0 0 8

0 5 D e c e m b e r 2 0 0 8

0 5 M a r c h 2 0 0 9

0 5 J u n e 2 0 0 9

US Euro Area UK


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2 Application of theory

Financial fragility: crisis linked to asset price bubblefuelled by underpriced credit. Time of realisation thatsituation unsustainable (Minsky moment), leading in

turn to tightening of credit, asset price falls and bank failures. Monetarist: highlight policy regime shift to laxity from

2000 onwards, warranted tightening from 2004-6 whichnevertheless exposed the weaknesses of the US housingmarket and overleveraged borrowers. Regime shift fromopen to closed wholesale (including interbank) marketsthat began in August 2007 almost wholly unexpectedeven by central banks.


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Uncertainty: financial innovations that were highlyopaque and wholly untested in a downturn.

Disaster myopia: pervaded both financial institutions

and most policy makers in boom period, sharpeningincidence of credit rationing after August 2007 as risk loving changed sharply to risk aversion. 2 key points: announcement by BNP Paribas in August 2007 that their funds

investing in ABS could not be valued, which brought on theinitial interbank market failure. failure of Lehmans in September 2008, which changed agents

views of what institutions are too big to fail, unleashingimmense systemic risks.

Agency costs: incentives to underprice credit fromtransfer of risk in securitisation. Asymmetricinformation worsened by opacity of structured creditproducts and helps to explain failure of wholesale

funding markets, since banks were uncertain abouttoxic assets on others balance sheets.


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Industrial: securitization enabled a wide range of new

players to enter markets for origination of loans and

also investment. Former worsened adverse selection of loans, heart of crisis. The latter include hedge funds,SIVs and conduits; heightened risks to banks that wereeither providing credit directly or had backup lines to

them. Hedge funds short selling, and later forced salesof assets central to falling asset prices in securitiesmarkets.

Standard indicators of financial instability (generic

sources of crisis) applied to US subprime crisis Regime shift to laxity or other favourable shock (USmonetary policy in early 2000s)

New entry to financial markets (subprime lenders) Debt accumulation (US subprime)


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Asset price booms (US housing) Innovation in financial markets (CDOs/SIVs) Underpricing of risk, risk concentration and lower

capital adequacy for banks (use of SIVS, incorrect ratings)

Regime shift to rigour possibly as previous policyunsustainable - or other adverse shock (house priceweakening, French bank BNP Paribas suspends threeinvestment funds worth 2bn euros, later Lehmans

failure) Heightened rationing of credit (interbank market and

wholesale money markets, also mortgage market and

later all private credit) Operation of safety net and/or severe economic crisis (

LOLR in money markets, Northern Rock, indirectly Bear Stearns but not Lehmans bank recapitalisationand guarantees - now worst recession since 1930s)


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3 Incentive problems Adverse selection - inadequate corporate governance of

loan officers in banks which allowed credit risk toaccumulate, passed on via securitisation; adverseselection feared in interbank market

Moral hazard - incentive of banks to avoid capitaladequacy by setting up SIVs/SPVs and thus holdingloans indirectly implicitly passing on risk to the safetynet where too big to fail, also incentive of originatorsof subprime loans not to monitor loans if securitised

Incentive of rating agencies to give top ratings to papercontaining low quality loans (as payment by issuer)

Incentives of UK retail depositors to run on NorthernRock due to low level of deposit insurance


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Incentives of lenders in the wholesale market toavoid counterparty risk and hoard liquidity forthemselves, thus entailing runs on Northern Rock and Bear Stearns, and later Lehmans.

Regulators failed to inform central banks earlyenough of potential liquidity problems, showinginstitutional problem of separating supervision andcentral bank functions.

Adverse selection and moral hazard incentives forcredit rationing in the interbank market from 2007and in the real economy from 2008

Financial crisis triggered by loss of confidence intoo big to fail, as authorities did not rescueLehmans for fear of moral hazard


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4 Liquidity management

We assess how the sub-prime crisis has changed thesituation for LOLR: New forms of liquidity risk interaction of funding

liquidity and market liquidity New responses of LOLR such as supporting non-banks,

lower quality collateral, longer maturities New challenges for LOLR such as confidentiality, stigma

and deposit insurance interaction

Coping with the systemic crisis since September 2008 Overall understanding requires to supplement bank

funding risk with market liquidity risk, and bank policies of mark to market and balance sheet

management


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Relevant liquidity risk paradigms

Some standard elements asset price fall leading to liquidity shock Deterioration of loan quality Fire sales and runs

Market liquidity risk and liquidity insurance(Davis, Bernardo and Welch) Reconsider Diamond-Dybvig for markets

Rationality of selling if fear liquidity will collapse Externalities similar to bank failures fire sales,

funding problems, contagion to other markets, aswith ABS, ABCP, interbank


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Role of market makers in uncertainty or asymmetricinformation uncertainty regarding ABS valuationand on counterparties

Dynamics relating to dealers capital Becomes impossible to sell assets, e.g. primary

securitisation markets Contagion via market price changes in context of

mark to market (Adrian and Shin) Financial institutions active balance sheet

management, positive relation of leverage and balance

sheet size Desired expansion in upturn, boosting liquidity Shock to prices led to desired contraction, but stopped

by obligations (e.g. backup lines) so cut back on

discretionary lending - interbank


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Interbank funding liquidity (Freixas et al) Imperfect information or market tension can lead

to shortages of funds even for solvent banks Bank runs in market occur as banks hoard

liquidity

Amplifying mechanisms of liquidity shocks(Brunnermeier) Borrowers balance sheet effects loss spiral and

margin spiral Lending channel effect hoarding liquidity Runs on institutions and markets Network effects Goldman Sachs and Bear

Stearns


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4 LOLR and the sub-primecrisis non systemic period

Needed to evolve to cope with new conditions Nature of LOLR

Open market operations more than direct lending -expansion to longer maturities

Protracted crisis fear NCBs lacked instruments? Investment banks covered Bear Stearns and

liquidity facilities reflect central role in financialsystem but not regulated by Fed


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Costs of LOLR Ambiguity of lending to reliquify markets impact

on solvency of institutions Conflicts with other policies, need to maintain

monetary stance and difficulty of interpretingstance given LIBOR spread

How much moral hazard generated by newLOLR? Minimising costs of LOLR

Reduction in collateral standards even ABS, reliquified by non market means

market maker of last resort or even first Inversion of traditional NCB role, adverse

selection and moral hazard


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Private sector solutions sought but not found for Northern Rock,only with guarantee for Bear Stearns wide scale of problemand uncertainty on valuation

Adequate information for LOLR, not the case for Bank of England in Northern Rock case

Loss of reputation to banks receiving LOLR notably NorthernRock decision to be overt in lending and leakage of

information need for new facilities instead of discount window Conflict with a partial deposit insurance scheme in the UK

reason for rescue? Domestic LOLR insufficient cross currency swap arrangement.

Need for cooperation and risk of gaming. Fortunate no major cross border failure? Challenge for exit strategies to prevent moral hazard to reactivate

markets


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LOLR and the sub-prime crisis systemic period

Response of fiscal authorities to crisis Recapitalisation Overriding of merger policy

Extension of deposit insurance Purchase of illiquid or impaired assets Guarantees

US guarantee of money market funds initial outlays 6% of GDP but total support in North

America and Europe $14 tn., 50% of GDP


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LOLR activity Growth in central bank balance sheets, to 15% of GDP

in UK and US Mainly developing from earlier innovations

Types of collateral Expansion of cross border activity Central bank swap lines

Some innovations UK standing facilities UK later revealed massive clandestine support for

major banks in October 2008

Ch i i i ll i US


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Changes initially in US Providing funds direct to borrowers and investors in markets rather

than via intermediaries, acting as market maker of last resort or even investor of last resort,

Market support for commercial paper, MBS Purchasing GSE obligations Further support for money funds

Institution support for Citicorp, AIG. Would Lehmans have been rescued had the law been changed

earlier?

Market support later emulated in UK, Eurozone UK shift to quantitative easing monetary policy not LOLR On balance, classic response to systemic crisis except for

further extension of LOLR role


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Conclusion

Sub prime crisis is most serious financial crisissince 1930s at global level

A number of novel features

Nevertheless validates much of traditional theoryas well as incentive mechanisms, underlining theneed to look for patterns of crisis buildup

Sub prime showed that liquidity risk assessmentneeds rethinking to allow for interaction of marketliquidity risk and funding risk


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LOLR challenges include: longer term provision variety of lower quality collateral including investment banks in the safety net confidentiality of bank support interaction with deposit insurance

Has the net effect of these changes been toincrease moral hazard?

Innovation mainly in non systemic period

Issue of exit strategies, not least given size of central bank balance sheets, QE

And need for reform of liquidity regulation

FSA model?


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ReferencesBanque de France (2008), Liquidity, Financial Stability

ReviewBarrell, R. and E. P. Davis (2008), The Evolution of the

Financial Market Crisis in 2008, National InstituteEconomic Review, No. 206.

BBC (2008) Timeline subprime lossesnews.bbc.co.uk/2/hi/business/7096845.stm

Davis, E P (2009), "The lender of last resort and liquidityprovision- how much of a departure is the sub-prime

crisis?", paper presented at the LSE Financial MarketsGroup conference on the Regulatory Response to theFinancial Crisis, 19th January 2009

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4 - Subprime Crisis

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