Money Markets Freeze:Causes and Developments since

August 2007Gerald P. Dwyer

Federal Reserve Bank of AtlantaUniversity of Carlos III, Madrid

Disclaimer

• These views are mine and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System.

7/18/2006 2/3/2007 8/22/2007 3/9/2008 9/25/2008 4/13/2009

Date

0.4

0.6

0.8

1.0

1.2

Wilshire 5000S&P 500NASDAQ

U.S. Stock IndiciesJanuary 2, 2007 to April 30, 2009

1/1/2000 4/9/2002 7/17/2004 10/25/2006 2/1/2009

Date

80

120

160

200

Inde

x va

lue

Housing Price IndicesJanuary 2000 to February 2009

Case Shiller indexOFHEO index

0

1

2

3

4

Tri

llion

Dol

lars

(U

.S.)

U.S. Mortgage Originations by Type

2001 through 2007

20032001 2002 2004

Source: Inside Mortgage Finance

Year

FHA / VAConventionalPrime JumboAlt ASubprimeHome Equity Lines

2005 2006 2007

1/1/1998 10/1/2000 7/2/2003 4/1/2006 12/31/2008

Date

0

10

20

30 Prime FRMPrime ARMSubprime FRMSubprime ARM

Note: Delinquent 90 days or more

Source: Mortgage Bankers Association

U.S. Delinquencies by Loan TypeFirst Quarter 1998 through Fourth Quarter 2008

Size of Financial Markets

Source: Bank of England Stability Report, 10/2007

Story

• A tiny part of securities markets has put asset markets around the world in a state of turmoil?

• How can that be?

Summary of Developments

• Prelude until August 9, 2007• Main Act from August 9, 2007 to September

16, 2008• Climax from September 16, 2008 to early 2009

– Financial crisis

• Denouement from early 2009 to ????

Structured Finance

• Mortgages are securitized– Residential Mortgage Backed Securities (RMBS)– Mortgages are pooled together and sold on the open market

• Agency securities• Others• Can be divided into tranches

• Tranching– Typical bond has all holders suffering losses

proportionately– Structured financial instruments structure receipts of

payments

Two Securities from One

Subprime mortgages

AAA rated

security

Equity tranche

of security

Collateralized Debt Obligations

• Take set of securities and restructure their payments– Corporate bonds– Residential mortgage backed securities (RMBS)

CDO Deals Idiosyncratic andTraded over the Counter

• A trust, generally in the Cayman Islands owns the assets backing the CDOs and distributes payments

• Not standardized contracts• Over-collateralization and triggers

– Can build up a reserve account for possible losses– Can be contingent on delinquencies and losses

• Manager can be passive or active• Traded over the counter

1/1/2006 8/31/2007 4/30/2009

30

70

110

06-1 vintage

ABX Indices by Vintage

1/1/2006 8/31/2007 4/30/2009

30

70

110

06-2 vintage

1/1/2006 8/31/2007 4/30/2009Date

20

50

80

07-1 vintage

AAAAAABBBBBB-

1/1/2006 8/31/2007 4/30/2009Date

20

50

80

07-2 vintage

Securities and “Risk Sharing”

• CDOs were purchased by entities all over the world

• AAA rating made them seem like a fine purchase– AAA CDO is not a AAA corporate bond

• CDO is based on a portfolio of loans • Behavior of cash flows in default is different

– Ratings were conditioned on rising house prices

• Mispricing of CDOs may partly explain the earnings from creating so-called arbitrage CDOs

1/2/2006 11/1/2006 9/1/2007 6/30/2008 4/30/2009

Date

0

100

200

300

spre

adLIBOR less OIS - 30 days

January 1, 2006 to April 30, 2009

1/2/2006 11/1/2006 9/1/2007 6/30/2008 4/30/2009

Date

0

100

200

300

spre

adLIBOR less OIS - 30 days

January 1, 2006 to April 30, 2009

Run on moneymarket funds

Northern Rock

End of year

1/2/2006 11/1/2006 9/1/2007 6/30/2008 4/30/2009

Date

0

100

200

300

spre

adLIBOR less OIS - 30 days

January 1, 2006 to April 30, 2009

Run on moneymarket funds

Northern Rock

End of yearKindergartenday

This Is Not All the Story

• House prices rose in many other places than parts of U.S.– House prices have fallen substantially in Ireland,

Spain and other countries– Nothing directly to do with subprime mortgages

or CDOs• Widespread increases of leverage• Widespread increases of maturity

transformation

One Cause

Source: http://library.thinkquest.org

Another Possible Cause

Who’s to Blame?• My personal estimate of proximate causes in

order of importance• Fannie and Freddie’s purchases of subprime

securities spurred on by Congress• Financial innovations – CDOs

– Reduced the cost of risky activities– Not clear how much this is due to increased issuance

of subprime loans• Private institutions took on more risk

– Increased leverage– Increased maturity transformation

Regulators to Blame?

• Federal Reserve and low Fed Funds rate– Would have to establish that short rates were

relatively low around the world, not just dollar rates• John Taylor claims this in talks and in his book

– Would have to establish that low rates induced people to buy houses even though long rates were unaffected

• Regulators– The combination of the developments caused the

crisis– It’s easy to see this after the fact

Financial Difficulties

• It’s the truck you don’t see that runs you down

Stability

Source: http://img2.travelblog.org/Photos2/