Slides by Frederica ShockleySlides by Frederica ShockleyCalifornia State University, ChicoCalifornia State University, Chico

Source: Source: http://research.stlouisfed.org/publications/review/08/09/Mizen.pdfhttp://research.stlouisfed.org/publications/review/08/09/Mizen.pdf

The Credit Crunch of 2007-2008:

A Discussion of the Background, Market Reactions, and Policy

Responses

- Paul Mizen

““Mispricing of Risk”Mispricing of Risk”

Crisis Due to “mispricing of risk” of new, Crisis Due to “mispricing of risk” of new, complicated assets based upon complicated assets based upon subprimesubprime & other & other mortgagesmortgages..

HighHigh leverageleverage contributed to risk. contributed to risk.

House Prices House Prices ↓→ ↓→ ForeclosuresForeclosures↑ → ↑ → Bank FailuresBank Failures

BackgroundBackground

The “Great Moderation” -years of macro The “Great Moderation” -years of macro stabilitystability Low inflationLow inflation Low short-term interest ratesLow short-term interest rates Steady growthSteady growth

Global savingsGlobal savings glut glut

Development of complex financial assetsDevelopment of complex financial assets

Credit BoomCredit Boom

FedFed dropped rates after dot com bust & dropped rates after dot com bust & again after 9/11.again after 9/11.

Rising house pricesRising house prices

Stable economic conditions.Stable economic conditions.

Disposable Income (DI) is income after taxes that is available for consumption & savings.

Disposable Income (DI) is income after taxes that is available for consumption & savings.

Savings Flowed into U.S.Savings Flowed into U.S.

After 1997 After 1997 Asian CrisisAsian Crisis many countries many countries bought U.S. bought U.S. treasuries & bondstreasuries & bonds.. Prices of Bonds Prices of Bonds ↑→ interest rates ↓→ Credit ↑↑→ interest rates ↓→ Credit ↑ Savings from less developed countries funded Savings from less developed countries funded

our deficits with growing imbalance.our deficits with growing imbalance.

1993 to 2005: U.S. savings as % of DI ↓ 1993 to 2005: U.S. savings as % of DI ↓ from 6% to 1%;from 6% to 1%;

Total debt to DI ↑ from 75% to 120%Total debt to DI ↑ from 75% to 120%

This is debt to Disposable Income (DI) which is income after taxes that is available for consumption & savings.

This is debt to Disposable Income (DI) which is income after taxes that is available for consumption & savings.

U.S. MortgagesU.S. Mortgages

PrimePrime: borrowers have good credit & meet : borrowers have good credit & meet income & house pricing requirements.income & house pricing requirements.JumboJumbo: borrowers have good credit & meet : borrowers have good credit & meet income requirements, but house price > amount income requirements, but house price > amount set by set by FannieFannie && FreddieFreddie..Alt-AAlt-A have higher risk of default because they do have higher risk of default because they do not conform to Fannie & Freddie requirements.not conform to Fannie & Freddie requirements.Sub-primeSub-prime: most risky loans often made to : most risky loans often made to people with bad credit history.people with bad credit history.

Mortgage Originations

Mortgage Originations

Sub-Prime Mortgages Grew Sub-Prime Mortgages Grew RapidlyRapidly

Late 90s increased to 13% of originations, Late 90s increased to 13% of originations, but halted by dot com bust.but halted by dot com bust.2002 – 2006: By 2006 Sub-Prime 2002 – 2006: By 2006 Sub-Prime mortgages = 20% of originations.mortgages = 20% of originations.Borrower faces higher upfront fees.Borrower faces higher upfront fees.Lender faces higher probability of Lender faces higher probability of prepaymentprepayment or default. or default.

Asset Backed SecuritiesAsset Backed Securities

Ginnie Mae Ginnie Mae && VAVA sold sold firstfirst securitiessecurities backed by mortgages in 1968.backed by mortgages in 1968.

$10.7 T in global asset backed securities $10.7 T in global asset backed securities by 2006 (Bank of England).by 2006 (Bank of England).

Many purchased by off-balance sheet Many purchased by off-balance sheet institutions owned by banks that originally institutions owned by banks that originally sold sold securitizedsecuritized products. products.

Complex SecuritiesComplex Securities

CDOCDO’s’s, , CDO’s CDO’s SquaredSquared, , CDO’s CubedCDO’s Cubed!!Great variation in characteristics of sub-prime Great variation in characteristics of sub-prime mortgages bundled together.mortgages bundled together.Not all low credit qualityNot all low credit qualityMany borrowers depended upon rising home Many borrowers depended upon rising home value to allow value to allow refirefi..Many who bought securities did not understand Many who bought securities did not understand risk.risk.

Sub-Prime TriggerSub-Prime Trigger

The sub-prime mortgage market triggered The sub-prime mortgage market triggered the crisis.the crisis.

Default rates started increasing in 2006.Default rates started increasing in 2006.

Pooled mortgagesPooled mortgages risky because defaults risky because defaults positively correlated.positively correlated.

Investors highly leveraged.Investors highly leveraged. If 20 to 1 If 20 to 1 → 5% loss → 100% capital ↓→ 5% loss → 100% capital ↓ Investors lose all with only low default rates.Investors lose all with only low default rates.

Global ImpactGlobal Impact

Originator faced low risk even if borrower Originator faced low risk even if borrower defaulted.defaulted.Automated underwritingAutomated underwriting & outsourcing of & outsourcing of credit credit scoresscores helped originators sell helped originators sell moremore mortgages.mortgages.With low interest rates throughout the world, With low interest rates throughout the world, investors investors “reached for yield.”“reached for yield.”Sales of securities went global.Sales of securities went global.

Sub-Prime AssetsSub-Prime Assets

Subprime was trigger, but other high Subprime was trigger, but other high yielding assets, e.g. yielding assets, e.g. hedge fundshedge funds, could , could have started the crisis.have started the crisis.People bought risky, complicated assets People bought risky, complicated assets because return was high.because return was high.After sub-prime defaults increased, After sub-prime defaults increased, rating rating agenciesagencies downgraded many sub-prime downgraded many sub-prime backed securities.backed securities.

Corporations Lost BillionsCorporations Lost Billions

Assets difficult to Assets difficult to assess assess → → UncertaintyUncertainty ↑ →banks stopped ↑ →banks stopped loaning to other loaning to other banksbanks..

A write down is the amount by which an asset’s value is reduced.

A write down is the amount by which an asset’s value is reduced.

Bear Stearns collapsed after hedge funds failed to rollover asset backed commercial paper.

Structured Investment Vehicle Structured Investment Vehicle (SIV)(SIV)

Funds that borrowed in short term Funds that borrowed in short term commercial paper marketcommercial paper market to finance to finance assets that they held long term.assets that they held long term.Borrowed at low rate & bought long-term Borrowed at low rate & bought long-term securities that paid high interest.securities that paid high interest.Some intended to run indefinitely, but all Some intended to run indefinitely, but all gone by gone by Oct. 2008Oct. 2008..

Liquidity CrisisLiquidity Crisis

Banks afraid to loan because they might have to Banks afraid to loan because they might have to cover losses on their cover losses on their conduitsconduits or SIV’s. or SIV’s.The Libor-The Libor-OISOIS spread increased from a long-run spread increased from a long-run 10 10 basis pointsbasis points to 364 in 10/08. to 364 in 10/08. The London inter-bank offer rate indicates is the rate

that banks charge each other for loans of 1 day to 5 years.

The London inter-bank offer rate indicates is the rate that banks charge each other for loans of 1 day to 5 years.

The London inter-bank offer rate indicates is the rate that banks charge each other for loans of 1 day to 5 years.

Three Month LIBOR – OIS SpreadThree Month LIBOR – OIS Spread

Indicator of Indicator of confidence banks confidence banks have in other banks.have in other banks.

Usually about 10 Usually about 10 basis points, but basis points, but peaked at 364 on peaked at 364 on 10/10/08.10/10/08.

GreenspanGreenspan says says TARPTARP decreased decreased spread.spread. Source:

http://www.microcappress.com/blog/credit-re-freeze-nipped-in-the-bud/641/

Credit Markets FrozeCredit Markets Froze

Cost of Insurance IncreasedCost of Insurance Increased

LCFI = Large Complex Financial InstitutionLCFI = Large Complex Financial Institution

Originate & Distribute BakingOriginate & Distribute Baking

In use for 40 years, but opacity In use for 40 years, but opacity ↑↑ → → mispricing of riskmispricing of risk:: Residential MSB’s backed by sub-prime Residential MSB’s backed by sub-prime

mortgages mortgages ↑↑ Steps between originator & holder ↑Steps between originator & holder ↑

Distorted incentives.Distorted incentives.

Difficult to evaluate risk.Difficult to evaluate risk.

Six Bad Incentive MechanismsSix Bad Incentive Mechanisms

1. Mortgage brokers motivated by up-front fees 1. Mortgage brokers motivated by up-front fees independent of borrower quality.independent of borrower quality. Often not employees of mortgage originators Often not employees of mortgage originators → not → not

subject to regulation.subject to regulation. Fraud in some cases.Fraud in some cases.

2. Originators had no more incentive to seek 2. Originators had no more incentive to seek quality borrowers than did brokers.quality borrowers than did brokers. Investors wanted more mortgages.Investors wanted more mortgages. Automated underwriting systems made mortgages Automated underwriting systems made mortgages

loser & faster.loser & faster.

More Bad IncentivesMore Bad Incentives

3. Mortgages 3. Mortgages ↑→↑→SecuritizationSecuritization profits for profits for originators originators ↑↑ Quality of new borrowers Quality of new borrowers ↓ → Standards ↓ → ↓ → Standards ↓ →

NINJA loans – No Verified Income, Job, or NINJA loans – No Verified Income, Job, or Assets.Assets.

Piggyback loansPiggyback loans ↑ ↑ Over time Risk of default ↑ Over time Risk of default ↑

More Bad IncentivesMore Bad Incentives

4. 4. TranchingTranching allowed financial entities to allowed financial entities to tailor securities for varying levels of risk tailor securities for varying levels of risk preference.preference.

5. Rating agencies made income rating 5. Rating agencies made income rating these financial products.these financial products. Issuers paid up-front fees to rating agency.Issuers paid up-front fees to rating agency. Rating agencies sold advice to issuers on Rating agencies sold advice to issuers on

how to get desired rating.how to get desired rating.

More Bad IncentivesMore Bad Incentives

6. 6. CDO’s ↑ → CDO’s ↑ → Return Return ↑→ Fund manager ↑→ Fund manager bonuses ↑bonuses ↑

“As long as the music is playing, you’ve got to get up and dance. We’re still dancing.” Chuck Prince, former CEO Citigroup. http://research.stlouisfed.org/publications/review/08/09/Mizen.pdf (page 22)

The ResultThe Result

Incentives of brokers, originators, Incentives of brokers, originators, SPVSPV’s’s, , rating agencies, & fund managers the rating agencies, & fund managers the same.same.

No No principal agent problemprincipal agent problem!!

Regulation, Supervision, & Regulation, Supervision, & Accounting PracticesAccounting Practices

Originators often ignored the quality of Originators often ignored the quality of borrowers & Fed & state agencies did nothing.borrowers & Fed & state agencies did nothing.Originators may have engaged in Originators may have engaged in predatory predatory lendinglending. . Consumer protection legislation not enforced.Consumer protection legislation not enforced.

CRACRA Regs Encourage Risky Loans Regs Encourage Risky Loans

HUDHUD required Freddie & Fannie to buy required Freddie & Fannie to buy mortgage securities for low income mortgage securities for low income homeowners mid 90s.homeowners mid 90s.HUD expected originators to impose HUD expected originators to impose higher standards on such lenders, but higher standards on such lenders, but Freddie & Fannie bought the mortgages Freddie & Fannie bought the mortgages anyway.anyway.Such securities increased 2004 to 2006.Such securities increased 2004 to 2006.

New Fed Rules for “Higher Priced” MortgagesNew Fed Rules for “Higher Priced” Mortgages

Source: http://research.stlouisfed.org/publications/review/08/09/Mizen.pdf (Page 30)

Escrow

First lien mortgage loans are the first or original mortgages taken out when someone buys a mortgage.

Escrow

First lien mortgage loans are the first or original mortgages taken out when someone buys a mortgage.

Other Potential ChangesOther Potential Changes

Require banks to hold same capital Require banks to hold same capital requirements for “off-balance-sheet” requirements for “off-balance-sheet” entities, e.g. SIV’s & entities, e.g. SIV’s & conduitsconduits..

Regulators need to evaluate the “big Regulators need to evaluate the “big picture” in order to reduce the picture” in order to reduce the externalityexternality cost of excessive risk taking.cost of excessive risk taking.

Regulation of Rating AgenciesRegulation of Rating Agencies

Rating agencies should be single product Rating agencies should be single product firms.firms.

They need to use models that take into They need to use models that take into consideration longer spans of data.consideration longer spans of data.

They need to be subject to regulation.They need to be subject to regulation.

ConclusionsConclusions

Reasons for credit crisis:Reasons for credit crisis: Period of macro stability with low inflation & Period of macro stability with low inflation &

low interest rates.low interest rates. Big increase in Big increase in supply of loanable fundssupply of loanable funds.. Financial innovation resulted in complex Financial innovation resulted in complex

instruments, e.g. MBS’s.instruments, e.g. MBS’s.Higher leverage;Higher leverage;

Sub-prime mortgages.Sub-prime mortgages. Risk assessment failed.Risk assessment failed.

ConclusionsConclusions

No one expected housing prices to fall No one expected housing prices to fall nationwide.nationwide.

Nationwide falling housing prices & higher Nationwide falling housing prices & higher interest rates led to defaults.interest rates led to defaults.

Other high yield assets, e.g. hedge funds, Other high yield assets, e.g. hedge funds, could have been trigger.could have been trigger.

Bank failures led to credit freeze in Bank failures led to credit freeze in commercial paper.commercial paper.

ConclusionsConclusions

Central bankersCentral bankers stepped in to provide stepped in to provide liquidityliquidity..

Regulation will need to increase if we are Regulation will need to increase if we are to prevent future crises.to prevent future crises.