Structured Finance and the Global Financial Crisis Feb

Structured Finance and the Global Financial Crisis Feb 23, 2009 Arjun Jayadev Assumption College 1

Which Crisis? n n During the second half of the war, there was an explosion of easy credit, driven by capital from abroad. This resulted in lavish displays of wealth — and opulent living was seen, especially in New York. Housing prices soared during the war. But when credit tightened afterward– collapse of real estate bubble and generalized crisis Feb 23, 2009 Arjun Jayadev Assumption College 2

Feb 23, 2009 Arjun Jayadev Assumption College 3

Structural Adjustment in the US after 1970 Intermediate Patterns Increasing Household Indebtedness Decline in Real Wages Proximate Causes Global Savings Glut (Lower Long Term Rates ‘Market Keynesianism’ Collapse in Personal Savings Hollowing out of Manufacturing Finance and Market Ideology Reign Supreme Increasing Global Imbalances Financial Innovation Growth of Shadow Banking Financial Deregulation Monetary Policy alone Accommodative Monetary Policy (Low Short Term Rate = Housing Bubble Feb 23, 2009 Arjun Jayadev Assumption College 4

Collapsed Real Wages Feb 23, 2009 Arjun Jayadev Assumption College 5

Destruction in Household Balance Sheets (Personal Savings Rates) Feb 23, 2009 Arjun Jayadev Assumption College 6

Growing Indebtedness of Households Feb 23, 2009 Arjun Jayadev Assumption College 7

Finance and Manufacturing as Percentage of National Income Feb 23, 2009 Arjun Jayadev Assumption College 8

Global Financial Imbalances n U. S. borrows 50 % of the worlds capital that is exported Feb 23, 2009 Arjun Jayadev Assumption College 9

Deficits and Debt Feb 23, 2009 Arjun Jayadev Assumption College 10

Ideology “You mean to tell me that the success of the economic program and my re-election hinges on the Federal Reserve and a bunch of f***g bond traders? ” Bill Clinton- 1994 From Woodward “ The Feb 23, 2009 Agenda” We’re Eisenhower Republicans here…We stand for lower deficits, free trade and the bond market. Isn’t that great? Bill Clinton-1998 Arjun Jayadev Assumption College 11

Financial Deregulation n n Gramm-Leach Bliley replaces Glass Steagall in 1998 Commodities Futures Modernization Act (1999) Sarbanes Oxley Rule (2002) SEC deregulation of brokers (2004) ‘Self Regulation’ and Trust in Ratings Agencies Feb 23, 2009 Arjun Jayadev Assumption College 12

Proximate Causes n n n Easy Credit Search for Yield Regulatory Loopholes (particularly CFMA 1999, SOX, 2002 and Leverage Rule, 2004) Shadow Banking/Securitization of Loan Chain Discovery of Enormous (Hidden) Leveraging Inadequate capitalization leading to Liquidity and then Solvency Crises Feb 23, 2009 Arjun Jayadev Assumption College 13

Easy Credit Feb 23, 2009 Arjun Jayadev Assumption College 14

Equity markets and the Search for Yield n Feb 23, 2009 Mortgage bubble took off in the aftermath of declining yield from shares Arjun Jayadev Assumption College 15

Structured finance: The players in securitization End borrowers I&P ($) Broker places mortgage loans to borrowers for fee Broker LEGEND KEY O&G – interest and principal SPV – special purpose vehicle SPE – special purpose enterprise SIV – special investment vehicle MBS – mortgage backed securities $ Mortgages Servicer Typically a specialized mortgage bank Originator $ I&P ($) Manages the flow of interests and principal (I&P); usually, but not necessarilly the Originator Conduit/trust/ SPV/SPE/SIV Exposure of founder: implicit guarantee in case of large losses. Feb 23, 2009 Can assume part of risks (insurance of mortgage loans, insurance of MBS returns). $ MBS Investment bank (underwriter) Founder: loan originator or investment bank Purpose: transfering ownerhship of claims (loans)) and collateral (mortgages)) in order to issue mortgage backed securities (bonds ). (bonds). Insurance company Mortgages Mutual funds, pension funds, hedge funds… $ CDOs, I&P ($) Rating agency Assigns credit rating to issued MBSs. Organizes issuing of MBSs and places MBSs to investors in financial markets. Institutional investor $ Financial returns ($) End lenders (wholesale) Arjun Jayadev Assumption College 16

A bank balance sheet Assets n Loans Feb 23, 2009 Liabilities n Deposits n Capital Arjun Jayadev Assumption College 17

A shadow banking balance sheet Assets n n Liabilities Asset Backed Securities Mortgage Backed Securities Credit Default Swaps Interest Rate Swaps Feb 23, 2009 n n Collateralized Debt Obligations Asset Backed Commercial Paper Arjun Jayadev Assumption College 18

Banking versus Shadow Banking FDIC n No Equivalent of FDIC n Risk Adjusted Capital Adequacy Ratios n No Capital Adequacy Ratios n Interbank Market sets price of liquidity n No state control (money) (LIBOR) over liquidity creation n Monetary Policy affects price, interest rates, macro balance Feb 23, 2009 Arjun Jayadev Assumption College n Feb 23, 2009 Arjun Jayadev Assumption College 19

IB Leverage Feb 23, 2009 Arjun Jayadev Assumption College 20

The ‘Magic’ of Securitization and Structured Finance Feb 23, 2009 Arjun Jayadev Assumption College 21

The CDS Market Feb 23, 2009 Arjun Jayadev Assumption College 22

“Subprime” Growth n n Subprime growth shot up in 2003 -2005 By 2006, most Subprime mortgages were securitized Share of subprime In total U. S. economy (measured by GDP): 1% (2001), increasing to 5% (2005) Feb 23, 2009 Arjun Jayadev Assumption College 23

Feb 23, 2009 Arjun Jayadev Assumption College 24

Bubble in Housing Prices Feb 23, 2009 Arjun Jayadev Assumption College 25

The Crisis Begins. . . n n In August 2007, Crisis begins with first wave of sub prime Failures Overleveraged shadow banks (easy credit) were invest ed in very bad bets (subprime), at scale, with no liquidity backstop (unregulated credit markets). Counterparty Risk was perceived as much larger. Liquidity starts freezing (Interbank markets start to experience wild shifts in ability to borrow and lend and much higher rates for borrowing) Feb 23, 2009 Arjun Jayadev Assumption College 26

Residential Real Estate Prices Crash Feb 23, 2009 Arjun Jayadev Assumption College 27

Crisis in Subprime Lending n Crisis in Subprime Lending Feb 23, 2009 % of delinquent loans (60+ days) Months from origination Arjun Jayadev Assumption College 28

MBS’s lose value Feb 23, 2009 Arjun Jayadev Assumption College 29

Total Predicted Losses 2. 2 -3. 6 Trillion Dollars! (Oct 08) Feb 23, 2009 Arjun Jayadev Assumption College 30

TED-Spread: Liquidity Crisis Feb 23, 2009 Arjun Jayadev Assumption College 31

LIBOR-Overnight Interest Swaps spread (Measure of Interbank liquidity) Feb 23, 2009 Arjun Jayadev Assumption College 32

Global Declines in Stock Markets Feb 23, 2009 Arjun Jayadev Assumption College 33

Famous Last Words n n "We have a good deal of comfort about the capital cushions at these firms at the moment. " - Christopher Cox, chairman of the U. S. Securities and Exchange Commission, March 11, 2008. Feb 23, 2009 Arjun Jayadev Assumption College 34

The Crisis of 2008 --? n n n n n Bailout of Fannie and Freddie, Collapse of Lehman, Bailout of AIG…. The Paulson Plan -- $700 bn. rescue Contagion to UK and EU…. The Paulson $200 bn. TARP, Citi takeover Recapitalization (still unclear) Collapse of Aggregate Demand Worldwide Crisis, Fiscal Stimulus? Feb 23, 2009 Arjun Jayadev Assumption College 35