M.K. Brunnermeier, "Deciphering the Liquidity and Credit Crunch 2007-08," forthcoming Journal of Economic Perspectives, 2009, 23(1):
"To answer this question, it is useful to first recall the three main factors leading up to the housing bubble. First, there are large capital inflows from abroad, especially from Asian countries. Asian countries bought U.S. Dollars both to peg the exchange rate on an export-friendly level and to hedge against a depreciation of their own currency against the dollar, a lesson learned from South-East Asia crisis in the late 1990s. These capital inflows contributed to a prolonged low-interest-rate environment. Second, fearing a deflationary period after the bursting of the Internet bubble, the Federal Reserve adopted a lax interest rate policy and thus did not counteract the buildup of the housing bubble. Third, the transformation of the banking system from a traditional banking model, in which the issuing banks hold loans until they are repaid, to the ―originate and distribute‖ banking model, in which loans are pooled, tranched and then resold, caused a decline in lending standards. Financial innovation that was intended to stabilize the banking system by transferring risk to other market participants led to an unprecedented credit expansion and helped feed the boom in housing prices."
So, the three main preconditions of the Housing Bubble are:
1) A lot of money from foreign countries invested here
2) Low interest rates
3) Banks, instead of keeping loans, bunched them and then sold them, causing them to ease lending standards
4) Investments meant to stabilize banks by transferring risk led to unwarranted lending
For me, 1,2, and 4, are enablers, while 3 is the cause.
"Two trends in the banking industry contributed significantly to the lending boom and housing frenzy that laid the foundations for the crisis. First, instead of holding loans on banks‘ balance sheets, banks moved to an ―originate and distribute‖ model. Banks repackaged loans and passed them on to various other financial investors, thereby off-loading risk. Second, banks increasingly financed their asset holdings with shorter maturity instruments. This left banks particularly exposed to a dry-up in funding liquidity."
So:
3A: Banks use shorter term investments
Warning: Explanation I like:
Securitization: Credit Protection, Pooling, and Tranching Risk
To offload risk, banks typically create ―structured‖ products often referred to as collateralized debt obligations (CDOs). The first step is to form diversified portfolios of mortgages and other types of loans, corporate bonds, and other assets like credit card receivables. The next step is to slice these portfolios into different tranches. These tranches are then sold to investor groups with different appetites for risk. The safest tranche—known as the ―super senior tranche‖—offers investors a (relatively) low interest rate, but it is the first to be paid out of the cash flows of the portfolio. In contrast, the most junior tranche—referred to as the ―equity tranche‖ or ―toxic waste‖—will be paid only after all other tranches have been paid. The mezzanine tranches are between these extremes. Legally, the portfolio is usually transferred to a ―special purpose vehicle,‖a financial entity whose sole purpose is to collect principal and interest cash flows from the underlying assets and pass them on to the owners of the various tranches. The exact cutoffs between the tranches are typically chosen to ensure a specific rating for each tranche. For example, the top tranches are constructed to receive a AAA rating. The more senior tranches are then sold to various investors, while the toxic waste is usually (but not always) held by the issuing bank, to ensure that it adequately monitors the loans."
Okay. CDO= Collateralized Debt Obligation: A bunch of bonds, etc.
Tranches:
Safest= Super senior: Low Interest: Usually AAA: Sold to investors: Paid 1st
Mezzanine= Between extremes: Paid 2nd
Junior= Equity= Toxic Waste: Usually held by bank ( Originating lender ): Paid last
Held by SPV=Special Purpose Vehicle: Collects interest and principal from what's in the bunches, and disperses the proceeds to holders of tranches
"Buyers of these tranches or regulator bonds can also protect themselves by purchasing credit default swaps, which are contracts insuring against the default of a particular bond or tranche. The buyer of these contracts pays a periodic fixed fee in exchange for a contingent payment in the event of credit default. Estimates of the gross notional amount of outstanding credit default swaps in 2007 range from $45 trillion to $62 trillion. One can also directly trade indices that consist of portfolios of credit default swaps, such as the CDX in the United States or iTraxx in Europe. Anyone who purchased a AAA-rated tranche of a collateralized debt obligation (CDO), combined with a credit default swap, had reason to believe that the investment had low risk."
CDS=Credit Default Swap: Insurance, paid with premiums, against default of bunches or what's in them
Good investment= Tranche + CDS
"Shortening the Maturity Structure to Tap Into Demand of Money Market Funds
Most investors prefer assets with short maturities, such as short-term money market funds. It allows them to withdraw funds at short notice to accommodate their own funding needs (see, for example, Diamond and Dybvig, 1983, and Allen and Gale, 2007) or it can serve as a commitment device to discipline banks with the threat of possible withdrawals (as in Calomiris and Kahn, 1991, and Diamond and Rajan, 2001). Funds might also opt for short-term financing to signal their confidence in their ability to perform (Stein, 2005). On the other hand, most investment projects and mortgages have maturities measured in years or even decades. In the traditional banking model, commercial banks financed these with deposits that can be withdrawn at short notice.
The same maturity mismatch was transferred to a ―shadow‖ banking system consisting of off-balance-sheet investment vehicles and conduits. These structured investment vehicles (SIVs) raise funds by selling short-term asset-backed commercial paper with an average maturity of 90 days and medium-term notes with an average maturity of just over one year primarily to money market funds. The short-term assets are called ―asset backed‖ because they are backed by a pool of mortgages or other loans as collateral. In the case of default, owners of the asset-backed commercial paper have the power to seize and sell the underlying collateral assets. Asset-backed commercial paper had become the dominant form of outstanding commercial paper by the start of 2006. The strategy of off-balance-sheet vehicles—investing in long-term assets and borrowing with short-term paper—exposes the banks to funding liquidity risk: Buyers in the commercial paper market might suddenly shy away. To ensure funding liquidity, the sponsoring bank grants a credit line, called a ―liquidity backstop.‖ As a result, the banking system still bears the liquidity risk from holding long-term assets and making short-term loans.At the same time the maturity mismatch on the balance sheet of investment banks also increased."
This is 3A. Long term loans financed with short term assets= Maturity Mismatch
"In summary, leading up to the crisis, commercial and investment banks were heavily exposed to maturity mismatch both through granting liquidity backstops to their off-balance sheet vehicles and through their increased reliance on repo financing. Any reduction in funding liquidity could thus lead to significant stress for the financial systems, as we witnessed starting in the summer of 2007."
3A again.
"Structured financial products can cater to the needs of different investor groups. Risk can be shifted to those who wish to bear it, and it can be widely spread among many market participants, which allows for lower mortgage rates and lower interest rates on corporate and other types of loans. Besides lower interest rates, securitization allows certain institutional investors to hold assets (indirectly) that they were previously prevented from holding by regulatory requirements. For example, certain money market funds and pension funds that were allowed to invest only in AAA-rated fixed-income securities could invest in a AAA-rated senior tranche of a portfolio constructed from BBB-rated securities. However, a large part of the credit risk never left the banking system, since banks, including sophisticated investment banks and hedge funds, were among the most active buyers of structured products (see, for example, Duffie, 2008). This suggests that other, perhaps less worthy motives were also at work in encouraging the creation and purchase of these assets."
The benefits:
1) Getting around regulations
2) Spreads and lowers risk
In hindsight, it is clear that one distorting force leading to the popularity of structured investment vehicles (SIVs) was regulatory and ratings arbitrage. The Basel I accord (an international agreement that sets guidelines for bank regulation) imposed on banks an 8 percent minimum capital requirement (capital charge) for holding loans on their balance sheets; the capital charge for contractual credit lines was much lower. Moreover, there was no capital charge at all for ―reputational‖ credit lines—noncontractual liquidity backstops that sponsoring banks provided to SIVs to maintain their reputation. Thus, moving a pool of loans into off-balance-sheet vehicles, and then granting a credit line to that pool to ensure a AAA-rating, allowed banks to reduce the amount of capital they needed to hold to conform with Basel I regulations while the risk for the bank remained essentially unchanged."
Okay. They're trying to get around capital requirements. Now, we're getting somewhere.
"Moreover, in retrospect, the statistical models of many professional investors and credit-rating agencies provided overly optimistic forecasts about structured finance products. One reason is that these models were based on historically low mortgage default and delinquency rates. More importantly, past downturns in housing prices were primarily regional phenomena—the United States had not experienced a nationwide decline in housing prices in the period following WWII. The assumed low cross-regional correlation of house prices generated a perceived diversification benefit that especially boosted the valuations of AAA-rated tranches (as explained in this symposium in the paper by Coval, Jurek, and Stafford)."
This is fine, but, again, people needed to be predisposed to accept this stuff.
"In addition, structured products may have received more favorable ratings compared to corporate bonds because rating agencies collected higher fees for structured products. ''Rating at the edge'' might also have contributed to favorable ratings of structured products versus corporate bonds."
Ratings agencies. Fine. But this also borders on fraud, negligence, and fiduciary misconduct, e.g., conflict of interest.
"While a AAA-rated bond represents a band of risk ranging from a near-zero default risk to a risk that just makes it into the AAA-rated group, banks worked closely with the rating agencies to ensure that AAA tranches were always sliced in such a way that they just crossed the dividing line to reach the AAA rating. As a consequence, CDO tranches must be downgraded when an incremental change in the underlying default probabilities or correlations occurs.Fund managers were attracted to buying structured products because they expected to generate high returns, but with a small probability of catastrophic losses. When the risk-free interest rate is low, this type of investment will be especially attractive to fund managers, whose compensations are linked to a percentage share of the upside but do not become negative in the event of losses. In addition, some fund managers may have favored the relatively illiquid junior tranches precisely because they trade so infrequently and were therefore hard to value. These managers could make their monthly returns appear attractively smooth over time because they had some flexibility with regard to when they could revalue their portfolios. "
A.Banks and Ratings Agencies conflict of interest. AAA Rating right on line, must be downgraded though with slight loss
B. Incentives for Managers to border on fraud, negligence, and fiduciary misconduct.
a. Manager gets paid when goes up, but nothing happens when it goes down
b. Hard to value
"The rise in popularity of securitized products ultimately led to a flood of cheap credit, as lending standards fell."
OKAY: BIG DISAGREEMENT: I believe that the products were used to fill the need, not the other way around. That's a big difference.
"This combination of cheap credit and low lending standards resulted in the housing frenzy that laid the foundations for the crisis."
OKAY: There's no excuse for low lending standards. Period. To say that cheap credit caused it is a mechanistic explanation of human agency. At best, it's an incentive, an inducement, to violate known investment precautions. Don't blame the products, and don't blame the inducements. People had to actually decide to do this. Period.THIS IS A MORAL PROBLEM, if not legal.
"Precautionary hoarding arises if lenders are afraid that they might suffer from interim shocks and that they will need funds for their own projects and trading strategies. Precautionary hoarding therefore increases when 1) the likelihood of interim shocks increases, and 2) outside funds are expected to be difficult to obtain.The troubles in the interbank lending market in 2007-08 are a textbook example of precautionary hoarding by individual banks. As it became apparent that conduits, structured investment vehicles, and other off-balance-sheet vehicles would likely draw on credit lines extended by their sponsored bank, each bank's uncertainty about its own funding needs skyrocketed. At the same time, it became more uncertain whether banks could tap into the interbank market after a potential interim shock, since it was not known to what extent other banks faced similar problems. These effects led to sharp spikes in the interbank market interest rate, LIBOR, both in levels and volatility."
Here's some stuff I like because it deals with hoarding, which might or might not be rational, and so it's something I'd like to look into.
"Network and counterparty credit risk problems are more easily overcome if a clearinghouse or another central authority or regulator knows who owes what to whom. Then, multilateral netting agreements, such as the service provided by SwapClear, can stabilize the system. However, the introduction of structured products that are typically traded over the counter has made the web of obligations in the financial system more opaque, consequently increasing systemic risk."
Here's a good reason to have a clearinghouse.
These mechanisms also form a natural point from which to start thinking about a new financial architecture. For example, fire-sale externalities and network effects suggest that financial institutions have an individual incentive to take on too much leverage, to have excessive mismatch in asset-liability maturities, and to be too interconnected. Brunnermeier (2008b) discusses the possible direction of future financial regulation using measures of risk that take these domino effects into account."
Too much leverage. That's it, but that's what they were intending to do.
Anyway, this is a great and very clear paper.
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