The Sub Prime Debacle and Financial Turmoil

Transcription

1 The Sub Prime Debacle and Financial Turmoil Presented at the 13th Finsia and Melbourne Centre for Financial Studies Banking and Finance Conference Monday 29th and Tuesday 30th September, 2008 The University of Melbourne, Faculty of Economics and Commerce By Dr. Robert A. Eisenbeis Chief Monetary Economist Cumberland Advisors

2 Chart 2

3 Introduction and Outline of Talk The US Mortgage Market and the Subprime Segment Market Turmoil and Root Causes Then look at what this may mean for the future of the markets Chart 3

4 Problems in Subprime Market Started Long Before Middle of August of 2007 Problems in the subprime market were clearly already developing by the start of 2006 when several institutions began to report credit related problems This included Banks like Countrywide, IndyMac and investment banks, like Bear Stearns and other institutions Festered for the early part of 2007 Positions became increasingly difficult to finance. Financial markets began to re-price and reevaluate risk and essentially seized up in late August of Chart 4

5 Brief Chronology of Beginning 12-Feb-07 ResMae files for bankruptcy 22-Feb-07 HSBC fired its first head of US mortgage lending business due to large losses 12-Mar-07Trading in share of New Century Financial were suspended due to bankruptcy fears and losses in sub prime loans 20-Mar-07People's Choice files for bankruptcy protection 2-Apr-07 New Century Financial files for Chap. 11 bankruptcy 3-May-07 UK sub prime lender Kensington agrees to takeover 15-Jun-07Bear Stearns suffered big losses on sub prime mortgage investments in two hedge funds 4-Jul-07FSA takes action against 5 sub prime lenders for offering loans to people who couldn't afford. 24-Jul-07 Sub prime losses hit profits at Countrywide 30-Jul-07 IKB Deutsche Industriebank, a German Bank, is rescued Chart 5

6 Brief Chronology of Beginning(Cont.) 6-Aug-07 American Home Mortgage files for bankruptcy 9-Aug-07 Federal Reserve injects funds into markets. The European Central Bank, pumps arecord 95 billion euros into money markets. Bundesbank organizes a meeting to rescue IKB and Bafin indicates it was looking into a billion special funding for Sachsen LB. Bank of Japan injects funds Paribas freezes withdrawals on three of its hedge funds hit by the U.S subprime market crisis. Chart 6

7 US Housing Market 80 million houses 25 million are paid off 55 million have mortgages 51 million are paying on-time 4 million are behind (8% of 55 million with 2% in foreclosure) This compares to 50% seriously delinquent in the 1930s Source: U.S. Treasury Department. Chart 7

8 Source: Mark Perry over at Carpe Diem Chart 8

9 Chart 9 $11.1 Trillion in 2007

10 Macro Environment and Macro Policy Errors Low US Interest Rates Figure 1. US Federal Funds Target Rate Fed Funds Target Rate Real 5 Year Rate from Tips /1/2000 7/1/2000 1/1/2001 7/1/2001 1/1/2002 7/1/2002 1/1/2003 7/1/2003 1/1/2004 7/1/2004 1/1/2005 7/1/2005 1/1/2006 7/1/2006 1/1/2007 7/1/2007 1/1/2008 7/1/2008 Percentage Chart 10

11 Macro Environment and Macro Policy Errors (Cont) Large and Persistent US Fiscal Deficits and Growing Trade Imbalances China and Japan Currency Under-valuation Accumulation of dollar reserves and accumulation of US Treasuries Zero Interest Rate Policy of Japan and Carry Trade Chart 11

12 Chart 12 Sources of Income for Large Complex Financial Institutions

13 LCFI Issuance of RMBS backed by Sub-Prime Lending Chart 13

14 Leverage Ratios of Different Types of Financial Firms 2007 Government-sponsored enterprises 24.7 Brokers and hedge funds 31.6 Credit unions 8.4 Savings institutions 8.4 Commerical banks Landis Source: Avenue, David Greenlaw, Vineland, Jan NJ Hatzius, 08360Anil K Kashyap, Hyun Song Shin, Chart 14 Asset/Capital

15 Leverage of Key Large Financial Institutions as of Year End 2007 Assets Shareholder Equity Leverage (Billions) (Billions) US Banking Institutions Bank of America $1,715 $ x Citigroup $2,187 $ x JP MorganChase $1,562 $ x Foreign Banking Institutions Deutsche 2, x UBS CHF 2,272 CHF x Credit Suisse CHF1,360 CHF x Fortis x Dexia x BNP 1, x Barclays x RBS 1, x Chart 15

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17 Chart 17 Figure 3. Permits Figure 3. Permits

18 Homes Sit Longer on the Market Millions Homes available for sale (Left axis) Months Months supply (Right axis) Sources: National Association of Realtors, Moody s Economy.com. Chart 18

19 Percentage change, year ago 40% 30% History Repeats Itself: Home Prices Don t Just Go Up Change in Home Prices in 100 plus years World War I Great World Depression War II 1970 s Boom 1980 s Boom Current Boom 20% 10% 0% -10% -20% Source: Robert J. Shiller, Chart 19

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22 Subprime Market Evolved From Model for Prime Loans Began as a variation on GSE model Securitization of residential mortgages Improved transparency Enhanced diversification Increased liquidity Lowered costs Permitted banks to use capital more efficiently, in an originate and distribute approach Relied on guarantee from GSE Chart 22

23 Created an Off-Balance Sheet Banking System Replaced GSE guarantee with Ratings Mathematical models Monoline insurance Alphabet soup of innovations RMBS CDOs, CDO 2 ABCP SIVs CLOs Lost transparency of original model Chart 23

24 When is a AAA not a AAA? Multilayered structured credit products High-grade structured-finance CDO Mortgage loans Mortgage bonds AAA AA A BBB BB-unrated 80% 11% 4% 3% 2% Senior AAA Junior AAA AA BBB Unrated 614 Landis Source: Avenue, International Vineland, Monetary NJ Fund Chart 24 A A Mezzanine structuredfinance CDO Senior AAA Junior AAA AA BBB Unrated 88% 5% 3% 2% 1% 1% 62% 14% 8% 6% 6% 4% CDO-Squared Senior AAA 60% Junior AAA 27% AA 4% A 3% BBB 3% Unrated 2%

25 Concerns over CDS market Prospect of rising default rates Concerns about counterparty risk especially monoline insurers who sold protection Source: Economist, 1/31/ Chart 25

26 Mortgage Delinquency Rates By Type and Vintage Chart 26

27 What Broke the Cycle? Downgrades in the Asset-Backed Securities Markets AAA Downgrades In the Asset-Backed Securities Markets 7,000 6, ,000 5, ,000 3,000 2,000 1, ,635 1, Source: Moody s Source: Moody s Chart 27

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29 High TED Spread reflects freezing up of credit markets Chart 29

30 Volatility in global equity markets much less than in 1990s Chart 30

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32 Figure 16. Central Bank Policy Rates Bank of Japan Federal Reserve European Central Bank Bank of England Percent /1/2007 2/1/2007 3/1/2007 4/1/2007 5/1/2007 6/1/2007 7/1/2007 8/1/2007 9/1/ /1/ /1/ /1/2007 1/1/2008 2/1/2008 3/1/2008 4/1/2008 5/1/2008 6/1/2008 7/1/ Chart 32

33 Program Federal Reserve Programs Date Term Auction Facility Dec. 12, 2007 Primary Dealer Credit Facility March 16, 2007 Term Securities Lending Program March 11, 2008 Term Discount Window Facility August 17, 2007 Loans to Banks to Fund Purchase of Asset Backed Commercial Paper from Mutual Funds September Chart 33

34 Loss Experience of Primary Dealers ($Billions) Chart 34

35 Consequences of Crisis-Broad and Far Reaching US housing market is forever changed and we don t know who or how credit will be provided at this moment. Regulatory Structure? Need for new bankruptcy process For US non bank institutions For UK institutions and EU Need for deposit insurance restructure in UK and in EU Revise structure for conduct of open market operations in US Need for new supervisory and regulatory approach Basel II v leverage constraint? What to do in a cross border failure? Need to Control Regulatory Incentives How should universal banking model be regulated? Spread to Auction Rate Municipal Market which has been impacted by problems in monoline insurance mkt. Chart 35

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37 Who Is To Blame? The Fed for having pursued too easy monetary policy Financial institutions and Wall Street firms who leveraged themselves Fannie and Freddie who traded on government guarantees For exploiting those guarantees through political lobbying and pandering Credit Rating Agencies who were conflicted and opted for fees and squandered their reputations Bank Regulators who pursued lax regulation, got distracted by Basel I & II, and overlooked, purposely, off balance sheet activities and the risks they posed. Congress who created the GSEs, who took their campaign contributions and who encouraged them to extend mortgages to those who could never repay in the name of putting people in homes, who passed the Community Reinvestment Act which compelled banks to make loans to poor borrowers who often could not repay. Chart 37

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