The Subprime Crisis Literature: Blanchard, O. (2009), The Crisis: Basic Mechanisms, and Appropriate Policies, IMF, WP 09/80. Hellwig, Martin (2008), The Causes of the Financial Crisis, CESifo Forum 9 (4), p. 12-21. - Losses in US-real estate: below 1,000 bn. $. (1.000 Mrd. $) - Losses on international stock markets (9/07 3/10): about 40,000 bn. $. - Real losses due to lower GDP growth rates: at least 10,000 bn. $. Seite 1 The Subprime Crisis Literature: Hellwig, Martin (2008), The Causes of the Financial Crisis, CESifo Forum 9 (4), p. 12-21. - Financing of real estate investment requires a maturity transformation - Golden rule of banking: maturity match - Who bears the risk of (i) refinancing, (ii) changes in the interest rate? - Individual versus aggregate risk - Loans with fixed interest rate => risk of interest rate changes is borne by creditors (banks) => Savings- and Loans Crisis 1980-82 - loans with variable interest rate => risk of interest rate changes is borne by debtors Seite 2
The Subprime Crisis Securitization of mortgage loans: - Transfer of risk to third parties - insurance companies: long term liabilities - foreigners: diversification - hedge funds: regulatory arbitrage - Packaging and tranching - The role of Fannie Mae and Freddy Mac - Moral hazard und subprime credit Seite 3 The Subprime Crisis - Increasing trade with CDOs and CDSs 2003-6 - Increasing share of subprime mortgages - Monetary policy of US-Fed - Development of real estate prices in the US - Compare: USA UK Spain Latvia Japan 1980s - Development of risk premia - Housing price bubble Seite 4
Share prices during the Millenium Bubble Seite 5 US- interest rates Seite 6
US- house prices Seite 7 US- house prices Seite 8
Interest rates Seite 9 New instruments of securitization Packaging and tranching of asset backed securities (ABS) in collateralized debt obligations (CDOs) - equity tranch: high risk, financed by 100% equity according to Basel II. Ends up in hedge funds and investment banks - mezzanine tranch: investment banks - senior tranch: pensions funds, insurance companies, and others - Packaging of mezzanine in CDO 2 : foreign banks, SIVs - Rating: evaluation of counterparty risk follows historical data - Neglect of macroeconomic risks (interest rate changes, housing price level) - Leverage Seite 10
CDO: Packaging Suppose you have a three loans over $ 100 return each. Each loan defaults with a probability of 10% in which case it pays zero. Default probabilities are independent. Expected returns on the portfolio Return 300 200 100 0 Probability 0.9 3 = 0.729 3 0.9 2 0.1 = 0.243 3 0.1 2 0.9 = 0.027 0.1 3 = 0.001 Face value of portfolio: 300; expected return: 270 Seite 11 CDO: Tranching Slice the portfolio in a senior tranch with almost no risk, a mezzanine tranch with limited risk and an equity tranch with high risk. Face value of 100 each. Tranch senior mezzanine equity Face value 100 100 100 returns 0 with prob. 0.1% 100 w.prob. 99.9% 0 with prob. 2.8% 100 w.prob. 97.2% 0 with prob. 27.1% 100 w.prob. 72,9% Expected return 99.9 97.2 72.9 Seite 12
CDO 2 : Packaging of CDOs Suppose you have a portfolio of three mezzanine tranches of independent CDOs. Each one structured as on previous slide. Expected returns on the portfolio Return 300 200 100 0 Probability 0.972 3 = 0.918 3 0.972 2 0.028 = 0.079 3 0.028 2 0.972 = 0.002 0.028 3 = 0.00002 Seite 13 CDO 2 : Tranching Slice the portfolio in three tranches with face value 100 each. Tranch senior mezzanine equity Face value 100 100 100 returns 0 with prob. 0.002% 100 w.prob. 99.998% 0 with prob. 0.2% 100 w.prob. 99.8% 0 with prob. 8.2% 100 w.prob. 91,8% Expected return 99.998 99.8 91.8 Seite 14
CDO and CDO 2 : Rating Suppose, an agency rates an asset A if the expected return is at least 99.8% face value, B if return is at least 95% and C otherwise. Individual loan: expected return 90%, CDO-senior tranch: exp d return 99.9%, rating C rating A CDO-mezzanine tranch: exp d return 97.2%, rating B CDO-equity tranch: exp d return 72.9%, CDO 2 -senior tranch: exp d return 99.998%, rating C rating A CDO 2 -mezzanine tranch: exp d return 99.8%, rating A CDO 2 -equity tranch: exp d return 91.8%, rating C Seite 15 BIS 2007 Seite 16
Structure of an MBS Seite 17 Mortgage loans Seite 18
securitized and sold mortgage loans Seite 19 Credit volume Seite 20
Credit defaults Seite 21 Credit defaults Seite 22
The Subprime Crisis 2007/09 Crash - Signs of upcoming inflation in the US - Fed raised interest rates - First signs of crisis: end of 2006 - First banks in distress: August 2007 - Dimensions (October 2008): Volume of mortgage loans in US: ~ 6.500 bn. $ Volume of subprime mortgage loans: ~ 1.100 bn. $ expected losses on subprime loans: 500 bn. $ expected losses on loans worldwide 1.300 bn. $ (2% GDP) - Maturity transformation and liquidity crisis: simplified balance sheet of bank (1) Seite 23 Bank Run: Northern Rock 14.9.2007 lliquidity of banks: Depositors withdraw funds, because the fear a bank s illiquidity. Thereby they may cause the bank s illiquidity (self-fulfilling prophecy). Bild: Reuters Seite 24
The Subprime Crisis 2007/09 - Aug./Sept. 07: SIVs of IKB and Sachsen LB, Northern Rock - Withdrawal of deposits - Crash of the inter-bank market - Response by central banks - Rules of accounting: mark to market - Regulatory capital - Deleveraging - Contagion via markets: simplified bank balance sheet (2) Seite 25 The Subprime Crisis - Lender of Last Resort and Moral Hazard - Systemic relevance? - The case of Lehman Brothers - Dimensions: Losses on stock markets (Jan. 08 to March 09): DAX 50%, DowJones 45%, Nikkei 49%, - Real economic consequences - Liquidity trap and credit crunch - Downward spiral Seite 26
Crash of the interbank-market Blanchard (2009) Seite 27 MSCI World Dec 05, 2009 Seite 28
MSCI World Sep 15, 2008-37 % Seite 29 Liquidity spirals Loss spiral: During a crisis, the asset prices decline and borrowers suffer an initial loss. Considering the difficulty to obtain liquidity timely, they have to sell some of the assets to keep their position. These sales depress the prices and tighten the market liquidity further, inducing further sales and so on. Margin spiral: Borrowers can get funding liquidity from the market, but are required to put their own capital at stake. Lenders reset margins each period. A liquidity shock raises the margins, because lenders become uncertain of the future asset prices. Higher margins reduce the market funding and enforce more sales. As a result, the prices drop and the margins rise further, which reduces funding liquidity again. Network effects amplify spirals. Brunnermeier (JEP 2009) Seite 30
Liquidity spirals Brunnermeier & Pedersen (RFS 2008) Seite 31 Liquidity spirals Declining asset prices => banks have to adjust positions to meet capital adequacy requirements they need to sell assets => market prices decline further. Cifuentes, Ferruci & Shin (2005) Banks desire a given leverage CAR Adrian & Shin (2008) Seite 32
Liquidity spirals 100 assets 90 deposits 10 equity 95 assets 90 deposits 5 equity Bank wants to operate with a leverage of 10. assset prices drop by 5% this reduces equity by 50% => bank has to sell almost half of its assets to reestablish leverage. 50 assets 45 deposits 5 equity Seite 33 Instruments of resolving the crisis 1. Providing liquidity to the market 2. Lender of last resort facilities 3. Lowering interest rates 4. Central bank acting as a clearing house 5. Guaranties for preventing bank runs 6. Recapitalisation of banks 7. Good bank bad bank 8. Fiscal stimulus packages 9. Quantitative Easing 10. Qualitative Easing Seite 34
Recapitalizing Banks To end the credit crunch, banks need fresh equity. Private investors are unwilling to invest in banks who hold troubled (toxic) assets. An unfollowed suggestion by the Bundesbank: original bank owns - bad assets - good assets Holding (w/o banking license) owns - bad assets - good bank govt. guarantee private funds Having no troubled assets, good bank can acquire equity from private investors. Credit crunch ends. Bank profits go partially to holding, balancing losses from bad assets. Original shareholders get the difference between their share of good bank s profit and losses from bad assets. Seite 35 Recapitalizing Banks Banks prefered another option: original bank owns - bad assets - good assets good bank owns - good assets - bad bank (w/o license) private funds govt. guarantee Limited liability: good bank has no risk and can acquire equity from private investors. Credit crunch ends. Bank profits go entirely to original bank and their shareholders, losses from bad assets are covered by govt. Seite 36
Recapitalizing Banks Outcome of bargaining process (in Germany): original bank owns - bad assets - good assets good bank owns - good assets - SPV govt. guarantee No limited liability: good bank has to cover eventual losses of SPV. Risk is still in the good bank. It cannot acquire equity from private investors. Credit crunch continues. Additional bank profits foregone. Losses from bad assets are more likely to exceed profits from good assets. Failing banks are covered by govt. Seite 37 Recapitalizing Banks Outcome of bargaining process: original bank owns - bad assets - good assets good bank owns - good assets - SPV govt. guarantee govt. funds To end credit crunch, w/o private equity, CB and govt. step in: CB buys assets from private banks, relieving their balance sheets. Govt. partially nationalizes banks, providing equity. Credit crunch ends. Profits from good assets and new credits minus losses from bad assets are split between initial bank owners and govt. => Moral hazard problem Seite 38
Recapitalizing Banks Example 1: original bank owns - bad assets => loss X - good assets => profit 10 additional funds Original shareholders => profit 10, opportunity costs R Bundesbank proposal Banks proposal Bargaining outcome 10 X (if X < 10) 10 10 X/2 (if X < 20) Govt. 10 X (if X > 10) X 10 X/2 R (if X < 20) Private investors 10 R 10 R 0 20 X R (if X > 20) Seite 39