The Financial Crisis. Gerald P. Dwyer Federal Reserve Bank of Atlanta University of Carlos III, Madrid

The Financial Crisis Gerald P. Dwyer Federal Reserve Bank of Atlanta University of Carlos III, Madrid

Disclaimer These views are mine and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System.

Complicated Developments Acronyms ABS, CDO, CDO squared, RMBS, SLABS, TARP, TALF Financial institutions all over much of the world Markets Money market funds Asset-backed securities Unprecedented actions, in our lifetimes Federal Reserve owns about $1 trillion in mortgagebacked securities Congress passed a $700+ billion stimulus package

Story Continues Housing sales fell last month after end of tax incentives for new home buyers Financial turmoil around government debt (sovereign debt) Concern about another financial crisis G20 discussing whether stimulus or straightening out central governments finances is the highest priority

Outline Basic background Summary of developments Prelude until August 9, 2007 Main Act from August 9, 2007 to September 16, 2008 Climax from September 16, 2008 to early 2009 Financial crisis Denouement from early 2009 to???? Sovereign debt crisis? Effects and causes of crisis and policy responses

Basics of Story Stock market is the development that got most people s attention Mortgage delinquencies Subprime mortgages

U.S. Stock Indices January 2, 2007 to June 02, 2010 1.2 1.1 1.0 0.9 0.8 Wilshire 5000 S&P 500 NASDAQ 0.7 0.6 0.5 0.4 1/1/07 7/1/07 1/1/08 7/1/08 1/1/09 7/1/09 1/1/10 Sources: Dow Jones, NY Times, Wall Street Journal, Haver Analytics

Housing Price Indices January 2000 to March 2010 220 200 Case Shiller Index 180 160 FHFA Index 140 120 100 80 1/1/00 1/1/01 1/1/02 1/1/03 1/1/04 1/1/05 1/1/06 1/1/07 1/1/08 1/1/09 1/1/10 Sources: S&P, FHFA, Haver Analytics

U.S. Delinquencies by Loan Type First Quarter 2002 to First Quarter 2010 35 30 Subprime ARM 25 Subprime FRM 20 15 Prime ARM 10 Prime FRM 5 0 3/1/02 12/1/02 9/1/03 6/1/04 3/1/05 12/1/05 9/1/06 6/1/07 3/1/08 12/1/08 9/1/09 Sources: Mortgage Bankers Association, Haver

4 3 U.S. Mortgage Originations by Type 2001 through 2007 Home Equity Lines Subprime Alt A Prime Jumbo Conventional FHA / VA 2 1 0 2001 2002 2003 2004 2005 2006 2007 2008 2009 * Source: Inside Mortgage Finance

Size of Global Financial Markets Source: Dwyer and Tkac, JIMF, December 2009

Story A tiny part of securities markets put asset markets around the world in a state of turmoil How can that be?

Mortgages Are Securitized Residential Mortgage Backed Securities (RMBS) Mortgages are pooled together and sold on the open market Can be divided into tranches Spreads risk to others who are willing to take a part of it Tranching Typical bond has all holders suffering losses proportionately Structured financial instruments structure receipts of payments

Three Securities Instead of One AAA rated RMBS Portfolio of Subprime Mortgages BBB- RMBS Equity RMBS

Collateralized Debt Obligation Create a collateralized debt obligation from BBB parts of residential-mortgage backed securities This BBB part is tranche itself Often 85 percent of CDO was AAA To many, AAA security seems like a fine security Many laws encourage this perception

CDOs from Tranches AAA rated CDO BBB tranches of RMBS BBB- CDO Equity CDO

Mortgages to CDOs Portfolio of subprime mortgages BBB tranche of RMBS AAA tranche of CDO Portfolio of subprime mortgages BBB tranche of RMBS CDO BBB tranche of CDO Portfolio of subprime mortgages BBB tranche of RMBS Equity tranche of CDO

Really More Complicated Than That More Tranches AAA Often a super-senior tranche above that AA A BBB BBB- Can have tranches in between Equity tranche Residual claimant tranche First-loss position

CDO Deals Idiosyncratic and Traded over the Counter A trust, generally in the Cayman Islands, owns the assets backing the CDOs and distributes payments Not standardized contracts Over-collateralization and triggers Can build up a reserve account for possible losses Can be contingent on delinquencies and losses Payment order can change over time Principal may be paid initially to AAA holders Proportionately to all after a couple of years Manager can be passive or active Traded over the counter

Securities and Risk Sharing CDOs were purchased by entities all over the world AAA rating made them seem like a fine purchase AAA CDO is not a AAA corporate bond CDO is based on lower-rated tranches of a portfolio of loans Behavior of cash flows in default is very different Ratings were conditioned on rising house prices CDOs are complex securities and very hard to value if mortgagees start to default

Two Developments Created Problems Falling home prices increase probability of default Loan to value matters Date of issuance of mortgage Location of borrower matters Effect of issuer may reflect this U.S. mortgages generally are recourse loans Not in all states Rising delinquency rate due to problematic mortgages Maybe issuer matters

Implications of Higher Probability of Default Specific characteristics of mortgages now matter Location in California, Nevada, Arizona or Florida Loan to value by location Difficulty valuing security lowers trading volume Less trading makes it harder to get a decent estimate of their value Correlation of losses across tranches may be quite different than supposed Common shock Not idiosyncratic losses on mortgages

06-1 vintage ABX Indies by Vintage 06-2 Vintage 100.0 100.0 80.0 80.0 60.0 60.0 40.0 40.0 20.0 20.0 100.0-1/2/06 1/2/08 1/2/10 07-1 Vintage AAA AA A BBB BBB- - 1/2/06 1/2/08 1/2/10 100.0 07-2 Vintage 80.0 80.0 60.0 60.0 40.0 40.0 20.0 20.0-1/2/06 1/2/08 1/2/10 Sources: Markit Group Limited/Haver Analytics - 1/2/06 1/2/08 1/2/10

Thousands $ Global Issuance of Collateralized Debt Obligations First Quarter 2005 to First Quarter 2010 200 180 160 140 120 100 80 Other Tranches High Yield Loans High Yield Bonds Investment Grade Bonds 60 40 20 0 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 2005 2006 2007 2008 2009 2010 Source: SIFMA

Summary of Developments Prelude until August 9, 2007 Main Act from August 9, 2007 to September 16, 2008 Climax from September 16, 2008 to early 2009 Financial crisis Denouement from early 2009 to????

PRELUDE UP TO AUGUST 9, 2007

Prelude Rumblings of what was to come Housing prices were peaking Mortgage delinquencies were increasing Mortgage brokers started to fail Prices of securities that were indicative of the problems started to fall

Main Act August 9, 2007 to September 16, 2008

What Happened on August 9? BNP Paribas halted redemptions in three funds holding asset-backed securities Fed injected $12 billion of reserves ECB created 95 billion euro fund for finetuning operation Why that day and not some other day?

LIBOR less OIS - 30 days January 1, 2006 to June 02, 2010 350 300 Run on money market funds 250 200 150 End of year 100 Northern Rock 50 August 9, 2007 0 1/1/06 7/1/06 1/1/07 7/1/07 1/1/08 7/1/08 1/1/09 7/1/09 1/1/10 Sources: Financial Times, Bloomberg, Haver Analytics

30-Day Commercial Paper and Treasury Rates January 1, 2007 through June 1, 2010 7 6 5 4 AA Asset Backed AA Financial AA Nonfinancial A2/P2 Nonfinancial Treasury 3 2 1 0 Run on Money Market Funds 1/1/07 7/1/07 1/1/08 7/1/08 1/1/09 7/1/09 1/1/10 Source: Federal Reserve Board, Haver Analytics

Concerns About Institutions Solvency Spread Northern Rock run Government Investment Funds (in U.S.) Run on Florida pool Bear Sterns Monoline insurers They sold insurance on tranches Credit default swaps

Concerns about Credit Rating Agencies Veracity of their ratings AAA CDO s decreased in value substantially in a short period AAA CDO is not a AAA corporate bond Exacerbated concerns about solvency

Climax September 16, 2008 to Early 2009

Concerns About Institutions Solvency Spread Fannie and Freddie (GSEs) put into conservatorship on September 7, 2008 September 15 Bank of American announces purchase of Merrill Lynch Lehman Brothers files for bankruptcy September 16 AIG given $85 billion bridge loan by the Fed Reserve Primary Fund breaks the buck

Run on Prime Funds

The Run on Money Market Funds Money market funds in the U.S. do not guarantee a net asset value of $1 but they have provided it in practice since their inception in in the 1970s Reserve Primary Fund s Net Asset Value was announced as $0.97 on September 16, 2008 Institutional investments had run on the fund, increasing the fall in value of remaining investments Institutional investments fell by $25 billion on September 15 alone

Total Net Assets in Taxable Money Market Funds 2500000 2000000 1500000 1000000 500000 0 8/8/2007 9/8/2007 10/8/2007 11/8/2007 12/8/2007 1/8/2008 2/8/2008 3/8/2008 4/8/2008 5/8/2008 6/8/2008 7/8/2008 8/8/2008 9/8/2008 10/8/2008 11/8/2008 12/8/2008 1/8/2009 2/8/2009 $ Millions Taxable General Purpose Taxable Government

30-Day Commercial Paper and Treasury Rates January 1, 2007 through June 1, 2010 7 6 5 4 3 AA Asset Backed AA Financial AA Nonfinancial A2/P2 Nonfinancial Treasury 2 1 0 Run on Money Market Funds 1/1/07 7/1/07 1/1/08 7/1/08 1/1/09 7/1/09 1/1/10 Source: Federal Reserve Board, Haver Analytics

Concerns About Institutions Spread The largest banks in the U.S. Citi, Chase, Bank of America Which investment bank would be next?

Policy Response September 19, 2008, Treasury announced that it would use funds from the Exchange Stabilization Fund to guarantee money market fund investments Federal Reserve responses Money Market Investor Funding Facility (MMIFF) Asset Backed Money Market Liquidity Facility (AMLF) Commercial Paper Funding Facility (CPFF)

Federal Reserve Liquidity Programs $ billions $1,800 $1,600 $1,400 $1,200 $1,000 Repos MMIFF PDCF AMLF CPFF Currency Swaps TAF TALF Discount Window $800 $600 $400 $200 $0 Dec-07 Feb-08 Apr-08 Jun-08 Aug-08 Oct-08 Dec-08 Feb-09 Apr-09 Jun-09 Aug-09 Oct-09 Dec-09 Feb-10 Apr-10 Source: Federal Reserve Board Through May 26 47

U.S. Not Only Country with Problems Foreign exchange rates affected Flight to dollar House prices rose in many countries besides U.S. House prices have fallen substantially in Ireland, Spain and other countries Nothing directly to do with subprime mortgages or CDOs in most countries Widespread increases of leverage Widespread increases of maturity transformation

Denouement Early 2009 to Present

FEDERAL RESERVE BALANCE SHEET - ASSETS $2,500 $2,000 Agency Debt & MBS Lending to Nonbank Credit Markets Short-Term lending to Financials Other Treasuries Federal Reserve Assets (Uses of Funds) $ billions $1,500 $1,000 $500 $0 Dec-07 Apr-08 Aug-08 Dec-08 Apr-09 Aug-09 Dec-09 Apr-10 Through May 26 Source: Federal Reserve Board

FEDERAL RESERVE BALANCE SHEET - Liabilities $2,500 $2,000 Treasury SFA Other Federal Reserve Liabilities (Sources of Funds) $ billions Banks Reserve Balances Currency in Circulation $1,500 $1,000 $500 $0 Dec-07 Apr-08 Aug-08 Dec-08 Apr-09 Aug-09 Dec-09 Apr-10 SFA = Supplementary Financing Account Through May 26 Source: Federal Reserve Board

Inflation?

The Great Recession

Unemployment Rate January 1948 to May 2010 12 10 8 6 4 2 0 1/1/48 1/1/53 1/1/58 1/1/63 1/1/68 1/1/73 1/1/78 1/1/83 1/1/88 1/1/93 1/1/98 1/1/03 1/1/08 Sources: BLS, NBER, Haver Analytics Assumes recession ended July 2009

Fiscal Policy Unprecedented federal government deficits How big is government spending multiplier? 0.5 to 1.5 Could even be negative now Sovereign debt crisis and the U.S. U.S. promises to pay dollars and the federal government can deliver them, unlike Greece

Sovereign Debt Crisis and the U.S. Federal government leveraging up when households and firms are deleveraging Does this make sense? Federal government can provide income support and help increase GDP now, and possibly in the future Federal government is increasing spending now and will have to increase taxes later to pay for it, which will lower GDP in the future

What caused the financial crisis? Or What have we learned?

Source: http://library.thinkquest.org One Cause

Another Version of Cause

What Caused the Crisis? My Personal Answer Proximate causes in order of importance for U.S. Fannie and Freddie s purchases of subprime securities spurred on by U.S. Congress Private institutions took on more risk due to decrease in perceived riskiness of economy Increased leverage Increased maturity transformation Financial innovations CDOs Reduced the cost of risky activities Ratings agencies mischaracterized their risk Not clear how much of increased issuance is due to increased issuance of subprime loans These spread the risk and created the conditions for uncertainty

U.S. Government to Blame? Support for excessive borrowing on mortgages Fannie and Freddie and support for them Maybe CRA Regulators and Policy uncertainty Bear Sterns, Lehman Brothers, AIG Deposit insurance for trading book Federal Reserve and low Fed Funds rate This is claimed by John Taylor and many others Perhaps people borrowed more on variable-rate mortgages The combination of the developments caused the crisis It s easy to see this after the fact

Fed Funds Rate Too Low from 2002 to 2006?

30-Year Mortgage Rate and Federal Funds Rate

Subprime Adjustable Mortgage Rate and Federal Funds Rate

What Do I Conclude? More than a little suprising to see two-year Treasury rate low and subprime adjustable rate not What does it mean? Are the data accurate representation of rates paid? Did the risk of mortgage made increase? Would a longer time period be clearer? For John Taylor s argument Case not proven

Policy Responses What was done wrong? Lots What was done right? Maybe some

Policy Responses What was done wrong? Lots What was done right? Maybe some What reflected people doing the best they could given what they knew? All of it

Financial Difficulties It s the truck you don t see that runs you down

Better Question What to do now given where we are?

A Quest for Stability Source: http://img2.travelblog.org/photos2/