The Financial Turmoil in 2007 and 2008 Events

The Financial Turmoil in 2007 and 2008 Events Gerald P. Dwyer, Jr. May 2008 Copyright Gerald P. Dwyer, Jr., 2008

Caveats I am speaking for myself, not the Federal Reserve Bank of Atlanta or the Federal Reserve System I probably know more about the general developments than you do and have analyzed the developments more But I don t know all that I would like

Complicated Acronyms ABS, ABCP, CDO, CDO squared, CPDO, RMBS, SIV, SLABS, SPV Operators in markets Financial institutions all over the world Monoline insurers Hedge funds Markets affected Markets for all these securities and others besides

Story Continues Financial Times story on wepage on May 21, 2008 Moody s Error Gave Top Ratings to Debt Products Constant Proportion Debt Obligations (CPDOs) Stories constantly concern new instruments, some very complicated

Structured product Constant Proportion Debt Obligation Investors provide cash Special Purpose Vehicle (SPV) Commonly a trust in the Cayman Islands (U.S. version at least) Holds assets based on credit default swaps Possibly borrows additional funds Makes payments to investors Investment bank runs SPV in exchange for a fee

Common Themes Securitization Loans used to back securities Often through Special Purpose Vehicles Credit Derivatives Financial instruments whose value is based on derived from the credit risk of other financial instruments or parties CPDOs are credit derivatives Leverage Borrowing short term to fund long-term positions

Background Defaults on subprime mortgages More such loans than historically Relatively low risk spreads How do we get from defaults on high-risk mortgages to difficulties with financial markets world wide?

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

U.S. Residential Mortgage-Backed Securities Issuance 1995 through 2007 3 Trillion Dollars (U.S.) 2 1 Agency Prime Jumbo Alt A Subprime Other 0 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 Year 2005 2006 2007 Source: Inside Mortgage Finance

Global Issuance of Asset-backed Securities First Quarter 2000 through Fourth Quarter 2007 Billion Dollars (U.S.) 700 600 500 400 300 CMBS (a) Prime RMBS (b) Subprime RMBS (b) Other 200 100 2000 2001 2002 2003 2004 2005 2006 2007 Source: Dealogic and Bank of England Financial Stability Report, April 2008 (a) Commercial mortgage-backed securities (b) Residential mortgage-backed securities (c) 'Other' includes auto, credit card and student loan ABS

U.S. Mortgage Delinquencies by Loan Type 8 First Quarter 1998 through Fourth Quarter 2007 6 Prime FRM Prime ARM Subprime FRM Subprime ARM Percent 4 2 0 1/1/1998 1/1/2000 12/31/2001 12/31/2003 12/30/2005 12/31/2007 Date Note: Delinquent 90 days or more Source: Mortgage Bankers Association

U.S. Mortgage Foreclosures by Loan Type First Quarter 1998 through Fourth Quarter 2007 14 12 10 Prime FRM Prime ARM Subprime FRM Subprime ARM Percent 8 6 4 2 0 1/1/1998 1/1/2000 12/31/2001 12/31/2003 12/30/2005 12/31/2007 Date Note: Foreclosure Inventories Source: Mortgage Bankers Association

Size of Assets Markets Source: Bank of England Stability Report, 10/2007

Story Tiny part of securities markets has put asset markets around the world in a state of turmoil? How can that be? Partly it s not true Not all asset markets around the world Partly true Disruptions in Norway, Germany, Euro area, and U.K. besides U.S.

Securitization of Mortgages Residential Mortgage Backed Securities (RMBS) Mortgages are pooled together and sold on the open market Agency securities Others Collateralized debt obligations (CDO) Credit instruments are pooled together (e.g. mortgages), payments are divided into tranches and sold on the open market A key difference is the division into tranches

Tranches on Securities Instead of one security (RMBS), several securities are issued (CDO) Tranches AAA (rated) Mezzanine tranches (rated AA to BB) Equity tranches (unrated) Priority of paying determined by tranche Priority on a pool of mortgages, some paying, some not Simple example (actually more involved) Suppose that all mortgages paying but one People who own AAA part get paid everything People who own mezzanine part get paid everything People who own equity part get paid everything expect mortgage payment not made

Loans Securitized Since 2000, mortgages are largest part of loans securitized Residential mortgages Commercial mortgages Others Credit card debts Auto loans Student loans (in U.S.)

Securitization and Special Purpose Vehicle (SPV) Special Purpose Vehicle is a separately incorporated entity for each CDO Receives cash flows from investors Acquires securities according to contract Receives cash flows from securities Pays investors following contract Can wind up close operations Sometimes buys and sells securities over time according to contract

Market for CDOs CDOs are traded over the counter Not on an organized exchange such as NYSE Trade through brokers and dealers

CDOs CDOs are not identical Standardized securities Each share of Microsoft common stock is identical The same provisions The same developments determine the income received by the owner Income received by each share is identical Residential CDOs Mortgage loans for houses Each loan is likely to have idiosyncratic characteristics Income received by AAA CDO owners not necessarily the same Same for a particular deal (SPV)

Idiosyncratic Securities How reduce idiosyncratic component of CDOs? Portfolio of loans Value tranches concentrate idiosyncratic component AAA Mezzanine Equity Idiosyncratic part most important for equity tranche

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 a portfolio of loans Behavior of cash flows in default is different Ratings were conditioned on rising house prices

Two Developments Created Problems Rising delinquency rate due to problematic mortgages Falling home prices increase probability of default Loan-to-value matters Date of issuance of mortgage Location matters Maybe issuer matters

Implications of Higher Probability of Default Characteristics of loans become more important to extent default predictable Securities become more difficult to value Tends to lower price Volume in over-the-counter market decreases Tends to lower price Correlation risk By construction, portfolio of loans reduces idiosyncratic risk Losses on lower-rated tranches associated with losses on higher-rated tranches Losses may have a higher correlation across tranches than perceived by buyers of higher-rated tranches Losses can be more highly correlated with a large common shock

Market-implied expectations of ultimate loss rates on US sub-prime mortgages (a)(b) Source: Bank of England Financial Stability Report April 2008. Bank of England calculations using data from JPMorgan Chase & Co. (a) Based on the collateralised debt obligation (CDO) model used in A simple CDO valuation model, Bank of England Financial Stability Review, Box 1, December 2005, pages 105 06, applied to 2007 H1 ABX tranches, assuming these prices reflect only credit risk. (b) The model estimates a market-implied probability of default of the underlying mortgages. This is a risk-neutral default probability. In the likely case that investors are averse to risk, the perceived probability of default will be lower than under the risk-neutral measure.

Widespread Losses on CDOs Derivative securities widely held Commercial banks and investment banks in U.S. Hedge funds Small towns in Norway Banks in Germany With possible losses, higher rated tranches become more similar to equity tranche

Losses on sub-prime asset-backed securities (a) Sources: Bank of England Financial Stability Report April 2008. Banks financial statements, Bank of America, BlackRock, Dealogic, JPMorgan Chase & Co., Moody s Investors Service, Standard and Poor s and Bank calculations. (a) See Box 1 on page 18 of Report for details. (b) Area below dotted line shows net write-downs by major UK banks and LCFIs since the start of 2007 to 22 April 2008, while total height of bar shows an S&P estimate (published on 13 March 2008) of write-downs by all investors. (c) In the absence of data on realised losses, this estimate is derived from data on actual delinquency rates on outstanding mortgages by vintage, and an assumption about the transition from delinquency to default, as described in Box 1. (d) This estimate is derived in the same way as for estimated credit losses, but assuming that serious delinquency rates on different vintages continue to rise at their average rate to date until the mortgages are four years old, when they are assumed to be plateau. See Box 1 for details.

Size of Assets Markets Source: Bank of England Stability Report, 10/2007

Troubles Spread Beyond Subprime Mortgage Loans Securitized loans in general Jumbo mortgage loans rates increased (relatively large mortgage loans) Commercial real estate Student loans Leveraged loans Other debt securities Flight to quality

Corporate Bond Spreads over Ten-Year Treasury Yield February 1, 1990 through May 19, 2008 10 8 Merrill Lynch High Yield Index Baa Aaa Percent 6 4 2 0 1/1/1990 12/31/1992 1/1/1996 1/1/1999 12/31/2001 12/31/2004 1/1/2008 Date

100 90 80 Stock Investors' Fear Index January 2, 1999 through May 21, 2008 70 60 Implied Volatility Level 50 40 30 20 10 S&P 500 Implied Volatility NASDAQ 100 Implied Volatility 1/1/1999 1/1/2000 12/31/2000 12/31/2001 12/31/2002 1/1/2004 12/31/2004 12/31/2005 12/31/2006 1/1/2008 Date

Why Did Turmoil Spread? Hard to say for sure, of course A couple of other developments CDOs used not only for subprime mortgages Concerns about ratings agencies Monoline insurers Losses at banks and consequent decreases in capital at banks affect their activities Purchases of securities Lending

Markets for Asset-backed Securities Banks make markets for all of these Secondary market for CDO equity is undeveloped and more problematic This reduces the incentive to create a CDO Why don t banks just hold original loans? They have their own financial difficulties from holding subprime mortgages What about straight asset-backed securities? Uncertainty about credit rating agencies evaluations Increase in credit spreads makes it less profitable to hold them Probably other issues leading to problems spreading

Residential Mortgage Backed Securities Housing prices falling in parts of the U.S. Prior run-up and fall over last couple of years Easy to document Why does house price matter for a mortgage? Affects ability to sell Mortgage holders tend to walk away from their house and mortgage loan when they are too much upside down Uncertain falling house prices make residential RMBSs riskier

U.S. Organizations Involved in CDOs and Other Activities Ratings agencies Monoline insurers

Ratings Agencies Rate corporate bonds Rate CDOs Receive payments from security issuer for rating Rating of value only if buyers find it valuable

Ratings of CDOs CDOs are rated by same organizations that rate corporate bonds Explains how they are rated AAA, AA, etc. Falling prices of CDOs called into question Informativeness of the ratings Incentives of the rating agencies Issuer pays for rating Rating of value only if buyers find it informative

AAA CDO and AAA Corporate Bond Behave Differently One is based on a portfolio of loans, one is not Reduces idiosyncratic credit risk Increases relative importance of common credit risk Underlying assets are different CDO Cash flows on a portfolio of loans Houses, cars, government guarantees on student loans Corporate bond Cash flow from firm s operations Firm s assets

Monoline Insurers Provide insurance on state and local government bonds Generally have AAA rating Provide guarantee of payment Effectively provides AAA rating on bonds State and local governments typically do not have AAA ratings Provide insurance on CDOs Similar to transfer of AAA rating to tranche This is in addition to rating of AAA by ratings agency Receive payments from security issuer for insurance Insurer makes payments to holders if there are losses

Monoline Insurers and CDOs As projected defaults on subprime mortgages increased, projected payouts by monoline insurers increased Losses created uncertainty about solvency of insurers and value of insurance Further increased uncertainty about the value of CDOs Spread problems to market for state and local government bonds

Problems Surfaced for Money Market Funds Some SPVs and Structured Investment Vehicles (SIVs) were financed by assetbacked commercial paper Money market funds held some Investors fled these money market funds Led to losses for funds

Problems Surfaced for Auction Rate Securities (ARSs) Rate reset on state and local government debt by frequent auctions Investment banks were unwilling to take ARSs on their balance sheets when there was no buyer and issuer had not paid them to do so Led to liquidity problems for some holders of ARSs Led to high interest rates for some issuers of ARSs Default interest rate is the contractually specified interest rate if the auction fails Not related to default by issuer

Runs on Financial Institutions Run on Northern Rock in the U.K. Run on Florida Government Investment Fund Possible runs on money market funds in the U.S.

Florida Local Government Investment Pool Supposed to operate like a bank, roughly speaking Put funds in, receive some interest with virtually no risk to principal Take funds out on demand without prior notice

Holdings of Florida Local Government Investment Pool Held some securities related to CDOs Asset-backed commercial paper (ABCP) Issued by structured investment vehicles (SIVs) SIVs bought CDOs and issued ABCP Difference is term to maturity CDOs are long-term securities ABCP is short-term paper Part of payoff is supposed to come from lending long-term and borrowing short-term

Developments Pool held some asset-backed commercial paper On Nov 15th David Evans at Bloomberg wrote an article in which he said What... municipal finance managers... across the country still haven't been told -- is that state-run pools have parked taxpayers' money in some of the most confusing, opaque and illiquid debt investments ever devised. These include so-called structured investment vehicles, or SIVs, which are among the subprime mortgage debt-filled contrivances that have blown up at the biggest banks in the world. Finance offices around Florida were receiving information about the pool s holdings and financial officers were getting concerned

What Happened? Source: Florida Local Government Investment Pool Issues in Perspective, February 8, 2008

A Run on the Fund

Really Same as a Bank Run Banks promise to pay back deposit in currency on demand Banks hold fractional reserves of currency Suppose no deposit insurance If you re worried about the value of your deposit, you go to the bank and get its value in currency Called a bank run Very sensible behavior for everyone involved

Run on Pool Was Essentially the Same Pool gave depositors the principal plus interest on withdrawal Pool did not just hold currency or insured deposits in banks Depositors became concerned about the value of some assets held by the pool Depositors withdrew funds Very sensible behavior

End Result Pool cannot honor everyone s request to take out all their funds at once Result in this case is losses to some depositors

Run A Government Policy Problem? Government-run fund, so in that sense, yes Suppose it had been a commercial bank Run on an individual institution, not the banking system Run on all banks means that funds are moved from deposits to currency Affects money supply Disrupts financial intermediation Run on an individual institution means funds are put into another institution Doesn t raise same issues Run would not have been an issue for the central bank Depositors suffer losses, so an issue for insurance

State of Florida Decision State of Florida decided to let local governments take losses on funds in pool Some gain, some lose Those who withdrew did not have losses Those who did not withdraw fast enough bear losses Hard to imagine fund operating successfully if local governments can put their funds in commercial money market funds

Financial Turmoil A Policy Problem? A period of financial instability What is financial stability? A period of financial instability is one in which a large number of agents experience reductions in their access to funds which are not warranted by their previous behaviour, and where these crises collectively have seriously adverse macro-economic effects. Allen and Wood (2006) There are problems with this definition, but it probably is the best one around

Does This Episode Qualify As Financial Instability? This is a period of financial instability according to this definition No doubt Geoffrey Wood thinks so It s his definition Created well before turmoil Manifestation of problems in many unrelated markets Prime mortgages Corporate bonds State and local financing Bank loans Not warranted by their previous behaviour? Lower forecasts of real GDP growth Seriously adverse macro-economic effect?