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Deciphering the 2007/8 Liquidity Deciphering the 2007/8 Liquidity and Credit Crunchand Credit Crunch

Markus K. BrunnermeierPrinceton University

Written notes will be available athttp://www.princeton.edu/~markus

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Overview of TalkOverview of Talk1. Run-up

Creation of structured productsDemand for structured productsConsequences: Buy-out bonanza, house price frenzy

2. Unfolding of crisisSubprime, ABCP, banking crisisQuant crisis

3. Mechanisms at work4. Difference to previous crises

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1.1 Creation of Structured Products1.1 Creation of Structured ProductsSecuritization I

Insuring CDS US$ ≈45tr (corporate debt ≈5tr)

PoolingTranching CDOs

CateringOpaqueness

Securitization IIShortening maturity SIVs et al.

Traditional business of banks“Ride yield curve”

Buy long-term assetsSell and roll over short-term assets (ABCP)

Opaqueness in off-balance sheet vehicles

Bond Tranches

Thickness “Loss Support”

AAA 80% 20%

AA 5% 15%

A 5% 10%

BBB+ 2% 8%

BBB 1% 7%

BBB- 2% 5%

BB 1% 4%Overcollateralization(Equity)

4% 0%

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Conduits SIVs SIV-litesassets US$ ≈1,400bn

not tradable loansless risky

•≈11% RMBS•≈11% ABS/CDOs

US$ ≈400bn assets are tradedless risky

•≈ 43% fin. Inst. Debt•≈ 23% RMBS•≈ 11% CDOs

US$ ≈12bnassets are tradedrisky

• >95% US RMBS

liabilities 26% ABCP68% MTN

7% capital/mez.notes

capital structure non-structured structuredopen dynamic (change size/financing)

structured (aggressively)

closedstatic (like CDOs)

Credit enhancement

Some(sponsoring bank)

No (but overcollateralized) No

Liquidity enhanc. (credit line)

Contractual100%

Contractual< outstanding ABCPReputational

Contractualcredit line is subject to market value tests

1.2 Shortening Maturity 1.2 Shortening Maturity -- SIVsSIVs et al.et al.

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1.3 Why Structured Products?1.3 Why Structured Products?Good reasons

Catering – transfer risk who can best bear it –stayed mostly within banking system

(complete markets)Bad reasons

Supply: Rating Arbitrage – Diluting existing bond holders

Transfer highly rated asset to SIV and issue AAA papersInstead of issuing A- minus rated papers+ banks’ rating was unaffected by this practice

Regulatory Arbitrage: Outmaneuver Basel I accord (SIVs)esp. reputational liquidity enhancements

Demand: Creative way to enhance portfolio returns

searching for yieldtrack record building - picking up nickels before the steamroller

Attraction of illiquidity (no price exists) + difficulty to value CDOs (correlation risk)

“mark-to-model”: Mark “up”, but not “down”smooth volatility and increase Sharpe ratiofraction of “level 3 assets” went up a lot

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1.4 Consequences of 1.4 Consequences of ““originate and distribute banking modeloriginate and distribute banking model””

Banks focus only on ““pipeline riskpipeline risk””Distance between borrowers and lenders

Opaqueness - obfuscation

Deterioration of lending standardsMortgages

Mortgage brokersPiggyback mortgages, NINJA loans, …Housing Frenzy

Corporate bondsPik bondsCovenant-lite bondsPrivate equity bonanza – LBO acquisition spree

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2. Unfolding of Crisis2. Unfolding of Crisis

1. Subprime2. ABCP, banking crisis3. Spillover to corporate credit4. Quant crisis

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2.1 2.1 SubprimeSubprime crisis crisis –– envelope calculationenvelope calculationSubprime mortgage: 15% of US$ 10tr = US$ 1.5tr

Say: 50 % default, only recoup 50%Total loss: US$ 375bn, incl. Alt-A say, US$ 500bn2% change in stock market > US$ 500bn Amplifying mechanism

needed

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2.2 ABCP 2.2 ABCP –– Banking CrisisBanking Crisis

ABCP dries up – no rolloverSIVs draw on credit lines of sponsoring bankLIBOR and flight to qualityBanking Crisis: IKB, SachenLB, Northern Rock

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3.5

4

4.5

5

5.5

6

6.5

7/1/07

7/8/07

7/15/0

77/2

2/07

7/29/0

7

8/5/07

8/12/0

78/1

9/07

8/26/0

7

9/2/07

9/9/07

9/16/0

79/2

3/07

9/30/0

710

/7/07

ABCPLIBOR 3 monthsT-Bill 3 monthsFedFund

600

700

800

900

1000

1100

1200

1300

6/27

/07

7/11

/07

7/25

/07

8/8/

07

8/22

/07

9/5/

07

9/19

/07

10/3

/07

ABCPFinCP

Outstanding ABCP Rates

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2.3 Spillover to Corporate Credit2.3 Spillover to Corporate Credit

Novelty effectLearning about structured products

0

100

200

300

400

500

600

1/1/07

2/1/07

3/1/07

4/1/07

5/1/07

6/1/07

7/1/07

8/1/07

9/1/07

10/1/

070

500

1000

1500

2000

2500

3000

CDX.HY.5y On the Run ABX.HE.BBB- On the Run

Note difference in scale!

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2.4 Quant Crisis2.4 Quant Crisis1. High frequency stat arbs

High frequency, IT driven, short-term reversal strategiesAug 1st to Aug 9th - price declines seven days in a rowe.g. Renaissance’s Medallion fund

2. Low frequency quant fundsValue-growth (HML) strategy, momentum strategy FX carry tradese.g. Goldman Sachs’ Global Alpha, AQR, …

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2.4 Quant Crisis2.4 Quant CrisisFunds’ assets in general

(Knowledge) Acquisition Cost

Market Liquidity

Order of Liquidation

Proprietary trading strategy (incl. credit)

High fixed costs Low/High

High

∞

Standard trading strategy(incl. carry trade, HML)

Low cost

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2

Cash holding No cost 1

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2.4 Quant Crisis2.4 Quant Crisis

Why? Many (not only quant) funds liquidate “relatively”liquid positions firstQuant funds are particularly loaded on these factors

HML Accumulative Returns

0.88

0.9

0.92

0.94

0.96

0.98

1

1.02

1/1/2

0072/1

/2007

3/1/2

0074/1

/2007

5/1/2

0076/1

/2007

7/1/2

0078/1

/2007

9/1/2

007

Date

Deutsche Bank Carry Trade ETF

0.98

1

1.02

1.04

1.06

1.08

1.1

1.12

1.14

1.16

1.18

1/1/2

0072/1

/2007

3/1/2

0074/1

/2007

5/1/2

0076/1

/2007

7/1/2

0078/1

/2007

9/1/2

007

Date

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2.4 Quant Crisis2.4 Quant CrisisDaily HFR indexes

85

90

95

100

105

6/1/20

076/8

/2007

6/15/2

0076/2

2/2007

6/29/2

0077/6

/2007

7/13/2

0077/2

0/2007

7/27/2

0078/3

/2007

8/10/2

0078/1

7/2007

8/24/2

0078/3

1/2007

Cum

ulat

ive

Retu

rn

Equity Market Neutral Index Macro Index Global Index

HFR indexes

Stat arb crisis

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3. Mechanisms3. Mechanisms

Market liquidityEase with which one can raise money by selling the asset

Funding liquidityEase with which one can raise money by borrowing using the asset as collateral

Each asset has two values/prices1. price2. collateral value

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3. 3. The 3 Flavors of (the same)The 3 Flavors of (the same)Funding Liquidity RiskFunding Liquidity Risk

Margin funding risk Prime brokerMargin has to be covered by HF’s own capitalMargins increase at times of crisis

Rollover risk CPInability to roll over short-term commercial paper

Redemption risk Depositors, HF-investorsOutflow of funds for HFs and banks

Essentially the same!Maturity mismatch: Long-term assets but

short-term borrowing

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3. Mechanism 13. Mechanism 1Collateral Crisis due to Collateral Crisis due to Increased Vol.Increased Vol. + Losses+ Losses

Permanent price shock is accompanied by higher future volatility (e.g. ARCH)

Realization how difficult it is to value structured products

estimate defaultcorrelations

Value-at-Risk shoots upMargins/haircuts increase Collateral value declinesFunding liquidity dries up

Rating Jan-May 2007 July-Aug 2007Bond

Investment grade 0-3 3-7

High yield 0-5 10+

Leveraged Loan

Senior 10-12 15-20

2nd lien 15-20 20-30

Mezzanine 18-25 30+

ABS and CDO

AAA 2-4 8-10

AA 4-7 20

A 8-15 30

BBB 10-20 50

Equity 50 100Source: Citigroup, IMF Stability report 2007

Liquidity/Margin Spiral

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3. Mechanism 1 3. Mechanism 1 -- Margins for S&P 500 FuturesMargins for S&P 500 Futures

Collateral Crisis due to Collateral Crisis due to Increased Vol.Increased Vol. + Losses+ Losses

0%

2%

4%

6%

8%

10%

12%

14%

Jan-82 Jan-84 Jan-86 Jan-88 Jan-90 Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06

US/Iraq war LTCM

Asian crisis

Black Monday10/19/87

1989 mini crash

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3. Mechanism 1 3. Mechanism 1 –– Why ARCH? Why ARCH?

Collateral Crisis due to Collateral Crisis due to Increased Vol.Increased Vol. + Losses+ Losses

t1 2

Λ

p1

m1

100

120

80 m1

Λ

vt = vt-1 + Δvt = vt-1 + σt εtσt+1= σ + θ |Δvt |

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3. Mechanism 1 3. Mechanism 1 –– Hyperbolic Star Hyperbolic Star

Collateral Crisis due to Collateral Crisis due to Increased Vol.Increased Vol. + Losses+ Losses

x1 < W1/m1 = W1/(σ + θ|Δp1|)_

customers’supply

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3. Mechanism 13. Mechanism 1Collateral Crisis due to Collateral Crisis due to Increased Vol.Increased Vol. + Losses+ Losses

Liquidity spiralMargin spiral (Redemption/roll-over spiral)Loss spiral

Both spirals reinforce each other

Source: Brunnermeier & Pedersen (2007)

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3. Mechanism 23. Mechanism 2Collateral Crisis due to Collateral Crisis due to LemonLemon’’s Problems Problem

Financiers are concernedCollateral is more risky +Receive a particular bad selection of collateral

Issuer knows best what’s in the pool of assetsRecall CDOs are particularly difficult to price

As margins/ABCP rate increase, selection of collateral worsens

Leads to a further increase and hence worse selection ultimately leads to a market breakdown.

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3. Mechanism 3 3. Mechanism 3 Expertise, Complexity and DiscretenessExpertise, Complexity and Discreteness

CP stops to be viewed as “cash substitute”Buyers of ABCP do not conduct a credit analysis.No expertise in credit quality evaluationDeterioration in fundamentals makes credit evaluation necessaryWithdrawal from ABCP market

Expertise is only slowly build up again

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3. Mechanism 4 3. Mechanism 4 RunRun on Financial Institutionson Financial Institutions

Run before others run – DYNAMICDYNAMICFinancial Institutions

On Banks: Demand depositors, by withdrawing On HFs: Prime brokers, by increasing margins

Investors, by redeeming fundsOn SIVs: Investors, by not rolling over ABCP

Note: “Liquidation policy” of SIVs favors early withdrawals!

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3. Mechanism 53. Mechanism 5GridlockGridlock RiskRisk

Interweaved network of financial obligationsLender and borrower at the same time

Example:

Gridlock, if A loses 30m – Deadlock, if A loses 55mOpaqueness makes matters worse

Regulator can’t interveneWarren Buffett is less likely to help out

B30m50m

40m

40m C30m

A60m

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3. Mechanism 63. Mechanism 6Precautionary Precautionary HoardingHoarding

“Funding cushion” for adverse eventsincreases for 3 reasons

1. SIVs might draw on credit lines2. Borrowing at interbank lending market is more

volatile (since other banks might have SIV exposure)

3. Increased credit counterparty risk

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3. Mechanism 73. Mechanism 7KnightianKnightian UncertaintyUncertainty

Market freezes up, sinceInvestors focus on worst-case analysisif it is difficult to assign probabilities to different outcomes (like value of CDOs)Investors/banks hoard because they fear the worst

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4. Differences to Previous Crisis4. Differences to Previous CrisisCommon theme:Common theme:interaction between funding and market liquidity. 1987 crash: culprit was portfolio insurance trading1994 mortgage crisis: primarily prepayment risk1998 LTCM crisis: specific convergence spread arbitrage

trades were well knowne.g. on-the run and off-run spread (not much in 2007)

known main player which needed to be bailed out2000 Internet bubble – role of analysts2007 culprit:

rating agencies housing market correction maturity mismatch

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5. Conclusion5. ConclusionCrisis with traditional elements: due to mismatch of maturities

Interaction between funding and market liquidityNew level of opaqueness

Structured products are difficult to valueoff-balance sheet vehicles (SIVs) (Basel accord)

Several mechanism/“liquidity spirals” are at workCollateral crisis due to increased volatility Run on financial institutions (dynamic)Gridlock riskHoarding