Seite 1

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 2

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 3

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 4

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 5

Share prices during the Millenium Bubble

Seite 6

US- interest rates

Seite 7

US- house prices

Seite 8

US- house prices

Seite 9

Interest rates

Seite 10

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 CDO2: foreign banks, SIVs

- Rating: evaluation of counterparty risk follows historical data

- Neglect of macroeconomic risks (interest rate changes, housing price level)

- Leverage

Seite 11

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 0.93 =0.729

3 ·0.92 · 0.1 = 0.243

3 ·0.12 · 0.9 = 0.027

0.13 =0.001

Face value of portfolio: 300; expected return: 270

Seite 12

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 13

CDO2: 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 0.9723 =0.918

3 ·0.9722 ·0.028 = 0.079

3 ·0.0282 ·0.972 = 0.002

0.0283 =0.00002

Seite 14

CDO2: 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 15

CDO and CDO2: 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%, rating C

CDO-senior tranch: exp‘d return 99.9%, rating A

CDO-mezzanine tranch: exp‘d return 97.2%, rating B

CDO-equity tranch: exp‘d return 72.9%, rating C

CDO2-senior tranch: exp‘d return 99.998%, rating A

CDO2-mezzanine tranch: exp‘d return 99.8%, rating A

CDO2-equity tranch: exp‘d return 91.8%, rating C

Seite 16BIS 2007

Seite 17

Structure of an MBS

Seite 18

Mortgage loans

Seite 19

securitized and sold mortgage loans

Seite 20

Credit volume

Seite 21

Credit defaults

Seite 22

Credit defaults

Seite 23

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 24

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 25

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 26

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 27

Crash of the interbank-market

Blanchard (2009)

Seite 28

MSCI World

Dec 05, 2009

Seite 29

MSCI World

-37 %

Sep 15, 2008

Seite 30

Liquidity spiralsLoss 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 ofthe assets to keep their position. These sales depress the prices and tightenthe market liquidity further, inducing further sales and so on.

Margin spiral:Borrowers can get funding liquidity from the market, but are required to puttheir own capital at stake. Lenders reset margins each period. A liquidityshock raises the margins, because lenders become uncertain of the futureasset prices. Higher margins reduce the market funding and enforce moresales. As a result, the prices drop and the margins rise further, whichreduces funding liquidity again.

Network effects amplify spirals.

Brunnermeier (JEP 2009)

Seite 31

Liquidity spirals

Brunnermeier & Pedersen (RFS 2008)

Seite 32

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 33

Liquidity spirals

100 assets 90 deposits

10 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 re-establish leverage.

90 deposits

5 equity

95 assets

45 deposits

5 equity

50 assets

Seite 34

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 35

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

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.

govt. guarantee

private funds

Seite 36

Recapitalizing Banks

Banks prefered another option:

original bank

owns - bad assets

- good assets

good bank

owns - good assets

- bad bank (w/o license)

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.

govt. guarantee

private funds

Seite 37

Recapitalizing Banks

Outcome of bargaining process (in Germany):

original bank

owns - bad assets

- good assets

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.

govt. guarantee“good“ bank

owns - good assets

- SPV

Seite 38

Recapitalizing Banks

Outcome of bargaining process:

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

original bank

owns - bad assets

- good assets

govt. guarantee“good“ bank

owns - good assets

- SPV

good bank

owns - good assets

- SPV

govt. funds

Seite 39

Recapitalizing Banks

Example 1:

original bank

owns - bad assets => loss X

- good assets => profit 10

additional funds => profit 10, opportunity costs R

Bundesbank proposal

Banks‘ proposal

Bargaining outcome

Original shareholders

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)

20 – X – R (if X > 20)

Private investors 10 – R 10 – R 0