Crisis Dissected Brunnermeier (2009) Journal of Economic Perspectives

The Crisis, in numbers Housing sector Housing Bubble Burst: wiped out several hundred $ billion in bank loans US Stock market wealth dropped $8 trillion between 2007 and 2008 Why did small (!!) housing losses bring large stock market value decline ??? Economic situation, pre-crisis: very low interest rates, large capital inflows from Asia: (e.g. China’s export-for-growth strategy led to buy US bonds to undervalue exchange rate)

New Model: “Originate & Distribute” Traditional: mortgage loan, funded by deposits, held as asset for e.g. 30 years New: intermediaries (Fannie Mae, Lehman) pool loans into Mortgage Backed Securities (MBS) they sell to (hopefully) wipe risk off balance sheet Pools split into different quality tranches For investors offer higher return with diversification

To “Distribute”: Creating MBS Bank creates off-balance sheet SPV (special purpose vehicle) with its own balance sheet with Sell short-term ABCP backed by long-term MBS Bank gives SPV back-up credit line if trouble funding => bank retains risk, not reflected in balance sheet PRE-SPV POST-SPV SPV creator (e.g. Lehman) removes SPV from its balance sheet yet it still owns some equity in SPV

Trend 1: Create SPV to Move Assets off balance sheet: Sell “Asset-backed securities”, e.g. ABCP SPECIAL PURPOSE VEHICLE (SPV) AssetsLiabilities 20 Mortgage AAA 20 Auto Loan AA 10 Tranche 1 AAA 10 Tranche 2 AA 20 Credit Card A30 Tranche 3 A 10 Equity (Lehman’s share) Lehman also provided back-up credit line SPV sells ABCP with avg maturity 90 days ABCP short-term backed by long-term e.g. MBS (making shadow bank similar to normal bank (maturity transformation)

Trend 2: Investment Banks Used Greater Short-term Funding via Repos Investment Bank AssetsLiabilities Assets Repo 20 LT Debt 10 Equity Bank sells repo with avg maturity 90 days Saver $100 Collateral sale Collateral Saver $100 At maturity At inception

Security of MBS Some institutional investors allowed to buy only AAA rated paper (high-rated tranche offered attractive return) ABCP buyers could buy credit default swap (CDS) to insure against default CDS: pay periodic fixed fee, receive compensation if instrument defaulted Believed small risk of CDS counterparty (AIG) default

Banks Used SPV Credit Ratings to Minimize Capital Basel I: Did NOT require capital for SPV even if provide it credit lines => Banks could reduce capital required by moving MBS to SPV along with credit line to give SPV high rating Optimistic ratings on MBS based on: History: No drop in US housing prices since 1945 Diversified (different regions’ housing P uncorrelated) Banks worked with ratings agencies to ensure AAA tranche just met requirement

“We’re still dancing” Banks relaxed lending standards since loans’ risk passed to those buying MBS tranches Citigroup’s CEO on July 10, 2007 “…as long as the music is playing, you’ve got to get up there and dance. We’re still dancing” Brunnermeier’s “Event Logbook” is step by step account of crisis, pages 82 to 91

How Shocks Amplify to Crises when Liquidity Dries Up Decompose liquidity into 2 types : Funding liquidity Market liquidity Synonym for margin: buyer’s stake

Funding Liquidity: Ease of funding from uninformed savers Trader buying asset on leverage, uses asset as collateral (traders routinely buy shares on margin) Trader provides own equity (margin > 0) Only short term funding available Margin or haircut = (security P) – (collateral value) Linked to asset price volatility: low margin (e.g. 5% [borrow 95%]) only if lender can seize without loss in default lender Price Buyer’s stake Margin High margin (e.g. 90% [borrow 10%]): trader puts up much own NW For assets with volatile P (uncertain value)

Funding Liquidity: Will someone buy my short-run paper ? After purchase, lender may choose to increase margin (cuts loan => trader must put up more money) An illiquid trader must sell some of asset for new margin Funding liquidity risk: Can’t roll over debt if dubious quality Zero funding liquidity = 100% margin (no one wants your asset as collateral, you must pay 100%) Types of funding liquidity risk: Margin/haircut funding risk: rise in haircut Rollover risk: higher cost to roll over short-term Redemption risk: bank demand depositors withdraw lender Price Buyer’s stake Margin

Market Liquidity: ease of finding buyer when need to sell asset Market illiquid if need large P cut to sell asset Measured three ways: Bid-ask spread: how much traders lose if they sell 1 unit of asset and immediately buy back Market depth: how many units trader can trade at current bid/ask price without moving P Market resiliency: how long it takes for temporary P drop to regain initial P

Leveraged Security Buyer’s Loss Spiral A leveraged trader’s NW falls with P falling => tightens borrowing limit E.g. Investor buys $100m asset on 10% margin (use $10m own NW; borrows $90m) Margin = NW/A or 10/100 = 10% Leverage ratio (A/NW) = 100/10 = 10 If P drops to $95m, trader’s stake now $5 (still owes $90) If margin stays 10% trader may adjust NW or A in A/NW ratio: 95/NW = 10 => NW = 9.5, need to add 4.5 cash so again A/NW = 10 A/5 = 10 => A = 50 so need to sell $45 to reduce assets to $50m Selling assets to meet margin at low P => sale tends to further cut P

Leveraged Security Buyer’s Margin Spiral Reinforces Loss Spiral As margin requirements rise, trader must sell more to cut leverage ratio Example: After selling $45m (previous example) hold asset = $50m with own NW of $5 => A/NW = 10 If lender raises margin required to 20% (20% => A/NW = 5). Trader can either 50/NW = 5 => NW = 10, increase stake to $10 A/5 = 5 => A = $25 so sell $25m with $5 own stake. Again, selling at bad time cuts P

Borrower Balance Sheet: Margin Spiral Adds to Loss Spiral Lenders usually raise margins at times of large P drops & tighter credit Other traders shun asset Data shows P shock indicates future volatility (when margins rise) Financiers reject assets as collateral if question its value