Structured Finance and the Global Financial Crisis

Feb 23, 2009Arjun Jayadev Assumption College 2 Which Crisis? During the second half of the war, there was an explosion of easy credit, driven by capital from abroad. During the second half of the war, there was an explosion of easy credit, driven by capital from abroad. This resulted in lavish displays of wealth — and opulent living was seen, especially in New York. This resulted in lavish displays of wealth — and opulent living was seen, especially in New York. Housing prices soared during the war. Housing prices soared during the war. But when credit tightened afterward– collapse of real estate bubble and generalized crisis But when credit tightened afterward– collapse of real estate bubble and generalized crisis

Feb 23, 2009Arjun Jayadev Assumption College 3

Feb 23, 2009Arjun Jayadev Assumption College 4 Structural Adjustment in the US after 1970 Decline in Real Wages Hollowing out of Manufacturing Collapse in Personal Savings Increasing Household Indebtedness ‘Market Keynesianism’ Finance and Market Ideology Reign Supreme Intermediate Patterns Increasing Global Imbalances Financial Deregulation Monetary Policy alone Proximate Causes Global Savings Glut (Lower Long Term Rates Accommodative Monetary Policy (Low Short Term Rate Financial Innovation Growth of Shadow Banking = Housing Bubble

Collapsed Real Wages

Destruction in Household Balance Sheets (Personal Savings Rates)

Growing Indebtedness of Households

Finance and Manufacturing as Percentage of National Income

Global Financial Imbalances U.S. borrows 50 % of the worlds capital that is exported U.S. borrows 50 % of the worlds capital that is exported

Deficits and Debt

“You mean to tell me that the success of the economic program and my re-election hinges on the Federal Reserve and a bunch of f***g bond traders?” Bill Clinton From Woodward “ The Agenda” We’re Eisenhower Republicans here…We stand for lower deficits, free trade and the bond market. Isn’t that great? Bill Clinton-1998 Ideology

Feb 23, 2009Arjun Jayadev Assumption College 12 Financial Deregulation Gramm-Leach Bliley replaces Glass Steagall in 1998 Gramm-Leach Bliley replaces Glass Steagall in 1998 Commodities Futures Modernization Act (1999) Commodities Futures Modernization Act (1999) Sarbanes Oxley Rule (2002) Sarbanes Oxley Rule (2002) SEC deregulation of brokers (2004) SEC deregulation of brokers (2004) ‘Self Regulation’ and Trust in Ratings Agencies ‘Self Regulation’ and Trust in Ratings Agencies

Proximate Causes Easy Credit Easy Credit Search for Yield Search for Yield Regulatory Loopholes (particularly CFMA 1999, SOX,2002 and Leverage Rule, 2004) Regulatory Loopholes (particularly CFMA 1999, SOX,2002 and Leverage Rule, 2004) Shadow Banking/Securitization of Loan Chain Shadow Banking/Securitization of Loan Chain Discovery of Enormous (Hidden) Leveraging Discovery of Enormous (Hidden) Leveraging Inadequate capitalization leading to Liquidity and then Solvency Crises Inadequate capitalization leading to Liquidity and then Solvency Crises

Easy Credit

Equity markets and the Search for Yield Mortgage bubble took off in the aftermath of declining yield from shares Mortgage bubble took off in the aftermath of declining yield from shares

Structured finance: The players in securitization Originator End borrowers Conduit/trust/SPV/SPE/SIV Investment bank (underwriter) Rating agency Institutionalinvestor End lenders (wholesale) Insurancecompany Broker Servicer $ $ $ $ $ Mortgages Mortgages MBS I&P ($) CDOs, I&P ($) Financial returns ($) LEGEND KEY O&G – interest and principal SPV – special purpose vehicle SPE – special purpose enterprise SIV – special investment vehicle MBS – mortgage backed securities Founder: loan originator or investment bank Purpose: transfering ownerhship of claims (loans) and collateral (mortgages) in order to issue mortgage backed securities (bonds). Exposure of founder: implicit guarantee in case of large losses. Assigns credit rating to issued MBSs. Organizes issuing of MBSs and places MBSs to investors in financial markets. Broker places mortgage loans to borrowers for fee Manages the flow of interests and principal (I&P); usually, but not necessarilly the Originator Typically a specialized mortgage bank Mutual funds, pension funds, hedge funds… Can assume part of risks (insurance of mortgage loans, insurance of MBS returns).

Feb 23, 2009Arjun Jayadev Assumption College 17 A bank balance sheet Assets Assets Loans Loans Liabilities Liabilities Deposits Deposits Capital Capital

Feb 23, 2009Arjun Jayadev Assumption College 18 A shadow banking balance sheet Assets Assets Asset Backed Securities Asset Backed Securities Mortgage Backed Securities Mortgage Backed Securities Credit Default Swaps Credit Default Swaps Interest Rate Swaps Interest Rate Swaps Liabilities Liabilities Collateralized Debt Obligations Collateralized Debt Obligations Asset Backed Commercial Paper Asset Backed Commercial Paper

Feb 23, 2009Arjun Jayadev Assumption College 19 Banking versus Shadow Banking Banking FDIC FDIC Risk Adjusted Capital Adequacy Ratios Risk Adjusted Capital Adequacy Ratios Interbank Market sets price of liquidity (money) (LIBOR) Interbank Market sets price of liquidity (money) (LIBOR) Monetary Policy affects price, interest Monetary Policy affects price, interest rates, macro balance rates, macro balance No Equivalent of FDIC No Equivalent of FDIC No Capital Adequacy Ratios No Capital Adequacy Ratios No state control over liquidity creation No state control over liquidity creation Shadow Banking

IB Leverage

The ‘Magic’ of Securitization and Structured Finance

The CDS Market

“Subprime” Growth Subprime growth shot up in Subprime growth shot up in By 2006, most Subprime mortgages were securitized By 2006, most Subprime mortgages were securitized Share of subprime In total U.S. economy (measured by GDP): 1% (2001), increasing to 5% (2005)

Bubble in Housing Prices

The Crisis Begins... In August 2007, Crisis begins with first wave of sub prime Failures In August 2007, Crisis begins with first wave of sub prime Failures Overleveraged shadow banks (easy credit) were invest ed in very bad bets (subprime), at scale, with no liqu idity backstop (unregulated credit markets). Counterparty Risk was perceived as much larger. Liquidity starts freezing (Interbank markets start to experience wild shifts in ability to borrow and lend and much higher rates for borrowing)

Residential Real Estate Prices Crash

Crisis in Subprime Lending Crisis in Subprime Lending Crisis in Subprime Lending % of delinquent loans (60+ days) Months from origination

MBS’s lose value

Total Predicted Losses Trillion Dollars! (Oct 08)

Feb 23, 2009Arjun Jayadev Assumption College 31 TED-Spread: Liquidity Crisis

Feb 23, 2009Arjun Jayadev Assumption College 32 LIBOR-Overnight Interest Swaps spread (Measure of Interbank liquidity)

Global Declines in Stock Markets

Famous Last Words "We have a good deal of comfort about the capital cushions at these firms at the moment." "We have a good deal of comfort about the capital cushions at these firms at the moment." - Christopher Cox, chairman of the U.S. Securities and Exchange Commission, March 11, Christopher Cox, chairman of the U.S. Securities and Exchange Commission, March 11, 2008.

The Crisis of ? Bailout of Fannie and Freddie, Collapse of Lehman, Bailout of AIG…. The Paulson Plan -- $700 bn. rescue Contagion to UK and EU…. The Paulson $200 bn. TARP, Citi takeover Recapitalization (still unclear) Collapse of Aggregate Demand Worldwide Crisis, Fiscal Stimulus?