Size of Financial Markets Source: Bank of England Stability Report, 10/2007
Story A tiny part of securities markets has put asset markets around the world in a state of turmoil? How can that be?
Summary of Developments Prelude until August 9, 2007 Main Act from August 9, 2007 to September 16, 2008 Climax from September 16, 2008 to early 2009 – Financial crisis Denouement from early 2009 to ????
Structured Finance Mortgages are securitized – Residential Mortgage Backed Securities (RMBS) – Mortgages are pooled together and sold on the open market Agency securities Others Can be divided into tranches Tranching – Typical bond has all holders suffering losses proportionately – Structured financial instruments structure receipts of payments
Two Securities from One Subprime mortgages AAA rated security Equity tranche of security
Collateralized Debt Obligations Take set of securities and restructure their payments – Corporate bonds – Residential mortgage backed securities (RMBS)
CDO Deals Idiosyncratic and Traded over the Counter A trust, generally in the Cayman Islands owns the assets backing the CDOs and distributes payments Not standardized contracts Over-collateralization and triggers – Can build up a reserve account for possible losses – Can be contingent on delinquencies and losses Manager can be passive or active Traded over the counter
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 Mispricing of CDOs may partly explain the earnings from creating so-called arbitrage CDOs
Run on money market funds Northern Rock End of year
Run on money market funds Northern Rock End of year Kindergarten day
This Is Not All the Story House prices rose in many other places than parts of U.S. – House prices have fallen substantially in Ireland, Spain and other countries – Nothing directly to do with subprime mortgages or CDOs Widespread increases of leverage Widespread increases of maturity transformation
One Cause Source: http://library.thinkquest.org
Whos to Blame? My personal estimate of proximate causes in order of importance Fannie and Freddies purchases of subprime securities spurred on by Congress Financial innovations – CDOs – Reduced the cost of risky activities – Not clear how much this is due to increased issuance of subprime loans Private institutions took on more risk – Increased leverage – Increased maturity transformation
Regulators to Blame? Federal Reserve and low Fed Funds rate – Would have to establish that short rates were relatively low around the world, not just dollar rates John Taylor claims this in talks and in his book – Would have to establish that low rates induced people to buy houses even though long rates were unaffected Regulators – The combination of the developments caused the crisis – Its easy to see this after the fact
Financial Difficulties Its the truck you dont see that runs you down