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Filename Discussion of “Deciphering the 2007-08 Liquidity and Credit Crunch” Markus Brunnermeier, Princeton Univ. * Any views expressed represent those.

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Presentation on theme: "Filename Discussion of “Deciphering the 2007-08 Liquidity and Credit Crunch” Markus Brunnermeier, Princeton Univ. * Any views expressed represent those."— Presentation transcript:

1 Filename Discussion of “Deciphering the 2007-08 Liquidity and Credit Crunch” Markus Brunnermeier, Princeton Univ. * Any views expressed represent those of the author only and not necessarily those of the Federal Reserve Bank of New York or the Federal Reserve System. Til Schuermann* Federal Reserve Bank of New York Liquidity Risk Conference, Imperial College London, UK, June 23-24, 2008

2 Filename 1 Some data  Spread between Treasury and Agency repo historically has been around 9 bp –March 26 it was around 141 bp  1-month LIBOR to Treasury spread average typically around 35 bp –April 25 around 208 bp!  Average 1-month LIBOR to OIS (overnight index swap) spreads are around 13 bp with a volatility of 3½ bp –April 21: 85 bp –volatility since Aug. 2007: 24 bp

3 Filename 2 Some more data  What’s a few trillion between friends…..  Early 2007: –ABCP + SIV + ARS + TOB + VRDM  $2.2 trn –O/N tri-party repo: $2.5 trn –Hedge funds AUM: $1.8 trn –Assets of 5 i-banks: $4 trn –Assets of 5 U.S. BHCs: $6 trn –Assets of all U.S. banks: $10 trn  Meanwhile, sum of write-offs to date (> $300bn) exceeds cost of S&L crisis (~ $250bn in current $)

4 Filename 3 Liquidity and the magic of securitization  Credit assets have traditionally been illiquid –Try trading a single mortgage, or credit card receivable  Securitization helped “liquify” these assets –Bundle, slice and sell  Need to solve significant information problems to get this done –How is an investor to efficiently evaluate a tranche of an ABS? –Can’t re-underwrite every credit in the pool –Credit rating agencies help address this information friction

5 Filename 4 Questioning the magic...  When it works, very efficient way of allocating credit risk / capital  Growth of securitization paralleled growth of repo markets –Efficient financing mechanism  But what if market participants feel the need to re- underwrite every credit asset in an ABS/MBS? –Mis-assessment of risk –Mis-valuation  Machine can grind to a halt

6 Filename 5 Liquidity: High overnight agency and MBS spreads to Treasury Source: Bloomberg

7 Filename 6 Liquidity: Abnormally low overnight Treasury repo rates Source: Bloomberg, FRBNY

8 Filename 7 Liquidity: Impact of TSLF Source: Bloomberg, FRBNY

9 Filename 8 Problems addressed by new lending facilities  TAF: illiquid term markets and the stigma that accompanies discount window borrowing.  TSLF: illiquid functioning in repo funding markets— illustrated by abnormal rates and high haircuts.  PDCF: the lack of market-based back-stop credit in repo markets. Depository InstitutionsPrimary Dealers Backstop Standing Facilities Discount WindowPrimary Dealer Credit Facility (PDCF) Auction FacilitiesTerm Auction Facility (TAF) Term Securities Lending Facility (TSLF) P Q

10 Filename 9 What can you pledge at the TSLF & PDCF?  TSLF: OMO collateral plus Aaa securities: private label RMBS, CMBS, Agency CMOs, ABS such as CDOs, CLOs  PDCF: above plus investment grade securities: corporates, munis, MBS (R and C), ABS –So long as it can be priced by the clearing banks  Importantly, previously repo-able securitized instruments are no longer “stuck” on firms’ balance sheets –Facilities designed as liquidity vehicles

11 Filename 10 Brunnermeier: overview  A well told account of events of 2007-08 (…?), embedded in modern theory of financial fragility –Emergence of subprime mess (spring 2007) –Liquidity crisis (starting late summer 2007) –Quant funds take a hit (August 2007) –Problems in interbank market (on and off since August 2007)  What’s the same, what’s different  Role of banks?

12 Filename 11 Banks as liquidity providers of 2 nd to last resort  A bank offers two short-term liquidity contracts A L E Loan commitments Transaction deposits  Seems very unstable –What if demand spikes for both at the same time? –And what if that happens systematically (affecting all banks) –Worry about bank runs

13 Filename 12 But maybe combining the 2 contracts reduces risk...  Diversification synergy –Combining transactions deposits and loan commitments reduces idiosyncratic risk –Transaction deposits hedge the systematic liquidity risk exposure of loan commitments  Flight to quality –Banks can bear systematic shocks to liquidity demand due to funding inflows –Deposit-lending synergy is stronger in a liquidity crisis (e.g. Fall 1998): hedging effect triples in size!  Theory: Kashyap, Rajan & Stein (2002); empirical: Gatev, Schuermann & Strahan (2007)  Seems related to government safety net –Funding flows not related to bank solvency or size –Effects absent prior to FDIC (Pennacchi, 2006)

14 Filename 13 Brunnermeier: banks hoard liquidity  Bank liquidity provision hasn’t worked so well this time –Banks hoarded liquidity  Why? –Size of off-B/S commitments in form of SPEs –Knightian uncertainty –Opacity of structured credit vehicles  Asymmetric information: never good, made worse with complexity of structured credit products and questions about rating agencies –But, with mark-to-market, transparency is increased and thus asy info problem mitigated

15 Filename 14 Brunnermeier: margin spirals  Right to focus attention on margins  Initial vs. variation margin –High initial, low variation: expensive up front, robust during crisis –Low initial, high variation: cheap up front, fragile during crisis  Hi-lo is stabilizing, lo-hi is destabilizing –In the face of stiff prime brokerage competition during good times, hard to maintain hi-lo  In presence of  asy info, margin requirements 

16 Filename 15 Agenda for strengthening financial infrastructure  Paper speaks directly to Geithner’s agenda for strengthening financial infrastructure –Establishment of central clearing house of CDS –Reduce level of outstanding contracts through bi- and multilateral netting –Incorporation of protocol for managing defaults into existing and future credit derivative contracts –Concrete targets for achieving substantially greater automation of trading and settlement

17 Filename 16 Thank You!

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