1. Slides by Frederica Shockley California State University, Chico Source: http://research.stlouisfed.org/publications/review/08/09/Mizen.pdf http://research.stlouisfed.org/publications/review/08/09/Mizen.pdf The Credit Crunch of 2007-2008: A Discussion of the Background, Market Reactions, and Policy Responses - Paul Mizen

2. “Mispricing of Risk” Crisis Due to “mispricing of risk” of new, complicated assets based upon subprime & other mortgages. High leverage contributed to risk. leverage House Prices ↓→ Foreclosures↑ → Bank Failures ForeclosuresBank FailuresForeclosuresBank Failures

3. Background The “Great Moderation” -years of macro stability Low inflation Low inflation Low short-term interest rates Low short-term interest rates Steady growth Steady growth Global savings glut Development of complex financial assets

4. Credit Boom FedFed dropped rates after dot com bust & again after 9/11. Fed Rising house prices Stable economic conditions.

5. Disposable Income (DI) is income after taxes that is available for consumption & savings.

6. Savings Flowed into U.S. After 1997 Asian Crisis many countries bought U.S. treasuries & bonds. Asian Crisis treasuries & bondsAsian Crisis treasuries & bonds Prices of Bonds ↑→ interest rates ↓→ Credit ↑ Prices of Bonds ↑→ interest rates ↓→ Credit ↑ Savings from less developed countries funded our deficits with growing imbalance. Savings from less developed countries funded our deficits with growing imbalance. 1993 to 2005: U.S. savings as % of DI ↓ from 6% to 1%; Total debt to DI ↑ from 75% to 120%

7. This is debt to Disposable Income (DI) which is income after taxes that is available for consumption & savings.

8. U.S. Mortgages Prime: borrowers have good credit & meet income & house pricing requirements. Jumbo: borrowers have good credit & meet income requirements, but house price > amount set by Fannie & Freddie. FannieFreddieFannieFreddie Alt-AAlt-A have higher risk of default because they do not conform to Fannie & Freddie requirements. Alt-A Sub-prime: most risky loans often made to people with bad credit history.

9. Mortgage Originations

10. Sub-Prime Mortgages Grew Rapidly Late 90s increased to 13% of originations, but halted by dot com bust. 2002 – 2006: By 2006 Sub-Prime mortgages = 20% of originations. Borrower faces higher upfront fees. Lender faces higher probability of prepayment or default. prepayment

11. Asset Backed Securities Ginnie Mae Ginnie Mae & VA sold first securities backed by mortgages in 1968. VAsecurities Ginnie Mae VAsecurities $10.7 T in global asset backed securities by 2006 (Bank of England). Many purchased by off-balance sheet institutions owned by banks that originally sold securitized products. securitized

12. Complex Securities CDOCDO’s, CDO’s Squared, CDO’s Cubed! Squared CDOSquared Great variation in characteristics of sub-prime mortgages bundled together. Not all low credit quality Many borrowers depended upon rising home value to allow refi. Many who bought securities did not understand risk.

13. Sub-Prime Trigger The sub-prime mortgage market triggered the crisis. Default rates started increasing in 2006. Pooled mortgages Pooled mortgages risky because defaults positively correlated. Pooled mortgages Investors highly leveraged. If 20 to 1 → 5% loss → 100% capital ↓ If 20 to 1 → 5% loss → 100% capital ↓ Investors lose all with only low default rates. Investors lose all with only low default rates.

15. Global Impact Originator faced low risk even if borrower defaulted. Automated underwriting Automated underwriting & outsourcing of credit scores helped originators sell more mortgages. credit scores more Automated underwriting credit scores more With low interest rates throughout the world, investors “reached for yield.” Sales of securities went global.

16. Sub-Prime Assets Subprime was trigger, but other high yielding assets, e.g. hedge funds, could have started the crisis. hedge fundshedge funds People bought risky, complicated assets because return was high. After sub-prime defaults increased, rating agencies downgraded many sub-prime backed securities. rating agencies rating agencies

17. Corporations Lost Billions Assets difficult to assess → Uncertainty ↑ →banks stopped loaning to other banks. A write down is the amount by which an asset’s value is reduced.

18. Bear Stearns collapsed after hedge funds failed to rollover asset backed commercial paper.

19. Structured Investment Vehicle (SIV) Funds that borrowed in short term commercial paper market to finance assets that they held long term. Borrowed at low rate & bought long-term securities that paid high interest. Some intended to run indefinitely, but all gone by Oct. 2008. Oct. 2008Oct. 2008

20. Liquidity Crisis Banks afraid to loan because they might have to cover losses on their conduits or SIV’s. The Libor-OIS spread increased from a long-run 10 basis points to 364 in 10/08. OIS The London inter-bank offer rate indicates is the rate that banks charge each other for loans of 1 day to 5 years.

22. Three Month LIBOR – OIS Spread Indicator of confidence banks have in other banks. Usually about 10 basis points, but peaked at 364 on 10/10/08. GreenspanGreenspan says TARP decreased spread. Greenspan Source: http://www.microcappress.com/blog/credi t-re-freeze-nipped-in-the-bud/641/

23. Credit Markets Froze

24. Cost of Insurance Increased LCFI = Large Complex Financial InstitutionLarge Complex Financial Institution LCFI = Large Complex Financial InstitutionLarge Complex Financial Institution

25. Originate & Distribute Baking In use for 40 years, but opacity ↑ → mispricing of risk: Residential MSB’s backed by sub-prime mortgages ↑ Residential MSB’s backed by sub-prime mortgages ↑ Steps between originator & holder ↑ Steps between originator & holder ↑ Distorted incentives. Difficult to evaluate risk.

26. Six Bad Incentive Mechanisms 1. Mortgage brokers motivated by up-front fees independent of borrower quality. Often not employees of mortgage originators → not subject to regulation. Often not employees of mortgage originators → not subject to regulation. Fraud in some cases. Fraud in some cases. 2. Originators had no more incentive to seek quality borrowers than did brokers. Investors wanted more mortgages. Investors wanted more mortgages. Automated underwriting systems made mortgages loser & faster. Automated underwriting systems made mortgages loser & faster.

27. More Bad Incentives 3. Mortgages ↑→Securitization profits for originators ↑ Quality of new borrowers ↓ → Standards ↓ → NINJA loans – No Verified Income, Job, or Assets. Quality of new borrowers ↓ → Standards ↓ → NINJA loans – No Verified Income, Job, or Assets. Piggyback loans ↑ Piggyback loans ↑ Over time Risk of default ↑ Over time Risk of default ↑

28. More Bad Incentives 4. Tranching allowed financial entities to tailor securities for varying levels of risk preference. 5. Rating agencies made income rating these financial products. Issuers paid up-front fees to rating agency. Issuers paid up-front fees to rating agency. Rating agencies sold advice to issuers on how to get desired rating. Rating agencies sold advice to issuers on how to get desired rating.

29. More Bad Incentives 6. CDO’s ↑ → Return ↑→ Fund manager bonuses ↑ “As long as the music is playing, you’ve got to get up and dance. We’re still dancing.” Chuck Prince, former CEO Citigroup. http://research.stlouisfed.org/publications/revie w/08/09/Mizen.pdf (page 22) http://research.stlouisfed.org/publications/revie w/08/09/Mizen.pdf

30. The Result Incentives of brokers, originators, SPV’s, rating agencies, & fund managers the same. SPV No principal agent problem! principal agent problemprincipal agent problem

31. Regulation, Supervision, & Accounting Practices Originators often ignored the quality of borrowers & Fed & state agencies did nothing. Originators may have engaged in predatory lending. Consumer protection legislation not enforced.

32. CRACRA Regs Encourage Risky Loans CRA HUDHUD required Freddie & Fannie to buy mortgage securities for low income homeowners mid 90s. HUD HUD expected originators to impose higher standards on such lenders, but Freddie & Fannie bought the mortgages anyway. Such securities increased 2004 to 2006.

33. New Fed Rules for “Higher Priced” Mortgages Source: http://research.stlouisfed.org/publications/review/08/09/Mizen.pdf (Page 30)http://research.stlouisfed.org/publications/review/08/09/Mizen.pdf Escrow First lien mortgage loans are the first or original mortgages taken out when someone buys a mortgage. Escrow First lien mortgage loans are the first or original mortgages taken out when someone buys a mortgage.

34. Other Potential Changes Require banks to hold same capital requirements for “off-balance-sheet” entities, e.g. SIV’s & conduits. Regulators need to evaluate the “big picture” in order to reduce the externality cost of excessive risk taking.

35. Regulation of Rating Agencies Rating agencies should be single product firms. They need to use models that take into consideration longer spans of data. They need to be subject to regulation.

36. Conclusions Reasons for credit crisis: Period of macro stability with low inflation & low interest rates. Period of macro stability with low inflation & low interest rates. Big increase in supply of loanable funds. Big increase in supply of loanable funds. Financial innovation resulted in complex instruments, e.g. MBS’s. Financial innovation resulted in complex instruments, e.g. MBS’s. Higher leverage; Sub-prime mortgages. Risk assessment failed. Risk assessment failed.

37. Conclusions No one expected housing prices to fall nationwide. Nationwide falling housing prices & higher interest rates led to defaults. Other high yield assets, e.g. hedge funds, could have been trigger. Bank failures led to credit freeze in commercial paper.

38. Conclusions Central bankers stepped in to provide liquidity. Regulation will need to increase if we are to prevent future crises.