L20 - Financial Crisis II

Question 1

Why did the 07-09 Financial Crisis spread so far?

Answer 1

• The crisis emanated in the USA and quickly spread to the UK probably because of its close economic relations with the USA. It then quickly spread to Europe and then on to the rest of the world.
• Contagion spread easily to the UK partly because of the size of its financial markets, some of which are the largest in the world, and partly because of the financial interconnectedness between London and New York
• This financial interconnectedness was most clearly revealed when Northern Rock, the market leader in the UK in mortgage provision at the time, experienced the first bank run in the UK in over a century.
• Like all other mortgage providers in the UK and the USA, Northern Rock’s balance sheet had expanded rapidly in the years prior to 2007 and it continued to do so throughout 2007.
• By way of example, in 2007, Northern Rock sold mortgages worth a record £10.7 billion, up 47 per cent from a year ago which was equivalent to 19 per cent of all new mortgage policies sold in the UK.

Question 2

What happened to Northern Rock?

Answer 2

• Northern Rock was funding a sizable portion of its mortgage provision by borrowing on the short-term money markets in the USA and, in keeping with the maturity transformation function of banks, lending for long-term mortgages in the UK.
• When the liquidity run on the US money markets gathered momentum Northern Rock was obliged to turn to the Bank of England as lender of last resort for liquidity provision on September 12th 2007, or face imminent collapse.
• This was granted on September 14th 2007 – almost a full year to the day before Lehman Brothers filed for Chapter 11 Bankruptcy (basically bankruptcy protection) in the USA often (incorrectly!) cited as the start of the financial crisis.
• The Bank of England bailout involved loans of the order to Northern Rock in the first few days following the Bank’s agreement to provide short term liquidity.
• It’s important to realise that Northern Rock was basically sound, that is, the bank’s assets were always sufficient to meet its long-run liabilities, but it had difficulties in raising money market funds to turn over its existing debt (the customary procedure) to underwrite its existing loans to home buyers.

Question 3

When did Northern Rock’s problem’s surface?

Answer 3

• Northern Rock’s problems surfaced because institutional lenders in the USA were becoming nervous about lending to mortgage banks following the US sub-prime crisis.
• Having failed to attract suitable takeover bids, Northern Rock was temporarily nationalised on February 22nd 2008. In other words, the international nature of the financial sector accompanied by maturity mismatches of assets and liabilities imported the crisis to the UK
• . But that begs the whole question of why lenders were becoming nervous about lending to mortgage providers in the first place

Question 4

What could be said to be the first sign a crash was imminent?

Answer 4

• On reflection, the first signs that something was about to happen came from the growing problems experienced by Bear Sterns. Bear Sterns was a New York based investment bank , securities trading and investment bank.
• It was not the biggest bank, but it was clearly ‘big’ with total assets in excess of $335bn at the end of 2005.
• At this time it was a big player in securitised mortgage provision and, as it’s financial position deteriorated, it increased its exposure to securitised market, especially mortgage backed securities, holding ever increasing amounts of what became toxic assets.

Question 5

In 2007 just before the collapse what was Bear Sterns exposure to the derivatives markets?

Answer 5

• By 2007, shortly before the bank’s collapse, their exposure to the derivatives market had grown to in excess of $13tn. They were clearly participating in the market for Credit Default Swaps.
• However, things took a turn for the worse when two hedge funds managed by Bear Sterns and heavily involved in the sub-prime mortgage market ran into difficulty.
• Bear Sterns response was to use its own collateral to bail out one of these (the lower risk fund). However, it offered to fund a bail out of only $25m for its other fund effectively seeking a market based bail out for this fund.
• This implied lack of confidence was quickly seized on by the market.

Question 6

(5) When Bear Sterns was struggling what did Merrill Lynch do?

Answer 6

• Instead of funding being forthcoming, Merrill Lynch called in $850 million collateral place with Bear Sterns but only managed to realise $100 million from sales of this.
• Contagion was already embryonic and there was widespread marking down of portfolios across the market as concerns gathered momentum and spread.
• Within a few weeks, as the sub-prime mortgage market collapsed, both funds were worth only a fraction of their value even when Bear Sterns was seeking to bail them out.

Question 7

(6) What happened on March 14^th 2008?

Answer 7

• Bear Sterns troubles continued to mount and on March 14th 2008, in response to a request for assistance, the Federal Reserve Bank of New York (in many ways the premier federal reserve bank in the USA) agreed to provide a $25bn temporary bail out.
• The bail out was temporary (28 days) because the New York Federal Reserve believed that Bear Sterns was fundamentally sound in the long term and that its problems stemmed from a temporary mismatch between its assets and its liabilities.
• The temporary facility was designed to give Bear Sterns time to re-structure unencumbered by lack of funding

Question 8

(7) Why was the temporary Bailout for Bear Sterns changed?

Answer 8

• The temporary facility was designed to give Baer Sterns time to re-structure unencumbered by lack of funding.
• The view taken clearly implies that Bear Sterns was ‘too big to fail’ and that a full blown collapse of Bear Sterns would send shock waves through the financial markets with severe implications for the real economy.
• However, before it was provided, the nature of the bail out was changed indicating a rapidly changing environment.
• The new arrangement was that the New York Federal Reserve would effectively buy $30bn of Bear Sterns assets and the remainder would be taken over by J. P. Morgan Chase.
• Initially a stock swap was agreed and equity in Bear Stearns was valued at $2 a share
  
  • • less than seven per cent of Bear Stearns‘ market value just two days before and around one per cent of its value just over a year earlier.
• Subsequently, and mainly to placate shareholders in Bear Sterns, equity in Bear Sterns was re-valued at $10 per unit, still well below what it had been trading at days earlier.

Question 9

(8) What other banks in the US were heavily involved in the sub-prime mortgage business?

Answer 9

• Like Bear Sterns and J. P. Morgan Chase, Lehman Brothers, was heavily involved in the sub-prime mortgage business.
• Significantly, and despite the unfolding events, the purchase of Bear Sterns by J. P. Morgan Chase was to be funded by collateralised loans linked to securitised home mortgages! (Spot the danger!)
• Since any losses arising out of this arrangement, including the first $1bn of the bail out provided by the Federal Reserve Bank of New York would initially be borne by J. P. Morgan Chase, J. P. Morgan Chase were exposed to disproportionately risk. (Spot the danger again!)
• However, for some undisclosed reason, Lehman Brothers retained on their books relatively large holdings of subprime and other lower-rated mortgage tranches when securitising the underlying mortgages.
• When the property market collapsed, Lehman Brothers, the fourth largest bank in the USA faced growing and unprecedented losses.

Question 10

(9) What happened when Lehman Brothers collapsed?

Answer 10

• However, for some undisclosed reason, Lehman Brothers retained on their books relatively large holdings of subprime and other lower-rated mortgage tranches when securitising the underlying mortgages.
• When the property market collapsed, Lehman Brothers, the fourth largest bank in the USA faced growing and unprecedented losses.

Question 11

What did the emergence of securitisation lead to an increase in?

Answer 11

• The emergence and growth of securitisation made possible increases in leverage unheard of before securitisation.
• These increases in leverage were systemic and introduced fragility into the economy that was apparently unnoticed or, at the very least, tolerated, by the authorities until the financial crisis erupted.
• Because of the importance of banking to the performance of the entire economy, fragility in the financial system introduced fragility into the corporate and household sectors and, in the case of Greece, to government.
• The combined effect was to increase the fragility of the financial system …….. Increases in leverage are a real phenomenon, but the fact that they went unnoticed pr tolerated for so long is behavioural.

Question 12

How leveraged was Bear Sterns and Lehman Brothers?

Answer 12

• As an example Bear Sterns and Lehman Brothers, to focus on just two banks, were highly levered. Shortly before the crisis broke, Lehman Brothers had assets of $680 billion supported by only $22.5 billion of firm capital.
• This relatively high level of leverage (a multiple of more than thirty) made it vulnerable to even relatively small declines in real estate prices. (Bear Sterns apparently had an even higher level of leverage but I have no figures to confirm this though the general magnitude of their leverage is undoubted.)

Question 13

Why did leverage increase to such a degree?

Answer 13

• But this begs the question of why leverage was increasing.
• Optimism and what Keynes referred to as “Animal spirits” is one reason and this is decidedly behavioural.
• 7However, low and falling interest rates globally along with benign economic conditions almost certainly compounded any feelings of optimism and, to the extent that this created a view that liquidity constraints were no longer relevant, would have spurred the growth of leverage

Question 14

What impact did the increased leverage have business and homeowners?

Answer 14

• Leverage in all sectors because when the value of assets deteriorates or becomes more uncertain, then the higher the leverage, the higher the probability that capital would be placed at risk and this increases the risk that the institution or household will become bankrupt.
• During the crisis asset values declined and by May of 2008, 850 UK companies had gone into administration, a rise of 54 per cent on the previous year. In the household sector, despite several efforts by the government to keep homeownership intact, repossessions increased in October 2008, by more than 70 per cent to over 11,000.

Question 15

What impact did the increased leverage have on UK financial institutions?

Answer 15

• Some idea of the extent of how fragile the financial system in the UK had become because of liquidity problems stemming from over leverage can be gleaned from numerous bank nationalisations and part-nationalisations.
• The relatively high rate of asset write downs with the prospect of more write downs to come, the UK Government nationalised Bradford and Bingley in September 2008 with the government taking control of £50 billion of mortgages and loans while selling the savings side to Santander.
• In October 2008, Lloyds took over HBOS the largest mortgage lender with about 20 per cent market share for £12 billion with a deal engineered by the government, and RBS was effectively under government control due to a large capital injection in the same month.

Question 16

What did Szego (2008) believe triggered the financial crisis?

Answer 16

• During the 1990s, economic conditions were benign, asset prices were rising, and there was no doubt a widespread feeling of economic optimism.
• Some idea of the extent to which risks were underestimated can be gleaned from the fact hat a large number fraudulent and criminal mortgages came to light in 2007 and it has been suggested that this was one of the triggers of the sub-prime crises, along with the availability of mortgages for low income or volatile income households

. (Szego, 2008) Szego, G. (2008), “The crash sonata in D major”, working paper, La Spienza University of Rome, Rome. (Read with caution!)

Question 17

How did perceptions of the risk of the sub-prime mortgage market come a change in the UK?

Answer 17

• In the years preceding the crisis, banks and mortgage providers were reporting relatively high profits and stock prices were rising. All this changed in the UK when the news of Northern Rock became public.
• Look at the archive footage of people queuing in front of the bank to withdraw their savings. Remember, this was the first bank run in the UK in over a century and it changed everything overnight adjustment increases with the level of optimism prior to the negative signal.
• The first negative signal was to be accompanied by more and more bad financial and economic news as the financial crisis unfolded and gathered momentum.
• This underestimation of risks is a behavioural factor – but the economic consequences of this are real enough!

Question 18

How did securitisation affect accounting pre-financial crisis?

Answer 18

• The accounting systems widely used today have evolved over time and certainly pre-date the emergence of securitisation.
• They have not coped well with increasing complexity of financial instruments. Securitisation has led to the emergence of complex assets that are hard to value and reflect on banks’ balance sheets.
• Many of these newly created assets do not even appear of banks’ balance sheets For example, and notwithstanding the example of Bear Sterns and Lehman Brothers given earlier, in the UK, HBOS had securitised £55 billion worth of mortgages rated AAA(!) in 2008. Of the two other part-nationalised institutions, RBS had £36 billion and Lloyds £23 billion of securitised mortgages.

Question 19

How did the opacity of the balance sheet feet into a lack of understanding of the risk involved?

Answer 19

• The opacity of balance sheets to reflect these and other complex assets that embed contingent liabilities, that is, credit default swaps etc) is one major reason for the crisis of 2008.
• Other things equal, securitisation is a major improvement in risk allocation since shocks can be absorbed more effectively by a large group of investors rather than a single institution. - (people could only see the benefits)
• However, the complexity in the design of instruments and the lack of capacity in accounting systems to represent them fully led to opacity and consequently, lack of understanding of the risks involved.

Question 20

How were tranches represented on the balance sheets?

Answer 20

• We have seen in earlier lectures that different tranches were combined into one security; derivative securities were constructed from derived tranches of mortgages and the original mortgage was translated into a security that was impossible to value accurately.
• The contingencies embedded in those instruments were not reflected in any form on the balance sheets.
• At the time of the first round of bank recapitalizations in October 2008, these difficult-to-see on balance sheet and difficult-to-value toxic assets were estimated to be up to £200 billion for the economy. Later in 2009, estimates for one bank, the RBS were £300 billion alone. Small wonder risks were underestimated!

Question 21

What problem the opacity of balance sheets cause and the financial crash started to spread globally?

Answer 21

• When faced with liquidity shortages, institutions have to sell assets and asset values decline. But when the assets are opaque and thus difficult to value, the increase in uncertainty leads to a greater risk of solvency, and thus further bank runs.
• This was high on the agenda of thinking by the authorities at the time.
• Deleveraging by reducing asset holdings is no longer an option in these circumstances. The only option remaining is to cut credit lines to borrowers and reduce the maturity and quantity of loans.
• With the severe effects this would have on the economy in mind, the UK Government promised continued access to mortgage and small business lending in every intervention including recapitalisations.