Topic 10: GFC 2008/9

Question 1

what happened to credit during 2000s

Answer 1

credit boom until 2007 then began to shrink

Question 2

which two forces drove the boom

Answer 2

global demand for safe assets

financial innovation and inadequate financial regulation

Question 3

what is the story behind demand for safe assets

Answer 3

commodity prices rose and fast growth in EM -> higher savings in EMs and thus higher demand for safe assets

there was a lack of safe assets in EMs -> led to higher demand in the US since US considered safest

Implications:
capital account surpluses (and current account deficit) in US
capital account deficit (and current account surplus) in EMs

Question 4

what happened to interest rates pre crisis

Answer 4

real rates declined since late 1990s to low levels due to increased demand for savings (bonds as safe assets)

Question 5

what was the impact of the high demand for safe US assets on the US financial system

Answer 5

high demand for safe US assets could not be met by government bonds alone

US banks and other financial institutions increased their production of safe assets:
greater use of securitisation
greater use of short term debt
more mortgage lending (in order to create MBS out of them because they were running out of mortgages)

Question 6

What is a mortgage backed security (MBS)

Answer 6

mortgage loans are pooled together
securities are issued backed by the payments of the loans in the pool
they have a tranche structure (senior paid first, then junior)

Question 7

What is a collateralized debt obligation (CDO)

Answer 7

Pool together all the junior/risky tranches of a MBS
then issue this as a senior tranche (securities issued backed by the payments of the pooled tranches)

Question 8

What is a CDO squared

Answer 8

tranches of CDO consist of CDOs

Question 9

how did securitization grow pre crisis and which was most prevalent

Answer 9

rapid growth since 2000s, CDOs grew fastest

Question 10

who carried out securitization

Answer 10

Securitization is carried out by special-purpose entities which lie off the
balance sheet of the sponsoring bank.
Assets in the securitization pool remain with these entities even if the
sponsoring bank goes bankrupt

Question 11

who insured SIVS/conduits

Answer 11

Credit enhancements for securitized products were provided not only by
sponsoring banks but also by insurance companies

Insurers sold credit default swaps in order to insure CDOs/MBS (buyer pays a fee but received FV if CDO/MBS defaulted)

Question 12

What were the benefits of MBS

Answer 12

freed up capital for mortgage lenders to make new loans (removed the loans from balance sheet but kept the unrated tranches)

MBS tranches tailor to the different risk appetites of buyers

Question 13

What were the benefits of CDOs

Answer 13

Create additional highly-rated securities through diversification.

Investors cannot do this on their own.
(Investors required by regulation to hold AAA-securities cannot buy
BBB-tranches, but can buy AAA-tranche of mezzanine CDO)

Question 14

How is CDO risk heightened

Answer 14

correlation between the assets in the CDO = hightened risk

Question 15

how was there maturity shortening

Answer 15

Global demand for safe assets → Higher demand for safe short-term debt

Securitization transformed long-term debt (mortgages, other loans) into
short-term debt.

Led to greater use of short-term repo financing by investment banks
→ Investment banks provided liquidity insurance, acting as traditional banks

Question 16

what happened to mortgage lending

Answer 16

Mortgage growth was particularly pronounced in the lower end of the market (subprime)

Non-prime mortgages were 32% of all mortgages in value terms in 2005, up from 10% in 2003

Rise in securitization amplified mortgage boom

Within non-prime mortgages, lending standards declined

Question 17

what happened to house prices

Answer 17

Mortgage boom was associated with a boom in house prices.

House prices doubled from 2000 to 2006

Higher house prices = higher value of collateral = higher loans could be taken = US financial system became very exposed to mortgage defaults

Question 18

Who was exposed to risk, what was the risk and how

Answer 18

U.S. financial system became heavily exposed to a correlated nation-wide
increase in mortgage defaults.

Risk exposures were particularly large for investment banks and insurers.
Credit enhancements and liquidity backstops to conduits and SIV.
Direct holdings of junior tranches of CDO/CDO^2

Banks and mortgage lenders were also exposed

Question 19

what was regulation like and incentives pre crisis

Answer 19

Aggregate capital was inadequate for the risk exposure → Fragility.

Fragility was caused by a combination of
Inadequate financial regulation
Short-termism
Over-optimism (nobody thought housing market would crash)

Question 20

Why was there inadequate regulation / what was it

Answer 20

Credit enhancements and liquidity backstops provided to special-purpose
entities by sponsoring banks carried small capital requirements.
→ Excessive incentive to set up special-purpose entities.

Capital requirements were based on ratings, without sufficient distinction
between securitized products and corporate bonds

Rating agencies were paid by sponsoring banks. Fees for rating securitized
products were higher than for corporate bonds -> incentive to make ratings more optimistic, rating thresholds only just met

Question 21

what is short-termism / what was evidence for this

Answer 21

Things are going fine now, don’t care about future

Rating agencies continue to create an … “even bigger monster–the CDO
market. Let’s hope we are all wealthy and retired by the time this house of
cards falters.” E-mail exchange between two rating agency managers, 2006, as reported in 2008 SEC investigation.

Question 22

what is over-optimism and why was it there

Answer 22

No correlated nation-wide defaults in the U.S. since the Great Depression.
Rising house prices from 2000 onward.
Managers in securitization firms increased their personal exposure to the
housing market before the crisis

Question 23

Why did house prices decline

Answer 23

A correlated nation-wide increased in mortgage defaults could arise from losses within financial system
Prices of securitized products declined
Less demand to make / buy MBS/CDOs
Mortgage lending and house prices would decline

Question 24

The crisis (start)

Answer 24

Subprime – February to August 2007.

Increase in subprime mortgage defaults.
UBS and Bear Stearns incurred losses in their internal hedge funds.
Rating downgrades of subprime MBS and CDO.