Week 4 - Financial crises: consequences

Question 1

How did the principle of MORTGAGE SECURITISATION supposedly enable the creation of low risk bonds out of subprime mortgages?

Answer 1

Mortgage securitisation was carried out through the “ORIGINATE-AND-DISTRIBUTE” model.
1. Originator banks lent money to thousands of subprime borrowers. These loans are securitised, i.e. the banks repackage them into tradeable bonds called mortgage-backed securities (MBS)…
2. by pooling together the subprime borrowers’ INTEREST and PRINCIPAL PAYMENTS into a COMMON MORTGAGE POOL.
3. This mortgage pool is split up into thousands of SMALL PIECES, with each being the UNDERLYING COLLATERAL for thousands of MBS bonds.
- The MBS bonds are sold to investors, in which the interest payments made by the subprime borrowers are passed onto the investors as their interest payments.
4. The RISK of INVESTING in MBS bonds is reduced, as these bonds are made up of small pieces of thousands of different mortgages with UNCORRELATED RISKS.
- The risk of default is DIVERSIFIED.

5. The risk is further diminished through TRANCHING, which creates HIGH GRADE investment bonds {AAA} with SENIORITY OF CLAIM.
   {^investors can decide which level of risk to take according to their risk appetite}
   - These bondholders are first in line to receive interest payments from the common mortgage pool,
   - shielding them from potential subprime losses which are primarily borne by the LOWEST GRADE EQUITY BONDHOLDERS {Bb}.

Question 2

Why is the principle that individual mortgage risks in Mortgage Securitisation were uncorrelated fundamentally flawed?

Answer 2

MS relied on the flawed assumption that not all borrowers would default simultaneously, that individual mortgage risks were uncorrelated.
1. But this failed to take into account that sometimes all borrowers do default simultaneously due to ECONOMY-WIDE FACTORS,
e.g. house price busts and recessions.
2. In these circumstances, the common mortgage pool becomes empty so that even INVESTMENT GRADE BONDHOLDERS at the head of the queue can make losses.

Question 3

Mezzanine bonds were still quite RISKY and hard to sell, so what did banks do with them? How are CDOs created?

Answer 3

Riskier Mezzanine MBS were usually re-packaged and sold as new securities to be more attractive: collateralised debt obligations (CDOs).
- A CDO is essentially created through another round of SECURITISATION… & supposedly diversified risk even further.
- …in which MBS bonds originating from different TRANCHES (and geographically dispersed regions) are bundled together…

Question 4

Moral hazard

Answer 4

The incentives of agents to engage in undesirable activities because they do not bear the consequences of their actions.

Question 5

Originator banks who created the mortgages underlying the MBS bonds earned a NON-CONTINGENT FEE (i.e. not based on the subsequent performance of the mortgages).
We also saw that the COMPLEXITY of MBS products {due to securitisation} created a LACK OF TRANSPARENCY making it difficult for investors to assess how much they were really worth {& to estimate the risk involved}. What moral hazard problem did these factors give rise to?

Answer 5

1. The originator banks had LITTLE INCENTIVE to SCREEN for HIGH QUALITY BORROWERS, as they simply sold off the loans shortly afterwards and received a non-contingent fee, hence BORE NONE of the LONG TERM RISK of the loans.
2. The lack of transparency allowed them to SNEAK BAD LOANS into the mortgage bundles.

Question 6

Financial regulators usually forced originator banks to hold on to a chunk of the lowest quality equity grade bonds.
Why did they think this would mitigate the moral hazard problem?

Answer 6

The originator banks are forced to have more “SKIN IN THE GAME”,
ie. they would be MORE EXPOSED to the RISK of subprime defaults improving incentives to carefully screen borrowers.

Question 7

2 triggers of the subprime mortgage crisis

Answer 7

1. 2004-07 US tightened monetary policy significantly, increased interest rates by 4 p.p.
   - Borrowers could no longer keep up with their repayments & started to DEFAULT in huge numbers.
2. Aug 2006 US house prices started falling (house price bubble finally burst)
   - The underlying COLLATERAL of the subprime loans became IMPAIRED & banks holding the subprime MBS bonds made significant losses.

Question 8

Insolvency vs Illiquidity

Answer 8

Insolvent bank, eg. Lehman Brothers
1. If assets < liabilities, ie. owes more than it owns
2. Should be allowed to FAIL

Illiquid bank (aka liquidity shortage), eg. Northern Rock
1. If it does not have the funds to meet its current debt repayments,
ie. temporarily unable to pay its bills {due to lack of reserves}
2. Should be BAILED OUT

Question 9

Bagehot dictum

Answer 9

State that a central bank must only rescue illiquid banks & not insolvent banks.
- LENDER OF LAST RESORT, ie. provides emergency lending (LIQUIDITY SUPPORT) to an illiquid bank

Question 10

Bank run & what causes it

Answer 10

1. Occurs when all depositors rush to the bank SIMULTANEOUSLY to WITHDRAW cash (happens in exceptional circumstances)
   - Ppl run to the bank to get to the front of the line to get paid first, scared that the bank will run out of funds
   - Can cause a solvent bank to become insolvent
2. Banks keep only a SMALL % of deposits as RESERVES; they lend out the rest to firms and households (fractional reserve banking)
   - b/c normally only a small fraction of depositors will need to withdraw their cash at any given moment.

Question 11

Northern Rock illiquidity

Answer 11

1. NR was a solvent bank with minimal investments in subprime mortgages.
2. It relied heavily on (short-term, 3 months) BORROWING from other
   financial institutions in the INTERBANK MARKET, rather than traditional retail deposits
3. Didn’t have enough retail deposits to repay its short-term debts & no bank will RENEW its funding b/c of the fear & SUSPICION from the subprime crisis
4. Hence, experienced a LIQUIDITY SHORTAGE - temporarily unable to ROLL-OVER its debts but not insolvent
5. Forced to seek liquidity support (emergency lending) from BoE - Bagehot dictum
6. But this initiated rumours among the public that NR was insolvent due to subprime losses, NR had the 1st BANK RUN since Victorian England

Question 12

4 stages of a bank run -> insolvency

Answer 12

1. RESERVES are depleted
   - b/c many customers want to withdraw their cash
2. Loans (illiquid assets) must be LIQUIDATED at “FIRE SALE VALUE”,
   ie. heavily discounted below market value b/c the bank needs the cash in a hurry
   eg. loans are sold to HSBC and HSBC buys them
   3.The bank cannot meet all its withdrawal demands b/c RESERVES + FIRE SALE VALUE OF ASSETS < DEPOSITS!
3. Eventually the bank runs out of cash & must be declared insolvent, closed by financial regulator

Question 13

Capital ratio

*The subprime losses were eroding their capital ratios so banks were to cut off lending to reduce risk & reduce risk of insolvency.

Answer 13

= Capital / assets

Question 14

Why do banks hold capital?

When does a bank become insolvent w.r.t. capital?

Answer 14

1. Capital = assets - liabilities
2. Banks hold capital to create a CUSHION against losses {that might be made when bank has made risky investments}…
   - When hold more assets, need to hold more capital b/c higher chance that the assets will fall in value during recession
3. …& thus REDUCE risk of INSOLVENCY
   - The more capital bank is holding, the more its assets can fall in value before the bank becomes insolvent.

A bank becomes insolvent when capital is depleted to 0

Question 15

Equity vs Debt trade-offs

Answer 15

1. Debt is much CHEAPER than equity
   eg. bondholders expect 2% return, shareholders 9% (from lecture)
2. but debt bears the RISK of INSOLVENCY
   - If not enough money to repay debt interests, debt holders can SUE the bank for BANKRUPTCY but not equity holders.

Question 16

Too big to fail

Answer 16

A bank is regarded as “too big to fail” if it is so LARGE and so INTERCONNECTED with other banks that allowing the bank to fail would have such disastrous consequences for the FINANCIAL SYSTEM as a whole and the wider (real) ECONOMY that the government would always be forced to BAIL it OUT.

Question 17

How did banks boost their capital ratios?

Answer 17

By DELEVERAGING.
1. Selling assets & repaying debts
- rmb that assets are the denominator
2. Cutting lending
- main assets on balance sheet are loans. So this is the easiest way to reduce assets

Question 18

Reforms to REGULATORY CAPITAL REQUIREMENTS were the chief reforms following the financial crisis - How does requiring banks to hold MORE CAPITAL (Basel III Accord) decrease the risk of bank insolvency? How does it decrease the associated moral hazard problem?

Answer 18

1. Forcing banks to hold more capital INCREASES the MARGIN between assets and liabilities and thus allows the bank to ABSORB LARGER LOSSES before becoming insolvent.
2. When a bank is forced to hold a large amount of equity capital, its SHAREHOLDERS have more INCENTIVE to MONITOR its risk-taking activities closely as they have more “skin in the game”, i.e. MORE TO LOSE if the bank goes bust.

Question 19

Contingent convertibles (coco bonds)

Answer 19

1. Cocos convert from DEBT into loss-absorbing EQUITY in bad times, when capital falls below thresholds
   - ie. investors get div payments but no right to sue bank for bankruptcy when int payments are not made
2. Achieve the best of both worlds in terms of decreasing BANK INSOLVENCY RISK but without compromising PROFITABILITY by…
   - combining LOW COST advantages of debt finance &
   - LOSS-ABSORBING advantages of equity finance during bad times when capital buffers are most needed

Question 20

Liquidity regulation by Basel III - Liquidity coverage ratio meaning

Answer 20

A bank must hold sufficient high-quality liquid assets to cover its total net cash outflows over 30 days

Question 21

How does the US Volcker rule aim to DECREASE BANK INSOLVENCY RISK? Why did the Trump administration relax these restrictions?

Answer 21

1. The Volcker rule BANS banks from PROPRIETARY TRADING in RISKY assets (i.e. trading in RISKY assets by banks for their own profit)
2. PROTECTS the bank from incurring large losses {if the trade goes bad} which might cause EROSION OF CAPITAL to the point of insolvency.
   ^this is a MORE DIRECT MEASURE to curb moral hazard by regulating the COMPOSITION of ASSETS that banks can invest in
3. The Trump administration relaxed the rules due to the COSTS imposed on the FINANCIAL SERVICES INDUSTRY in complying with the rules.

Question 22

How do alternative measures to directly target bank executives’ COMPENSATION decrease moral hazard & their excessive risk-taking behaviour? (from PS4)

Answer 22

1. Bonuses to be paid out for a number of years after they have been earned and only if the firm has remained in good health
2. Will reduce traders’ INCENTIVES to invest in high-yielding, risky assets which
   flatter short-term profits but at the expense of the banks’ long run solvency

Question 23

In the aftermath of the financial crisis, the UK government dramatically increased the deposit (full) insurance limit from £2000 to £85,000. How does this forestall the possibility of a bank run?

Why do you think the UK government was reluctant to increase deposit insurance before the crisis occurred? (from PS5)

Answer 23

1. Due to limited reserve holdings, depositors realise that they might not get back 100 cents on the dollar, hence they will all rush to be first in line to withdraw, which causes INSOLVENCY through a SELF-FULFILLING EQUILIBRIUM.
2. Increasing deposit insurance averts the self-fulfilling eqm b/c depositors’ savings would be GUARANTEED by the government even if the bank fails. Hence, they will stay at home and the bank run is averted.
3. The UK government was reluctant to increase deposit insurance due to concerns about MORAL HAZARD.
4. With the SAFETY NET provided by DI, depositors know they will not suffer losses if a bank fails, so they do not impose market discipline on these institutions by withdrawing funds when they suspect that the bank is taking on too much risk.
5. Banks with a government safety net have an incentive to make risky, high interest loans to borrowers, as they are not exposed to the downside risk which is borne instead by the TAXPAYER.

Question 24

In debating the merits of raising capital requirements, the authors refer to a trade-off between “bank stability and profitability”.

2 reasons raising capital requirements might harm investment spending (from PS4)

Answer 24

Equity finance is significantly more EXPENSIVE than debt finance as shareholders demand a higher return to compensate for higher risk.
1. Banks in pursuing profit maximisation might choose to meet the higher capital requirements by DECREASING ASSETS, in
particular CUTTING LENDING, instead of raising additional equity.
- the credit supply curve shifts left and loan rates increase.
2. Higher equity requirements CONSTRAIN banks’ ability to engage in LEVERAGING and decreases profit margins and in turn, shareholder returns. (decreased profitability, leading to lower lending)
- Consequently, may be hard for banks to raise additional equity even if they wanted to, forcing bank closures which decreases market competition leading to higher interest
rates for borrowers.

In both cases, firms face HIGHER BORROWING COSTS which induces them to cut investment spending.
- However, this effect may be overstated as bigger capital buffers make banks safer, so the cost of other forms of funding (like bonds) should fall, as bondholders are willing to accept lower interest rates due to lower risk.

Question 25

Why is the moral hazard problem more acute for banks which are regarded as “too big to fail”?

Some regulators have argued breaking up large banks into smaller banks should relieve this problem. 2 drawbacks of this policy? (from PS4)

Answer 25

In addition to FDIC covered depositors, there is also an implicit safety net for non-FDIC insured creditors such as bondholders and depositors above the $250,000 limit.
1. Thus, none of the banks creditors have much INCENTIVE to MONITOR the bank
by examining its activities closely and WITHDRAW their money if the bank was
taking excessive risks.
- Hence, “too big to fail banks” are likely to take on even greater RISKS, hence making bank failure even more likely.

Drawbacks
1. Might be too DIFFICULT to disentangle the tightly interwoven assets and liabilities of the parent bank
2. larger banks may benefit from ECONOMIES OF SCALE,
eg. fixed costs of information processing technology or complying with financial regulation etc.

Question 26

Why do the authors argue that the alternative option of “ring-fencing” banks employed in the UK might not be effective in curbing excessive risk-taking and leveraging? (from PS4)

Answer 26

Ring-fencing means that customer deposits will be separated from banks’ other liabilities.
- Banks would only be allowed to hold SAFE ASSETS, e.g. cash, government bonds, loans to individuals and firms.
- Riskier assets, e.g. trading in shares and derivatives, would sit outside the ring-fence, backed by separate capital.

However, even once the new ring-fences are in place, banks are still permitted to grant RISKY MORTGAGES
e.g. commercial-property loans, which DO NOT SIT OUTSIDE the ring-fence.

Question 27

In the aftermath of the financial crisis, the Basel III accord introduced liquidity regulation requiring banks to hold sufficient high-quality liquid assets to cover their total net cash outflows over 30 days. How does this forestall the possibility of bank insolvency?
(In your answer, you should discuss the consequences of fire sale of assets).

[10m, Specimen paper]

Answer 27

1. This question concerns the possibility of a bank run. Suppose there are rumours that a bank is on the brink of insolvency.
2. Due to LIMITED RESERVE holdings, if many depositors simultaneously rush to the bank to withdraw, this forces cut-price asset sales eventually leading to insolvency (this should be illustrated using balance sheets).
3. Hence depositors, even those who believe the rumours are probably untrue, rush to the bank to withdraw foreseeing that they might not get back 100 cents on the dollar if they are not first in line, which precipitates the bank insolvency through a self-fulfilling equilibrium.
4. Forcing banks to hold ample liquid assets reassures depositors there is no need to run, which prevents this self-fulfilling equilibrium