Week 6

Question 1

How did Northern Rock begin?

Answer 1

Northern Rock began in the 19th century as mutually owned building society with a business focused on serving it’s local community, which is in the Northeast of England.

Question 2

When did Northrn Rock go public?

Answer 2

The bank went public in 1997, and grew at an annual rate of over 20% for the next 10 years.

Question 3

Was Northern Rock 2007 one of the larger banks?

Answer 3

With total assets of 113.5 billion Pounds, making it the 5th largest UK bank by mortgage assets as of June, 2007.

Question 4

Did Northern Rock engage in a lot of supreme lending?

Answer 4

No. Northern Rock focused on prime lending, so not subprime, had minimal subprime exposure. And the UK housing market actually remained strong through the summer of 2007, unlike the United States market which had already shown signs of weakness, particularly on the subprime side.

Question 5

What was one of the consequences of the rapid growth?

Answer 5

But the rapid growth that Northern Rock had, beginning when it went public in 1997, had outstripped it’s traditional deposit pace. So the bank had to rely on nontraditional funding sources. Typically, what a bank is doing is it’s taking deposits old style bank. Especially, an old style building society or savings and loans in the United States is just taking deposits, saving deposits, and putting them largely into mortgage assets, into housing.

Question 6

What happened to Northern Rock in 2007?

Answer 6

Over the summer of 2007, some of these nontraditional funding sources began to dry up and efforts to organize a private rescue for the bank failed.

Question 7

What was the problem of Northern Rock?

Answer 7

What we see is, we have a gap between what our investments are, and what our deposit base can handle.

Question 8

Did privat rescue of the bank work?

Answer 8

No, it failed.

Question 9

What went so terribly wrong after the attempted rescue?

Answer 9

Now we’re gonna have some words leak out, some information leak out about this attempt of a private rescue, in fact, on September 13th, 2007. The BBC broke news that Northern Rock had sought assistance from the Bank of England.

Question 10

What did the Bank of England do?

Answer 10

The Bank of England granted that assistance the next morning. At this point, whether or not they had decided to do it the day before, they would have had no choice by the next morning but the run on retail branch deposits began that day.

Question 11

What happened after the news that Northern Rock got assistance from the bank of Englnd?

Answer 11

Once it became public that Northern Rock was going to get assistance from the Bank of England, now people started going to the bank. Individuals, not just wholesale funding, which had been drying up in the summer but in fact, the retail funding.

Question 12

Why could a bank run like that of Northern happened much more easily tha in Englan?

Answer 12

Now this can happen in the UK must more at this time than it can happen in the United States because full deposit insurance for accounts in the UK was capped at 2,000 Pounds. Compare that will $100,000 in the United States and at this point, maybe 2,000 Pounds is approximately $3,000. And then there’s 90% coverage up to 35,000 pounds but 90% coverage is really not going to make you feel very safe. You certainly don’t want to lose 10% of the value of your account. It’s much better to just go and run to the bank.

Question 13

What question should be asked about Northern Rock?

Answer 13

Here’s what he had to say, the real question raised by the Northern Rock episode is not so much why retail depositors are so prone to loss of confidence that lead to bank runs, but instead why sophisticated lenders who operate in capital markets chose suddenly to deny lending to a bank that had an apparently solid asset book and virtually no subprime lending. That’s one way to think about the whole global financial crisis writ large. Even where there was limited subprime exposure, there was a run by wholesale lenders and we will max, in the next few lessons, examine exactly what happened at Northern Rock.

Question 14

How can Northern Rock be seen?

Answer 14

We can think of what happened at Northern Rock in the summer of 2007 as a microcosm of the overall global financial crisis.

Question 15

What is one reason why Northern Rock can be seen as the microcosm of the financial crisis?

Answer 15

We notice that it is shadow banking, it is nontraditional banking where we had this enormous amount of growth. The same thing really shows at Northern Rock. Here’s a picture that illustrates the gap between their traditional funding source of retail deposits and the total amount of their balance sheet that they needed to finance in the years from 1998 to 2007.

Question 16

Were retail deposits growing?

Answer 16

The bottom section of this picture is the retail deposits and the retail deposits we can see grew. At a mild rate. From June 1998 through June 2007. But overall the balance sheet was growing at the speed of the very top line.

Question 17

What are securitized notes?

Answer 17

The securitized notes that were offered by Northern Rock were more akin to asset back commercial paper in the United States, which we studies in the previous module. Except for the fact that it did not engage in a lot of maturity transformation.

Question 18

What does the y-Axis tell us?

Answer 18

The securitized notes that were offered by Northern Rock were more akin to asset back commercial paper in the United States, which we studies in the previous module. Except for the fact that it did not engage in a lot of maturity transformation.

Question 19

Which source of funding was the largets problem for Northern Rock?

Answer 19

Other liabilities is the category just above securitized notes, and that’s really where we’re gonna see the largest problem. And this is not broken up all that carefully in Northern Rock’s official filings. But largely from what we know from a variety of sources, this was wholesale funding of many different types. Sometimes it was just a very specific financing organized with a large institutional investor, or sovereign wealth fund. Sometimes it would be notes that were shorter term notes, like commercial paper issued by Northern Rock. Or just deposits that are coming from large depositors, not retail depositors. Finally at the top is a very thin sliver of equity.

Question 20

What is wholesaling?

Answer 20

In banking, the term wholesaling refers to services that are designed for large, institutional clients, including real estate developers, pension funds and large corporations, as opposed to retail banking which provides services to standard, individual customers. A wholesaler can also be a sponsor of a mutual fund, or act as an underwriter in a new issue.

Question 21

What does this picture tell us?

Answer 21

That wholesale ran first

Question 22

What is a covered bond?

Answer 22

A covered bond is a security created from the public sector loans or mortgage loans where the security is backed by a separate group of loans. Covered bonds typically carry a 2-10 year maturity rate and enjoy relatively high credit ratings, depending on the quality of the pool of loans (“cover pool”) backing the bond. Covered bonds are often attractive to investors looking for high-quality instruments that offer attractive yields. They provide an efficient, lower-cost way for lenders to expand their business rather than issuing unsecured debt instruments.

Question 23

What percentage did the bank of England approximately cover after the run?

Answer 23

28%

Question 24

What are monolines?

Answer 24

Our next case study is a group of insurance companies that you will often hear referred to as the monolines, because they have a single type of insurance. Unlike a large diversified insurance company that will offer life insurance, property and casualty insurance, health insurance, the monolines had a very very narrow business for most of their existence. And that narrow business was to insure, basically to provide credit enhancement to municipal bond offerings.

Question 25

What would a municipality do in the 1970s?

Answer 25

Beginning in the 1970s, what would happen is, a municipality would wanna have a bond issue. And the municipality might be a relatively small municipality. And so what do lenders know about this municipality all over the world? Not very much. So in order to have a higher credit rating, they would go and they would find almost like a cosigner on the loan, a cosigner that was an insurance company. And that insurance company was simply in the business of saying, we promise to pay if this particular municipality is unable to pay. We will pay. And so by doing this, you would get the credit rating if you were actually lending money to the municipality. You would get the credit rating that was the higher of the insurance company or the municipality. And these insurance companies all had AAA ratings.

Question 26

How did monoline companies get involved in structured products?

Answer 26

This is a nice, quiet, calm business. This changed a lot in the 2000s. So during the global savings glut period, when there was an enormous amount of activity in structured products, structured products being a term for securitizations and then the extra layers of securitizations that we might see in CDOs, for example. The monoline insurance companies saw this as an opportunity to expand. Instead of just insuring municipalities, why don’t we also provide credit enhancement for these securitizations, so we get a bundling together of mortgages, for example, into mortgage-backed securities. And now to add an extra layer of safety to that, we have an insurance company that stands behind it and promises, much like the government would promise, on the agencies, the government-sponsored enterprises, would promise on conforming loans, the monoline insurance companies would make those same promises on structured products.

Question 27

What was one of the problems of these monoline companies?

Answer 27

Now, this business grew very rapidly. I mean, monoline insurance companies were not very well capitalized to be able to do this. There was a bit of a cognitive dissonance that was going on, some bubble thinking that was going on in the idea that there was no way that all of this insurance would get needed at the same time.

Question 28

What was the factor of th biggest insurance companies?

Answer 28

As of January 2008, the two largest insurers in this space, MBIA and Ambac, had a combined $265 billion in structured product guarantees. This is a factor of a hundred greater by far, we are three digits greater in terms of the factor for what their equity was. They just don’t have anywhere near the kind of equity that could support these guarantees if they’re actually called. But, nevertheless, they maintain during this time their AAA ratings.

Question 29

What is the fundamental problem with the monolines?

Answer 29

So remember the business that we’re in here, which is originally about guaranteeing municipal bonds. So ultimately it’s a very staid business and one that’s necessary for the normal functioning of the economy that the bond insurers are in, but now all of a sudden they’ve started to make guarantees for structure products.

Question 30

How was the drop in the monolines?

Answer 30

Very steep.And in these lines, what we see is a very very steep drop happening right around the same time that we have problems in the Bear Stearns funds, that we see downgrades of subprime securities, and then accelerating through the fall until basically the stock prices were very very close to, were very close to zero for all of these companies. Now, this is gonna turn out to cause problems, as you might expect, for municipal, for the municipal debt and the municipal borrowers that were using the bond insurers in the first place to guarantee their debt.

Question 32

What is a classic problem with securites?

Answer 32

To see why we have auction rate securities we have to understand what the problem is with normal securities. And the traditional way to solve normal securities would be you have a primary offering, an investment bank gathers together all of the debt for example that needs to be sold, finds investors, and then afterwards would manage a secondary market. So if there’s a small municipality or a medium sized municipality, say, New Haven, Connecticut, where I am standing, that needs to borrow. New Haven can go to a investment bank. The investment bank will try to arrange, say $100 million bond offering. Needs to find investors for that. And then, after those investors buy those bonds, the investment bank will stand ready to sometimes transact and help to find a seller or to find a buyer for anybody who has bonds and wants to sell them. Now, the problem with this mechanism is that $100 million, while it’s a lot for individual people, is not a lot for institutions, and it doesn’t make for a very thick market with a lot of trade. So, anybody who might be looking to buy some of these New Haven bonds to start with might be worried about their inability to get out of it and to sell it later, if they wanted to. So, these illiquid secondary markets can make it very, very difficult to sell the bonds in the first place. We have a little bit of a chicken and egg problem. Nobody wants to buy them because they’re afraid they won’t be able to get out of them later. Auction rate securities are a solution to this illiquidity.

Question 33

What do auction rate securities do to solve this conundrum?

Answer 33

So instead of an investment bank just saying, I’m gonna sell this New Haven debt at one time, and then later if you need some help we’ll try to find match up buyers and sellers. What they promise to do instead is to have periodic auctions. So come in every month, for example, and we will give you the opportunity to place bids and offers on this particular debt. It’s a lot like having a specific time where everybody shows up to sell their wares. A town market that might happen every time on Saturday. Everyone knows if you show up on this particular day, that’s when you can buy and sell. The same thing works for securities. Makes it much simpler for buyers and sellers to get together if we know there’s a certain time to show up.

Question 34

For what kind of auctions were these bonds used?

Answer 34

These types of securities are used, these types of auctions are used for quiet types of securities. Municipal bonds being the main type, student loan pools being another type that was very popular. So these are really not subprime types of things. They’re things that are needed for ordinary functioning of the economy.

Question 36

When did the first auction fail?

Answer 36

And we begin, beginning of 2008, and on January 22 we have Lehman Brothers, doing the very, very first failed auction. And we begin, beginning of 2008, and on January 22 we have Lehman Brothers, doing the very, very first failed auction. So they failed to come and buy all of the pieces of their auction. Over the subsequent few weeks, auctions continued to succeed, and then beginning in early February, we start to see an increasing amount of failures. A failure meaning, somebody comes to the auction, says I would like to sell this debt. There are no buyers that show up, and the broker-dealer, that in normal times had been buying these securities, decides this is not a good use for our money any more.

Question 37

What happens once an auction fails?

Answer 37

And this is falling predominantly on the extra costs that happen here. Because the way this works in the system is that when the auctions fail, the borrowers, the municipalities being most important in this case, have to pay a higher interest rate. So we start from the subprime failure, we move in the next step towards bond insurers running out of money and losing their credit rating, and we end up with small municipalities suddenly having to pay higher interest rate costs. A direct effect going that has seemingly to a place that might have no subprime at all. It could be a city that hasn’t seen a single subprime sale, but they’ve been captured in this maelstrom of the meltdown.

Question 38

What kind of business was Bear Stearns involved in during the crisis?

Answer 38

They were significant players in all parts of the subprime space. They were in loan origination, so they actually owned firms that went out and made the sales and then they would take the mortgages and warehouse them before they actually sent them out in securitizations. They traded all kinds of subprime securities and they were in the asset management business where they had funds that specialized in buying those securities in the open market, often on a leverage basis.

Question 39

What was the first problem of Bear Stearns in 2007?

Answer 39

As discussed, their first problems happened in the middle of 2007, they suspended redemptions in two of their funds. They took those funds back on their balance sheet, effectively bailing them out. Once again, for reputational reasons, paying off the lenders of those funds, and taking all of the collateral, everything that the funds had, onto its own balance sheet.

Question 40

What is remarkable about this graph?

Answer 40

That number hovers between $15 and $20 billion per day in February of 2008, leading into March of 2008. We then see, starting on March 9th, a liquidity level of nearly $20 billion collapsed to zero over that week, $20 billion down to zero. This is an investment bank that has no retail deposits. There is nothing obvious here to run. Yet, it goes from really being a very substantial organization to being gone over the course of a week.

Question 41

Why was it so confusing that Bear Stearns ran out of money within a week?

Answer 41

Because it was an investment bank and not a retail bank

Question 42

What is prime brokerage?

Answer 42

Prime brokerage is when you are doing the brokerage activities for a large institutional investor, typically a hedge fund.

Question 43

What did prime brockers do ton Bear Stearns

Answer 43

So a hedge fund that has a very big business comes, deposits some money with the broker dealer, goes and buys some stocks or bonds, and now, the broker dealer can lend those things out. While prime broker, clients, like hedge funds, are very savvy and get concerned quite quickly, and rightly, as it turns out. Because when Lehman Brothers failed, Prime brokerage clients did lose some money.

Question 44

What was the second things that got Bear Stearns into trouble?

Answer 44

A second thing that happens is a term of art in the financial world, called a Novation. A Novation is where somebody comes and stands in between two parties in a derivatives transaction and pretty much takes one of those parties out. So for example, let’s say that Bear Stearns has entered into a derivative transaction on a simple interest rate swap of the type that we talked about in a previous module with a counterparty. Now that counterparty, in ordinary times, isn’t worried at all about Bear Stearns being able to hold up their end of the bargain. But if suddenly they see in this week that there are rumors and concerns about Bear Stearns being able to transact, that party might say, this is a very simple transaction, but I don’t wanna deal with the possibility of a counterparty that becomes bankrupt. So that client calls a different investment bank and tells that investment bank, would you please take over this particular position from Bear Stearns? Would you stand in the middle of us, and so no longer will we have any exposure to Bear Stearns?

Question 45

Why are novations so bad?

Answer 45

Now, that type of activity is something that creates a tremendous amount of chatter among traders. When there are novations, a lot of people start to get worried.

Question 46

What is the issue with collateral

Answer 46

One side asks for collateral from the other side when the trade has moved. Now, the trouble is when there is nervousness among traders about the existence of a specific type of company, then their counterparties will always come to them and ask for more collateral. Whereas, if you have the other side of the trade with the counterparty that is still perceived as safe, you can’t do the same thing.

Question 47

What wasw the third factor that got Bear Stearns into trouble?

Answer 47

the summer of 2007 was that maturity shortened. So one way that you can try to feel a little safer when you’re making a loan to an institution that you might think is not safe is to say, all right, I’m not sure if you’re gonna survive the month. I feel a little bit better about you surviving one day. So instead of giving them a loan, Bear Stearns getting loans, particularly in the sale and repurchase market, which is one that we’ll discuss in detail in the next module. Instead of being able to get 30-day term loans, a lot more of their activity moved to be overnight, and now it’s a very fragile situation. If you’re only able to borrow for very short periods of time, now, virtually, all or a much larger chunk of your portfolio can run very quickly. And that is kinda of a final step of what happened to Bear Stearns, which is as they came to the place where most of their loans were rolling over on a very short horizon, once there was sufficient cascade of nervousness in the market and their counterparties were unwilling to give them that money, that’s the final piece to the puzzle. The final run, draining $20 billion of liquidity in one week.

Question 48

When did JP Morgan take over Bear Stearns?

Answer 48

On March 13th

Question 49

What effects did the involvement of the FED have?

Answer 49

That people thought that they would not let any bank fail