THE SUB PRIME CRISIS – EVENTS AND

APPLICATION OF THEORY

E Philip Davis

NIESR and Brunel University

West London

e_philip_davis@msn.com

www.ephilipdavis.com

groups.yahoo.com/group/financial_stability

Course on Financial Instability at the Estonian Central Bank,9-11 December 2009 – Lecture 4

1 The build up to the crisis – global background

• Low real interest rates stimulated borrowing and financial innovation– Long rates were low because of high saving especially by

Asian economies – Short rates were held low in the US

• Buildup of debt and asset price boom• New features of the market were not stress tested for

downturns– New asset backed securities hid risk rather than shared or

reduced it– Reliance on wholesale markets was unwise

Real interest rates

-2

-1

0

1

2

3

4

5

6

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

UK long real rate US long real rate UK short rreal rate US short real rate

Personal sector borrowing

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

1.8

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

rati

o t

o p

ers

on

al d

isp

os

ab

le in

co

me

s

France Germany Spain UK US

Real house prices

0.5

0.6

0.7

0.8

0.9

1

1.1

1.2

1.3

1.41

97

0Q

1

19

71

Q4

19

73

Q3

19

75

Q2

19

77

Q1

19

78

Q4

19

80

Q3

19

82

Q2

19

84

Q1

19

85

Q4

19

87

Q3

19

89

Q2

19

91

Q1

19

92

Q4

19

94

Q3

19

96

Q2

19

98

Q1

19

99

Q4

20

01

Q3

20

03

Q2

20

05

Q1

20

06

Q4

Lo

g s

ca

le 2

00

0q

1 =

1

France House prices Germany House prices Spain House pricesUK House prices US House prices

The build up to the US crisis• Structural background:

– Rush to sub prime lending in US, encouraged by government and compensation schemes for bankers

– Accelerating shift to securitisation, credit assessment neglected for CDOs and other ABS

– Low levels of liquidity and aggressive liability management by banks

– Some ABS held in SIVs and conduits, ABCP financed (Basel 1)

– Context of global liquidity glut and search for yield (sub-prime and ABS)

– Suspicion of “disaster myopia”

• The non systemic period (August 2007-August 2008)• Market liquidity risk

– Realisation of risks of sub-prime plus uncertainty about valuation of ABS…

– …led to ABS sales, leading to market liquidity failure, with price falls due to liquidity risk and lower risk appetite, not just credit risk

– Aggravated by margin requirements and credit limits on arbitrageurs, and restriction on risk appetite of market makers

– Rush to sell worsened by mark to market’s impact on capital of institutions and solvency – contrast to banking crises of past with book values

– Contagion spread via market collapse of ABCP financing conduits and SIVs

– And via traders attempts to hedge, meet margin calls and realise gains in more liquid markets

• Funding risk– Effect on interbank via inability of banks to

securitise, backup calls from conduits and SIVs, and suspicion of other banks’ solvency due to price of ABS

– Hence hoarding of liquidity, and wide spreads in interbank market, also quantity rationing of funds, especially at longer maturities

– Collapse of Northern Rock due heavy dependence on wholesale funds, and later of Bear Stearns and Lehman Brothers

– Close relation of funding risk to market liquidity risk revealed overall

• The Systemic period (September 2008-)– Failure of Lehmans leading to complete drying-up

of wholesale markets, including commercial paper– Problems for money market funds breaking the

dollar – also mutual funds and hedge funds– Massive redemptions of such funds leading to

sales in illiquid markets– Flight to quality in government bonds– Bank failures and government recapitalisations– Crisis spreading to real economy – risk of adverse

feedback loop (Bernanke)– Major recession has ensued

US problems

• Losses in the US on sub prime loans perhaps $1.4 trillion– Sold on as asset backed securities– Over half to European banks

• Sub prime loans may have defaults of over $1 trillion because of US bankruptcy law – unwise lending masked by ‘originate and distribute’ model – Evaluation of securities based on individual not group

default rates

• Lehman was a US bank

US, UK, EU credit spreadsSpread between BAA corporate and government bonds

0

1

2

3

4

5

6

7

8

9

10

05

Ma

rch

20

00

05

Ju

ne

20

00

05

Se

pte

mb

er

20

00

05

De

ce

mb

er

20

00

05

Ma

rch

20

01

05

Ju

ne

20

01

05

Se

pte

mb

er

20

01

05

De

ce

mb

er

20

01

05

Ma

rch

20

02

05

Ju

ne

20

02

05

Se

pte

mb

er

20

02

05

De

ce

mb

er

20

02

05

Ma

rch

20

03

05

Ju

ne

20

03

05

Se

pte

mb

er

20

03

05

De

ce

mb

er

20

03

05

Ma

rch

20

04

05

Ju

ne

20

04

05

Se

pte

mb

er

20

04

05

De

ce

mb

er

20

04

05

Ma

rch

20

05

05

Ju

ne

20

05

05

Se

pte

mb

er

20

05

05

De

ce

mb

er

20

05

05

Ma

rch

20

06

05

Ju

ne

20

06

05

Se

pte

mb

er

20

06

05

De

ce

mb

er

20

06

05

Ma

rch

20

07

05

Ju

ne

20

07

05

Se

pte

mb

er

20

07

05

De

ce

mb

er

20

07

05

Ma

rch

20

08

05

Ju

ne

20

08

05

Se

pte

mb

er

20

08

05

De

ce

mb

er

20

08

05

Ma

rch

20

09

05

Ju

ne

20

09

US Euro Area UK

2 Application of theory

• Financial fragility: crisis linked to asset price bubble fuelled by underpriced credit. Time of realisation that situation unsustainable (“Minsky moment”), leading in turn to tightening of credit, asset price falls and bank failures.

• Monetarist: highlight policy regime shift to laxity from 2000 onwards, warranted tightening from 2004-6 which nevertheless exposed the weaknesses of the US housing market and overleveraged borrowers. Regime shift from open to closed wholesale (including interbank) markets that began in August 2007 almost wholly unexpected even by central banks.

• Uncertainty: financial innovations that were highly opaque and wholly untested in a downturn.

• Disaster myopia: pervaded both financial institutions and most policy makers in boom period, sharpening incidence of credit rationing after August 2007 as risk loving changed sharply to risk aversion. 2 key points: – announcement by BNP Paribas in August 2007 that their funds

investing in ABS could not be valued, which brought on the initial interbank market failure.

– failure of Lehmans in September 2008, which changed agents’ views of what institutions are “too big to fail”, unleashing immense systemic risks.

• Agency costs: incentives to underprice credit from transfer of risk in securitisation. Asymmetric information worsened by opacity of structured credit products and helps to explain failure of wholesale funding markets, since banks were uncertain about “toxic assets” on others’ balance sheets.

• Industrial: securitization enabled a wide range of new players to enter markets for origination of loans and also investment. Former worsened adverse selection of loans, heart of crisis. The latter include hedge funds, SIVs and conduits; heightened risks to banks that were either providing credit directly or had backup lines to them. Hedge funds’ short selling, and later forced sales of assets central to falling asset prices in securities markets.

• Standard indicators of financial instability (“generic sources of crisis”) – applied to US subprime crisis– Regime shift to laxity or other favourable shock (US

monetary policy in early 2000s)– New entry to financial markets (subprime lenders)– Debt accumulation (US subprime)

– Asset price booms (US housing)– Innovation in financial markets (CDOs/SIVs)– Underpricing of risk, risk concentration and lower capital

adequacy for banks (use of SIVS, incorrect ratings)– Regime shift to rigour – possibly as previous policy

unsustainable - or other adverse shock (house price weakening, French bank BNP Paribas suspends three investment funds worth 2bn euros, later Lehmans failure)

– Heightened rationing of credit (interbank market and wholesale money markets, also mortgage market and later all private credit)

– Operation of safety net and/or severe economic crisis ( LOLR in money markets, Northern Rock, indirectly Bear Stearns – but not Lehmans – bank recapitalisation and guarantees - now worst recession since 1930s)

3 Incentive problems• Adverse selection - inadequate corporate governance of

loan officers in banks which allowed credit risk to accumulate, passed on via securitisation; adverse selection feared in interbank market

• Moral hazard - incentive of banks to avoid capital adequacy by setting up SIVs/SPVs and thus holding loans indirectly – implicitly passing on risk to the safety net where “too big to fail”, also incentive of originators of subprime loans not to monitor loans if securitised

• Incentive of rating agencies to give top ratings to paper containing low quality loans (as payment by issuer)

• Incentives of UK retail depositors to run on Northern Rock due to low level of deposit insurance

• Incentives of lenders in the wholesale market to avoid counterparty risk and hoard liquidity for themselves, thus entailing runs on Northern Rock and Bear Stearns, and later Lehmans.

• Regulators failed to inform central banks early enough of potential liquidity problems, showing institutional problem of separating supervision and central bank functions.

• Adverse selection and moral hazard incentives for credit rationing in the interbank market from 2007 and in the real economy from 2008

• Financial crisis triggered by loss of confidence in “too big to fail”, as authorities did not rescue Lehmans for fear of moral hazard

4 Liquidity management

• We assess how the sub-prime crisis has changed the situation for LOLR:– New forms of liquidity risk – interaction of funding liquidity

and market liquidity– New responses of LOLR such as supporting non-banks, lower

quality collateral, longer maturities– New challenges for LOLR such as confidentiality, “stigma”

and deposit insurance interaction– Coping with the systemic crisis since September 2008

• Overall understanding requires to supplement bank funding risk with market liquidity risk, and bank policies of mark to market and balance sheet management

Relevant liquidity risk paradigms• Some standard elements

– asset price fall leading to liquidity shock– Deterioration of loan quality– Fire sales and runs

• Market liquidity risk and liquidity insurance (Davis, Bernardo and Welch)– Reconsider Diamond-Dybvig for markets– Rationality of selling if fear liquidity will collapse– Externalities similar to bank failures – fire sales,

funding problems, contagion to other markets, as with ABS, ABCP, interbank

– Role of market makers in uncertainty or asymmetric information – uncertainty regarding ABS valuation and on counterparties

– Dynamics relating to dealers’ capital– Becomes impossible to sell assets, e.g. primary

securitisation markets

• Contagion via market price changes in context of mark to market (Adrian and Shin)– Financial institutions’ active balance sheet

management, positive relation of leverage and balance sheet size

– Desired expansion in upturn, boosting liquidity– Shock to prices led to desired contraction, but stopped

by obligations (e.g. backup lines) – so cut back on discretionary lending - interbank

• Interbank funding liquidity (Freixas et al)– Imperfect information or market tension can lead

to shortages of funds even for solvent banks– “Bank runs” in market occur as banks hoard

liquidity

• Amplifying mechanisms of liquidity shocks (Brunnermeier)– Borrowers balance sheet effects – loss spiral and

margin spiral– Lending channel effect – hoarding liquidity– Runs on institutions and markets– Network effects – Goldman Sachs and Bear

Stearns

4 LOLR and the sub-prime crisis – non systemic period

• Needed to evolve to cope with new conditions

• Nature of LOLR– Open market operations more than direct lending -

expansion to longer maturities– Protracted crisis – fear NCBs lacked instruments?– Investment banks covered – Bear Stearns and

liquidity facilities – reflect central role in financial system but not regulated by Fed

• Costs of LOLR– Ambiguity of lending to reliquify markets – impact

on solvency of institutions– Conflicts with other policies, need to maintain

monetary stance and difficulty of interpreting stance given LIBOR spread

– How much moral hazard generated by “new” LOLR?

• Minimising costs of LOLR– Reduction in collateral standards…– …even ABS, reliquified by non market means –

market maker of last resort – or even first– Inversion of traditional NCB role, adverse

selection and moral hazard

– Private sector solutions sought but not found for Northern Rock, only with guarantee for Bear Stearns – wide scale of problem and uncertainty on valuation

– Adequate information for LOLR, not the case for Bank of England in Northern Rock case

– Loss of reputation to banks receiving LOLR notably Northern Rock – decision to be overt in lending and leakage of information – need for new facilities instead of discount window

– Conflict with a partial deposit insurance scheme in the UK – reason for rescue?

– Domestic LOLR insufficient – cross currency swap arrangement. Need for cooperation and risk of “gaming”. Fortunate no major cross border failure?

– Challenge for exit strategies to prevent moral hazard to reactivate markets

LOLR and the sub-prime crisis – systemic period

• Response of fiscal authorities to crisis– Recapitalisation– Overriding of merger policy– Extension of deposit insurance– Purchase of illiquid or impaired assets– Guarantees– US guarantee of money market funds– initial outlays 6% of GDP but total support in North

America and Europe $14 tn., 50% of GDP

• LOLR activity– Growth in central bank balance sheets, to 15% of GDP

in UK and US– Mainly developing from earlier innovations

• Types of collateral• Expansion of cross border activity• Central bank swap lines

• Some innovations – UK standing facilities• UK later revealed massive clandestine support for

major banks in October 2008

• Changes initially in US– Providing funds direct to borrowers and investors in markets rather

than via intermediaries, acting as “market maker of last resort” or even “investor of last resort”,

– Market support for commercial paper, MBS…

– Purchasing GSE obligations

– Further support for money funds

– Institution support for Citicorp, AIG….

– Would Lehmans have been rescued had the law been changed earlier?

• Market support later emulated in UK, Eurozone• UK shift to quantitative easing – monetary policy not LOLR• On balance, classic response to systemic crisis except for

further extension of LOLR role

Conclusion

• Sub prime crisis is most serious financial crisis since 1930s at global level

• A number of novel features• Nevertheless validates much of traditional theory

as well as incentive mechanisms, underlining the need to look for patterns of crisis buildup

• Sub prime showed that liquidity risk assessment needs rethinking to allow for interaction of market liquidity risk and funding risk

• LOLR challenges include:– longer term provision– variety of lower quality collateral– including investment banks in the safety net– confidentiality of bank support– interaction with deposit insurance

• Has the net effect of these changes been to increase moral hazard?

• Innovation mainly in non systemic period• Issue of exit strategies, not least given size of

central bank balance sheets, QE• And need for reform of liquidity regulation –

FSA model?

ReferencesBanque de France (2008), “Liquidity”, Financial Stability

Review

Barrell, R. and E. P. Davis (2008), “The Evolution of the Financial Market Crisis in 2008”, National Institute Economic Review, No. 206.

BBC (2008) “Timeline – subprime losses” news.bbc.co.uk/2/hi/business/7096845.stm

Davis, E P (2009), "The lender of last resort and liquidity provision- how much of a departure is the sub-prime crisis?", paper presented at the LSE Financial Markets Group conference on the Regulatory Response to the Financial Crisis, 19th January 2009