Capitalism

HS449

Anush Kapadia
akapadia@iitb.ac.in
Subprime

● Deficit, schools, China: this is worried the Hamilton Project Dems

● How did it happen in housing?
○ the share of American real estate in global wealth: 20%
○ 70 percent of American households owned their own home
○ In 2007 American consumers bought c. 16 percent of global output
○ home prices x 2 leading to 2006
○ Increased household wealth by $6.5 trillion
○ Consumer spending $937 billion to global demand between 2000 and
2007

● But how is this linked to banking? Why should this result in a credit
crisis?
● Collateral for borrowing
Subprime

● Fourfold transformation:

● the securitization of mortgages

● incorporation into strategies of banking growth
● the mobilization of new funding sources
● Internationalization

● Fallout from the collapse of BW

Subprime

● 1979 inflation rates in the US hitting 14%

● Without gold, the only discipline on the system was political
● Volcker decided to raise rates
● “It was the moment the power of the modern Fed was born.”
● In June 1981 the prime lending rate touched 21%
● Inflation collapsed: 14.8% in March 1980 to 3% by 1983
● Discipline labour, outsourcing of manufacturing
● Changes in housing finance
Subprime

● Changes in housing finance lead to huge changes in banking

● 30 year, fixed rate loans for mortgages from commercial banks and
savings and loans banks, 5 percent down payment
● Government insured deposits, capped interest rates
● Howe ownership expanded to 66% by the 1970s
● But these banks/S&Ls could not survive in a post-BW world of fluctuating
interest rates and inflation
● Inflation good for borrowers, bad for lenders
● Bank portfolios of fixed-interest loans under stress, borrow in floating
● Depositors fled for money market instruments offering higher rates
● The solution to the banking crisis ina free market era was: deregulate
● Didn’t save the S&Ls, but banks came through (bailouts, mergers)
Subprime

● Stabilized by the late 1980s

● Prepayment risk: refinance at lower rate
● Bad deal for banks:
○ rising interest rates means lower value for fixed-rate assets
○ Falling interest rates, borrowers refinance
● Lending for 30 years at fixed rates was a model that could only work under
BW and financial repression!
● Created an ecology of small lenders that now disappeared
○ Banks went to scale
○ Market-based model of financing

“The solution was to go for scale, to adopt a new market-based model of

financing and to place government institutions at the center of the system.”
 Banks

Assets Liabilities
Uses of funds Sources of funds
Loans
Deposits
Mortgages
Equity
(Government) Bonds

7
 Banks

Assets Liabilities
Loans
Mortgages Deposits
(Government) Bonds Equity Capital
Reserves

● Crisis as two stages of commoditization revolution:

○ Asset-side revolution: securitization

○ Liabilities-side revolution: wholesale funding/borrowing

● INDEPENDENT DEVELOPMENTS!
● CONJUNCTURE in the 2000s

8
 Banks making a loan...

Assets Liabilities
+ Loans
+ Deposits
(Cash Reserves)

...to a loan customer

Assets Liabilities
+ Deposits
+ Loan
(Cash withdrawal)

9
 Share of Deposits in Domestic U.S. Bank Offices Insured by FDIC

https://www.moneyandbanking.com/commentary/2014/6/30/how-securitization-really-works
 Fannie Mae’s “Securitization”

Assets Liabilities
“Prime” Mortgages Bonds

11
Subprime

● Fannie Mae (1938)

● Federal Housing Authority-insured mortgages
● Fannie bought these loans
● Raised money from bonds that were equivalent to T-bills
● This was a form of “securitization” but NOT complete
● Privatized in 1968 to get it off fiscal balance sheet
● Hit hard by Volcker shock but survived
● Flourished with housing boom on the 1990s
● By 2000, backstopping 50% of the market

● 1990s: from Prime to Subprime

● From white majority to poorer ethnic minorities
 Securitized Liabilities in the United States (U.S. Dollars in Trillions)

https://www.moneyandbanking.com/commentary/2014/6/30/how-securitization-really-works
 S&P/Case-Shiller U.S. National Home Price Index

https://fred.stlouisfed.org/series/CSUSHPINSA
“It is a deep irony that the era in which America is
commonly thought of as leading the world in a
market revolution saw its housing market become
dependent on a government-sponsored mortgage
machine descended from the New Deal. It was also
the source of deep and irreducible politicization of
the mortgage issue in the United States.”
 Private Sector’s Securitization
following Ginnie Mae c. 1970

Assets Liabilities
Mortgages Pools Securities
AAA Tranche
BBB Tranche
Equity Tranche

16
Subprime

● 1990s: from Prime White to Prime Minority

● From white majority to poorer ethnic minorities
● Targets for GSEs for minorities
● But this was still Prime! So this is not a cause of the crisis
● Toxic loans came from private lenders who mimicked securitisation
● What the private sector copied was the originate to distribute +
securitization model
● Broad exposure to whole housing market w/o having ground operation
● Illegible, wrapped by Ratings Agencies
● In 2008, only 6 AAA rated companies and a 12 nations
● Payment by issuer!: conflict of interest
● But mortgages supposed to be much more standard that companies
Subprime

● Mortgage risk spread around the system

● In 1980, 67% of mortgages held on bank balance sheets
● Break down of monitoring in the chain of origination and distribution
○ Originators
○ wholesalers of packages of mortgages
○ underwriters who assessed risk
○ GSEs and servicers

● Early 2000s: second wave of securitization

● Not dispersion but concentration
● Not prime but subprime
Subprime

● Post BW work was one of fluctuation in ER and i

● Hedging instruments for these new risks
● Investment banks as sellers of these new products
○ Swaps
○ Credit default swaps
● Proprietary trading through leverage
● Cash pools searching for yield: 80s, petrodollars, ‘90s-’00s, China,
family offices, institutional investors
● 50% return on equity in the early ‘80s!
● Wholesale funding/borrowing model
○ Money market funding for capital market lending
○ This became “shadow banking”
● Wall St. firms become household names
○ Emerging market debt to dot com to derivatives to housing
 Shadow Banks

Assets Liabilities
Securitised Loans REPO
Commercial paper

20
Retail vs Market-based Banking

REGULAR BANKING
Assets Liabilities

LOANS DEPOSIT
CB A/C CAPITAL

SHADOW BANKING

SPV CDO SIV MMMF

Assets Liabilities Assets Liabilities Assets Liabilities Assets Liabilities

CDS IRS
LOANS ABS ABS CDO CDO ABCP ABCP DEPOSIT

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 MMMF

Assets Liabilities
Asset-backed Commercial Paper “Deposit”
from SIVs NAV = $1

22
Subprime

● Wall St. firms become household names

○ Emerging market debt to dot com to derivatives to housing
○ Moved across the securitization chain, esp. Smaller ones

● Traditional commercial banks were in trouble

○ Consolidation into Universal Banks
○ From Jimmy Stewart to service providers for a fee
● Wanted to get into mortgage game but tied up by regulations
● Clinton, through Rubin, obliged

● Survivors of S&L and mortgage specialists

○ Moved up the chain as well
Subprime

● In the wake of dot com crash, rate cuts

● Massive refinancing, strain on GSEs, irregularities, caps on their capital
● With GSEs contained, interest rates rock bottom in 2004, private label
securitization engine had the field
● The engineering for subprime more complicated: more fees
● Squeezed more AAA tranches out of subprime
● CDS: AIG
● CDO, CDO-squared
 Layers of securitization

https://www.zerohedge.com/article/1125000300-number-pages-needed-be-read-every-cdo-squared-purchase
https://www.zerohedge.com/article/1125000300-number-pages-needed-be-read-every-cdo-squared-purchase
Subprime

● Search for safe yield

● Global cash pools looking for AAA assets
● Legally mandated in some cases: pension funds
● Self-insurance for East Asian exporters: huge forex reserves
●
● But these are long-term investors who would have held to maturity
○ The problem was that investment banks held their own product
Subprime

● The problem was also FUNDING

● WHOLESALE FUNDING: COMMODITIZATION OF LIABILITIES
● The repo market where the synthetic AAAs were the main collateral
material
● REPO: repurchase order
● Cash pools went into short-term money market instruments like
commercial paper and repo
○ Liquid
○ Higher yield than cash
● OTC market
● 2007, funded through repo:
○ Lehman: 50%
○ Goldman Sachs, Merrill Lynch and Morgan Stanley: 40%
● If the repo market closes to them, they are dead
Retail vs Market-based Banking

REGULAR BANKING
Assets Liabilities

LOANS DEPOSIT
CB A/C CAPITAL

SHADOW BANKING

SPV CDO SIV MMMF

Assets Liabilities Assets Liabilities Assets Liabilities Assets Liabilities

CDS IRS
LOANS ABS ABS CDO CDO ABCP ABCP DEPOSIT

Cash pools
29
 SIVs backed by Investment Banks

Assets Liabilities
CDOs Repo
“Liquidity put” ABCP

Years Months/Days
Lend long Borrow short

30
“And this brings us to the true heart of the 2007–2008 crisis. If the mortgage
production line was holding hundreds of billions of private label MBS and ABS
on its own balance sheet, how were those holdings funded? ”

Investment Banks: fragile funding

Assets Liabilities
MBS Repo
ABS

“Lehman got its funding wholesale by tapping the cash pools and so too
would the new mortgage lenders, including Lehman. This was the truly
lethal mechanism at the heart of the crisis.”
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Subprime

● This engine generated a bunch of toxic securities

● “Grotesque” scale
● Between 1999 and 2003, 70 percent of the new mortgages were
GSE-conforming.
● By 2006, 70 percent of new mortgages were subprime, private label MBS.
● In both 2005 and 2006, $1 trillion in unconventional mortgages issued
● GSEs also participated as buyers
● Countrywide originated 20% of all US mortgages in 2006
● Lehman scraped the bottom of the barrel
● Machine demanded more raw material
● Race to the bottom in origination
● Huge for banks:
○ early 2000s, 35% of all profit from finance
○ 2007: $66 billion in bonuses
Subprime

● Subprime only 12% of all securitised assets

● Of the $5 trillion, $1trillion in the ABCP market
● Market for ABCP larger than for the short-term Treasury bills!!

● “ABCP: the place where private label MBS met wholesale funding.”

● Economists did not see it coming: Rajan vs Summers

● Central bankers lost control: 2006, inverted yield curve
● Then the music finally stopped….