Group Task 3, Financial Markets Week 7

-Submitted by
Raunak Nath nath.raunak@gmail.com

The Global Financial Crisis (2007 – 2009)

Abstract

The Global Financial Crisis of 2007, also known as the Sub-Prime Mortgages crisis,
originated in the United States, resulted in unprecedented intervention by the Govt.
across the globe to bailout strained financial institution which were at the risk of a
default and is a subject of research for many economists or used as a case study by
many students in their curriculum. If not for the intervention, we would have seen the
colossal collapse of the financial system creating a global economic crisis and the
effects of the crisis are still prevalent. The crisis resulted in erosion of billions of
investor’s wealth and record high unemployment in many developed and developing
countries. Through this review paper, we have tried to briefly describe the events
that led to the crisis and the financial system which resulted in the crisis being
transmitted worldwide. We also look at the joint effort of governing bodies and their
policy responses to revive the economy from recession and fill the cracks in the
financial system exposed through the Global Financial Crisis.

Defining Financial Crisis

Financial or Banking crisis can be defined by one of the two types of events of
occurring:
 Bank runs that lead to the closure, merging, or takeover by the public sector
of one or more financial institutions
 If there are no runs, the closure, merger, takeover or large-scale government
assistance of financial institutions (or a group of institutions)

A financial crisis usually leads to increase in external debt and due to huge
assistance or bailouts from governments it also leads to sovereign-debt crisis.
The below graph taken from the study “Credit Boom Gone Bust”[1], which describes
that the banking crisis are usually preceded by sharp increase in credit supply.
 Figure 1 Money and Credit Aggregates Relative to GDP (USA)

The above graph shows the time-series of credit, assets and broad money compared
to the GDP. As can be seen from the graph, the bank loans/assets and the broad
money have a relationship. The relationship shared by these three macro-variables
are disturbed due to increase in banking loans/assets whereas the broad money
remained approximately the same. This is also evident in the events leading to the
Great depression in US as is for The Global Financial Crisis (2007-09)

The Global Financial Crisis Timeline

The below table describes major events of the Financial Crisis

Figure 2 Financial Crisis Timeline

TIMELINE EVENTS REMARKS

2007

JAN-JUL Subprime Mortgage underwriters’ files for bankruptcy. Rating

agencies downgrades MBS. German govt. Bank supports a
German bank IKB
AUGUST Problems in Subprime Mortgage markets spill over to the
Interbank market with haircuts on Repo rising. ABS issuers have
trouble rolling over their outstanding papers. MMFs freezes Crisis build-up
redemption. Run on US subprime originator Countrywide

SEPT-DEC Run on UK bank Northern Rock. National Bureau of Economic

research announce December to the peak business cycle

2008
 MAR-JUL Federal Reserve announces creation of Term Securities Lending
Facilities to promote Liquidity. JPM agrees to buy Bear Stearns
with Federal Reserve's assistance. Federal Reserve creates
Primary Dealer Credit Facility. US SEC bans naked short-selling
of financial stocks

SEPTEMBER Federal Govt. takes over Fannie Mae and Freddie Mac.
Lehman Brother Files for Bankruptcy. The Primary Reserve
Fund, MMF, breaks the bucks causing he run on. MMFs. US
Treasury announce temporary guarantees MMFs and Federal
Reserve creates of Asset backed Commercial Papers MMF Spread of Crisis and Govt. Responses
Liquidity Facility

OCTOBER Crisis spreads to Europe. US Congress announces TARP,

authorizing 700$ billion of expenditure. Central banks in the
United States, England, China, Canada, Sweden, Switzerland,
and the European Central Bank cut interest rates in a coordinated
effort to aid world economy.US Treasury invests 250$ billion in 9
major banks

2009

MAY Results of the Supervisory Capital Assessment Program (“stress

tests”) announced.

JUNE National Bureau of Economic Research subsequently declares

June to be the business cycle trough.
Policy and Regulation Responses

OCTOBER Unemployment rate peaks at 10.0 percent.

Build-up of Crisis

The financial crisis of 2007-09 started with a series of short-term runs in early
August. Formerly called "safe" markets. For some time, the crisis has been building
up with issues in the subprime sector and subprime originators. Subprime mortgage
losses, or more specifically, the risk of such losses, once the downturn in house
prices began, were a catalyst for the crisis. But, they cannot alone explain the crisis
as the prospective subprime losses were clearly not large enough on their own to
account for the magnitude of the crisis. Somehow the prospective losses had to be
amplified to generate the crisis. The financial crisis was a bank run, but in sectors of
the money markets where financial institutions provided bank-like debt products to
institutional investors. These financial institutions were mostly shadow banks1.

The main vulnerability was short-term debt, mostly repurchase agreements2 and
commercial paper. These markets were not only big, but they were unregulated.
Major institutional investors, money market funds, nonfinancial companies, states or

1 Shadow banks are financial institutions other than regulated depository institutions (banks, commercial banks, credit
unions) that channel the savings into investments.
2 Repo transactions is a collateralized overnight deposit at bank. Depositors are usually large investors: money market
funds, states, municipalities etc. The value of collateral above the deposit is called a haircut i.e. let’s say for a 100$ deposit,
the collateral is valued at 110$ making the transaction with a 10% haircut.
counties, and other large investors are depositors/investors. For an insured account
at a bank, the amount of their deposits is too high and therefore the need for
collateral to try to cover the deposit. According to IMF(2010), the total outstanding
repo between 2002-2007 at a given time, relative to GDP, stood between 20-30% for
US and 30-50% for EU countries. The instability of the short-term debt markets led to
a shortage of US dollars, which did not impact developed markets, but also emerging
markets, which relied on US dollars to roll over short-term US dollar asset debt. The
foreign exchange swap that uses US dollars as the main swap currency for cross-
currency swap financing was also affected by the shortage of US dollars.

Crises are often followed by credit booms, as discussed in the previous section. The
credit boom took the form of an increase in the issuance of asset-backed securities,
especially mortgage-backed securities, in the case of the United States.

The development of the shadow banking system was the product of multiple factors.
Given competition from money market mutual funds and junk bonds, the
conventional banking model has become less profitable. Securitization3, the sale of
loan pools to special purpose vehicles that finance the purchase of the loan pools via
issuance of asset-backed securities in the capital markets, was an important
response. Over the period portrayed in figure 3, the private-label securitization
market grew from under $500 billion in issuance to over $2 trillion in issuance in
2006, the year before the crisis.

Figure 3 U.S Private-Label Term Securitization Issuance by Type (in billion USD).

The increased supply of asset-backed/mortgage-backed securities prior to beginning

of the crisis, as shown, is consistent with the assumption of the credit boom. The
large loan pools had a demand for insured securities and far exceeded the risk-free
govt. asset market (US Treasuries, which were mostly held by foreign investors).
Therefore; 1.) Asset backed securities and repurchase agreements with collateral
substituted the insured Govt. deposits (US treasuries) 2.) There were indirect
holdings of unsecured money market instruments through MMF, where the portfolio
was short-term and globally diversified. The collateral in most instruments were

3 Securitization is off-balance sheet financing for banks and other financial intermediaries
mortgages and resulted in the increase of housing prices.

Eventually in September 2008, Lehman Brothers filed for Chapter 11 bankruptcy,

which proved to be the tipping point of the financial crisis as it led to a run in Money
Market Funds(MMFs) as is evident when Real Primary Fund, a MMF, “broke the
buck” when Lehman failed as it held its asset-backed commercial papers. As main
holders of these securities, the MMFs saw their value decline further as the
underlying assets of these securities were sold in the market. In 2007, the fund
sponsor bailing out these funds solidified the investor confidence and, without any
investor due diligence, was deemed risk-free. In addition, the investor was blindly
finding the highest yielding funds. Suddenly, many financial institutions were at risk
of default due to the disruptions in the economy. After the run on prime MMFs, which
were the crucial credit suppliers to the corporations and financial intermediaries,
there was a shortage of private credit suppliers. Gorton and Metric (2012), in their
journal “Securitized Banking and the Run on Repo” shows the reduction in credit
supply by the increase in the haircut from almost 0% in the beginning of 2007 to
more than 40% towards the end of 2008 and remained high post that as shown in
the figure 4 below.

Figure 4 Avg. Repo Haircut

This erosion of confidence in stability of financial system in US and Europe resulted

in banks holding liquidity and transmitted the crisis globally.

Policy Responses

The shocks to a variety of financial markets have proven to be much more disruptive
than the subprime losses themselves. Ultimately, in order to ensure no serious
repercussions for the rest of the financial system and the economy, central banks
and governments have had to intervene or bail out major financial institutions.
Central banks engaged in unprecedented intervention and US Congress announced
Troubled Asset Relied Program (TARP), authorizing 700$ billion in expenditures. Six
central banks worldwide synchronized policy rate cuts in Oct 2008 in an effort to
stabilize market functions and reduce the impact of economic contraction. Since
then, continuous international regulatory and policy actions have continued to
mitigate these threats and avoid a repeat of the Global Financial Crisis. These policy
actions by Central Banks through Monetary Policies and by Governments through
Financial Regulations are described in the below:

1. Central Bank—Monetary Policy and Liquidity Support

o Interest rate change
 Reduction of interest rates
o Liquidity support
 Reserve Requirements, longer funding terms, more auctions
and/or higher credit lines
2. Government—Financial Sector Stabilization Measures
o Recapitalization
 Capital injection (common stock/preferred equity)
 Capital injection (subordinated debt)
o Liability guarantees1

 Enhancement of depositor protection

 Debt guarantee (all liabilities)

 Debt guarantee (new liabilities)

 Government lending to an individual institution
o Asset purchases
 Asset purchases (individual assets, bank by bank)
 Asset purchases (individual “bad bank”)
 Provisions of liquidity in context of bad asset purchases/removal
 On-balance-sheet “ring-fencing” with toxic assets kept in the
bank
 Off-balance-sheet “ring-fencing” with toxic assets moved to a
“bad bank”
 Asset guarantees

Comprehensive Capital Analysis and Review (CCAR)

In the wake of the 2008 global recession, the concept of systematic stress tests first
emerged. CCAR is a regulatory mechanism developed by the Federal Reserve in the
United States to review, control and oversee large banks and financial institutions,
collectively referred to in the regulation as Bank Holding Companies (BHCs). The
regulations consist of two related programs, which are listed below, and the
evaluation is carried out annually. The evaluation is carried out both qualitatively and
quantitatively, and the Fed may order BHCs to retain the shareholders' distribution of
capital if the target capital requirements are not met.

 Comprehensive Capital Analysis and Review.

 The Dodd-Frank Act supervisory stress testing: Forward looking stress tests
on BHCs’ capital structure on a quantitative base on three scenarios:
Baseline, Averse and Severely Adverse.

The core part of the regulation assesses whether the BHCs:

 Possess adequate capital

 Capital structure is stable given various test scenarios in the stress test
  Planned capital distribution to shareholders are viable and acceptable in
terms of the minimum capital requirement

The SCAP of the Fed, usually referred to as the "stress tests," showed that the
information system of BHCs to timely report its risk exposure to
customers/counterparties and inadequacies in their internal methods of capital
assessment. In retrospect, strong bank capital requirements needed for the trading
book assets of BHCs and increased attention to liquidity risks would have rendered
financial institutions immune to adverse economic conditions and ensured that these
institutions would maintain adequate liquidity and no credit supply shortages,
resulting in recessions and taxpayer money bailouts.

It is very difficult to identify stress testing and incorporate an infrastructure in a

financial institution and it is a significant overhead expense for the institution. There
is no single definition of stress and, moreover, it is difficult to define what
circumstances constitute the three scenarios needed for stress testing under the
Regulation. Moreover, the complex procedure of identifying the key risk drivers and
quantifying them and further translating them into key portfolio parameters, such that
the BHCs operates under the defined risk mandate, is a difficult and a costly task.
Some banks have stopped the practice of offering their customers free checking
accounts in response to the costs that the legislation puts on banks. In response to
the new legislation, small banks have been forced to terminate some companies,
such as mortgages and car loans. The number of compliance regulatory teams has
increased. Further research suggests that the core reforms put in place have
substantially boosted resilience without unduly limiting credit availability or economic
growth

Mortgage Backed Securities

A MBS is a type of asset backed security where the underlying home loans are
pooled together and sold to investment industry at discount to be included in an
MBS. MBS behave very similar to the bonds as the investor buying the MBS
receives the periodic interest/coupon payments collected from underlying home
loans.

The creation of MBS begins from the bank or credit union that extends a mortgage
loan to a borrower. The lender will pool the loans with similar characteristics together
to sell them as securities or in some cases the loans are sold to trust, issuer of MBS,
to be pooled together which are then sold to investors or retained as investments.
This process called as securitization is diagrammatically explained in the below
figure.
 Figure 5 Creation of MBS (Source : Wikipedia)

Benefits
The process of securitization is beneficial to the banks or the credit unions that
extends the mortgage loans as it changes their role from the lender to that of the
middlemen when they sell those loans to the MBS issuer. Hence, transfer the risk to
the MBS issuer. Mortgage loans are usually have a maturity of around 30 years, and
selling their pooled loans at a discount allows the lenders to recycle their capital and
make new loans on the funds received. Moreover, it allows the investor to have an
exposure to the home loans market and indirectly bringing the potential borrowers
and lender together.

Role of MBS in the Global Financial Crisis

The MBS played a major role in the global financial crisis which is also called as the
sub-prime mortgage crisis. As discussed before, MBS were used as a substitute for
ever increasing demand for alternate investments with low risks and used as a
collateral in repo transaction which allowed the losses in sub-prime mortgages to
amplify into other sectors and caused an economic recession. The ever increasing
house prices (asset-price bubble) and demand for MBS caused the banks to lower
their lending standards. With crash in the house prices many mortgage loan
borrowers began to default as the house prices were less than the debt they owed to
the lenders. This led to the decline of value of the MBS and many funds saw their
investments decline leading to loss of confidence in the financial system and caused
the bank run which led to the crisis and intervention from the fed to bailout the
financial institutions.
The potential benefits of the MBS did not manifest in the Global Financial Crisis due
to the lack of risk management processes on the bank’s part and the lack of due
diligence on the investor’s part. Securitization is an off-balance sheet financing for
the banks/financial intermediaries between the home loan borrowers and
investors/funds, which worked as shadow banks to fill the gap between the supply
and demand of low risk fixed income securities.

References

1. Bernanke, Ben S. 2010. “Causes of the Recent Finan- cial and Economic
Crisis.” Testimony before the Financial Crisis Inquiry Commission,
Washington, D.C., September 2.
https://www.federalreserve.gov/newsevents/testimony/bernanke20100902a.ht
m
2. International Monetary Fund. 2010. Global Financial Stability Report:
Sovereigns, Funding, and Systemic Liquidity. Washington, D.C.: International
Monetary Fund.
3. Pozsar, Zoltan. 2011. “Institutional Cash Pools and the Triffin Dilemma of the
U.S. Banking System.” International Monetary Fund Working Paper 11/190.
4. Schularick, Moritz, and Alan M. Taylor. Forthcoming. “Credit Booms Gone
Bust: Monetary Policy, Leverage Cycles, and Financial Crises, 1870–2008.”
American Economic Review.
5. Gorton, Gary, and Andrew Metrick. Forthcoming. “Securitized Banking and
the Run on Repo.” Journal of Financial Economics.
6. Wikipedia:
https://en.wikipedia.org/wiki/Dodd%E2%80%93Frank_Wall_Street_Reform_a
nd_Consumer_Protection_Act#Impact
https://en.wikipedia.org/wiki/Comprehensive_Capital_Analysis_and_Review
https://en.wikipedia.org/wiki/Mortgage-backed_security
7. Investopedia:
https://www.investopedia.com/terms/m/mbs.asp