The Credit Crunch of 2007-2008:

A Discussion of the Background, Market Reactions, and Policy Responses

- Paul Mizen

Slides by Frederica Shockley California State University, Chico

Source: http://research.stlouisfed.org/publications/review/08/09/Mizen.pdf

Mispricing of Risk
Crisis Due to mispricing of risk of new, complicated assets based upon subprime & other mortgages. High leverage contributed to risk. House Prices Foreclosures Bank Failures

Background
The Great Moderation -years of macro stability

Low inflation Low short-term interest rates Steady growth

Global savings glut Development of complex financial assets

Credit Boom
Fed dropped rates after dot com bust & again after 9/11. Rising house prices Stable economic conditions.

Disposable Income (DI) is income after taxes that is available for consumption & savings.

Savings Flowed into U.S.

After 1997 Asian Crisis many countries bought U.S. treasuries & bonds.

Prices of Bonds interest rates Credit Savings from less developed countries funded our deficits with growing imbalance.

1993 to 2005: U.S. savings as % of DI from 6% to 1%; Total debt to DI from 75% to 120%

This is debt to Disposable Income (DI) which is income after taxes that is available for consumption & savings.

U.S. Mortgages
Prime: borrowers have good credit & meet income & house pricing requirements. Jumbo: borrowers have good credit & meet income requirements, but house price > amount set by Fannie & Freddie. Alt-A have higher risk of default because they do not conform to Fannie & Freddie requirements. Sub-prime: most risky loans often made to people with bad credit history.

Mortgage Originations

Sub-Prime Mortgages Grew Rapidly

Late 90s increased to 13% of originations, but halted by dot com bust. 2002 2006: By 2006 Sub-Prime mortgages = 20% of originations. Borrower faces higher upfront fees. Lender faces higher probability of prepayment or default.

Asset Backed Securities

Ginnie Mae & VA sold first securities backed by mortgages in 1968. $10.7 T in global asset backed securities by 2006 (Bank of England). Many purchased by off-balance sheet institutions owned by banks that originally sold securitized products.

Complex Securities
CDOs, CDOs Squared, CDOs Cubed! Great variation in characteristics of sub-prime mortgages bundled together. Not all low credit quality Many borrowers depended upon rising home value to allow refi. Many who bought securities did not understand risk.

Sub-Prime Trigger
The sub-prime mortgage market triggered the crisis. Default rates started increasing in 2006. Pooled mortgages risky because defaults positively correlated. Investors highly leveraged.

If 20 to 1 5% loss 100% capital Investors lose all with only low default rates.

Global Impact
Originator faced low risk even if borrower defaulted. Automated underwriting & outsourcing of credit scores helped originators sell more mortgages. With low interest rates throughout the world, investors reached for yield. Sales of securities went global.

Sub-Prime Assets
Subprime was trigger, but other high yielding assets, e.g. hedge funds, could have started the crisis. People bought risky, complicated assets because return was high. After sub-prime defaults increased, rating agencies downgraded many sub-prime backed securities.

Corporations Lost Billions

Assets difficult to assess Uncertainty banks stopped loaning to other banks.
A write down is the amount by which an assets value is reduced.

Bear Stearns collapsed after hedge funds failed to rollover asset backed commercial paper.

Structured Investment Vehicle (SIV)

Funds that borrowed in short term commercial paper market to finance assets that they held long term. Borrowed at low rate & bought long-term securities that paid high interest. Some intended to run indefinitely, but all gone by Oct. 2008.

Liquidity Crisis
Banks afraid to loan because they might have to cover losses on their conduits or SIVs. The Libor-OIS spread increased from a long-run 10 basis points to 364 in 10/08.

The London inter-bank offer rate indicates is the rate that banks charge each other for loans of 1 day to 5 years. The London inter-bank offer rate indicates is the rate that banks charge each other for loans of 1 day to 5 years.

The London inter-bank offer rate indicates is the rate that banks charge each other for loans of 1 day to 5 years.

Three Month LIBOR OIS Spread

Indicator of confidence banks have in other banks. Usually about 10 basis points, but peaked at 364 on 10/10/08. Greenspan says TARP decreased spread.

Source: http://www.microcappress.com/blog/credi t-re-freeze-nipped-in-the-bud/641/

Credit Markets Froze

LCFI = Large Complex Financial Institution

Cost of Insurance Increased

Originate & Distribute Baking

In use for 40 years, but opacity mispricing of risk:

Residential MSBs backed by sub-prime mortgages Steps between originator & holder

Distorted incentives. Difficult to evaluate risk.

Six Bad Incentive Mechanisms

1. Mortgage brokers motivated by up-front fees independent of borrower quality.

Often not employees of mortgage originators not subject to regulation. Fraud in some cases.

2. Originators had no more incentive to seek quality borrowers than did brokers.

Investors wanted more mortgages. Automated underwriting systems made mortgages loser & faster.

More Bad Incentives

3. Mortgages Securitization profits for originators

Quality of new borrowers Standards NINJA loans No Verified Income, Job, or Assets. Piggyback loans Over time Risk of default

More Bad Incentives

4. Tranching allowed financial entities to tailor securities for varying levels of risk preference. 5. Rating agencies made income rating these financial products.

Issuers paid up-front fees to rating agency. Rating agencies sold advice to issuers on how to get desired rating.

More Bad Incentives

6. CDOs Return Fund manager bonuses

As long as the music is playing, youve got to get up and dance. Were still dancing. Chuck Prince, former CEO Citigroup. http://research.stlouisfed.org/publications/revie w/08/09/Mizen.pdf (page 22)

The Result
Incentives of brokers, originators, SPVs, rating agencies, & fund managers the same. No principal agent problem!

Regulation, Supervision, & Accounting Practices

Originators often ignored the quality of borrowers & Fed & state agencies did nothing. Originators may have engaged in predatory lending. Consumer protection legislation not enforced.

CRA Regs Encourage Risky Loans

HUD required Freddie & Fannie to buy mortgage securities for low income homeowners mid 90s. HUD expected originators to impose higher standards on such lenders, but Freddie & Fannie bought the mortgages anyway. Such securities increased 2004 to 2006.

New Fed Rules for Higher Priced Mortgages

Escrow
First lien mortgage loans are the first or original mortgages taken out when someone buys a mortgage.

Source: http://research.stlouisfed.org/publications/review/08/09/Mizen.pdf (Page 30)

Other Potential Changes

Require banks to hold same capital requirements for off-balance-sheet entities, e.g. SIVs & conduits. Regulators need to evaluate the big picture in order to reduce the externality cost of excessive risk taking.

Regulation of Rating Agencies

Rating agencies should be single product firms. They need to use models that take into consideration longer spans of data. They need to be subject to regulation.

Conclusions
Reasons for credit crisis:

Period of macro stability with low inflation & low interest rates. Big increase in supply of loanable funds. Financial innovation resulted in complex instruments, e.g. MBSs.
Higher leverage; Sub-prime mortgages.

Risk assessment failed.

Conclusions
No one expected housing prices to fall nationwide. Nationwide falling housing prices & higher interest rates led to defaults. Other high yield assets, e.g. hedge funds, could have been trigger. Bank failures led to credit freeze in commercial paper.

Conclusions
Central bankers stepped in to provide liquidity. Regulation will need to increase if we are to prevent future crises.