Financial crisis 2008

Created by: Parshwadeep Lahane

Disclaimer

 I am no financial expert. Made solely out of interest generated after

seeing the debacle on wall street
 All content is based on research, readings on internet, newspapers
and my understanding from it.
 Free to use. I hope people can take it as base and improve/update it
over time as crisis evolves
Let’s start with Basics
 Bank

 Operation
 Take money as deposits on which they pay interests
 Lend it to borrowers who use if for investment or consumption
 Borrow money from other banks (inter bank market)
 Make profit on the difference between interest paid and received

Source: The Economist: Making Sense of Modern Economy

 Potential problems in Bank

 Most of bank liabilities have shorter maturity period than assets

 This can be a potential cause of bank failure incase all depositors take
out money at once (bank run)

 Credit risk
 Possibility that borrowers will be unable to repay their loans
 More risk in prosperity period as lending terms tends to be relaxed

 Interest rate risk

 Most deposits at floating rate
 Loans at fixed rate
 If floating rate is more than fixed rate bank loses ( S&LI ,America 1979)

Source: The Economist: Making Sense of Modern Economy

 Criticality of Banking system

 As bank provide credit and operate payments- failure can have a more
damaging effect on the economy than the collapse of other businesses
 Hence need for more regulation by government
 Reserve requirement – holding a proportion of bank deposits at the central bank
(CRR)
 Match a proportion of risky assets (i.e loans) with capital in form of equity or
retained earnings
 Capital of internationally active banks should amount to at least 8% of the value of
risky assets. (Basel Accord)

Source: The Economist: Making Sense of Modern Economy

 Investment Banks
 Help firms raise money in the capital markets (equity and bonds market)

 Advise firms whether to finance themselves with debt or equity

 Underwrite such issues by agreeing often with other banks in syndicate, to buy any
unsold securities

 Paid a commission for this service

 Advice on mergers and acquisitions

(most lucrative work- not during
sub-prime crisis though!!)

 Glass-Steagall act – prevented

commercial banks from giving Investment
banks services
Source: The Economist: Making Sense of Modern Economy
 Institutional investors

 At most basic , they are simply vast pools of money

 Institutional investors are
 Pension funds
 Mutual funds
 Insurance companies
 Dominate the securities( stocks, bonds) market
 Control a huge chunk of most rich countries retirement savings and
other wealth
 These have been growing at the expense of banking system
 As biggest owners of stocks and bonds they have growing influence
in corporate finance and hence corporate governance

Source: The Economist: Making Sense of Modern Economy

Pension funds

 Designed for employees of companies or governments

 Common form –Trust- overseen by trustees for the benefit plan
members
 In traditional pension plan, the employer guarantees a fixed pension in
old age. The company and employee both pay monhtly contributions into
pension fund, where the money is invested.
 Trustee is responsible to make sure that the fund’s asset cover its
liabilities. Usually actuaries hired to carry this out.
 401K plans – allow for choosing from a menu of mutual funds. Blurring
the distinction between mutual and pension funds
Hedge funds

 Try explicitly to make money whether markets are going up or down

 Mostly private partnerships instead of public companies
 Most regulators allow only rich to invest in them
 Over the years shifted from being largely private funds for rich
families to being larger institutions whose investors are pension
funds, hospitals, endowments and foundations.
Insurance companies

 Oldest type of institutional investor

 From protection to savings + protection
 Law of large numbers – risk can be managed by pooling individual
exposures in large portfolios
 Catch1- law works if risk are not correlated
 Catch2- losses in any 1 year may differ hugely from the long run trend
 Central Bank-US FED
 Primary purpose is to address banking panics
 To strike a balance between private interests of banks and the centralized responsibility
of government
 To supervise and regulate banking institutions
 To protect the credit rights of consumers

 To manage the nation's money supply through monetary policy to achieve the sometimes
conflicting goals of
 maximum employment
 stable prices
 moderate long-term interest rates

 To maintain the stability of the financial system and contain systemic risk in financial
markets

 To provide financial services to depository institutions, the U.S. government, and foreign
official institutions, including playing a major role in operating the nation’s payments
system
 To facilitate the exchange of payments among regions
 To respond to local liquidity needs

Source: Wikipedia
 Government securities/bonds

• Governments usually borrow by issuing securities, government bonds and

bills to make up for the expenses and revenue (tax collected) differential
• One can treat it as commercial paper
• Least risky investment in US

Source: Wikipedia
 Credit Rating Agency (CRA)

 Company that assigns credit ratings for issuers of certain types of debt
obligations as well as the debt instruments themselves
 A credit rating for an issuer takes into consideration the issuer's credit
worthiness (i.e., its ability to pay back a loan), and affects the interest
rate applied to the particular security being issued
 Ex: Moody's (U.S.), Standard & Poor's (U.S.)
 Credit ratings are used by investors, issuers, investment banks, broker-
dealers, and governments.
 For investors, credit rating agencies increase the range of investment
alternatives and provide independent, easy-to-use measurements of
relative credit risk.

Source: Wikipedia
 Mortgage Broker

 Mainly found in developed economies like US, Western Europe

 Professionals who are paid a fee to bring together lenders and borrowers
 Sells mortgage loans on behalf of businesses (ex. Banks)
 Tasks undertaken:
 Marketing to attract clients
 Assessment of the borrowers circumstances (Mortgage fact find forms interview). This may
include assessment of credit history (normally obtained via a credit report) and affordability
(verified by income documentation)
 Assessing the market to find a mortgage product that fits the clients needs (Mortgage
presentation/recommendations)
 Applying for a lenders agreement in principle (pre-approval)
 Gathering all needed documents (paystubs / payslips, bank statements, etc.),
 Completing a lender application form
 Explaining the legal disclosures
 Submitting all material to the lender

Source: Wikipedia
 Sub-prime mortgage – What’s that?

 Home loans made to borrowers with poor credit ratings — a group

generally defined by FICO scores below 620 on a scale that ranges
from 300 to 850
 FICO - a number that is based on a statistical analysis of a person's
credit report, and is used to represent the creditworthiness of that
person.
(FICO is the acronym for Fair Isaac Corporation, a publicly-traded corporation (under the symbol
"FIC") that created the best-known and most widely used credit score model in the US.)

 Creditworthiness—the likelihood that the person will pay his or her

debts. Calculated by credit reporting agencies.
Ex. Equifax, Experian, and TransUnion in US

Source: Wikipedia
 Secondary Mortgage markets

 The secondary mortgage market allows banks to sell mortgages,

giving them new funds to offer more mortgages to new borrowers.
 If banks had to keep these mortgages the full 15 or 30 years, they
would soon use up all their funds, and potential homebuyers would
have a more difficult time to find mortgage lenders.
 Many of the mortgages on the secondary market are bought by
Fannie Mae.
 Other are packaged into mortgage-backed securities, and sold to
investors.

Source:http://www.urbandigs.com/2007/08/how_mortgage_backed_securities.html
 Mortgage Backed Security (MBS)

STEP 1 - A pool of mortgages are owned by a bank or lender. They are grouped into categories by credit risk including
subprime, alt-a (between subprime and prime), and prime.

STEP 2 - The pool of mortgages are packaged into a mortgage backed security.

STEP 3 - The mortgage backed security is then sliced and diced into different classes with varying maturities (called
tranches). Each tranche offers varying degrees of risk to the investor. The first loan to default will be placed into the Junk
tranche while the strongest loans receive the highest credit rating of 'AAA' and are placed at the top of the tranche
division. As with any asset associated with risk, the highest risk tranche receives the highest rate of return or yield while
the lowest risk (AAA rated) will receive the lowest yield.

STEP 4 - The tranches are then resold to investors who are willing to take on the varying degrees of risk and maturities.

Source:http://www.urbandigs.com/2007/08/how_mortgage_backed_securities.html
Collateralized Debt Obligation (CDO) simplified
MBS

MBS CDO

• Created in 1987 by now defunct investment firm Drexel Burnham Lambert

• Not traded on exchange but OTC market
 OTC market

 A decentralized market of securities not listed on an exchange where market

participants trade over the telephone, facsimile or electronic network instead of a
physical trading floor. There is no central exchange or meeting place for this
market.
 In the OTC market, trading occurs via a network of middlemen, called dealers, who
carry inventories of securities to facilitate the buy and sell orders of investors
 Trading is private and prices and
volumes are not disclosed
 Price discovery non transparent

Source : http://www.investopedia.com/terms/o/over-the-countermarket.asp
Now we are ready to look into the mess !
 Evolution of home mortgage
Home loan funding

1930s
Principal + interest payable over long term

Lender-Banks Borrower-Individuals
• Owning a house was not affordable to many
• Great Depression brought industry to a halt. Large scale defaulters and lenders
could not recover by reselling
• To simulate the industry again Government as part of New Deal policy created
the Federal National Mortgage Association (Fannie Mae) in 1938. This created a
secondary market for mortgages
Bought loan Home loan funding

Cash Principal + interest payable

over long term
Transfer of credit risk, market risk

Had Access to long term borrowing Lender-Banks Borrower-Individuals

Bought only those which conformed to
certain underwriting standard ( called Prime
Mortgages)

Source :http://www.imf.org/external/pubs/ft/fandd/2007/12/dodd.htm ,Subprime Mortgage Market Turmoil, Christopher L. Peterson, Asst Prof of Law, Univ of Florida
 Evolution continued…

 Fannie Mae proved very successful . But by 1960s , borrowing done by it

constituted a significant share of the debt owed by US government.
 1968- Government National Mortgage Association (Ginnie Mae) was
created to handle government guaranteed mortgages.
 Fannie Mae became federally chartered, privately held
 1970- Ginnie Mae developed MBS -- shifted the market risk to investors --
eliminated debt incurred to fund government housing program
 1970-Federal National Mortgage Corporation (Freddie Mac) created
 To securitize conventional mortgages
 Provide competition to Fannie Mae

 Over time Fannie Mae and Freddie Mac together provided enormous
amount of funding for US mortgage
 Since Fannie Mae and Freddie Mac guaranteed loans, much of credit risk
stayed with them. Size and diversification allowed them to handle it.
Source :http://www.imf.org/external/pubs/ft/fandd/2007/12/dodd.htm ,
 New Model of mortgage lending

Bought loan Home loan funding

Cash

Transfer of credit & market risk

Lender-Banks
Principal + interest payable
over long term
Securitization

SPV
Advantages
Cash

fees
MBS

• More liquidity in market

• Risk spread out
• Long term funding for mortgage lending
Transfer of market risk

• MBS- allows originators to earn fee income

from underwriting activities without exposure to
credit, market or liquidity risks as they see the
loans they make
Further evolution..

 1977- Private label securitization started first done by BOA and Salomon
Brothers
 1980s- pricing, liquidity and tax hurdles were resolved in same
 Unlike 2-3 party , private label securitization has 10 or more different
parties playing independent role
 Big private players in this field were
 Wells Frago
• Indymac
 Lehman Brothers
• Washington Mutual
 Bear Stearns
• Countrywide
 JP Morgan
 Goldman Sachs
 Bank Of America
 Details : Private Sub-prime mortgage process
1. Brokers identify borrowers
2. Originator and broker identify a loan for
borrower after looking at his credit rating
3. Formal application for loan by borrower
4. Originator transfers the loan to the
subsidiary of an investment banking firm
( Seller)
5. Seller(Investment bank) collects a pool
of loans and call it as SPE/SIV/SPV. Off
balance sheet instrument
6. SPV can be a corporation, partnership
or limited liability company. Most often a
Trust. It has nothing else except mortgage
loans
7. Underwriter purchases all the securities
(derivative income streams)
8. In designing SPV and its tranches
underwriter works with credit rating agencies
9. Underwriter then sells the securities to
the investors
10. High rated tranches might be guaranteed
by a 3rd party insurance company
11. Seller also arranges to sell the rights to
service the loan pool to a company or
sometimes Originator takes these rights
12. MERS – document custodian. Company to
keep track of mountains of paper work on loans
Source : Subprime Mortgage Market Turmoil , testimony by Christopher L. Peterson
in the pool. At National level.
Possible inter linkage in the US subprime mortgage market

Source: http://www.norges-bank.no/templates/article____66901.aspx
Reasons for forming of Subprime mess
 Giant pool of money available for investment through savings of Oil exporters , economic
development in BRIC countries.

 Private share in mortgage market growth in large part through origination and
securitization of high risk sub-prime and Alt-A mortgages.

 Building up of the housing bubble

 Private Banks made use of CDOs to sell to investors

• Lax regulations which did not keep pace with the innovations happening in financial
engineering

• US kept interest rates too low for too long in post dotcom bust period

• Hedge funds, Wall street firms and instructional investors found lower tranches in MBS
and CDO attractive which were highly risky

• Hedge funds leverage ratio of the order of 500%.

• To sum up in 3 words as noted by Harvard dean: Leverage(high), Transparency (low)

and Liquidity (abundant)
 Big assumptions
 Belief that modern capital markets had become so much more advanced than their
predecessors that banks would always be able to trade debt securities. This encouraged
banks to keep lowering lending standards, since they assumed they could sell the risk
on.

 Many investors assumed that the credit rating agencies offered an easy and cost-
effective compass with which to navigate this ever more complex world. Thus many
continued to purchase complex securities throughout the first half of 2007 – even though
most investors barely understood these products.

 Most crucially, there was a widespread assumption that the process of “slicing and
dicing” debt had made the financial system more stable. Policymakers thought that
because the pain of any potential credit defaults was spread among millions of investors,
rather than concentrated in particular banks, it would be much easier for the system to
absorb shocks than in the past.

 Housing prices will keep going up all time

Source :http://www.ft.com/cms/s/0/a09f751e-6187-11dd-af94-000077b07658,dwp_uuid=698e638e-e39a-11dc-8799-0000779fd2ac.html
 Misaligned incentives & pitfalls

 “churning” of capital “allows even an institution without a great amount of fixed capital
to make a huge amount of loans, lending in a year much more money than it has

 If an individual or class of victims obtains a large judgment, the lender’s management

can simply declare bankruptcy, liquidate whatever limited assets are left, and possibly
reform a new company a short time later.

 Securitization conduit divides various lending tasks into multiple corporate entities—a
broker, an originator, a servicer, a document custodian, etc.—the conduit tends to
prevent the accumulation of a large enough pool of at risk assets to attract the
attention of class action attorneys, which tend to be the only actors capable of
obtaining system-impacting judgments.

Source : Subprime Mortgage Market Turmoil , testimony by Christopher L. Peterson

Good days turn bad. Crisis at the door (mid 2006
onwards):
 Through financial innovations loans issued to borrowers at minimal rate,
adjusted rate. By mid 2006 time to pay bigger amounts comes
 Household income did not increase in same proportion as house prices
 Subprime mortgage owners start defaulting
 Rating agencies revise ratings of MBS/CDO as expected number of defaults turn
out higher. Many ratings are lowered
 Bewildered investors lost faith in ratings, many stop buying MBS/CDO altogether
 Alarm bell at SIV/SPVs
 Banks find themselves in non-comfortable position , stop making loans
 Housing prices plummet owing to increase in foreclosure, delinquency and
stoppage of loans
what a mess….
 More frenzy in market and more defaults, again revised ratings, again further stoppage of funding and further
stoppage of loans, further fall in house prices as demand and supply mismatch....problem feeding itself in circular
fashion.

 As MBS/CDO market is shaken….investors start debating other derivatives true worth…panic spreads across and
people start getting out….further hurting the banks

 The crisis unfolded as silent Tsunami on Wall Street where by the time people realized the graveness of the mess
they were in , it had gone beyond control.

 Since, most of the player in the market, mortgage brokers, investment banks were running in debts. They are
suddenly caught unaware and are in insolvency and start tumbling down….many are saved by nationalization as
their fall would spread the contagion way far .

 Central government start pumping in money as last resort but one thing is surely not returning soon and which is
very vital in financial industry -FAITH.
 In Short

 When homeowners default, the

amount of cash flowing into
MBS declines and becomes
uncertain.
 Investors and businesses
holding MBS have been
significantly affected.
 The effect is magnified by the
high debt levels maintained by
individuals and corporations,
sometimes called financial
leverage.

Source :http://www.imf.org/external/pubs/ft/fandd/2007/12/dodd.htm ,
Those good old days were gone now!!
How Subprime became Global Financial Crisis?
How could problems with subprime mortgages, being such a small sector of global
financial markets, provoke such dislocation?

 Lets look into it from start again:

 Industry data suggest that between 2000 and
2006, nominal global issuance of credit

In billion US $
instruments(MBS/CDO) rose twelvefold, to
$3,000bn a year from $250bn
 Became intense from 2004, partly because
investors were searching for ways to boost returns
after a long period in which central banks had kept
interest rates low.
 “slicing and dicing” was fuelling a credit bubble,
leading to artificially low borrowing costs, spiraling
leverage and a collapse in lending standards

Source: Financial Times , http://www.ft.com/cms/s/0/a09f751e-6187-11dd-af94-000077b07658,dwp_uuid=698e638e-e39a-11dc-8799-0000779fd2ac.html

 Build up into a financial crisis…
 In 2003, Bank of International Settlements(BIS) repeatedly warned that risk dispersion might not
always be benign. But US Federal Reserve was convinced that financial innovation had changed
the system in a fundamentally beneficial way.
 No efforts made to correct debt to equity ratios of bank
 Huge trust in the intellectual capital of Wall Street –supported by the fact that banks were making
big money.
 When high rates of subprime default emerged in late 2006, market players assumed that the
system would absorb the pain.
 Initial estimate of subprime loss put to $50bn-$100bn by US FED
 Subprime losses started to hit the financial system in the early summer of 2007 in unexpected
ways. As the surprise spread, the pillars of faith that had supported the credit boom started to
crumble.
 Investors woke up to the fact that it was dangerous to use the ratings agencies as a guide for
complex debt securities.
 In the summer of 2007, the agencies started downgrading billions of dollars of supposedly “ultra-
safe” debt – causing prices to crumble.

Source: Financial Times , http://www.ft.com/cms/s/0/a09f751e-6187-11dd-af94-000077b07658,dwp_uuid=698e638e-e39a-11dc-8799-0000779fd2ac.html

 Poor Investors….
 Shocked investors (sitting in all parts of the world) lost faith in ratings, many stopped buying complex
instruments altogether
 That created an immediate funding crisis at many investment vehicles ( remember SIV), since most had
funded themselves by issuing notes in the asset-backed commercial paper market.
 Many banks had not yet passed on the risk to others. Many were holding asset-backed securities in
“warehouses” and were working on splicing them up into CDOs, getting them rated by a credit agency
such as Moody’s or Standard & Poor’s. Several banks were caught out not only because it took time to
structure the securities but because they deliberately held on to what they regarded as “safe” tranches
of loans. Ex. UBS was badly damaged by retaining “super-senior” CDO debt.
 It also meant that banks were no longer able to turn assets such as mortgages into subprime bonds and
sell these on.
 That in turn meant the key assumption that the capital markets would always stay liquid – was
overturned.
 Assumption that banks would be better protected from a crisis because of risk dispersion – also
cracked.
 As investment vehicles lost their ability to raise finance, they turned to their banks for help. That
squeezed the banks’ balance sheets at the very moment that they were facing their own losses on debt
securities and finding it impossible to sell on loans.
Source: Financial Times , http://www.ft.com/cms/s/0/a09f751e-6187-11dd-af94-000077b07658,dwp_uuid=698e638e-e39a-11dc-8799-0000779fd2ac.html
 Desperate banks….

 As a result, western banks found themselves running out of capital

 Banks started hoarding cash and stopped lending to each other as financiers lost
faith in their ability to judge the health of other institutions – or even their own.
 The London interbank offered rate(LIBOR), the main measure of interbank lending
rates, rose sharply
 Firms became reluctant to participate in money markets ... as a result subprime credit
problems turned into a systemic liquidity crunch.
 Vicious deleveraging spiral got under way. As banks scurried to improve their balance
sheets, they began selling assets and cutting loans to hedge funds.
 But that hit asset prices, hurting those balance sheets once again.
 Mark-to-market accounting forced banks to readjust their books after every panicky
price drop

Source: Financial Times , http://www.ft.com/cms/s/0/a09f751e-6187-11dd-af94-000077b07658,dwp_uuid=698e638e-e39a-11dc-8799-0000779fd2ac.html

 Lessons learned & Action plans ….

 lesson of the CDO collapse is that technology does not obviate the need to
assess a borrower carefully. Neither banks nor credit agencies did this well
enough on behalf of investors and it proved a painful experience for everyone
 In the medium term, regulators are preparing reforms that aim to make the
system look credible
 These would force banks to hold more capital and ensure that the securitization
process is more transparent
 Separately, groups such as the IIF are trying to introduce measures that could
rebuild confidence in complex financial instruments
 More immediately, the banks are trying to rekindle investor trust by replenishing
their capital bases

Source: Financial Times , http://www.ft.com/cms/s/0/a09f751e-6187-11dd-af94-000077b07658,dwp_uuid=698e638e-e39a-11dc-8799-0000779fd2ac.html

 Subprime losses by Big Banks

Worldwide :US$ 586.2 billion and still counting

Source: Financial Times

Finance & Economy

 The collapse of an enormous financial institution stirs uncertainty,

and uncertainty rattles Wall Street. Lenders are happiest when they
are confident they will be repaid. If they think there's a chance that
borrowers will default, they simply don't make loans. Their refusal, in
turn, can shut down the economy and the financial system.
 Financial system is what provides the funding for all the other
sectors of the economy, and if you have a broken financial system,
you have a broken economy
Investments devalued across the Globe

Source: BBC News, http://news.bbc.co.uk/2/hi/talking_point/7644574.stm

Subprime impact across globe

Source: Financial Times

Impact of Financial crisis-felt across the globe

Source: Reuters, http://www.reuters.com/news/globalcoverage/creditcrisis

Thanks
Market share shifted from 2003 to mid 2006
Mortgage market % share

100 • Government share fell by 43%

24
80
57 where as private share rose
60
sharply by 138% over a period of 3
%

40 76

43
years
20

0
2003 mid-2006
Year

Government sponsered Private( Wall Street firms)

• Subprime lending increased by

massive 205% over 3 years

• Alternative–A similarly expanded

by 384%

• Increase in Prime was mere

16.7%
Between sub-prime and prime
 Global pool of money

• After 1997/98 financial crisis – Developing countries focus on export-

driven growth and the associated accumulation of foreign exchange
reserves
• The strength of exports relative to domestic demand has seen saving
outstrip investment in most of these economies

• Accordingly, we have the ironic situation whereby a range of developing

countries are (in net terms) the providers of capital to some of the world’s
most developed economies.

• This rapidly rising “savings glut” has been a principal source of

increased global liquidity.
Source:http://www.rbnz.govt.nz/speeches/2968727.html
 Rise of Global Liquidity (1998 onwards)

• The flow of increased global liquidity through markets has provided the impetus for many changes

• To generate a return on this liquidity has spurred massive growth in securitization of debt and the
development of a vast array of derivatives. The propagation of these instruments can itself be seen as a
source of liquidity growth. From a monetary policy perspective, this implies a very big increase in the
liquidity that is not directly controlled by central banks.
•
•Bank for International Settlements, highlighted a number of important new features:
• the unbundling and re-pricing of risk through major advances in financial engineering, resulting in
improved ability to lever lending via new markets such as for credit transfer products;
• the emergence of new financial players such as hedge funds and private equity firms that have not
been traditional intermediaries;
• more reliance of financial firms on markets to handle growing complexity;
• a reliance on market liquidity even in stress situations; and
• a surge in volume and value of transactions.
Source:http://www.rbnz.govt.nz/speeches/2968727.html
FED interest rate

• To catch up with dot com boom

FED kept interest rate low for long
•
•This indirectly resulted in
investors looking for other safe
heavens

• They got attracted to housing

market
High Banks leverage ratio’s to fund MBS/CDO
Building up of the housing bubble
 Housing prices and Income

• Housing
prices were
increasing

•Income slope
was almost flat

Source: http://varbuzz.com/meltdown/
Starting 2006 housing bubble busted
LIBOR rate
 Credit rating of complex financial instruments

Source: IMF and WSJ

Speedy Foreclosures
Top 10 Bankruptcies
The American way of debt

Source: http://www.nytimes.com/interactive/2008/07/20/business/20debt-trap.html?ei=5070
 Average debt of American in 2004

Source: http://www.nytimes.com/interactive/2008/07/20/business/20debt-trap.html?ei=5070