The Global Financial Crisis: Anxiety, Part 1

The Global Financial Crisis
Module 6 Anxiety, Part 1
Andrew Metrick
Outline
Module 6
01 Some notable events in 2007 07 Asset-backed commercial paper
02 ABX 08 ABCP data
03 ABX data 09 ABCP runs, part 1
04 Anxiety spreads to interbank 10 ABCP runs, part 2

markets
11 Summary
05 LIBOR-OIS
06 LIBOR-OIS data
01 Some Notable Events in 2007

Some Notable Events in 2007
April 2007
New Century: 4/2/07 (REIT with market cap of
$1.75 billion on 1/1/07, delisted 3/13, filed for
bankruptcy 4/2)
June 2007
S&P/Moody’s significant downgrades beginning

in June 2007
Bear Stearns suspends redemptions: 6/7/07
July 2007
Bear Stearns liquidates funds: 7/31/07
August 2007
BNP Paribas funds: 8/9/07

02 ABX
ABX
The ABX-HE (or just “ABX”), is an index of credit default

swaps (CDS) written on subprime mortgage
securitizations. The price of the ABX index is essentially
a measure of perceived value of subprime securities with
various ratings; the return (or spread) on the ABX is
essentially a risk premium for subprime.
The index was created by the firm Markit, and first

released in January 2006 covering the 20 largest
subprime securitizations that closed in the last six
months of 2005. These indices were denoted as ABX-HE
2006-1. Subsequent releases were denoted 2006-2, 2007-
1, and 2007-2 before subprime activity became too small
for index construction.
The launch of ABX in 2006 was a notable event, as it

allowed everyone to see, speculate, and hedge – for the
first time – market expectations about subprime.
03 ABX Data
ABX.HE Spreads, 2006-1 Series, BBB Rating
January – July 2007
Basis Points
1,000
900
800
700
New Century
600
Bear Stearns Funds
500
400
300
200
100
0
Jan-07 Feb-07 Mar-07 Apr-07 May-07 Jun-07
Source: Markit
ABX.HE Spreads, 2006-1 Series, AAA Rating
January – July 2007
Basis Points
50
45
New Century
Bear Stearns Funds
40
35
30
25
20
15
10
0
Jan-07 Feb-07 Mar-07 Apr-07 May-07 Jun-07
Source: Markit
ABX.HE Spreads, 2006-1 Series, BBB Rating
July – December 2007
Basis Points
5,000
4,500
4,000
3,500
BNP Paribas
3,000
2,500
2,000
1,500
1,000
500
0
Jul-07 Aug-07 Sep-07 Oct-07 Nov-07 Dec-07
Source: Markit
ABX.HE Spreads, 2006-1 Series, AAA Rating
July – December 2007
Basis Points
500
450
400
350
300
BNP Paribas
250
200
150
100
50
0
Jul-07 Aug-07 Sep-07 Oct-07 Nov-07 Dec-07
Source: Markit
04 Anxiety Spreads to Interbank Markets

How Could We Be So Wrong?
“… given the fundamental factors in place that should support the

demand for housing, we believe the effect of the troubles in the
subprime sector on the broader housing market will likely be
limited, and we do not expect significant spillovers from the
subprime market to the rest of the economy or to the financial
system.”
- Chairman Bernanke in a speech on May 17, 2007

Anxiety Spreads
The bad news in subprime was well-known by the time of

Chairman Bernanke’s speech. Indeed, the news events in the
spring of 2007 seem uncorrelated with the movements in the
ABX.
Instead, the problem became the uncertainty about the

location of subprime risk. Which securitized bonds were
exposed to subprime? Which financial institutions would need
to support their investment vehicles?
The financial system is not equipped to analyze “safe”

investments. The resources for deep analysis of information
are not there.
Consider what you would do if you had uninsured deposits at

a bank, and you became nervous about the bank’s solvency. Is
it rational to analyze the bank’s balance sheet, or to just take
your money out?
05 LIBOR-OIS
LIBOR-OIS
The London Interbank Offered Rate (LIBOR) is a

measure of the interest rates that banks charge
each other for unsecured dollar funding over
various time periods (overnight, one-month, three-
month etc.)
The Overnight Index Swap (OIS) is a fixed-floating

interest-rate swap for various time periods.
Because the amounts owed daily are small and
counterparties must continuously post collateral
for expected payments, the fixed leg of this swap is
considered to be a good proxy for risk-free interest
rates.
The LIBOR-OIS spread is thus a good measure for

the riskiness of banks’ unsecured borrowing.
Historically, this spread was very small (around ten
basis points).
06 LIBOR-OIS Data
3 Month LIBOR-OIS Spread
Basis Points
400
350
300
250
200
Lehman Brothers
Bear Stearns
150 BNP Paribas
100
50
0
Jan-07 Mar-07 May-07 Jul-07 Sep-07 Nov-07 Jan-08 Mar-08 May-08 Jul-08 Sep-08 Nov-08
Source: Bloomberg.
07 Asset-Backed Commercial Paper

Asset-Backed Commercial Paper
Asset-backed commercial paper (ABCP) is primarily

a method of maturity transformation – funding a
pool of long-term assets with short-term liabilities.
ABCP is designed to meet specific needs of

investors (often money-market mutual funds), and
includes credit enhancement and liquidity support
to achieve this goal.
Obligor Obligor Obligor Obligor Obligor Obligor Obligor Obligor Obligor
Seller Seller Seller

collections on previously advances against new
transferred receivables receivables
credit support payments liquidity advances
Credit Enhancement ABCP Conduit Liquidity Providers

Providers fees fees
Payments on purchase price of new nominal dividends

fees
maturing ABCP ABCP
Administrator Issuing & Paying Agent Conduit Owner

Payments on purchase price of new
maturing ABCP ABCP
ABCP Investors
ABCP vs. Securitization
ABCP may appear similar to securitization, but there

are many differences:
Investments can be revolving and fluctuate

in size
Conduits may invest in various asset types
Typically engage in maturity

transformation, with backup liquidity
support
No scheduled amortization of assets and

liabilities
Source: Fitch (2001).

08 ABCP Data
ABCP Outstanding
Billion dollars
1,400
Max on 08/08/07
1,200
1,000
800
600
400
200
0
1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Source: Fitch Ratings, Federal Reserve Bank of St. Louis.

ABCP Data
ABCP programs grew rapidly in the 1990s, and

then again in the crucial 2003-2007 period.
As of 2007, ABCP programs took many forms,

and were not dominated by any particular type of
sponsor.
ABCP Program Types
ABCP programs by program type, as of July 2007
Market Share Programs with Programs with Programs with Programs with Programs with Programs with
Number of
Program Type Assets by Outstanding Extendible Credit Support Large US Bank Small US Bank Foreign Bank Nonbank
Programs
(%) Paper (%) (%) Sponsors (%) Sponsors (%) Sponsors (%) Sponsors (%)
Diversified
Multi-seller receivables and 98 45 19 30 19 4 57 20
loans
Credit-car
Nonmortgage
receivables and 40 11 62 28 8 10 8 74
single seller
auto loans
Mortgages and
Mortgage single mortgage-
11 2 67 0 9 9 0 82
seller backed
securities (MBS)
Highly rated
Securities long-term
35 13 9 17 14 11 66 9
arbitrage securities,
including MBS
Highly rated
Structured
long-term
investment 35 7 0 0 11 0 23 66
securities,
vehicle
including MBS
Highly rated
long-term
CDO 36 4 25 0 0 3 3 94
securities,
including MBS
Hybrid and other N.A. 84 18 20 10 5 2 12 81
Total 339 100 24 16 10 5 30 55

09 ABCP Runs, Part 1

ABCP “Runs”
Covitz, Liang and Suarez define an ABCP “run” as a

week when the program does not issue new CP
despite having at least 10% of outstanding CP
mature.
Runs became endemic in August 2007, and once a

program experienced a run it was unlikely to ever
leave that state. By December 2007 more than 40%
of programs were in a run state.
ABCP “Runs”
Percent, Weekly
60
Fraction of ABCP programs experiencing runs
Unconditional hazard of leaving the run state
50
40
30
20
10
0
Jan-07 Feb-07 Mar-07 Apr-07 May-07 Jun-07 Jul-07 Aug-07 Sep-07 Oct-07 Nov-07 Dec-07 Jan-08
Source: Covitz, Daniel, Nellie Liang, and Gustavo A Suarez, 2013, The evolution of a financial crisis: Collapse of the asset-backed commercial paper market, The Journal of Finance 68, 815-848.
ABCP Outstanding
ABCP outstanding down $350 billion from its August 2007 peak
Billion dollars, Weekly (Wednesday)
1,300
1,200
1,100
1,000
900
800
700
Jan-07 Feb-07 Mar-07 Apr-07 May-07 Jun-07 Jul-07 Aug-07 Sep-07 Oct-07 Nov-07 Dec-07
10 ABCP Runs, Part 2

ABCP “Runs”
Maturity of new issues fell significantly
Days, Weekly (Wednesday)
40
35
30
25
20
15
10
Jan-07 Feb-07 Mar-07 Apr-07 May-07 Jun-07 Jul-07 Aug-07 Sep-07 Oct-07 Nov-07 Dec-07 Jan-08
ABCP “Runs”
Even for firms that could issue, risk spreads rose significantly
Percentage Points, Daily
1.0
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0.0
-0.1
Jan-07 Feb-07 Mar-07 Apr-07 May-07 Jun-07 Jul-07 Aug-07 Sep-07 Oct-07 Nov-07 Dec-07
ABCP “Runs”
01 By the end of 2007, ABCP

outstanding was down about $350
billion from its August 2007 peak.
02 The maturity of new issues also

fell significantly.
03 Even for programs that were able

to issue, risk spreads rose
significantly.
11 Summary
Summary
Module 6
01 The problems in subprime were 03 The anxiety is driven by a financial

clear to all market participants in system ill-equipped to analyze
early 2007. risks in seemingly “safe” assets.
This sets the stage for a good old-
02 These problems were not expected fashioned bank run, but now taking
to infect the whole financial place in the shadow banking
system, but uncertainty about the markets.
location of risks led to a spread of
anxiety beginning in the middle of
2007.

The Global Financial Crisis: Anxiety, Part 1

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The Global Financial Crisis

Module 6 Anxiety, Part 1

01 Some notable events in 2007 07 Asset-backed commercial paper

02 ABX 08 ABCP data

03 ABX data 09 ABCP runs, part 1

04 Anxiety spreads to interbank 10 ABCP runs, part 2

01 Some Notable Events in 2007

S&P/Moody’s significant downgrades beginning

Bear Stearns liquidates funds: 7/31/07

BNP Paribas funds: 8/9/07

The ABX-HE (or just “ABX”), is an index of credit default

The index was created by the firm Markit, and first

The launch of ABX in 2006 was a notable event, as it

04 Anxiety Spreads to Interbank Markets

“… given the fundamental factors in place that should support the

- Chairman Bernanke in a speech on May 17, 2007

The bad news in subprime was well-known by the time of

Instead, the problem became the uncertainty about the

The financial system is not equipped to analyze “safe”

Consider what you would do if you had uninsured deposits at

The London Interbank Offered Rate (LIBOR) is a

The Overnight Index Swap (OIS) is a fixed-floating

The LIBOR-OIS spread is thus a good measure for

07 Asset-Backed Commercial Paper

Asset-backed commercial paper (ABCP) is primarily

ABCP is designed to meet specific needs of

Seller Seller Seller

credit support payments liquidity advances

Credit Enhancement ABCP Conduit Liquidity Providers

Payments on purchase price of new nominal dividends

Administrator Issuing & Paying Agent Conduit Owner

ABCP may appear similar to securitization, but there

Investments can be revolving and fluctuate

Conduits may invest in various asset types

Typically engage in maturity

No scheduled amortization of assets and

Source: Fitch (2001).

Source: Fitch Ratings, Federal Reserve Bank of St. Louis.

ABCP programs grew rapidly in the 1990s, and

As of 2007, ABCP programs took many forms,

Hybrid and other N.A. 84 18 20 10 5 2 12 81

Total 339 100 24 16 10 5 30 55

09 ABCP Runs, Part 1

Covitz, Liang and Suarez define an ABCP “run” as a

Runs became endemic in August 2007, and once a

10 ABCP Runs, Part 2

01 By the end of 2007, ABCP

02 The maturity of new issues also

03 Even for programs that were able

01 The problems in subprime were 03 The anxiety is driven by a financial

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