C07 ANATOMY OF THE GREAT FINANCIAL CRISIS OF 2007 2009

Financial crisis overview #

Cheap interest rate clubbed with Financial innovations, such as securitization reduced the credit risk borne by the originator. This led to originating banks becoming less concerned with the credit quality of their borrowers, which led to more relaxed lending standards. What started as subprime crisis escalated to other asset classes and geographical areas. Govt around the world intervened by lowering interest rate and providing liquidity support.

Banks increasingly financed their long-term assets through short term liabilities, gave rise to a maturity mismatch. When the crisis struck and house prices stalled, those short-term liabilities could not be rolled over.

At the peak of crisis in Sept 08, Leaham declared bankruptcy, triggered a massive loss of confidence, and froze the interbank lending market. Other banks, were either bought out by competitors or converted to bank holding companies and became regulated by Fed. Fannie Mae and Freddie Mac, were nationalized, and the large financial services and insurance company, AIG, was bailed out to prevent further systemic issues.

Subprime Mortgages and Collateralized Debt Obligations #

Subprime Mortgages is secured loan issued to borrower with poor credit holder. A typical subprime loan could be structured as a 30 years 2 – 28 adjustable rate mortgage (ARM). 2 year is relatively low fixed teaser rate, which then reverts to much higher variable rate for remaining 28 years of mortgage. This was compounded by

• 100% Loan to Value
• Interest only
• NINJA Loans : No Income No Jobs and Assets.
• Liar Loans: Provided on little fake evidence.

Some subprime borrowers, hoped to refinance houses after their teaser period or sell at profit due to soaring prices in housing. When the house prices declined, borrowers started defaulting.

Role of CDOs: CDO is securitization structure whereby the pool of assets are sliced into multiple tranches. Senior tranches were considered very safe with AAA rating. Junior trances of multiple CDO structure were then often bundled together and repackaged as CDO Squared. These structures were opaque. The fact that senior tranches were given AAA rating by agencies were unrealistic and based on historical data for prime mortgages and did not take into other factors. This was further exacerbated by a conflict of interest whereby rating agencies were paid by the issuer and, therefore, incentivized to provide favorable rating.

Short Term Funding and Systemic Risk #

SIVs used short term funding for long term assets. Two instruments for funding were asset backed commercial papers (ABCP) and repurchase agreements (repos). Commercial paper is short term unsecured form of financing primarily used by high quality issuers. ABCPs are similar but back by collateral, such as credit card loans or mortgages. Due to inherent assumption that the issuer will be able to roll over the obligation at maturity. REPOs are another source. In Repos haircut was applicable.  Because ABCP and repos were funded by short term and dependent on roll over capability, this exposed SIVs to huge liquidity risk in the event of crisis. As housing prices started to decline, lenders started questioning the quality of asset residing with SIV structures.  Many hedge funds were unable to roll over their debt forcing them to start selling their CDO investments and other higher quality assets to meet margin calls. LIBOR – OIS spread is indicator of overall health of the financial system, rose from nearly 0% precrisis to over 3.6% at the peak of the crisis. This indicates increasing credit risk, and hence more reluctance to lend in interbank market. The events of the crisis illustrate the idea of systemic risk.

Central Bank Intervention #

To prevent further systemic issues, the Fed and other central banks around the world intervened by providing liquidity support and lowering interest rates. Following actions were taken by the Fed

• Long term loans secured by high quality collateral
• Discount window
• Liquidity against high quality illiquid assets
• Funding to purchase asset backed commercial papers
• Acquiring assets issued by Fannie Mae and Freddie Mac