Financial system channels resources to uses
Alp Simsek (MIT) Lessons from the History of Crises 7
I &ippliers of capital • …. m elXNs _ S3Virqs · RIms ….. C<I!!h
I Users of capital ·FiIms tINI1 .,..”,. >Go> Ul II”ots IfIaI. SP8Ild ……… do:b W)’Ing a hou,..,
Mortgages: Loans collateralized by houses
Subprime mortgage: Borrowers with lower credit ratings.
Alp Simsek (MIT) Lessons from the History of Crises 8
Solution: Securitization redistributes mortgage risks
Alp Simsek (MIT) Lessons from the History of Crises 9
Aside: Derivatives and securitization
Derivative security: Value derives from another security. Financial innovation created new derivatives in recent years. An interesting example is collateralized debt obligations (CDOs). These are constructed in two steps:
Pool underlying securities (mortgages, but also corporate bonds, loans etc). Sell claims to parts of the cash flows on the pool (“tranches”).
Alp Simsek (MIT) Lessons from the History of Crises 10
Structure of a CDO
Consider a bond with promise (or face value) of $100. Suppose (for simplicity) it pays $0 in case of default. Construct an equally weighted portfolio of many such bonds. Create tranches by seniority:
The most senior tranche has a face value of $70. It pays in full unless over 30% of the bonds default, in which case it pays the remaining value of the bonds. The next most senior has a face value of $15. It pays in full unless over 15% of the bonds default, in which case it pays whatever remaining value is above $70. And so on until you reach the equity tranche, which has a face value of $3 and pays only the value of the bond portfolio above $97.
Alp Simsek (MIT) Lessons from the History of Crises 11
Structure of a CDO
Alp Simsek (MIT) Lessons from the History of Crises
Equity Tranche Mezzanine Tranche
Senior Tranche
Super Senior Tranche
70 85 97 100 Bond Portfolio’s Ability to Pay
12
Why CDOs?
Credit rating agencies rate bonds according to probability of paying in full. There is a scarcity of the bonds with the highest rating (AAA):
These bonds account for only about 5% of the supply of corporate bonds, But many institutional investors are restricted to hold only high-rated bonds.
CDO creates a supply of AAA tranches even if no individual bond is rated AAA. The low-rated tranches can be sold to hedge funds and other investors who are looking for high yield and can tolerate high risk.
Alp Simsek (MIT) Lessons from the History of Crises 13
CDO alchemy
Figure: From Benmelech and Dlugosz (2009).
Alp Simsek (MIT) Lessons from the History of Crises 14
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Are CDO ratings reliable? Pitfalls with CDO ratings:
Unlike AAA bonds, AAA tranches of CDOs are “optimized” so that there is just enough collateral to ensure AAA rating.
Riskier than a AAA bond (marginally AAA).
Rating agencies are good at modeling idiosyncratic default risk. Not so good at modeling aggregate shocks (and correlations).
Alp Simsek (MIT) Lessons from the History of Crises 15
Back to story: Subprime mortgages securitized
Subprime Originations
(Billions)
Total Mortgage
Originations (Billions)
Subprime Mortgage Backed
Securities (Billions)
Subprime Share in Total Originations
(% of Dollar Value)
Percent Subprime
Securitized (% of
Dollar Value)
50.4%2001 $2,215 $190 8.6% $95
2002 $2,885 $231 8.0% $121
2003 $3,945 $335 8.5% $202
2004 $2,920 $540 18.5% $401
2005 $3,120 $625 20.0% $507
2006 $2,980 $600 20.1% $483
52.7%
74.3%
80.5%
60.5%
81.2%
This is vulnerable to a drop in nationwide house prices. Why?
16Alp Simsek (MIT) Lessons from the History of Crises
House prices rose and then fell…
Alp Simsek (MIT) Lessons from the History of Crises 17
Defaults and delinquencies increased
0
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Prime Past Due
Sub-Prime Past Due
Alp Simsek (MIT) Lessons from the History of Crises 18
Markets recognized risks in AAA tranches
Figure: From Brunnermeier (2009).
The spreads are calculated from CDS prices. They provide a measure of the default probability for corresponding tranches.
19Alp Simsek (MIT) Lessons from the History of Crises
Aside on credit default swaps (CDS)
A CDS is an insurance contract on the default of a particular bond. For example, suppose you own a corporate bond from company XYZ with principal $1,000. If company XYZ defaults, you might get back $500 instead of $1,000. You may buy a CDS for XYZ from someone (CDS seller). In this case, you will definitely get $1,000. If XYZ defaults, the CDS seller pays you $1000 (in exchange for the bond) so that your total of $1000 is guaranteed. You “swap” the default risk with the CDS seller.
Alp Simsek (MIT) Lessons from the History of Crises
Example
In October 2008, the 5-year CDS rate on Morgan Stanley debt with face value $10,000 was $1,000. This means that you could enter a swap where you paid $1,000 a year for five years, and in return you get payment $10,000 if MS defaults (in exchange for the MS bond). This price provides a measure of the probability that MS will default. For example, if the recovery rate on MS debt is 50% (in a default, MS would only pay fifty cents on the dollar), this (roughly) implies:
20% chance that Morgan Stanley would default in the next year, About 70% chance of default in the next five years.
Alp Simsek (MIT) Lessons from the History of Crises
CDS during the Euro-debt crisis
Estimated probability of default on sovereign bonds over the next five years in September 2011 (CNNMoney article on September 16).
Alp Simsek (MIT) Lessons from the History of Crises
Back to story: Markets recognized risks
Figure: From Brunnermeier (2009).
Alp Simsek (MIT) Lessons from the History of Crises
Key aspect: Some financial institutions made losses Krishnamurthy (2010), “How Debt Markets Have Malfunctioned in the Crisis.”
Alp Simsek (MIT) Lessons from the History of Crises
Their default risks increased
Figure: From Brunnermeier (2009).
Alp Simsek (MIT) Lessons from the History of Crises
Some of them became bankrupt
Some others (Bear Sterns, Freddie, Fannie, AIG…) were bailed out with government support.
Alp Simsek (MIT) Lessons from the History of Crises
Stock market crashed
Alp Simsek (MIT) Lessons from the History of Crises
The US economy entered the Great Recession
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Alp Simsek (MIT) Lessons from the History of Crises
Economic activity fell below potential
Triggered strong policy response by the Fed and the treasury. Alp Simsek (MIT) Lessons from the History of Crises
Monetary policy appears to be constrained
Triggered unconventional policies: Quantitative easing etc. Triggered also bailouts and stabilizers, which raised deficits….
Alp Simsek (MIT) Lessons from the History of Crises
Fiscal policy steps in, raising government deficits
Alp Simsek (MIT) Lessons from the History of Crises
The shock seemed small relative to damage
Alp Simsek (MIT) Lessons from the History of Crises
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The mystery of the subprime crisis: Whodunit?
The subprime crisis features many candidates for a culprit:
Extension of subprime loans by banks, e.g., lax lending standards. Securitization and the CDOs. Rating agencies. CDS (looks innocent so far, but still a key character) Large financial institutions that made the losses. Government (Fed+treasury) suport or bailout of banks
In fact, books written (movies made) about each candidate. But economics is about prioritizing & focusing on first order. Where should we focus our efforts? Some history could help…
Alp Simsek (MIT) Lessons from the History of Crises 3
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Lessons from history: Crises are “universal”
Allen and Gale (2009): Crises are “universal”phenomena. They happened in different periods and in different countries. They happened in developing and developed countries.
Banking crises: Erosion of most banking capital. Currency crises: Forex attacks and devaluation (not our focus). Twin crises: Both at the same time…
Alp Simsek (MIT) Lessons from the History of Crises
Alp Simsek (MIT) Lessons from the History of Crises
Schularick-Taylor (AER, 2012):
Severe drops in investment and output, partial recovery. Alp Simsek (MIT) Lessons from the History of Crises 3
They find much more persistent effects, little recovery.
Alp Simsek (MIT) Lessons from the History of Crises
Lessons from history: Optimism/bad news
Alp Simsek (MIT) Lessons from the History of Crises
Examples from recent history
Read Allen and Gale (2009) for a brief discussion of recent crises:
Scandinavian crises (Norway, Finland, Sweden) of early 1990s. The Japanese crisis of early 1990s Asian crises of late 1990s (Asian “dragons” & “tigers”): Russian default of 1998 and the LTCM mini-crisis in the US. The Argentina crisis of early 2000s.
Alp Simsek (MIT) Lessons from the History of Crises
Common denominator: Banks and the government
Universality suggests points 1-4 might not be so central: happened without subprime, CDOs, rating
agencies, CDS…. In contrast, point 5 appears to be a common feature of crises.
Severe financial events that don’t involve banks need not generate crises. The bust of the NASDAQ bubble in 2001 wiped out a lot of wealth (more than subprime). But banks were not exposed. Only mild recession.
Point 6 is also in the mix. Most episodes feature gov support.
Alp Simsek (MIT) Lessons from the History of Crises
1
Lessons from history: Summary
History suggests:
Crises are typically followed by large drops in output. Crises are associated with ex-ante optimism/ex-post bad news.
Alp Simsek (MIT) Lessons from the History of Crises
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Back to the subprime crisis: Whodunit?
Recall that we had the following candidates for blame:
Extension of subprime loans by banks, e.g., lax lending standards. Securitization and the CDOs. Rating agencies. CDS (looks innocent so far, but still a key character) Large financial institutions that made the losses. Government support of bailout of banks
Alp Simsek (MIT) Lessons from the History of Crises 2
Common denominator: Banks and the government
Universality suggests points 1-4 might not be so central: happened without subprime, CDOs, rating
agencies, CDS…. In contrast, point 5 appears to be a common feature of crises.
Severe financial events that don’t involve banks need not generate crises. The bust of the NASDAQ bubble in 2001 wiped out a lot of wealth (more than subprime). But banks were not exposed. Only mild recession.
Point 6 is also in the mix. Most episodes feature gov support.
Alp Simsek (MIT) Lessons from the History of Crises