Download Money Markets Freeze: Causes and Developments since August 2007

The Crisis of 2008 and
the Future of Regulation
Gerald P. Dwyer
Federal Reserve Bank of Atlanta
University of Carlos III, Madrid
Disclaimer
• These views are mine and not necessarily
those of the Federal Reserve Bank of Atlanta
or the Federal Reserve System.
Housing Price Indices
January 2000 to February 2009
200
Index value
Case Shiller index
OFHEO index
160
120
80
1/1/2000
4/9/2002
7/17/2004
Date
10/25/2006
2/1/2009
U.S. Mortgage Originations by Type
2001 through 2007
FHA / VA
Conventional
Prime Jumbo
Alt A
Subprime
Home Equity Lines
Trillion Dollars (U.S.)
4
3
2
1
0
2001
2002
2003
2004
Year
Source: Inside Mortgage Finance
2005
2006
2007
U.S. Delinquencies by Loan Type
First Quarter 1998 through Fourth Quarter 2008
30
Prime FRM
Prime ARM
Subprime FRM
Subprime ARM
20
10
0
1/1/1998
10/1/2000
Note: Delinquent 90 days or more
Source: Mortgage Bankers Association
7/2/2003
Date
4/1/2006
12/31/2008
Size of Financial Markets
Source: Bank of England Stability Report, 10/2007
Story
• A tiny part of securities markets has put asset
markets around the world in a state of
turmoil?
• How can that be?
Structured Finance
• Mortgages are securitized
– Residential Mortgage Backed Securities (RMBS)
– Mortgages are pooled together and sold on the open market
• Agency securities
• Others
• Can be divided into tranches
• Tranching
– Typical bond has all holders suffering losses
proportionately
– Structured financial instruments structure receipts of
payments
Two Securities from One
AAA
rated
security
Subprime
mortgages
Equity
tranche
of
security
Collateralized Debt Obligations
• Take set of securities and restructure their
payments
– Corporate bonds
– Residential mortgage backed securities (RMBS)
CDO Deals Idiosyncratic and
Traded over the Counter
• A trust, generally in the Cayman Islands owns
the assets backing the CDOs and distributes
payments
• Not standardized contracts
• Over-collateralization and triggers
– Can build up a reserve account for possible losses
– Can be contingent on delinquencies and losses
• Manager can be passive or active
• Traded over the counter
ABX Indices by Vintage
110
110
70
70
06-1 vintage
06-2 vintage
30
30
1/1/2006
8/31/2007
4/30/2009
AAA
AA
A
BBB
BBB-
80
1/1/2006
07-2 vintage
50
50
20
20
8/31/2007
Date
4/30/2009
80
07-1 vintage
1/1/2006
8/31/2007
4/30/2009
1/1/2006
8/31/2007
Date
4/30/2009
Securities and “Risk Sharing”
• CDOs of ABS were purchased by entities all over
the world
• AAA rating made them seem like a fine purchase
– AAA CDO is not a AAA corporate bond
• CDO is based on a portfolio of loans
• Behavior of cash flows in default is different
– Ratings were conditioned on rising house prices
• Mispricing of these CDOs may partly explain the
earnings from creating so-called arbitrage CDOs
LIBOR less OIS - 30 days
January 1, 2006 to April 30, 2009
spread
300
200
100
0
1/2/2006
11/1/2006
9/1/2007
Date
6/30/2008
4/30/2009
LIBOR less OIS - 30 days
January 1, 2006 to April 30, 2009
Run on money
market funds
spread
300
200
End of year
100
Northern Rock
0
1/2/2006
11/1/2006
9/1/2007
Date
6/30/2008
4/30/2009
LIBOR less OIS - 30 days
January 1, 2006 to April 30, 2009
Run on money
market funds
spread
300
200
End of year
Kindergarten
day
100
Northern Rock
0
1/2/2006
11/1/2006
9/1/2007
Date
6/30/2008
4/30/2009
This Is Not All the Story
• House prices rose in many other places than
parts of U.S.
– House prices have fallen substantially in Ireland,
Spain and other countries
– Nothing directly to do with subprime mortgages
or CDOs
• Widespread increases of leverage
• Widespread increases of maturity
transformation
One Cause
Source: http://library.thinkquest.org
Another Possible Cause
Who’s to Blame?
• My personal estimate of proximate causes in
order of importance
• Fannie and Freddie’s purchases of subprime
securities spurred on by Congress
• Financial innovations – CDOs
– Reduced the cost of risky activities
– Not clear how much this is due to increased issuance
of subprime loans
• Private institutions took on more risk
– Increased leverage
– Increased maturity transformation
Regulators to Blame?
• Federal Reserve and low Fed Funds rate
– Would have to establish that short rates were
relatively low around the world, not just dollar rates
• John Taylor claims this in talks and in his book
– Would have to establish that low rates induced people
to buy houses even though long rates were unaffected
• Regulators
– The combination of the developments caused the
crisis
– It’s easy to see this after the fact
Financial Difficulties
• It’s the truck you don’t see that runs you
down
Stability
Source: http://img2.travelblog.org/Photos2/