Financial instruments and the financial crisis.

1. Ken Ayotte Financial Instruments and the Financial Crisis

2. Financial Crisis: Outline Two financial instruments and one concept are crucial to understanding the financial crisis. The instruments are: Asset backed securities (ABS) Credit default swaps (CDS) The concept is: Bank runs and “liquidity” What is “liquidity”, how do financial institutions create it, and why does it disappear quickly? Ken Ayotte

3. (Simplified) Securitization Transaction Structure Trustee Rating Agency Credit Enhancement Borrowers $ Originator Assets $ SPV SPV balance sheet Securities $ Liabilities Assets Investors Senior tranche (AAA) Receivables (mortgage payments, CC payments, etc) Junior tranche (BBB) First-loss (unrated)

4. MBS issuance volumeby year Ken Ayotte Mortgage securitization has dropped off dramatically, particularly the non-agency market (agency = Fannie Mae and Freddie Mac)

6. Auto and student loan ABS were affected severely by the crisis Ken Ayotte

7. Assets $ SPV Securities $ Investors Securitization Transaction Structure: “Bankruptcy Remoteness” Borrowers (Receivables) $ Originator Bankruptcy-Remoteness from originator: -True Sale - Non-consolidation “Bankruptcy-Proofness” of SPV “Structured financings are based on one central, core principle: a defined group of assets can be structurally isolated, and thus…[is] independent from the bankruptcy risks of the originator” Committee on Bankruptcy and Corporate Reorganizations of the Association of the Bar of the City of New York

8. Ken Ayotte Securitization and the financial crisis: connections Studies find some empirical evidence that securitization caused loan quality to deteriorate Subprime loans and the 619/620 credit score A “moral hazard” problem by originators: less screening of borrowers Loan terms also deteriorated: “Covenant-lite” corporate loans and “no-doc” mortgage loans But blaming securitization alone is oversimplifying Other securitization defaults less severe than in subprime Sub-prime securitization and pricing history Who bought this stuff, and why?

9. Ken Ayotte The rating agencies? Excerpts from NYT, July 9, 2008, based on report by SEC “It could be structured by cows and we would rate it,” an analyst wrote in April 2007, noting that she had only been able to measure “half” of a deal’s risk before providing a rating. “We do not have the resources to support what we are doing now,” a managing analyst wrote in an e-mail message in February 2007. Rating agencies appear to have been overwhelmed (and perhaps conflicted) by new innovation, its complexity, and the volume of deals

10. Do pension fund managers have enough incentive to do the right thing?

12. Financial innovation: A useful but novel tool (ABS) was not fully understood, and was thus misused

13. This innovation magnified various failures of incentives:

14. By banks who originated loans to sell them

15. By rating agencies who have no “skin in the game” to evaluate risk properly

16. By fund/asset managers who do not bear the full cost of bad investments

18. Ken Ayotte Liquidity, banks, and bank runs We say an asset is more liquid when it can be converted into cash more quickly, and without a discounted price. Firms, investors, consumers, etc. value liquidity in assets, because they can use them more easily to meet unexpected obligations. What makes some assets more liquid than others? Recall the “lemons problem”: when buyers have less information than sellers, markets become illiquid. Which assets remedy this problem? Safety: low-risk assets generally more liquid Maturity: shorter-maturity generally more liquid Transparency: easy-to-value assets more liquid Banks and other financial institutions play a crucial role in creating liquidity. How does this happen?

19. Theory: How does a bank create liquidity? Most of a typical bank’s liabilities are demand deposits: any depositors can withdraw at any time, and receive a certain amount. Short-term + safe = liquid! But most bank assets are long-term, illiquid assets (e.g. loans) that earn higher returns Banks hold only enough short-term assets to meet the expected amount of withdrawals If the bank has many depositors, the required amount of short-term assets can be estimated very accurately So banks “create liquidity” by transforming long-term, illiquid assets (loans) into short-term, liquid claims (deposits) Ken Ayotte

20. The problem with “liquidity creation” In normal times, this works fine. But what if too many people want their money at once? This liability mismatch (short-term liabilities and long-term assets) creates risk of a “bank run”: Bank has to liquidate long-term assets at low prices (a “fire sale”) to satisfy withdrawal demands The “fire sale” prices reduces the value of the bank’s equity, creating a risk of insolvency This induces more pressure for depositors to run the bank…downward spiral! Ken Ayotte

22. But the bank run logic occurred in many other contexts where longer-term, illiquid assets were financed with short-term liabilities:

23. Many SPV’s holding mortgages were financed with commercial paper

24. Failure of Bear Stearns: a run on repos: collateralized overnight loans

25. AIG Investments division: Securities lending

26. AIG lends securities to investors for cash.

27. They invested the cash in subprime MBS

28. Borrowers demanded their money back… Ken Ayotte

29. Lehman’s failure and the Reserve Primary Fund From Bloomberg.com: Money funds aim to maintain what’s called a net asset value, or NAV, of $1. That means every dollar an investor puts in is worth at least a dollar at all times…If a fund’s share value drops below $1 because of an investment loss, it’s called “breaking the buck.” The previous week, Reserve Primary valued its short-term Lehman loans at 100 percent. On Sept. 15, the fund determined they were worth 80 cents on the dollar. The problem was, to pay all the investors who demanded money the fund needed to sell assets. It couldn’t. “The market was frozen, and nobody could buy or sell,” said Jack Winters, a retired 33-year veteran of the industry… When Lehman filed for bankruptcy, losses on Lehman paper led to runs on money markets and panic sales. That the failure of one company can lead to failures of its counterparties is called systemic risk Ken Ayotte

30. What else brought down AIG?Credit default swaps A “derivative” is a financial instrument whose value is derived from some other asset, index, event, value or condition (known as the underlying asset). A "credit default swap" (CDS) is a credit derivative contract between two counterparties. The protection buyer makes periodic payments to the protection seller, and in return receives a payoff if an underlying financial instrument defaults. Ken Ayotte

31. Credit Default SwapsCash Flows on CDS . . . Premium Premium Premium Payments from Buyer to CDS Seller No default occurs (high probability) Notional (=Principal) Default occurs (low probability) Payments from CDS Seller to Buyer . . . Premium Premium AIG sold protection on “super-senior” tranches of MBS. As the value of these underlying securities fell, AIG’s expected liabilities grew… Payments from Buyer to CDS Seller

32. The failure of AIG, cont’d CDS contracts try to limit counterparty risk (the risk that the protection seller can’t pay) through collateral requirements. The collateral requirements were triggered by the value of the underlying securities (the MBS) and AIG’s credit rating. Both deteriorated. AIG did not have enough liquid assets to post as collateral. AIG’s CDS exposure created a bank run that was pre-arranged by contract. All counterparties had the right to demand collateral at the same time, based on the same triggers. Ken Ayotte For an excellent review of AIG’s collapse, see William K. Sjostrom, Jr., “The AIG Bailout”

33. Government response: trade-offs Policy makers face difficult decisions, during and after a financial crisis. Bailouts or bankruptcy? Allowing troubled firms to fail protects taxpayer and prevents a moral hazard problem gambling on bailouts, irresponsible lending But allowing creditors to take losses can create systemic risk For more, see Ayotte and Skeel, “Bankruptcy or Bailouts?” available on www.ssrn.com Regulation or free market? Many beneficial properties of these securities (ABS, CDS, etc). Next crisis might be caused by the next new innovation. But profit motive can create bank run problem and systemic risks. Ken Ayotte