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1、Financial crisis 2008,Created by:Parshwadeep Lahane,Disclaimer,I am no financial expert.Made solely out of interest generated after seeing the debacle on wall streetAll content is based on research,readings on internet,newspapers and my understanding from it.Free to use.I hope people can take it as
2、base and improve/update it over time as crisis evolves,Lets start with Basics,Bank,OperationTake money as deposits on which they pay interestsLend it to borrowers who use if for investment or consumptionBorrow money from other banks(inter bank market)Make profit on the difference between interest pa
3、id and received,Source:The Economist:Making Sense of Modern Economy,Potential problems in Bank,Most of bank liabilities have shorter maturity period than assets This can be a potential cause of bank failure incase all depositors take out money at once(bank run)Credit risk Possibility that borrowers
4、will be unable to repay their loansMore risk in prosperity period as lending terms tends to be relaxed Interest rate riskMost deposits at floating rateLoans at fixed rate If floating rate is more than fixed rate bank loses(S&LI,America 1979),Source:The Economist:Making Sense of Modern Economy,Critic
5、ality of Banking system,As bank provide credit and operate payments-failure can have a more damaging effect on the economy than the collapse of other businessesHence need for more regulation by governmentReserve requirement holding a proportion of bank deposits at the central bank(CRR)Match a propor
6、tion of risky assets(i.e loans)with capital in form of equity or retained earningsCapital of internationally active banks should amount to at least 8%of the value of risky assets.(Basel Accord),Source:The Economist:Making Sense of Modern Economy,Investment Banks,Help firms raise money in the capital
7、 markets(equity and bonds market)Advise firms whether to finance themselves with debt or equityUnderwrite such issues by agreeing often with other banks in syndicate,to buy any unsold securities Paid a commission for this serviceAdvice on mergers and acquisitions(most lucrative work-not during sub-p
8、rime crisis though!)Glass-Steagall act prevented commercial banks from giving Investment banks services,Source:The Economist:Making Sense of Modern Economy,At most basic,they are simply vast pools of moneyInstitutional investors arePension fundsMutual fundsInsurance companiesDominate the securities(
9、stocks,bonds)marketControl a huge chunk of most rich countries retirement savings and other wealthThese have been growing at the expense of banking systemAs biggest owners of stocks and bonds they have growing influence in corporate finance and hence corporate governance,Institutional investors,Sour
10、ce:The Economist:Making Sense of Modern Economy,Pension funds,Designed for employees of companies or governmentsCommon form Trust-overseen by trustees for the benefit plan membersIn traditional pension plan,the employer guarantees a fixed pension in old age.The company and employee both pay monhtly
11、contributions into pension fund,where the money is invested.Trustee is responsible to make sure that the funds asset cover its liabilities.Usually actuaries hired to carry this out.401K plans allow for choosing from a menu of mutual funds.Blurring the distinction between mutual and pension funds,Hed
12、ge funds,Try explicitly to make money whether markets are going up or downMostly private partnerships instead of public companiesMost regulators allow only rich to invest in themOver the years shifted from being largely private funds for rich families to being larger institutions whose investors are
13、 pension funds,hospitals,endowments and foundations.,Insurance companies,Oldest type of institutional investorFrom protection to savings+protectionLaw of large numbers risk can be managed by pooling individual exposures in large portfolios Catch1-law works if risk are not correlatedCatch2-losses in
14、any 1 year may differ hugely from the long run trend,Central Bank-US FED,Primary purpose is to address banking panicsTo strike a balance between private interests of banks and the centralized responsibility of governmentTo supervise and regulate banking institutionsTo protect the credit rights of co
15、nsumersTo manage the nationsmoney supplythroughmonetary policyto achieve the sometimes conflicting goals ofmaximum employmentstable pricesmoderate long-term interest ratesTo maintain the stability of the financial system and contain systemic risk in financial marketsTo provide financial services to
16、depository institutions,the U.S.government,and foreign official institutions,including playing a major role in operating the nations payments systemTo facilitate the exchange of payments among regionsTo respond to local liquidity needs,Source:Wikipedia,Government securities/bonds,Governments usually
17、 borrow by issuingsecurities,government bondsand bills to make up for the expenses and revenue(tax collected)differential One can treat it as commercial paper Least risky investment in US,Source:Wikipedia,Credit Rating Agency(CRA),Company that assignscredit ratingsforissuersof certain types ofdebt o
18、bligations as well as the debt instruments themselves A credit rating for an issuer takes into consideration the issuerscredit worthiness(i.e.,its ability to pay back aloan),and affects theinterest rateapplied to the particular security being issuedEx:Moodys(U.S.),Standard&Poors(U.S.)Credit ratings
19、are used byinvestors,issuers,investment banks,broker-dealers,and governments.For investors,credit rating agencies increase the range of investment alternatives and provide independent,easy-to-use measurements of relativecredit risk.,Source:Wikipedia,Mortgage Broker,Mainly found in developed economie
20、s like US,Western EuropeProfessionals who are paid a fee to bring together lenders and borrowers Sellsmortgage loanson behalf of businesses(ex.Banks)Tasks undertaken:Marketing to attract clientsAssessment of the borrowers circumstances(Mortgage fact find formsinterview).This may include assessment o
21、f credit history(normally obtained via a credit report)and affordability(verified by income documentation)Assessing the market to find a mortgage product that fits the clients needs(Mortgage presentation/recommendations)Applying for a lenders agreement in principle(pre-approval)Gathering all needed
22、documents(paystubs/payslips,bank statements,etc.),Completing a lender application formExplaining the legal disclosuresSubmitting all material to the lender,Source:Wikipedia,Sub-prime mortgage Whats that?,Home loans made to borrowers with poor credit ratings a group generally defined by FICO scores b
23、elow 620 on a scale that ranges from 300 to 850 FICO-a number that is based on a statistical analysis of a persons credit report,and is used to represent the creditworthinessof that person.(FICOis the acronym forFair Isaac Corporation,a publicly-traded corporation(under the symbol FIC)that created t
24、he best-known and most widely used credit score model in theUS.)Creditworthinessthe likelihood that the person will pay his or her debts.Calculated by credit reporting agencies.Ex.Equifax,Experian,andTransUnion in US,Source:Wikipedia,Secondary Mortgage markets,The secondary mortgage market allows ba
25、nks to sell mortgages,giving them new funds to offer more mortgages to new borrowers.If banks had to keep these mortgages the full 15 or 30 years,they would soon use up all their funds,and potential homebuyers would have a more difficult time to find mortgage lenders.Many of the mortgages on the sec
26、ondary market are bought by Fannie Mae.Other are packaged into mortgage-backed securities,and sold to investors.,Source:http:/,Mortgage Backed Security(MBS),Source:http:/,STEP 1-A pool of mortgages are owned by a bank or lender.They are grouped into categories by credit risk including subprime,alt-a
27、(between subprime and prime),and prime.STEP 2-The pool of mortgages arepackagedinto a mortgage backed security.STEP 3-The mortgage backed security is thensliced and dicedinto different classes with varying maturities(called tranches).Each tranche offers varying degrees of risk to the investor.The fi
28、rst loan to default will be placed into the Junk tranche while the strongest loans receive the highest credit rating of AAA and are placed at the top of the tranche division.As with any asset associated with risk,the highest risk tranche receives the highest rate of return or yield while the lowest
29、risk(AAA rated)will receive the lowest yield.STEP 4-The tranches are thenresoldto investors who are willing to take on the varying degrees of risk and maturities.,Collateralized Debt Obligation(CDO)simplified,MBS CDO,MBS,Created in 1987 by now defunct investment firm Drexel Burnham Lambert Not trade
30、d on exchange but OTC market,OTC market,A decentralized market of securities not listed on an exchange where market participants trade over the telephone,facsimile or electronic network instead of a physical trading floor.There is no central exchange or meeting place for this market.In the OTC marke
31、t,trading occurs via a network of middlemen,called dealers,who carry inventories of securities to facilitate the buy and sell orders of investors Trading is private and prices and volumes are not disclosedPrice discovery non transparent,Source:http:/,Now we are ready to look into the mess!,Evolution
32、 of home mortgage,Source:http:/www.imf.org/external/pubs/ft/fandd/2007/12/dodd.htm,Subprime Mortgage Market Turmoil,Christopher L.Peterson,Asst Prof of Law,Univ of Florida,1930s,Lender-Banks,Borrower-Individuals,Home loan funding,Principal+interest payable over long term,Owning a house was not affor
33、dable to many Great Depression brought industry to a halt.Large scale defaulters and lenders could not recover by reselling To simulate the industry again Government as part of New Deal policy created the Federal National Mortgage Association(Fannie Mae)in 1938.This created a secondary market for mo
34、rtgages,Lender-Banks,Borrower-Individuals,Home loan funding,Principal+interest payable over long term,Bought loan,Cash,Transfer of credit risk,market risk,Had Access to long term borrowingBought only those which conformed to certain underwriting standard(called Prime Mortgages),Evolution continued,F
35、annie Mae proved very successful.But by 1960s,borrowing done by it constituted a significant share of the debt owed by US government.1968-Government National Mortgage Association(Ginnie Mae)was created to handle government guaranteed mortgages.Fannie Mae became federally chartered,privately held1970
36、-Ginnie Mae developed MBS-shifted the market risk to investors-eliminated debt incurred to fund government housing program1970-Federal National Mortgage Corporation(Freddie Mac)created To securitize conventional mortgagesProvide competition to Fannie MaeOver time Fannie Mae and Freddie Mac together
37、provided enormous amount of funding for US mortgageSince Fannie Mae and Freddie Mac guaranteed loans,much of credit risk stayed with them.Size and diversification allowed them to handle it.,Source:http:/www.imf.org/external/pubs/ft/fandd/2007/12/dodd.htm,New Model of mortgage lending,Lender-Banks,Ho
38、me loan funding,Principal+interest payable over long term,Bought loan,Cash,Transfer of credit&market risk,MBS,Cash,Transfer of market risk,Advantages More liquidity in market Risk spread out Long term funding for mortgage lending MBS-allows originators to earn fee income from underwriting activities
39、 without exposure to credit,market or liquidity risks as they see the loans they make,SPV,Securitization fees,Further evolution.,1977-Private label securitization started first done by BOA and Salomon Brothers1980s-pricing,liquidity and tax hurdles were resolved in sameUnlike 2-3 party,private label
40、 securitization has 10 or more different parties playing independent role Big private players in this field wereWells FragoLehman BrothersBear StearnsJP MorganGoldman SachsBank Of America,Indymac Washington Mutual Countrywide,Details:Private Sub-prime mortgage process,1.Brokers identify borrowers,2.
41、Originator and broker identify a loan for borrower after looking at his credit rating,3.Formal application for loan by borrower,4.Originator transfers the loan to the subsidiary of an investment banking firm(Seller),5.Seller(Investment bank)collects a pool of loans and call it as SPE/SIV/SPV.Off bal
42、ance sheet instrument,6.SPV can be a corporation,partnership or limited liability company.Most often a Trust.It has nothing else except mortgage loans,7.Underwriter purchases all the securities(derivative income streams),8.In designing SPV and its tranches underwriter works with credit rating agenci
43、es,9.Underwriter then sells the securities to the investors,10.High rated tranches might be guaranteed by a 3rd party insurance company,11.Seller also arranges to sell the rights to service the loan pool to a company or sometimes Originator takes these rights,12.MERS document custodian.Company to ke
44、ep track of mountains of paper work on loans in the pool.At National level.,Source:Subprime Mortgage Market Turmoil,testimony by Christopher L.Peterson,Possible inter linkage in the US subprime mortgage market,Source:http:/www.norges-bank.no/templates/article_66901.aspx,Reasons for forming of Subpri
45、me mess,Giant pool of money available for investment through savings of Oil exporters,economic development in BRIC countries.Private share in mortgage market growth in large part through origination and securitization of high risk sub-prime and Alt-A mortgages.Building up of the housing bubblePrivat
46、e Banks made use of CDOs to sell to investorsLax regulations which did not keep pace with the innovations happening in financial engineeringUS kept interest rates too low for too long in post dotcom bust period Hedge funds,Wall street firms and instructional investors found lower tranches in MBS and
47、 CDO attractive which were highly riskyHedge funds leverage ratio of the order of 500%.To sum up in 3 words as noted by Harvard dean:Leverage(high),Transparency(low)and Liquidity(abundant),Big assumptions,Belief that modern capital markets had become so much more advanced than their predecessors tha
48、t banks would always be able to trade debt securities.This encouraged banks to keep lowering lending standards,since they assumed they could sell the risk on.Many investors assumed that the credit rating agencies offered an easy and cost-effective compass with which to navigate this ever more comple
49、x world.Thus many continued to purchase complex securities throughout the first half of 2007 even though most investors barely understood these products.Most crucially,there was a widespread assumption that the process of“slicing and dicing”debt had made the financial system more stable.Policymakers
50、 thought that because the pain of any potential credit defaults was spread among millions of investors,rather than concentrated in particular banks,it would be much easier for the system to absorb shocks than in the past.Housing prices will keep going up all time,Source:http:/,Misaligned incentives&
