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Money Markets Freeze:Causes and Developments since
August 2007Gerald P. Dwyer
Federal Reserve Bank of AtlantaUniversity 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.
7/18/2006 2/3/2007 8/22/2007 3/9/2008 9/25/2008 4/13/2009
Date
0.4
0.6
0.8
1.0
1.2
Wilshire 5000S&P 500NASDAQ
U.S. Stock IndiciesJanuary 2, 2007 to April 30, 2009
1/1/2000 4/9/2002 7/17/2004 10/25/2006 2/1/2009
Date
80
120
160
200
Inde
x va
lue
Housing Price IndicesJanuary 2000 to February 2009
Case Shiller indexOFHEO index
0
1
2
3
4
Tri
llion
Dol
lars
(U
.S.)
U.S. Mortgage Originations by Type
2001 through 2007
20032001 2002 2004
Source: Inside Mortgage Finance
Year
FHA / VAConventionalPrime JumboAlt ASubprimeHome Equity Lines
2005 2006 2007
1/1/1998 10/1/2000 7/2/2003 4/1/2006 12/31/2008
Date
0
10
20
30 Prime FRMPrime ARMSubprime FRMSubprime ARM
Note: Delinquent 90 days or more
Source: Mortgage Bankers Association
U.S. Delinquencies by Loan TypeFirst Quarter 1998 through Fourth Quarter 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?
Summary of Developments
• Prelude until August 9, 2007• Main Act from August 9, 2007 to September
16, 2008• Climax from September 16, 2008 to early 2009
– Financial crisis
• Denouement from early 2009 to ????
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
Subprime mortgages
AAA rated
security
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 andTraded 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
1/1/2006 8/31/2007 4/30/2009
30
70
110
06-1 vintage
ABX Indices by Vintage
1/1/2006 8/31/2007 4/30/2009
30
70
110
06-2 vintage
1/1/2006 8/31/2007 4/30/2009Date
20
50
80
07-1 vintage
AAAAAABBBBBB-
1/1/2006 8/31/2007 4/30/2009Date
20
50
80
07-2 vintage
Securities and “Risk Sharing”
• CDOs 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 CDOs may partly explain the earnings from creating so-called arbitrage CDOs
1/2/2006 11/1/2006 9/1/2007 6/30/2008 4/30/2009
Date
0
100
200
300
spre
adLIBOR less OIS - 30 days
January 1, 2006 to April 30, 2009
1/2/2006 11/1/2006 9/1/2007 6/30/2008 4/30/2009
Date
0
100
200
300
spre
adLIBOR less OIS - 30 days
January 1, 2006 to April 30, 2009
Run on moneymarket funds
Northern Rock
End of year
1/2/2006 11/1/2006 9/1/2007 6/30/2008 4/30/2009
Date
0
100
200
300
spre
adLIBOR less OIS - 30 days
January 1, 2006 to April 30, 2009
Run on moneymarket funds
Northern Rock
End of yearKindergartenday
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/