Ken Ayotte

Financial Instruments

and the

Financial Crisis

Ken Ayotte

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?

(Simplified) Securitization Transaction Structure

Originator

SPV

Assets $

Investors

Securities $

Borrowers

Credit Enhancement

Rating AgencyTrustee

$

Senior tranche (AAA)

Junior tranche (BBB)

First-loss (unrated)

SPV balance sheet

LiabilitiesAssets

Receivables

(mortgage payments, CC payments, etc)

Ken Ayotte

MBS issuance volumeby year

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 20080.0

500.0

1,000.0

1,500.0

2,000.0

2,500.0

3,000.0

3,500.0

Chart Title

NonAgency

Agency

Vol

ume

($B

)

Mortgage securitization has dropped off dramatically, particularly the non-agency market

(agency = Fannie Mae and Freddie Mac)

2007 ABS Outstanding by type (Total = $2,472B)

198.5

347.8

46.2

585.6

26.9243.9

1,023.5

Automobile Loans

Credit CardReceivables

Equipment Leases

Home EquityLoans

ManufacturingHousing

Student Loans

Student Other

Ken Ayotte

Auto and student loan ABS were affected severely by the crisis

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 20080.00

10,000.00

20,000.00

30,000.00

40,000.00

50,000.00

60,000.00

70,000.00

80,000.00

90,000.00

100,000.00

Annual loan securitization volume

Auto Loan ABS Student Loan ABS

Securitization Transaction Structure: “Bankruptcy Remoteness”

Originator

SPV

Assets $

Investors

Securities $

Borrowers

(Receivables)

$

Bankruptcy-Remoteness from originator:

-True Sale

- Non-consolidation

“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

“Bankruptcy-Proofness” of SPV

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?

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

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

Ken Ayotte

Summary: My view of what caused the housing boom and bust

• The boom and bust in housing was caused by:• Financial innovation: A useful but novel tool (ABS)

was not fully understood, and was thus misused• This innovation magnified various failures of

incentives:• By banks who originated loans to sell them• By rating agencies who have no “skin in the game” to

evaluate risk properly• By fund/asset managers who do not bear the full cost of

bad investments

• What were the consequences of the housing bust?

Ken Ayotte

Mortgage losses and corporate failures

• Losses on mortgages and MBS caused massive write-downs, and thus reduced equity capital at financial institutions, threatening their solvency.

• This led to a series of major collapses of financial institutions in 2008:– Mar 24: Bear Stearns– Sept 7: Fannie Mae and Freddie Mac– Sept 15: Lehman Bros., Merrill Lynch– Sept 16: AIG – Sept 24: Washington Mutual– Sept 29: Wachovia

• But many of these failures were also caused by a lack of liquidity.

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 liquidMaturity: shorter-maturity generally more liquidTransparency: easy-to-value assets more liquid

Banks and other financial institutions play a crucial role in creating liquidity. How does this happen?

Ken Ayotte

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

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

The modern “bank-run”

• Not caused by small depositor runs at insured banks: most deposits are FDIC-insured

• But the bank run logic occurred in many other contexts where longer-term, illiquid assets were financed with short-term liabilities:• Many SPV’s holding mortgages were financed with commercial

paper• Failure of Bear Stearns: a run on repos: collateralized overnight

loans• AIG Investments division: Securities lending

• AIG lends securities to investors for cash.• They invested the cash in subprime MBS• Borrowers demanded their money back…

Ken Ayotte

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

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.

No default occurs

(high probabilit

y)

Credit Default SwapsCash Flows on CDS

Default occurs

(low probability)Premium Premium. . .

No

tion

al(=

Prin

cipal)

Paymentsfrom CDS Sellerto Buyer

Paymentsfrom Buyerto CDS Seller

Premium Premium. . . Paymentsfrom Buyerto CDS Seller

Premium

AIG sold protection on “super-senior” tranches of MBS. As the value of these underlying securities fell, AIG’s expected liabilities grew…

Ken Ayotte

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.

For an excellent review of AIG’s collapse, see William K. Sjostrom, Jr., “The AIG Bailout”

Ken Ayotte

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.