THE FINANCIAL CRISIS OF 2007–2009

  THE FINANCIAL CRISIS OF 2007–2009

• In the run-up to the financial crisis of 2007–2009, interest rates in the United States were kept at historically low levels. The cheap cost of money made it easier for people to borrow and acquire real estate property, thus fueling a rapid and unsustainable increase in house prices.
• Financial innovations, such as securitization, also meant that mortgages could now be easily originated by lenders, repackaged, and sold to investors seeking higher yields—thus, reducing the credit risk borne by the originators.
• Banks increasingly financed their long-term assets through short-term liabilities. This gave rise to a maturity mismatch between the duration of the assets and the liabilities, which exposed banks to significant liquidity risk. When the crisis struck and house prices stalled, those short-term liabilities could not be rolled over
• At the peak of the crisis in September 2008, the large U.S. investment bank, Lehman Brothers, declared bankruptcy
• Two of the large mortgage-backed securities (MBS) issuers in the United States, Fannie Mae and Freddie Mac, were nationalized, and the large financial services and insurance company, American International Group (AIG), was bailed out to prevent further systemic issues.
• The reduction in lending standards partly resulted from the move to the so-called originate-to-distribute (OTD) model. Under this model, lenders no longer hold the mortgages on their balance sheet but move them into bankruptcy-remote structured investment vehicles (SIVs) through securitization
• Securitization involves the pooling of assets together in order to sell claims against them. An example of such structure is the collateralized debt obligation (CDO) whereby the pool is sliced into multiple tranches (e.g., senior, junior, and equity). 
• Cash flows and defaults are determined as per the waterfall structure whereby senior tranches receive cash flows first but absorb losses last. The senior tranches were considered very safe and structured to have a AAA rating, even though the underlying mortgages consisted of NINJA and liar loans
• The fact that senior CDO tranches were given a AAA rating demonstrates that rating agencies provided unrealistically high ratings, which were often based on historical data for prime mortgages and did not take into account the increasingly speculative nature of the marketplace
• Rating agencies often relied heavily on data provided by the issuers without performing their own checks. This was further exacerbated by a conflict of interest whereby rating agencies were paid by the issuer and, therefore, incentivized to provide favorable ratings.
• The huge demand for subprime mortgages resulted in questionable practices by some lenders and mortgage brokers. The compensation structure for originating a mortgage was typically based on quantity rather than quality of the mortgages.  

subprime mortgages 

• A typical subprime loan could be structured as a 30-year 2-28 adjustable-rate mortgage (ARM). This type of product comes with a 2-year relatively low fixed teaser rate, which then reverts to a much higher (and possibly unaffordable) variable rate for the remaining 28 years of the mortgage.
• 100% loan-to-value—no up-front payment required
• Interest-only—only servicing the interest cost during the life of the mortgage without reducing the outstanding principal
• NINJA loans—loans to borrowers with no income, no job, and no assets
• Liar loans—loans for which little evidence was collected to confirm employment and income claims of the applicant

 Short-Term Funding and Systemic Risk

• Because SIVs holding mortgages were primarily funded short term through asset-backed commercial paper (ABCP) and repos, they relied heavily on their ability to roll over these obligations at maturity. This exposed the SIVs to significant funding liquidity risk in the event of crisis
• As house and mortgage-backed security prices declined, lenders started questioning the quality of assets residing within the SIV structures
• The banks that had sponsored the SIVs were also affected because they had often extended backstop lines of credit to those entities
• money market funds had significant exposure to ABCP. The declining ABCP prices resulted in a run on money market funds by institutional and other large investors, which further exacerbated the liquidity crisis
• The events of the crisis illustrate the idea of systemic risk, or risk of system failure resulting in the shutdown of the entire financial market due to vulnerabilities, such as the aforementioned asset-liability maturity mismatch.
• The lesson learned is that even when a bank believes it has sufficient capital, overreliance on short-term funding sources is very dangerous because this type of funding can disappear overnight during times of crisis.

responses made by central banks

• Providing long-term loans secured by high-quality collateral 
• Allowing investment banks and securities firms to borrow directly from the Fed via the discount window (this was unavailable to investment banks precrisis) 
• Providing liquidity against high-quality illiquid assets 
• Providing funding to purchase asset-backed commercial paper 
• Acquiring assets issued by Fannie Mae and Freddie Mac
• Specific government interventions implemented in the United States during the crisis include the following:
• Term Auction Facility (TAF)—providing funds to depository institutions 
• Primary Dealer Credit Facility (PDCF)—Fed lending to primary dealers via repos
•  Government bailout of Fannie Mae and Freddie Mac in September 2008 
• Troubled Asset Relief Program (TARP)—purchasing toxic assets from financial institutions starting October 2008