Unravelling the Credit Crunch

Cover Page
......Page 1
Title Page
......Page 2
Unravelling the Credit Crunch......Page 4
Contents......Page 6
List of Figures......Page 9
Introduction......Page 12
1.1 U.S. Residential Property: The Crunch Begins......Page 13
1.1.2 Worst Hit Areas......Page 14
1.1.3 Speculate to Accumulate......Page 15
1.1.4 Leverage......Page 16
1.1.5 Mortgage Foreclosures......Page 17
1.1.6 Property-related Activity......Page 18
1.1.7 Residential Property Outside the United States......Page 19
1.2 Old and New Style Banking......Page 20
1.2.2 How Safe is an Old Style Bank?......Page 21
1.2.3 The Originate and Distribute Model......Page 22
1.2.4 Ratings and Lemons......Page 24
1.3 What Happened in the Markets: The Second Stage......Page 25
1.3.1 Trends in the ABX......Page 26
1.3.2 Short Rate......Page 27
1.3.4 The Wider Debt Markets......Page 29
1.3.5 Stocks......Page 30
1.3.6 Special Purpose Failures......Page 31
1.4.1 Freddie and Fannie Fail......Page 32
1.4.2 Lehman Loses......Page 33
1.4.3 The Various Fates of the Final Three......Page 34
1.4.4 Bailouts and Busts......Page 35
1.4.5 Qualitative Easing......Page 36
Summary......Page 37
Notes......Page 39
2.1 Mortgage Structures and Borrowers......Page 42
2.1.1 Basic Mortgages......Page 43
2.1.2 Mortgage Collateral and LTV......Page 44
2.1.3 Mortgage Affordability and PTI......Page 45
2.1.5 Interest Rates and Prepayment......Page 47
2.1.6 Hybrid ARMs......Page 49
2.1.7 Option ARMs......Page 50
2.1.8 Borrower Quality and FICO......Page 51
2.1.9 Prime, Alt-A and Subprime......Page 52
2.1.10 Houses as ATMs: Second Mortgages and HELOCs......Page 53
2.2.1 Mortgage Brokers......Page 54
2.2.2 The Lender and Servicing......Page 55
2.2.4 Correspondent Lending......Page 56
2.2.5 Who Decides? The Changing Rôle of the Loan Officer......Page 57
2.3.1 Where did it all go wrong? Incentive Structures in the Mortgage Industry......Page 58
2.3.2 Bad Behaviour in the Mortgage Market: Fraud and Related Scams......Page 59
2.3.4 Making Slime: The Rise of Subprime......Page 60
2.3.5 Teaser Rate Subprime Loans......Page 61
2.3.7 ARM Resets......Page 62
2.3.8 Predatory Lending......Page 63
2.4.1 Countrywide’s Growth…......Page 64
2.4.2 …And Decline......Page 65
Notes......Page 68
Introduction......Page 72
3.1.1 Primary and Secondary Markets......Page 73
3.1.2 Equity, Debt and Leverage......Page 74
3.1.3 Bonds and Credit Spread......Page 75
3.1.5 Bankruptcy and Seniority......Page 76
3.1.6 Secured Bonds......Page 77
3.1.7 Asset Backed Securities......Page 78
3.2.1 What Are Prices Good For?......Page 79
3.2.2 Trading Securities......Page 80
3.3.1 What is Asset Liquidity?......Page 81
3.3.5 Bond Market Liquidity......Page 82
3.4.2 Bonds Are Different......Page 83
3.4.3 What is the Credit Spread of a Bond For?......Page 84
3.4.4 Why Credit Spreads Matter......Page 85
3.4.5 The Effect of ABS Issuance in the ODM......Page 86
3.4.7 The Variation of Asset Returns......Page 87
3.4.8 The Interaction between Rates, Asset Prices, and Beliefs......Page 88
3.4.9 Pre-Crunch Conditions......Page 89
Notes......Page 90
Introduction......Page 93
4.1.1 Where Does the Money Come From?......Page 94
4.1.3 Funding Liquidity Risk......Page 95
4.1.4 Liabilities and Confidence......Page 96
4.1.6 The Uninformative Nature of NII......Page 97
4.2.1 Retail Deposits......Page 98
4.2.3 The Growth of Non-Deposit Funding......Page 99
4.2.7 Repurchase Agreement......Page 100
4.2.8 The Risk of Repo to the Lender......Page 101
4.2.10 Managing Liability Liquidity......Page 102
4.2.11 How Financials Fail: Part 2......Page 103
4.3 Central Banks......Page 105
4.3.2 Financial Stability......Page 106
4.3.4 The Conduct of Monetary Policy......Page 107
4.3.5 The Window and Collateral at the Window......Page 108
4.3.6 Emergency Funding: The Lender of Last Resort......Page 109
4.4.1 Engineering the Repo......Page 110
4.4.3 The Pawnbroker of Last Resort......Page 111
4.5.1 Before the Stress......Page 112
4.5.2 Rate Cuts Fail: the TAF is Introduced......Page 113
4.5.3 Financing Not Liquidity: the TSLF and the PDCF......Page 114
4.5.5 The Evolution of Central Bank Policy......Page 115
4.6.1 What Was Northern Rock?......Page 116
4.6.3 How Risky Was Northern Rock’s Funding Strategy?......Page 117
4.6.5 Uncertainty Persists......Page 118
Notes......Page 119
5.1 The Crash of 1929 and the Great Depression......Page 123
5.1.2 Cheap Money and Its Consequences......Page 124
5.1.3 The Crash......Page 125
5.2 Political Reactions......Page 126
5.2.2 The Reconstruction Finance Corporation......Page 127
5.3 The New Deal......Page 128
5.3.2 Banking and the Glass-Steagall Acts......Page 129
5.3.3 Lending in a Depression......Page 130
5.4.2 Supporting Home Ownership......Page 132
5.4.4 The Secondary Mortgage Market......Page 133
5.4.5 Lyndon Johnson and the Strange Status of Fannie......Page 134
5.4.7 Conforming Loans......Page 135
5.4.9 A Fractured Landscape......Page 136
5.5.1 The Use of Mortgage Backed Securities......Page 137
5.5.2 Pass Throughs: Who Got What?......Page 138
5.5.3 The Growth of Private Label MBS......Page 139
Notes......Page 140
Introduction......Page 144
6.1.1 What Can Be Securitised?......Page 145
6.1.2 Tranching......Page 146
6.1.3 It’s Raining Cash......Page 148
6.1.5 Making it Better: Credit Enhancement......Page 149
6.1.6 Why Securitise?......Page 150
6.1.7 The Rating of Securitisation Tranches......Page 152
6.2 The Securitisation of Subprime Mortgages......Page 153
6.2.3 The ABX......Page 154
6.3.1 The Idea of Hedging......Page 155
6.3.2 Models in Finance......Page 157
6.3.3 How Financial Models Differ......Page 159
6.4 Model Risk......Page 160
6.4.1 Elementary Mistakes......Page 161
6.4.3 Theory and Induction......Page 162
6.4.4 Stress Testing......Page 163
6.5 Where Did It All Go Wrong?......Page 164
6.5.2 Underwriting Standards......Page 165
6.5.4 A Waxman Pecora?......Page 166
6.6 The Write-downs......Page 167
6.6.2 ABS Liquidity Risk......Page 168
6.6.4 The Consequences of the Write-downs......Page 169
Notes......Page 170
7.1 The Growth, Distress, and Rescue of Fannie Mae and Freddie Mac......Page 174
7.1.2 Oversight......Page 175
7.1.3 Their Own Private Idaho......Page 176
7.1.4 Fannie and Freddie in the Greenspan Boom......Page 177
7.1.6 Conservatorship......Page 178
7.1.7 Full Circle: The Consequences of Conservatorship and the Future of Fannie and Freddie......Page 179
7.1.8 And finally... The FHLBs......Page 180
7.2.2 Building an American Supermarket......Page 181
7.2.4 Breaking down Glass-Steagall......Page 182
7.3 The End of the Broker/Dealer......Page 183
7.3.3 The Rise of Lehman Brothers......Page 184
7.3.4 Choppy Seas......Page 185
7.3.6 The Aftermath......Page 186
7.4.1 What Distinguished the Broker/Dealers......Page 187
7.4.2 Reviewing the CSE Regime......Page 188
7.4.3 An Old Architecture in a New World......Page 189
7.5.1 Incentive Compensation......Page 190
7.5.2 Collective Bargaining......Page 191
7.5.4 Compensation in an Era of State Capitalism......Page 192
Notes......Page 193
Introduction......Page 199
8.1.2 Separating Default Risk From Funding......Page 200
8.1.3 The Pros and Cons of Exchanges......Page 201
8.1.5 The Beneficial Effects of Credit Derivatives......Page 203
8.1.6 Risks Created By Credit Derivatives......Page 204
8.1.7 Portfolio Credit Default Swaps......Page 205
8.2 ABS in Structured Finance......Page 206
8.2.1 CDOs of ABS......Page 207
8.3.1 Delta Hedged ABS Tranches......Page 208
8.3.2 Credit Derivatives on the ABX......Page 210
8.3.4 Structured Finance Risks and their Management......Page 211
8.3.5 Size is (nearly) everything......Page 212
8.4.1 Taking Insurance Risk......Page 213
8.4.3 Insurance Accounting......Page 214
8.5.1 AIG before the storm......Page 215
8.5.3 The Danger of Downgrades......Page 216
8.5.5 $85B at Credit Card Rates......Page 217
8.5.6 Aftermath......Page 218
8.6.2 Conduits as Old Style Banks......Page 219
8.6.3 SIVs......Page 220
8.6.5 SIV and Conduit Risks......Page 221
8.6.7 Stand or Delever?......Page 222
8.6.9 Where did subprime risk go?......Page 223
8.6.10 The MLEC, R.I.P.......Page 224
Notes......Page 225
Introduction......Page 230
9.1.2 Financial Guarantees......Page 231
9.1.3 The Monoline Insurers......Page 232
9.1.4 Ambac and MBIA before Structured Finance......Page 233
9.2.1 New Business......Page 234
9.2.2 Other Exposure......Page 235
9.2.4 Counterparty Risk......Page 236
9.2.5 Credit Support Default......Page 237
9.2.7 Case Study: Bill Ackman vs. the Monolines......Page 239
9.3.1 The Markets are Visible and Everyone’s Actions Matter......Page 241
9.3.2 Diversification is Hard to Get......Page 242
9.3.4 Possible Mistakes......Page 243
9.4 Auction Rate Securities......Page 244
9.4.3 The Reality of Auction Failures......Page 245
9.4.4 Lies, Damned Lies, and Marketing......Page 246
Notes......Page 247
Introduction......Page 251
10.1.1 Accounting Standards and Financial Statements......Page 252
10.1.2 Fair Value and Accrual......Page 253
10.1.3 Fair Value vs. Accrual......Page 254
10.1.5 Valuation and the Crunch......Page 255
10.1.6 Consolidation......Page 256
10.1.7 The Consequences of the Consolidation Rules......Page 257
10.2 Regulation and Regulatory Capital......Page 258
10.2.2 Something Simple: The 1988 Accord......Page 259
10.2.3 Market Risk in ’96......Page 260
10.2.4 The Basel 2 Project......Page 261
10.2.6 Calculating Capital......Page 262
10.2.7 Risks included in Basel 2......Page 263
10.3 The Consequences of Basel 2......Page 264
10.3.1 Bigger Is Better......Page 265
10.3.4 Northern Rock’s Basel 2 Waiver......Page 266
10.3.5 Model Risk and Internal Models......Page 267
10.4.1 Diversity and the Level Playing Field......Page 268
10.5 Understanding Earnings......Page 269
10.5.1 Accrual Accounting, Capital Requirements, and the Behaviour of Financial Institutions......Page 270
10.5.2 All the Fun of the Fair......Page 271
10.6.1 Bubble and Crash: Japan towards the Millennium......Page 272
10.6.2 Regulation and Accounting in Japan......Page 273
10.7.1 Underlying Causes of a Crisis......Page 274
10.7.2 The Loss of Confidence......Page 275
10.7.3 The Financial System Transmits Stress......Page 276
10.7.5 Rewriting the Rules......Page 277
Notes......Page 279
11.1 Transmission......Page 285
11.1.1 Two Spirals......Page 286
11.2 The Provision of Credit to the Broad Economy......Page 287
11.2.1 Modifying Mortgages......Page 288
11.2.3 Funding the Economy: Forcing the Horse to Drink......Page 289
11.2.4 Government Bailouts......Page 290
11.3 What Worked and What Didn’t......Page 291
11.3.2 Understanding Valuation, Understanding Earnings......Page 292
11.3.3 Lessons in Risk Management......Page 293
11.3.4 The Tail of Risk......Page 294
11.3.6 Unfunded Risk Taking......Page 295
11.3.8 Structured Finance Risks......Page 296
11.4 Central Banks, Regulators and Accountants......Page 297
11.4.1 The Failures and Futures of Regulatory Capital......Page 299
11.4.2 Central Bank Mandates......Page 300
11.4.3 Rescues and Moral Hazards......Page 301
11.4.6 Transparency, Accounting and Disclosure......Page 302
11.5 Experimental Finance......Page 303
11.6 The Financial System from 2009......Page 304
11.6.1 Some changed thinking......Page 305
Notes......Page 306