Financial Crisis 2008.ppt

financialcrisis2008 createdby parshwadeeplahane disclaimer iamnofinancialexpert madesolelyoutofinterestgeneratedafterseeingthedebacleonwallstreetallcontentisbasedonresearch readingsoninternet newspapersandmyunderstandingfromit freetouse ihopepeoplecantakeitasbaseandimprove updateitovertimeascrisisevolves let sstartwithbasics bank operationtakemoneyasdepositsonwhichtheypayinterestslendittoborrowerswhouseifforinvestmentorconsumptionborrowmoneyfromotherbanks interbankmarket makeprofitonthedifferencebetweeninterestpaidandreceived source theeconomist makingsenseofmoderneconomy potentialproblemsinbank mostofbankliabilitieshaveshortermaturityperiodthanassetsthiscanbeapotentialcauseofbankfailureincasealldepositorstakeoutmoneyatonce bankrun creditriskpossibilitythatborrowerswillbeunabletorepaytheirloansmoreriskinprosperityperiodaslendingtermstendstoberelaxedinterestrateriskmostdepositsatfloatingrateloansatfixedrateiffloatingrateismorethanfixedratebankloses s li america1979 source theeconomist makingsenseofmoderneconomy criticalityofbankingsystem asbankprovidecreditandoperatepayments failurecanhaveamoredamagingeffectontheeconomythanthecollapseofotherbusinesseshenceneedformoreregulationbygovernmentreserverequirement holdingaproportionofbankdepositsatthecentralbank crr matchaproportionofriskyassets i eloans withcapitalinformofequityorretainedearningscapitalofinternationallyactivebanksshouldamounttoatleast8 ofthevalueofriskyassets baselaccord source theeconomist makingsenseofmoderneconomy investmentbanks helpfirmsraisemoneyinthecapitalmarkets equityandbondsmarket advisefirmswhethertofinancethemselveswithdebtorequityunderwritesuchissuesbyagreeingoftenwithotherbanksinsyndicate tobuyanyunsoldsecuritiespaidacommissionforthisserviceadviceonmergersandacquisitions mostlucrativework notduringsub primecrisisthough glass steagallact preventedcommercialbanksfromgivinginvestmentbanksservices source theeconomist makingsenseofmoderneconomy atmostbasic theyaresimplyvastpoolsofmoneyinstitutionalinvestorsarepensionfundsmutualfundsinsurancecompaniesdominatethesecurities stocks bonds marketcontrolahugechunkofmostrichcountriesretirementsavingsandotherwealththesehavebeengrowingattheexpenseofbankingsystemasbiggestownersofstocksandbondstheyhavegrowinginfluenceincorporatefinanceandhencecorporategovernance institutionalinvestors source theeconomist makingsenseofmoderneconomy pensionfunds designedforemployeesofcompaniesorgovernmentscommonform trust overseenbytrusteesforthebenefitplanmembersintraditionalpensionplan theemployerguaranteesafixedpensioninoldage thecompanyandemployeebothpaymonhtlycontributionsintopensionfund wherethemoneyisinvested trusteeisresponsibletomakesurethatthefund sassetcoveritsliabilities usuallyactuarieshiredtocarrythisout 401kplans allowforchoosingfromamenuofmutualfunds blurringthedistinctionbetweenmutualandpensionfunds hedgefunds tryexplicitlytomakemoneywhethermarketsaregoingupordownmostlyprivatepartnershipsinsteadofpubliccompaniesmostregulatorsallowonlyrichtoinvestinthemovertheyearsshiftedfrombeinglargelyprivatefundsforrichfamiliestobeinglargerinstitutionswhoseinvestorsarepensionfunds hospitals endowmentsandfoundations insurancecompanies oldesttypeofinstitutionalinvestorfromprotectiontosavings protectionlawoflargenumbers riskcanbemanagedbypoolingindividualexposuresinlargeportfolioscatch1 lawworksifriskarenotcorrelatedcatch2 lossesinany1yearmaydifferhugelyfromthelongruntrend centralbank usfed primarypurposeistoaddressbankingpanicstostrikeabalancebetweenprivateinterestsofbanksandthecentralizedresponsibilityofgovernmenttosuperviseandregulatebankinginstitutionstoprotectthecreditrightsofconsumerstomanagethenation smoneysupplythroughmonetarypolicytoachievethesometimesconflictinggoalsofmaximumemploymentstablepricesmoderatelong terminterestratestomaintainthestabilityofthefinancialsystemandcontainsystemicriskinfinancialmarketstoprovidefinancialservicestodepositoryinstitutions theu s government andforeignofficialinstitutions includingplayingamajorroleinoperatingthenation spaymentssystemtofacilitatetheexchangeofpaymentsamongregionstorespondtolocalliquidityneeds source wikipedia governmentsecurities bonds governmentsusuallyborrowbyissuingsecurities governmentbondsandbillstomakeupfortheexpensesandrevenue taxcollected differentialonecantreatitascommercialpaperleastriskyinvestmentinus source wikipedia creditratingagency cra companythatassignscreditratingsforissuersofcertaintypesofdebtobligationsaswellasthedebtinstrumentsthemselvesacreditratingforanissuertakesintoconsiderationtheissuer screditworthiness i e itsabilitytopaybackaloan andaffectstheinterestrateappliedtotheparticularsecuritybeingissuedex moody s u s standard poor s u s creditratingsareusedbyinvestors issuers investmentbanks broker dealers andgovernments forinvestors creditratingagenciesincreasetherangeofinvestmentalternativesandprovideindependent easy to usemeasurementsofrelativecreditrisk source wikipedia mortgagebroker mainlyfoundindevelopedeconomieslikeus westerneuropeprofessionalswhoarepaidafeetobringtogetherlendersandborrowerssellsmortgageloansonbehalfofbusinesses ex banks tasksundertaken marketingtoattractclientsassessmentoftheborrowerscircumstances mortgagefactfindformsinterview thismayincludeassessmentofcredithistory normallyobtainedviaacreditreport andaffordability verifiedbyincomedocumentation assessingthemarkettofindamortgageproductthatfitstheclientsneeds mortgagepresentation recommendations applyingforalendersagreementinprinciple pre approval gatheringallneededdocuments paystubs payslips bankstatements etc completingalenderapplicationformexplainingthelegaldisclosuressubmittingallmaterialtothelender source wikipedia sub primemortgage what sthat homeloansmadetoborrowerswithpoorcreditratings agroupgenerallydefinedbyficoscoresbelow620onascalethatrangesfrom300to850fico anumberthatisbasedonastatisticalanalysisofaperson screditreport andisusedtorepresentthecreditworthinessofthatperson ficoistheacronymforfairisaaccorporation apublicly tradedcorporation underthesymbol fic thatcreatedthebest knownandmostwidelyusedcreditscoremodelintheus creditworthiness thelikelihoodthatthepersonwillpayhisorherdebts calculatedbycreditreportingagencies ex equifax experian andtransunioninus source wikipedia secondarymortgagemarkets thesecondarymortgagemarketallowsbankstosellmortgages givingthemnewfundstooffermoremortgagestonewborrowers ifbankshadtokeepthesemortgagesthefull15or30years theywouldsoonuseupalltheirfunds andpotentialhomebuyerswouldhaveamoredifficulttimetofindmortgagelenders manyofthemortgagesonthesecondarymarketareboughtbyfanniemae otherarepackagedintomortgage backedsecurities andsoldtoinvestors source mortgagebackedsecurity mbs source step1 apoolofmortgagesareownedbyabankorlender theyaregroupedintocategoriesbycreditriskincludingsubprime alt a betweensubprimeandprime andprime step2 thepoolofmortgagesarepackagedintoamortgagebackedsecurity step3 themortgagebackedsecurityisthenslicedanddicedintodifferentclasseswithvaryingmaturities calledtranches eachtrancheoffersvaryingdegreesofrisktotheinvestor thefirstloantodefaultwillbeplacedintothejunktranchewhilethestrongestloansreceivethehighestcreditratingof aaa andareplacedatthetopofthetranchedivision aswithanyassetassociatedwithrisk thehighestrisktranchereceivesthehighestrateofreturnoryieldwhilethelowestrisk aaarated willreceivethelowestyield step4 thetranchesarethenresoldtoinvestorswhoarewillingtotakeonthevaryingdegreesofriskandmaturities collateralizeddebtobligation cdo simplified mbscdo mbs createdin1987bynowdefunctinvestmentfirmdrexelburnhamlambertnottradedonexchangebutotcmarket otcmarket adecentralizedmarketofsecuritiesnotlistedonanexchangewheremarketparticipantstradeoverthetelephone facsimileorelectronicnetworkinsteadofaphysicaltradingfloor thereisnocentralexchangeormeetingplaceforthismarket intheotcmarket tradingoccursviaanetworkofmiddlemen calleddealers whocarryinventoriesofsecuritiestofacilitatethebuyandsellordersofinvestorstradingisprivateandpricesandvolumesarenotdisclosedpricediscoverynontransparent source nowwearereadytolookintothemess evolutionofhomemortgage source http www imf org external pubs ft fandd 2007 12 dodd htm subprimemortgagemarketturmoil christopherl peterson asstprofoflaw univofflorida 1930s lender banks borrower individuals homeloanfunding principal interestpayableoverlongterm owningahousewasnotaffordabletomanygreatdepressionbroughtindustrytoahalt largescaledefaultersandlenderscouldnotrecoverbyresellingtosimulatetheindustryagaingovernmentaspartofnewdealpolicycreatedthefederalnationalmortgageassociation fanniemae in1938 thiscreatedasecondarymarketformortgages lender banks borrower individuals homeloanfunding principal interestpayableoverlongterm boughtloan cash transferofcreditrisk marketrisk hadaccesstolongtermborrowingboughtonlythosewhichconformedtocertainunderwritingstandard calledprimemortgages evolutioncontinued fanniemaeprovedverysuccessful butby1960s borrowingdonebyitconstitutedasignificantshareofthedebtowedbyusgovernment 1968 governmentnationalmortgageassociation ginniemae wascreatedtohandlegovernmentguaranteedmortgages fanniemaebecamefederallychartered privatelyheld1970 ginniemaedevelopedmbs shiftedthemarketrisktoinvestors eliminateddebtincurredtofundgovernmenthousingprogram1970 federalnationalmortgagecorporation freddiemac createdtosecuritizeconventionalmortgagesprovidecompetitiontofanniemaeovertimefanniemaeandfreddiemactogetherprovidedenormousamountoffundingforusmortgagesincefanniemaeandfreddiemacguaranteedloans muchofcreditriskstayedwiththem sizeanddiversificationallowedthemtohandleit source http www imf org external pubs ft fandd 2007 12 dodd htm newmodelofmortgagelending lender banks homeloanfunding principal interestpayableoverlongterm boughtloan cash transferofcredit marketrisk mbs cash transferofmarketrisk advantagesmoreliquidityinmarketriskspreadoutlongtermfundingformortgagelendingmbs allowsoriginatorstoearnfeeincomefromunderwritingactivitieswithoutexposuretocredit marketorliquidityrisksastheyseetheloanstheymake spv securitizationfees furtherevolution 1977 privatelabelsecuritizationstartedfirstdonebyboaandsalomonbrothers1980s pricing liquidityandtaxhurdleswereresolvedinsameunlike2 3party privatelabelsecuritizationhas10ormoredifferentpartiesplayingindependentrolebigprivateplayersinthisfieldwerewellsfragolehmanbrothersbearstearnsjpmorgangoldmansachsbankofamerica indymacwashingtonmutualcountrywide details privatesub primemortgageprocess 1 brokersidentifyborrowers 2 originatorandbrokeridentifyaloanforborrowerafterlookingathiscreditrating 3 formalapplicationforloanbyborrower 4 originatortransferstheloantothesubsidiaryofaninvestmentbankingfirm seller 5 seller investmentbank collectsapoolofloansandcallitasspe siv spv offbalancesheetinstrument 6 spvcanbeacorporation partnershiporlimitedliabilitycompany mostoftenatrust ithasnothingelseexceptmortgageloans 7 underwriterpurchasesallthesecurities derivativeincomestreams 8 indesigningspvanditstranchesunderwriterworkswithcreditratingagencies 9 underwriterthensellsthesecuritiestotheinvestors 10 highratedtranchesmightbeguaranteedbya3rdpartyinsurancecompany 11 selleralsoarrangestoselltherightstoservicetheloanpooltoacompanyorsometimesoriginatortakestheserights 12 mers documentcustodian companytokeeptrackofmountainsofpaperworkonloansinthepool atnationallevel source subprimemortgagemarketturmoil testimonybychristopherl peterson possibleinterlinkageintheussubprimemortgagemarket source http www norges bank no templates article 66901 aspx reasonsforformingofsubprimemess giantpoolofmoneyavailableforinvestmentthroughsavingsofoilexporters economicdevelopmentinbriccountries privateshareinmortgagemarketgrowthinlargepartthroughoriginationandsecuritizationofhighrisksub primeandalt amortgages buildingupofthehousingbubbleprivatebanksmadeuseofcdostoselltoinvestorslaxregulationswhichdidnotkeeppacewiththeinnovationshappeninginfinancialengineeringuskeptinterestratestoolowfortoolonginpostdotcombustperiodhedgefunds wallstreetfirmsandinstructionalinvestorsfoundlowertranchesinmbsandcdoattractivewhichwerehighlyriskyhedgefundsleverageratiooftheorderof500 tosumupin3wordsasnotedbyharvarddean leverage high transparency low andliquidity abundant bigassumptions beliefthatmoderncapitalmarketshadbecomesomuchmoreadvancedthantheirpredecessorsthatbankswouldalwaysbeabletotradedebtsecurities thisencouragedbankstokeeploweringlendingstandards sincetheyassumedtheycouldselltheriskon manyinvestorsassumedthatthecreditratingagenciesofferedaneasyandcost effectivecompasswithwhichtonavigatethisevermorecomplexworld thusmanycontinuedtopurchasecomplexsecuritiesthroughoutthefirsthalfof2007 eventhoughmostinvestorsbarelyunderstoodtheseproducts mostcrucially therewasawidespreadassumptionthattheprocessof slicinganddicing debthadmadethefinancialsystemmorestable policymakersthoughtthatbecausethepainofanypotentialcreditdefaultswasspreadamongmillionsofinvestors ratherthanconcentratedinparticularbanks itwouldbemucheasierforthesystemtoabsorbshocksthaninthepast housingpriceswillkeepgoingupalltime source misalignedincentives pitfalls churning ofcapital allowsevenaninstitutionwithoutagreatamountoffixedcapitaltomakeahugeamountofloans lendinginayearmuchmoremoneythanithasifanindividualorclassofvictimsobtainsalargejudgment thelender smanagementcansimplydeclarebankruptcy liquidatewhateverlimitedassetsareleft andpossiblyreformanewcompanyashorttimelater securitizationconduitdividesvariouslendingtasksintomultiplecorporateentities abroker anoriginator aservicer adocumentcustodian etc theconduittendstopreventtheaccumulationofalargeenoughpoolofatriskassetstoattracttheattentionofclassactionattorneys whichtendtobetheonlyactorscapableofobtainingsystem impactingjudgments source subprimemortgagemarketturmoil testimonybychristopherl peterson gooddaysturnbad crisisatthedoor mid2006onwards throughfinancialinnovationsloansissuedtoborrowersatminimalrate adjustedrate bymid2006timetopaybiggeramountscomeshouseholdincomedidnotincreaseinsameproportionashousepricessubprimemortgageownersstartdefaultingratingagenciesreviseratingsofmbs cdoasexpectednumberofdefaultsturnouthigher manyratingsareloweredbewilderedinvestorslostfaithinratings manystopbuyingmbs cdoaltogetheralarmbellatsiv spvsbanksfindthemselvesinnon comfortableposition stopmakingloanshousingpricesplummetowingtoincreaseinforeclosure delinquencyandstoppageofloans whatamess morefrenzyinmarketandmoredefaults againrevisedratings againfurtherstoppageoffundingandfurtherstoppageofloans furtherfallinhousepricesasdemandandsupplymismatch problemfeedingitselfincircularfashion asmbs cdomarketisshaken investorsstartdebatingotherderivativestrueworth panicspreadsacrossandpeoplestartgettingout furtherhurtingthebanksthecrisisunfoldedassilenttsunamionwallstreetwherebythetimepeoplerealizedthegravenessofthemesstheywerein ithadgonebeyondcontrol since mostoftheplayerinthemarket mortgagebrokers investmentbankswererunningindebts theyaresuddenlycaughtunawareandareininsolvencyandstarttumblingdown manyaresavedbynationalizationastheirfallwouldspreadthecontagionwayfar centralgovernmentstartpumpinginmoneyaslastresortbutonethingissurelynotreturningsoonandwhichisveryvitalinfinancialindustry faith inshort whenhomeownersdefault theamountofcashflowingintombsdeclinesandbecomesuncertain investorsandbusinessesholdingmbshavebeensignificantlyaffected theeffectismagnifiedbythehighdebtlevelsmaintainedbyindividualsandcorporations sometimescalledfinancialleverage source http www imf org external pubs ft fandd 2007 12 dodd htm thosegoodolddaysweregonenow howsubprimebecameglobalfinancialcrisis letslookintoitfromstartagain industrydatasuggestthatbetween2000and2006 nominalglobalissuanceofcreditinstruments mbs cdo rosetwelvefold to 3 000bnayearfrom 250bnbecameintensefrom2004 partlybecauseinvestorsweresearchingforwaystoboostreturnsafteralongperiodinwhichcentralbankshadkeptinterestrateslow slicinganddicing wasfuellingacreditbubble leadingtoartificiallylowborrowingcosts spiralingleverageandacollapseinlendingstandards source financialtimes inbillionus howcouldproblemswithsubprimemortgages beingsuchasmallsectorofglobalfinancialmarkets provokesuchdislocation buildupintoafinancialcrisis in2003 bankofinternationalsettlements bis repeatedlywarnedthatriskdispersionmightnotalwaysbebenign butusfederalreservewasconvincedthatfinancialinnovationhadchangedthesysteminafundamentallybeneficialway noeffortsmadetocorrectdebttoequityratiosofbankhugetrustintheintellectualcapitalofwallstreet supportedbythefactthatbanksweremakingbigmoney whenhighratesofsubprimedefaultemergedinlate2006 marketplayersassumedthatthesystemwouldabsorbthepain initialestimateofsubprimelossputto 50bn 100bnbyusfedsubprimelossesstartedtohitthefinancialsystemintheearlysummerof2007inunexpectedways asthesurprisespread thepillarsoffaiththathadsupportedthecreditboomstartedtocrumble investorswokeuptothefactthatitwasdangeroustousetheratingsagenciesasaguideforcomplexdebtsecurities inthesummerof2007 theagenciesstarteddowngradingbillionsofdollarsofsupposedly ultra safe debt causingpricestocrumble source financialtimes poorinvestors shockedinvestors sittinginallpartsoftheworld lostfaithinratings manystoppedbuyingcomplexinstrumentsaltogetherthatcreatedanimmediatefundingcrisisatmanyinvestmentvehicles remembersiv sincemosthadfundedthemselvesbyissuingnotesintheasset backedcommercialpapermarket manybankshadnotyetpassedontherisktoothers manywereholdingasset backedsecuritiesin warehouses andwereworkingonsplicingthemupintocdos gettingthemratedbyacreditagencysuchasmoody sorstandard poor s severalbankswerecaughtoutnotonlybecauseittooktimetostructurethesecuritiesbutbecausetheydeliberatelyheldontowhattheyregardedas safe tranchesofloans ex ubswasbadlydamagedbyretaining super senior cdodebt italsomeantthatbankswerenolongerabletoturnassetssuchasmortgagesintosubprimebondsandselltheseon thatinturnmeantthekeyassumptionthatthecapitalmarketswouldalwaysstayliquid wasoverturned assumptionthatbankswouldbebetterprotectedfromacrisisbecauseofriskdispersion alsocracked asinvestme