Limited Time Offer: Save 10% on all 2022 Premium Study Packages with promo code: BLOG10

Deciphering the Liquidity and Credit Crunch 2007-2008

Deciphering the Liquidity and Credit Crunch 2007-2008

After completing this reading, you should be able to:

  • Describe the key factors that contributed to the lending boom housing frenzy.
  • Explain the banking industry trends leading up to the financial crisis and assess the triggers for the liquidity crisis.
  • Describe how securitized and structured products were used by investor groups and describe the consequences of their increased use.
  • Describe the economic mechanisms through which the mortgage crisis amplified into a financial crisis.
  • Distinguish between funding liquidity and market liquidity and explain how the evaporation of liquidity can lead to a financial crisis.
  • Analyze how an increase in counterparty credit risk can generate additional funding needs and possible systemic risk.

What is a Credit Boom?

A credit boom or “lending spree” is the rapid expansion of lending by financial institutions that is usually unsustainable. In a credit boom, credit to the private sector grows at a higher rate than during a typical business cycle.

Why is a credit boom unsustainable?

Lending increases, but the quality of the projects being funded and the creditworthiness of borrowers decline, putting lenders at risk of financial distress.

  • Financial distress among banks trickles down to just about every sector in an economy.
  • Excess credit growth is known to increase financial vulnerability.

What Happened in the Lead Up to the 2007/2008 Financial Crisis?

Several arguments have been put forth as to what really caused the crisis, but we look at the significant developments. Between 2000 and 2007, relaxed lending standards increased the demand for homes; prices rose. The relaxed standards combined with irrational exuberance encouraged speculation, which led to a rapid rise in mortgage defaults. That is when the so-called housing bubble burst.

The Trends of Banking Industry Leading up to the Liquidity Squeeze

The lending boom and the housing frenzy that marked the beginning of the crisis were significant as a result of two trends in the banking industry:

  1. An originate and distribute model was applied by banks rather than holding loans on their balance sheets.
  2. Banks increasingly financed their asset holdings with shorter maturity instruments, exposing themselves to crippling liquidity problems in their day-to-day running.

Securitization: Credit Protection, Pooling, and Tranching Risk

Collateralized debt obligations (CDOs) are structured products created by banks to offload risk. The first step entails forming diversified portfolios of mortgages, corporate bonds, and various other assets is the first step. These portfolios are then sliced into different tranches that are sold to investor groups having different risk appetites.

The safest tranche is also known as the senior tranche. It offers the lowest interest rate, but it is the first to receive cash flows from the underlying asset portfolio. The middle tranche provides a slightly higher interest rate and ranks just below the senior tranche. It takes the second spot during cash flow distribution. The most junior tranche, also called the equity tranche, offers the highest interest rate but ranks last during cash flow distribution. It is also the first tranche to absorb any loss that may be incurred.

Investors in these tranches can protect themselves from default by purchasing credit default swaps. The CDS guarantees a pre-specified compensation if in the event that a given tranche defaults. In turn, the investors must make regular payments to the credit protection seller (writer of the CDS).

Each tranche is assigned its credit rating. For instance, the senior tranche is constructed to receive a AAA rating. Highly rated tranches are sold to investors, but the junior ranking ones may end up being held by the issuing bank. That way, the bank has an incentive to monitor the underlying loans.

Funding Liquidity Risk vs. Market Liquidity Risk

Funding liquidity risk refers to the possibility that a bank could find itself unable to settle obligations with immediacy. It has much to do with:

  • The risk that a bank will be unable to pay its debts when they fall due
  • The risk that the bank cannot meet the demand of customers wishing to withdraw their deposits
  • The risk that a bank will be unable to roll over short-term credit, e.g., commercial paper.

Market liquidity risk refers to the risk that an individual or firm cannot quickly purchase or sell an asset without causing a drastic change in the asset’s price.

  • In a liquid market, the trade-off is mild: selling quickly will not reduce the price much.
  • In an illiquid market, selling quickly will require cutting the price by some amount.

These two risks were material in the height of the 2007/2009 financial crisis.

Maturity Mismatch

In the traditional banking model, the bank used to finance long-term mortgage loans with deposits that could be withdrawn at short notice. This left the banks exposed to serious funding liquidity risk. Most banks would struggle to provide depositors with their money since the deposits were tied in long-term assets.

Similar problems arose under the off-balance-sheet investment model. The structured investment vehicles would raise funds for long-term investments through short-term instruments and medium-term notes maturing in less than a year.

In an attempt to restore liquidity, banks also relied heavily on overnight borrowing through repo transactions. In an overnight repo contract, a bank borrows funds by selling a collateral asset today and promising to repurchase it the following day. Too much reliance on repo contracts would force investment banks to roll over a large part of their funding daily, a trend that proved all the riskier.

The Rise in the Popularity of Securitized and Structured Products

The needs of different investor groups can be catered for by structured financial products. Those wishing to bear risks can have the risks shifted to them hence spreading it widely across most market participants. Therefore, lower mortgage and interest rates are allowed for on corporate and other loan types.

Through securitization, certain institutional investors are allowed to indirectly hold assets that regulatory requirements would have otherwise prevented them from holding, besides enjoying lower interest rates.

Regulatory and rating arbitrage is one distorting force that resulted in the popularity of structured investment vehicle, in hindsight. Banks are required to hold capital of at least 8% of the loans on their balance sheet, under the Basel I accord. For contractual credit lines, this capital was much lower.

This preferential treatment of non-contractual credit lines was meant to be corrected by the subsequent Basel II accord, but the move was largely ineffective. Asset ratings were used as a basis for implementing capital charges by the Basel II. Banks were, however, able to reduce their capital charges by pooling loans in off-balance-sheet vehicles.

A better rating was assigned to assets issued by these vehicles as compared to individual securities in the pool due to the reduction of idiosyncratic risk via diversification. Since these structured investment vehicles were sponsored by banks that were not sufficiently downgraded for granting liquidity backstops, the overall rating was improved even further by the issuance of short-term assets.

Moreover, overly optimistic forecasts concerning financial products were provided by the statistical model of most professional investors and credit rating agencies. This can be attributed to the fact that the basis of these models was historically low mortgage and delinquency rates.

A perceived diversification benefit especially boosting the valuations of triple-A rated tranches, was generated by the assumed low cross-regional correlation of house prices.

Rating agencies would earn better fees for their ratings on structured products compared to corporate bonds. As a result, more favorable ratings may have been received by structured products. Another contributing factor to the favorable ratings for structured products in comparison to corporate bonds might have been rating at the edge. Since they seemingly offered higher expected returns with a small likelihood of catastrophic loss, the purchase of structured products was attractive to fund managers searching for yields.

Furthermore, as a result of the relatively illiquid junior tranches trading so infrequently and therefore difficult to value, they may have been favored more by some managers who could make their monthly returns appear attractively smooth over time.

Consequences: Cheap Credit and the Housing Boom

The ultimate reason behind the rapid growth of cheap credit in the run-up to the 2007/2008 crisis has much to do with:

  1. The increased popularity of securitized products increasing
  2. Falling of lending standards.

Essentially, banks would, through securitization, transfer a large proportion of their risk exposure to other financial institutions. Banks would only assume the total risk for a few months before pooling loans and selling them to other institutions. As such, they had little incentive to take monitor the creditworthiness of the borrower. Lending requirements were relaxed to attract as many applications as possible.

Scholars have offered empirical evidence that a decline in credit quality occurred due to increased securitization. The mortgages offered by mortgage brokers were granted under the premise that house prices would continue to rise indefinitely. Therefore, the argument was that the increased value of a house could be used by the owner to refinance the loan, rendering background checks an unnecessary burden.

The housing frenzy that marked the beginning of the crisis could be attributed to this combination of cheap credit and low standards of lending. By early 2007, the risk of liquidity or the so-called credit bubble was a concern to most observers, but a majority were still hesitant to bet on the bubble.

The Unfolding of the Crisis: Events Logbook

Subprime mortgage defaults increased sharply in February 2007, effectively triggering the liquidity crisis. At the fore of the crisis was UBS, a renowned multinational investment bank. Upon incurring roughly $125 million of subprime-related losses, UBS shut down its internal hedge fund, Dillion Read. A few months later, Moody’s marked a total of sixty-two trances across 21 U.S. subprime deals for a downward review. This was an indication of a possible future downgrading of these tranches.

In June and July 2007, the credit markets were further unnerved by rating downgrades of other tranches by Moody’s, Standard and Poors and Fitch. In mid-June, two hedge funds operated by Bear and Sterns experienced large scale problems while trying to meet margin calls. In a bid to save face and salvage what had been left of its reputation, Bear Stearns pumped some $3.2 billion into the hedge funds.

This was followed by an announcement by a major U.S. home lender, Countrywide Financial Corp, that there was a major drop in earnings on July 24th. There was a 6.6% decline in sales of new homes year-on-year, as revealed by an index from the National Association of Home Builders on July 26th. This was followed by a continuous decline in house prices through late 2008

Asset-Backed Commercial Paper

The short-term asset-backed commercial paper market began to dry up in July 2007. This happened amid widespread concern on the valuation of structured products and an erosion of confidence in the reliability ratings. The first European victim of the subprime crisis was IKB, a small German bank.

On July 31st, the American Home Mortgage Investment Corp announced it had failed to secure funding for lending obligations. A week later, it declared bankruptcy.

These events constitute a variety of market signals that served to indicate reluctance by money market participants to lend to each other.

The LIBOR, Repo, and Federal Fund Markets

Banks use the repo market, the federal funds market, commercial paper, and the interbank bank market to secure funding. Repo contracts allow market participants to obtain their collateralized funding through the sale of their own or their clients’ securities. Upon maturity of the loan, they can buy them back.

Banks lend to each other short-term in the interbank or LIBOR market, with the interest rate applicable being a subject of negotiations. The average indicative interest rate quote for such loans is LIBOR.

Interest rate spread measures the difference in interest rates between two bonds whose risks are different. The TED spread – the risk-free U.S. T-bill rate – has been the historical focal point for most market observers. In times of uncertainty, banks tend to impose higher interest rates on unsecured loans. This makes LIBOR increase.

Central Banks Step Forward

Quantitative hedge funds whose trading strategies were based on statistical models incurred heavy losses between 1st and 9th August 2007. This triggered margin calls and fire sales. As a matter of fact, August 9th marked the start of the first liquidity wave on the interbank market. There was a significant rise in the perceived default and liquidity risks for banks, thereby driving up the LIBOR. Ninety-five billion pounds were injected into the interbank market by the European Central Bank on the same date. Some $24 billion were also injected into the market by the U.S. Federal Reserve. This was in response to the freezing up of the interbank market.

On the \({ 17 }^{ th }\) of August, the Federal Reserve reduced the discount rate by half a percentage point to 5.75, a move aimed at alleviating the liquidity crunch. This broadened the type of collaterals banks posted while elongating the lending horizon to 30 days. The Federal Funds rate was lowered by half a percentage point, to 4.75.s

Continuing Write-Downs of Mortgage-related Securities.

A series of write-downs characterized October of 2007. It was apparent that major international banks had cleaned their books, and the liquidity injections of the Fed were seemingly effective.

When it became clear the previous total loss estimate of around $200 billion was, in fact, significantly less than the actual loss, matters worsened. Additionally, larger write-downs had to be taken by many banks. As the LIBOR peaked in mid-December 2007, the TED spread widened even further.

The Federal Reserve realized that broad cuts in the federal funds rate and discount rate never reached the banks affected by the liquidity crunch. On the \({ 12 }^{ th }\) of December 2007, The Term Auction Facility (TAF) was created to enable anonymous bidding for 28-day loans by commercial banks against a broad set of collateral, plus various mortgage-backed securities.

The Monoline Insurers

By January and early February of 2008, the biggest worry of the investment community was the potential downgrading of the monoline insurers amid the ongoing bank write-downs. The focus of the monoline insurers primarily was providing municipal bonds with insurance against default. In the recent past, however, the role of monoline insurers has extended to guaranteeing mortgage-backed securities plus other structured finance products.

As losses increased to unprecedented amounts, all three major rating agencies had no choice but to mull the downgrading of “big name” monoline insurers. Fitch downgraded one of the monoline insurers, triggering quite a shock in financial markets worldwide. The Federal Open Market Committee, during its regular meeting on January 30th, cut the federal funds rate by another half percentage point.

Bear Stearns

In March 2008, a series of events put Bear Stearns (investment bank) under serious pressure. For starters, credit spreads between agency bonds and credit spreads increased even further. What is more, Carlyle Capital, to whom Bear Stearns was a creditor, was badly hurt by the widening of the spreads, the reason being that the Amsterdam-based hedge fund had heavily invested in agency bonds. To add salt to injury, Bear Stearns had large amounts of agency paper on its books.

In the same month, the Federal Reserve announced its $200 billion Term Securities Lending Facility. The program made it possible for investment banks to swap mortgage-related bonds for Treasury bonds for up to 28 days.

Bear Stearns had roughly 150 million trades spread across various counterparties. For this reason, the general perception among market players was that the investment bank was too interconnected to fail. To minimize counterparty credit risk, some big party had to step in. A deal was brokered by officials from the Federal Reserve Bank of New York, where JP Morgan was to acquire Bear Stearns for $2 a share. This presented an unprecedented fall from grace for a firm whose share was trading at $150 less than a year before. It was also agreed that the New York Fed grant a $30 billion loan to JP Morgan Chase.

Government-Sponsored Enterprises: Fannie Mae and Freddie Mac

In the subsequent months, mortgage delinquency rates continued to increase, and the spread between agency bonds and U.S T-bills widened. Among the most adversely affected were Fannie Mae and Freddie Mac’s – publicly traded but government-chartered enterprises. Combined, the two institutions were behind the largest proportion of securitized assets. Besides, they had close to $1.5 trillion in bonds outstanding between them.

Featured Study with Us
CFA® Exam and FRM® Exam Prep Platform offered by AnalystPrep

Study Platform

Learn with Us

    Subscribe to our newsletter and keep up with the latest and greatest tips for success
    Online Tutoring
    Our videos feature professional educators presenting in-depth explanations of all topics introduced in the curriculum.

    Video Lessons

    Daniel Glyn
    Daniel Glyn
    I have finished my FRM1 thanks to AnalystPrep. And now using AnalystPrep for my FRM2 preparation. Professor Forjan is brilliant. He gives such good explanations and analogies. And more than anything makes learning fun. A big thank you to Analystprep and Professor Forjan. 5 stars all the way!
    michael walshe
    michael walshe
    Professor James' videos are excellent for understanding the underlying theories behind financial engineering / financial analysis. The AnalystPrep videos were better than any of the others that I searched through on YouTube for providing a clear explanation of some concepts, such as Portfolio theory, CAPM, and Arbitrage Pricing theory. Watching these cleared up many of the unclarities I had in my head. Highly recommended.
    Nyka Smith
    Nyka Smith
    Every concept is very well explained by Nilay Arun. kudos to you man!
    Badr Moubile
    Badr Moubile
    Very helpfull!
    Agustin Olcese
    Agustin Olcese
    Excellent explantions, very clear!
    Jaak Jay
    Jaak Jay
    Awesome content, kudos to Prof.James Frojan
    sindhushree reddy
    sindhushree reddy
    Crisp and short ppt of Frm chapters and great explanation with examples.

    Leave a Comment