Lessons from the Current Credit Crunch

for the Global Financial Community

Lucjan T. Orlowski

Professor of Economics Professor of Economics

John F. Welch College of Business, Sacred Heart University

Seminar for Sacred Heart University

Luxembourg MBA Program

June 16, 2008, Luxembourg

Main Thesis

• Current global financial crisis

– triggered by the subprime mortgage failure in US

– a symptom of systemic deficiencies

• Remedies cannot be sought on a macro-scale

– US Fed will not resolve systemic flaws through massive liquidity injection

– the cure shall be sought on a micro-scale by revamping risk management policies and improving risk assessment of complex structured debtimproving risk assessment of complex structured debt

• Considerable excess liquidity in global financial system still exists

– proliferates market risk contributing to persistent over-valuation of different asset classes

– recent monetary policy decisions shifted asset bubble from derivatives to commodities

• Disciplined monetary policies needed to implode the bubble

– reduce excess liquidity

– promote “back to basics” in banking and investing

– strengthen USD

• Disciplined fiscal policies will help as well by containing budget deficits and reducing borrowing needs

Triggers of Subprime Mortgage Crisis:

Some Stylized Facts

• Easy monetary policy until 2004 (fed funds rate at 1% from July 03 to July 04; steadily increased to

5.25 in Jan 07 and kept till July 07; since then reduced to the current 2.0 in several steps)

• Plentiful international liquidity due to large net savings from Far East (including China) and

from oil-exporters - international investors seeking higher returns and safety in U.S. Treasury

and agency securities

• Yields on long-term US bonds depressed by heavy international demand

• U.S. financial institutions stepping-in with high-yielding complex structures securities (i.e.

derivatives backed by pools of mortgages)

• Default risk increasing - mortgage brokers promoting subprime and Alt-A lending (borrowers

with weak credit, income and assets or reduced documentation)

• 40% of new mortgages in 2006 sub- or near-prime (comparing to merely 9% in 2001)!

• Banks interest margins increase with low interest expenses and higher interest income (see

FDIC quarterly reports)

• High risk of subprime mortgages transferred to investors through CMOs (IMF Global

Financial Stability reports endorsing their expansion in subsequent issues till April 2007)

• Housing bubble bursts in August 2007

Selected Repercussions of Current Financial Crisis

• Slowdown of the economy: US consumer confidence index falls from

peak of 110 in July 2007 to 62.3 in April 2008, housing starts plunge by 59 %

between January 2006 (peak) and April 2008; existing home sales fall by 31%

since October 2005; headline CPI inflation increases to 4.2% in May 2008 (y-o-y);

unemployment reaches 5.5% in May; gold prices peaked at over USD 1000 per

ounce in April before falling to 900 in mid-May; USD has fallen to record low

levels against the leading international currencies

• Considerable propagation of market risk: market volatility index • Considerable propagation of market risk: market volatility index

VIX daily average January-July 2007 = 13.25, August 2007-March2008 =

23.25

• Eroding tax incomes of municipalities, recent downgradings of

municipal bonds

• Spillover effects into the global economy as well as global

financial markets and institutions

(Predictable) Problems with Derivatives

• Total outstanding value of collateralized debt obligations (CDOs) = $900

billion (as of July 07), of which CDO-squared $28 billion (Credit Suisse

data)

• CDOs entail significant information asymmetry and adverse selection

problem leading to their mispricing

• Mispricing of esoteric derivatives; their prices did not reflect the de facto • Mispricing of esoteric derivatives; their prices did not reflect the de facto

risks implied by underestimated asymmetric information

• Potential expansion of Level 3 asset category and further write-downs

(mortgage-related assets but also complex derivative contracts, credit card

receivables, loans linked to leveraged buyout loans and asset backed commercial

paper)

Obscurity of Level 3 Assets

• Level 3 assets – illiquid, valuation based on management assumptions, ‘marked-to-model’ with unobservable inputs

• Estimated value among US financial institutions USD 500 billion

• Level 3 assets as percentage of equity: Bear Sterns 313%, Morgan Stanley 235%, Goldman Sachs 192%, Lehman Morgan Stanley 235%, Goldman Sachs 192%, Lehman Brothers 171%, Merrill Lynch 130%, Citigroup 117%, JP Morgan/Chase 58%, Bank of America 28% (Q1 2008, Bloomberg data)

• More troubles brewing: declining housing prices ⇒ increasing debt/equity; debt/equity>1 ⇒ mortgages become uncovered ⇒related securities unmarketable reclassified as Level 3 category

• Re-classification of ‘toxic’ assets into Level 3 category allows hiding them, decreases banks transparency

Propagation of Default and Liquidity Risks

• Considerable jump in credit default swaps (CDS) – their notional

value increased from $10 trillion in June 2005 to $62 trillion at the

end of 2007

• The rise in CDS corresponds with huge increase in counterparty risk

• Large CDS dealers, including Bear Sterns have suffered• Large CDS dealers, including Bear Sterns have suffered

• Spillover effects from rising default risk into liquidity risk

• Proliferation of liquidity risk best exemplified by the massive run on

Bear Sterns: $17 billion liability withdrawal on March 13 and 14,

2008, including cash withdrawal of $5 billion by Renaissance Technologies Corp.,

pullout of loan commitments of $500 million each by Rabobank and ING

• Liquidity indexes for Bear and other banks reduced by decreasing values of

CMOs (and other structured instruments), i.e. increasing liquidity risk

Demise of Bear Stearns: Causes and Lessons

• Bear’s policy mistakes and consequences:

1. Largest exposure to mortgage markets among the Big5 Wall Street investment banks

2. Concentration of risk in a falling market – lack of diversified business model

3. Highly leveraged balance sheet ($13.4 trillion in derivative instruments; $28 billion in Level 3 assets versus $11.7 billion equity as of Nov 27; overall the leverage ratio rose from 26 in 2005 to 32.8 in 2007)

4. Collapse of two hedge funds last summer, both having large exposure to mortgage derivatives

5. Lost of Wall Street and investors confidence – March liquidity crisis

6. The annual cost of a 5-year contract to insure Bear’s $10 million debt rose from below $100 thousand in October 2007 to above $700 thousand by mid-March 2008

6. The annual cost of a 5-year contract to insure Bear’s $10 million debt rose from below $100 thousand in October 2007 to above $700 thousand by mid-March 2008

• Response: fire sale to JP Morgan/Chase (acting as FRB NY conduit to buy Bear) - $2/share offer on March 17, raised to $10 on March 25 (Bear Stearns stock value: $205 in Aug 07, $160 in Jan 08, $2 on March 17, 2008)

• Bear may not be too big to fail, but it is too entangled to fail (with significant position in interest rate swaps); its failure could reverberate across the financial system causing a domino effect. However, is this Wall Street and the Fed common opinion really valid?

• In a different vein: Should the bail-out be so complete?

Credit Risk Amplifiers

• The use of complex derivatives such as synthetic CDOs or CDS creating

exposure to assets without having to own them

• ‘Mark-to-market’ valuation: increasing market risk elevates asset price volatility

and credit risk ⇒ perpetual mix of market/credit risk

• Imperfect algorithms for ‘mark-to-model’ valuation ⇒ mispricing of illiquid

assets

• Counter-party risk: spillover effects of a single institution troubles onto others;

hedging counter-party risk is difficult due to derivatives sold in bilateral OTC hedging counter-party risk is difficult due to derivatives sold in bilateral OTC

agreements and not traded on exchanges

• Excessive leverage (as measured by 2007 vs 2005 assets/equity ratios): Bear Sterns 33 vs 26, Morgan Stanley 33 vs 31, Lehman’s 31 vs 25, while Merrill

Lynch scoring 28 vs 18 in and Goldman Sachs 27 vs 25)

• Impact of leptokurtosis : under-estimating risk during turbulent market periods

by using Value-at-Risk (VaR) methodology based on normal distribution

assumption. Chain reaction: volatility episodes lift up VaR, trigger selling of assets,

which further exacerbates volatility. VaR incorrectly assumes that all risks can be

quantified

Trust erosion as mesured by TED spread

TED spread (3M LIBOR – 3MTBill) as of May 29, 2008, one-year daily data. September and

December levels oscillated around historic 1987 peak level (stock market crash). TED declined

after the Fed September and January easing. Seems to be settling around 80 bps. Three distinctive

waves of distrust (September – subprime crisis outbreak, December – expected spillovers and

bank failures, March – Bear Sterns demise)

Bank-Level Remedies

• More holistic approach to risk management, view it as a team-effort; compensate

portfolio managers for company-level balance of risks

• Emphasize overall risk, in particular market risk (because of strong spillover effects

of market risk on asset price volatility), not just credit risk

• Employ stress testing (analysis of ‘go-wrong’ scenarios and their possible effects)

with caution; too many identified scenarios may be implausible

• A more parsimonious approach: stick to ‘plain-vanilla’ debt securities (those based

on a guaranteed reimbursement of the principal with the return not linked to derivatives), and

basic derivatives; stay away from ‘derivatives on derivatives’ with complicated basic derivatives; stay away from ‘derivatives on derivatives’ with complicated

option characteristics, i.e. CDOs or CDO-squared

• Strengthen internal control over security trading (Why did Soc.Gen. allow Jerome

Kerviel to generate EUR5 bln loss from relatively straightforward exchange-traded futures

contracts? )

• Further the ARCH-class methodology for time-varying volatility analysis

emphasizing time-varying market and credit risk measures (in-mean GARCH

variance) and leptokurtosis (GED parameterization)

Tasks for Regulators

• Further Basel II: stick to the discipline of Pillar 1 (minimum capital

requirements), but expand the scope of Pillar 2 (supervisory review process – SRP)

and Pillar 3 (enhanced disclosure)

• Within Pillar 2: improve internal procedures for assessing institution specific risks;

in particular, set up more elaborate guidelines for (so far barely mentioned in this

pillar) liquidity risk

• Within Pillar 3: extend requirements for disclosure of actually incurred risks,

consider requiring ‘special financial stability reports’ of financial institutions

• Comply with GSE credit guidelines, standardize scorecards for

credit risk assessment, at least for long-term credit

• Work toward standards on central clearing contracts on credit-

default swaps, do not squash them as they are crucial for mitigating default

risk

• In general terms, do not squander derivatives, but attempt to

standardize them and improve their transparency in order to

reduce asymmetric information

Monetary Policy – Constraints and Systemic Remedies

• Stick to forward-looking inflation targeting; a disciplinary anchor (inflation

target) needed for a credible policy

• The current ‘Grand Easing’ shifting the bubble from derivatives and

residential property toward gold and commodities

• Inflation Forecast Targeting (IFT) (L. Svensson, J.Monetary Ec.,1999)

combines discretion with a disciplinary rule, helps instill confidence in the future

value of money

• IFT cannot be too rigid, i.e., based on ‘mechanical’ Taylor rule, because of • IFT cannot be too rigid, i.e., based on ‘mechanical’ Taylor rule, because of

leptokurtosis of most financial variables (exacerbated volatility at turbulent times)

• The recent Fed easing is ‘inter-temporally inconsistent’, as the policy action

is inconsistent with the inflation projection; the aim of reducing the burden of

ARMs resetting shall be explained as a temporary detour from IFT

• Forecast Targeting (FT, not IFT) prescribed by M. Woodford (J.Ec.Persp,, 2008)

- pragmatic but dilutes the policy discipline, would have to be highly transparent to

reduce the deepening information asymmetry between the Fed and the markets,

entails potentially large market risk

• Relative Inflation Forecast Targeting (RIFT) (L. Orlowski, J. Pol. Modeling,

2008) - a policy framework for the economies converging to a common currency

Preference for Targeting Headline Rather Than Core

Inflation – Due to Their Widening Gap and Spillover Effects

CPI and trimmed-mean Core PCE inflation rates in the United States. January 2000 – April 2008 sample period, year-on-year data.

4.0

4.5

5.0

CPI inf

1.0

1.5

2.0

2.5

3.0

3.5

00 01 02 03 04 05 06 07

Core PCE inf

Data Source: Federal Reserve Bank of Dallas and Federal Reserve Bank of St. Louis

Concluding Remarks

• The financial market vicissitudes are not over yet, the

‘conundrum’ is still unwinding

• Liquidity is plentiful, so are market risks, mainly due to

uncertainty about the U.S. business cycle

• Some features of robust monetary policy: 1. an official quantified inflation target, treat the current easing as temporary

2. clear specification of the policy goals and loss function parameterization2. clear specification of the policy goals and loss function parameterization

3. forward-looking character (IFT for the U.S., RIFT for emerging markets)

4. not over-promising in terms of growth and employment

5. transparency

• Neither tighter regulations and supervision nor massive

bailouts of financial institutions will resolve the financial

instability problems; their internal discipline and search for

prudent strategies and policies will