Post on 12-Jan-2023
Finance 499: Undergraduate Research
Title: 2008 Subprime crisis
Opening-Aftermath of the crisis
The financial crisis that was brought into the limelight in
2008 was claimed to be the second worst crisis after the
1932 Great Depression. Lehman Brothers, the fourth largest
investment bank in the United States, was declared bankrupt,
and the government had to face the accusations of
encouraging “moral hazard” and bail out various institutions
that were considered as “too big to fail,” such as AIG.
Housing prices tanked and foreclosures rates went up
significantly. Consumers lost their confidence, credit
markets were frozen, banks were not willing to lend to each
other and the whole financial market and economic activities
were essentially brought to a halt. The Dow Jones
Industrial Average index fell from 14,000 points to 6,600 by
March 2009. The unemployment rate ratcheted up to 10.1% by
October 2009, the highest rate since 1983i. As of the time
this paper is written, the rate is hovering around 7.7%.
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Despite the fall in unemployment, many skeptics opined that
it was primarily due to the increase in discouraged workers
or those who give up looking for a job. To increase
employment, the US real GDP has to increase. Typically after
a recession, the economy will grow at a rate of 4.2% per
annum, but after this recession, the US economy has been
growing at a rate of 2.2%. The 2008 financial crisis has
still its imprints, and it remains to be seen whether the US
can come out of the recession and start growing.
Overview of investigation:
What caused the crisis and who is to blame? The paper aims
to seek the answers to the two questions. The paper will
delineate that “intelligence hazard” and avaricious culture
in the banking industry, i.e. excessive risk exposure in
pursuit of higher returns and utilization of flawed
financial models/ standard ratings, the corrosive
relationships that have developed between the government and
Wall street, and the incompetence of the Federal Reserve
were the reasons that contributed to the financial meltdown.
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The mechanism on how it happened:ii
In a traditional sense, a bank (lender) would conduct due
diligence before it lent money to a house buyer (borrower),
because the lender would have a stake in the loan, and a bad
debt did not reflect well on a lender’s financial
performance/balance sheet. The establishment of Fannie Mae
and Freddie Mae and the redlining regulation, however, gave
rise to a financial activity called securitization. Under
securitization, instead of getting the interest and partial
principal payment from the borrower over time, the lender
could now sell the right of the payment to an investment
bank, in return for a fee. In other words, the lender
transferred the risk of default to another buyer, the
investment bank. Since the lender did not need to bear the
default risk anymore but can get paid for the loan that it
made, it had less incentive to conduct due diligence on the
borrower’s ability to pay back what he borrowed. Lender
started to make loans to a homebuyer who had shady credit
score, or the subprime borrower. The investment bank which
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bought the right of payment from the lender set up a special
entity for the collective right to get the payment, packaged
it into tranches called the CDO, and issued shares, called
the Mortgage backed securities (MBS) to the general public
who wanted high returns for their investment, and earned
handsomely for the selling of shares.
Government intervention in the housing market (as discussed
in the section “a brief look into the history) kept housing
prices high and thus everyone thought it was a good idea to
buy a house as an asset. The frenzy of borrowing and
securitization began.
To prevent exposure to credit risk, or the default on
interest and or principal payments by mortgage holders, the
investment bank bought a form of insurance, or CDS, from an
insurer, such as most notably, AIG. The bank would pay an
insurance premium to AIG to insure against credit risk. In
exchange, AIG promised to pay the investment bank if it
turned out that the borrower did default.
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In the era of rising house prices, the structure looked
profitable and risk free. Everyone in the mortgage food
chain stood to benefit as long as the home buyer didn’t
default.
Housing prices began to decline in 2006 and increasing
defaults and foreclosures have caused banks to run out of
money and the inability of AIG to pay its promised payment
saw Lehman Brothers to declare bankruptcy and Bears Stern
and Merrill Lynch to be bought at pennies. The United States
was thus sent into a period of recession.
A brief look into the history: How banks came up with the
idea of securitization
To fully grasp the scenario of the financial crisis, I found
it important to go back to the 1930s to talk about the
establishment of Fannie and Freddie Mae. During that time,
the United States had just come out from the Great
Depression, and in 1939, President Franklin D. Roosevelt and
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congress passed a bill to establish Fannie Mae to expand the
secondary mortgage market by securitizing mortgages in the
form of Mortgage backed securities. Fannie Mie and Freddie
Mae gave the implicit guarantee that they would buy the
mortgages from the lenders and thus enabled lenders to
provide more long term mortgages. The initial motivation
for securtization was to increase liquidity to the mortgage
market. The increased house prices and the guarantee
subsequently brazened the Wall Street risk takers for
extensive securitization. Here you are talking about
current day right? Not the period immediately post Great
Depression.
Fannie and Freddie were not( in the early stages of the
housing price run up) buying up subprime loans.
It is a recipe for disasters. In 2003, Fannie and Freddie
became the biggest mortgage companies in the United States,
holding mortgages for about 31million households, with
amount totaled up to 5.4 trillion dollars (70% of the
mortgage market).iii With these two companies acting as the
big brothers of the real estate, increasingly, the
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requirements to buy a house became loose, and banks were
taking more risks in making risky house loans.
Originally it was nonbank lenders that were making risky
loans, not Fannie and Freddie which had higher standards for
securitization.
The continued government intervention in real estate through
Fannie and Freddie by injecting capital also created a
housing bubble that kept propping up housing prices without
the break to return to a “balance point.” When it started to
in 2006, the bubble burst.
The banking system: Why banks could not recover from shock
Banks faced bankruptcy during the financial crisis due to
the following main reasons: Intelligence hazard and Wall
Street’s greed. Banks took too much risks with models that
were flawed (were the models flawed or was it the data that
the models were using to estimate VAR, etc flawed?), such as
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the Value at Risk model (VAR), which justified higher
leverage for higher earnings (Are you saying that the
earnings that were estimated using these models ended up
being too ooptimistic?) and underestimated correlation and
volatility, thus were lacking of equity buffer. The use of
RAROC on tranches too enabled high leverage without taking
into account the default of tranches, which although were
given AAA ratings, worked like a Ponzi scheme.
Wall Street’s greed also contributed to banks being too
short funded with an extreme duration gap , and thus a big
decrease in the value of the assets during the meltdown
Explain better. Greed too led to the misleading and
blatantly wrong ratings from the rating agencies. Avarice
was at play and rationale failed to stop the frenzy.
Banks have been using VAR to
calculate the equity buffer, or the
capital that a bank needed to withstand a change in the
maximum interest rate (the change was denoted in basis
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VAR=( -D.V.n. √N. σ)/ (1+r)
D: duration, V: value,
n: Standard deviation,
points). Under the international regulation, to be in the
99% percentile, or to sustain only a 1% chance of bankruptcy
the next business days, for 10 days, a bank must adjust the
standard deviation, or n, to 2.33, and N, to 10, and then
come up with the VAR as an equity buffer.
VAR had not been a reliable modeliv. UBS, reported 50 VAR
exceptions for 2008 and 29 for 2007. At the 99% confidence
level chosen, there should have only been about 2.5
exceptions per year. Credit Suisse experienced 25 and nine
VAR exceptions in 2008 and 2007, respectively, also at 99%
confidence level. The model might be a decent one to use
during a calm financial period and gave banks lots of
earnings due to the low equity required, but the model
proved to be disastrous for banks in 2008, a period of wild
volatility. So isn’t this saying that the data they were
using to estimate VAR values came from periods with adverse
events that were not sizable?
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One of the shortcomings of the model was that it calculated
the equity buffer solely by looking at past events. The
financial instruments and derivatives that were the
culprits, such as the CDOs and CDS, were new creations of
Wall Street, and thus there was no historical data available
on the behaviors of these instruments. Lacking of this
crucial information meant that banks were not able to
capture the correlation of the movements of the different
assets. It turned out that the correlation between the
various asset classes was remarkably high, and together with
the high volatility in interest rate in the year 2008, the
risk exposure of banks went up a notch. VAR of banks went
up accordingly by a significant amount, but it was too
sudden and too late for banks to have enough equity buffer.
Banks were distressed.
At this point, it is worth mentioning that the decrease in
bank’s asset value, apart from banks were being too short
funded, was exacerbated by the default of the mortgages
(assets). Banks were using the Risk-adjusted return on
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capital (RAROC) framework to calculate the profitability of
its tranches, which were rated AAA by rating agencies, and
the scenario backfired.
RAROC was introduced in the 1970s by Bankers Trust. It
enabled banks to compete with commercial papers due to fewer
capital requirements (unclear-I don’t understand the
connection to commercial paper are you saying the model was
first used to evaluate RAROC on commercial paper which is a
short term debt instrument issued by credit worthy firms)
but should only be used to make loans to good standing
borrowers since RAROC did not take into account default
risk. The era of Great Moderation in the 1980s saw the
volatility index (VIX) and overall risk go down. There was
a sense of complacency in the market, and banks started to
take on more risks by upping their leverage. RAROC thus
began to be used and seemed to cause no major problems.
Using RAROC and VAR, the two flawed models to evaluate risky
and new instruments, have enabled banks to lever up. Banks’
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leverage ratio was able to go up to a dangerous level. The
financial crisis saw Freddie Mae leveraged 40 to 1, while
Bears Stern was 33 to 1, which means it had only $3 equity
for every $100 asset. Intelligence hazard implied that Wall
Street used the models knowing the potential risk but did
not stop due to high returns.
Aside from not having enough equity as buffer, greed led to
banks’ great loss on their asset value. It has been a
tradition for banks to be the maturity intermediary, and in
the years leading to the financial crisis, banks had been
actively borrowing short term monies (deposit, or liability)
to fund long term assets due to the prospect of great money
earning potential in the mortgage market. The duration gap
increased and the extreme short funding situation put banks
at high risk of losing asset value when interest rate
increases.
When LDL < ADA , an increase in
the interest rate would force a bank to pay higher interest
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Duration Gap, ΔV: (LDL/1+rL)-(ADA/1+rA) * Δrf
expense but does not receive higher interest revenue.v Here
you are talking about what happens to net interest income
not the value of equity which is what the duration model
looks at
If the bank’s asset has a duration of 5 and interest rate
rose for 3%, the asset value would be wiped out for 15%.
During the financial crisis, the wide duration gap and the
increase in rate have caused banks to lose out a big chunk
of its asset value. The duration model says what happens to
both the value of assets and value of liabilities when
interest rates change. So, if interest rates rise the value
of assets and the value of liabilities both fall, but the
value of assets falls by more-hence the market value of
equity falls.
To add disaster to the recipe, rating agencies such as
Moody’s, S&P, and Fitch gave out blatantly ignorant ratings
(AAA, which means as safe as US treasury bonds) on the
tranches sold by the investment
banks. As mentioned, RAROC should
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ΔV ΔΦ or Δrf
only be used when evaluating an asset that will not default.
The rating agencies had a conflict of interest, because they
were given a huge fee by the bank to evaluate the tranches.
Tranches turned out to be not AAA and borrowers default and
credit risk increases. Banks did not anticipate the fall in
the value of loan and eventually have its asset wiped out.
From the discussion above, it is clear that the lack of
equity buffer and the drop in banks’ asset prices
contributed to banks’ distress. It is worth noting that the
former is mainly associated with interest rate risk (Δrf),
while the later, credit risk. (ΔΦ) Unclear
The diagram above indicates how the change in the credit
risk premium ((ΔΦ) and/or a change in the interest rate
(Δrf) change the value of the bank. When banks leveraged
up, the slope of the tangent got steeper, meaning that more
equity buffer was needed. However, banking industry’s
underestimation of the volatility in the interest rate and
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the complacency to use RAROC has caused them to belly up
within days during 2008, a period of rare volatility.
Banks should be able to hedge against interest rate risk in
the futures market. However, they failed to hedge. Banks
should also be able to hedge against credit risk by getting
CDS. It would work provided that the counterparty is
solvent. Unfortunately, in 2008, the counterparty was AIG,
which was not able to fulfill their promise for payments
until the government bailed it out.
The banking industry’s serious of overdependence of
financial models that were at flawed, constant ignorance of
potential risks in pursuit of higher returns, and standard
rating agencies’ collusion for profitable ratings culminated
in the 2008 financial crisis.
Government deregulation and Failure of the FED: what
completed the risky game
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Government’s deregulation and the corrosive relationships
between Washington and Wall Street was the reason that the
aforementioned problems in the baking industry were
tolerated and further helped in building up the crisis.
Washington started out as being a strict regulator. As part
of the new deal, President Franklin D. Roosevelt passed the
Glass Steagall Act in 1933 to disallow banks with customer
deposits from engaging in investment banking activities.
The regulatory policies at that time were biased toward
control and protection rather than open markets and
competition. It was Glass-Steagall that prevented the banks
from using insured depositories to underwrite private
securities and dump them on their own customers. From 1933
to 1999, there were very few large bank failures comparable
to the panic of 2008. The law worked exactly as intended.
In April 1998, Travelers and Citicorp were trying to merge,
and Sanford Weil found loopholes within the act and join
with powerful forces to overturn the act. In 1999,
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Democrats led by President Bill Clinton repealed Glass-
Steagall at the behest of the big banks. The Gramm-Leach-
Bliley Act was enacted by congress, effectively undid many
of the provisions of the Glass Steagall Act of 1933,
resulted in large part deregulation and easy lending
policies. Once again, banks originated fraudulent loans and
once again they sold them to their customers in the form of
securities.
Aside from the repeal of Glass Steagall as a milestone of
government’s deregulation, the government has also been
deregulating in many other areas.vi For example, In May
1998, congress blocked the bill by the Commodity Futures
Trading Commission (CFTC) for regulation, thereby giving
more freedom to the derivatives market and became the basis
for massive speculation. Then in 2004, the Securities and
Exchange Commission (SEC) adopted a voluntary regulation
scheme for investment banks that enabled them to incur much
higher levels of debt, and loosen capital reserve
requirements based on their internal “risk assessment
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models.” In 2006, a law was passed and handcuffed the SEC
from properly regulating the private credit rating
companies, paving way for rampant collusion to give out AAA
ratings and incorrectly assessment of the quality of
mortgage backed securities.
WHAT drove deregulation? Robert Weissman, the lead author of
the report, "Sold Out: How Wall Street and Washington
Betrayed America," captured it succinctly. "Congress and
the Executive Branch responded to the legal bribes from the
financial sector, rolling back common-sense standards,
barring honest regulators from issuing rules to address
emerging problems and trashing enforcement efforts. The
progressive erosion of regulatory restraining walls led to a
flood of bad loans, and a tsunami of bad bets based on those
bad loans.” Wasn’t deregulation also a product of academic
thinking that the invisible hand of the markets does the
best in allocating capital, that the market should police
itself?
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Thus, granted that the United States is labeled as a
democratic country, one almost always does not realize that
it is not so much as democratic as a dictated, because
important decisions always are decided by a few individuals’
who contributed big campaign money.
The financial sector invested more than $5 billion in
political influence purchasing in Washington over the past
decade, with as many as 3,000 lobbyists winning deregulation
and other policy decisions that led directly to the current
financial collapse. It is equivalent to having 5 lobbyists
for each and every one of the congressman. One of the most
prominent of which is the Financial Services Roundtable
which was set up in 2000 and represents 100 of the largest
integrated financial services companies and whose members
are the CEOs of the 100 largest financial services
companies.
Having a comfortable relationship with the government, and
thus the lack of regulation, has not only enabled Wall
Street to cover its underlying problematic structure, as
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mentioned in the section “The banking system,” but also
enabled the powerful banks to take power into their own
hands to create risky and complicated derivatives, such as
the collateralized debt obligations (CDO) and credit default
swaps (CDS) that led to massive speculative and ridiculous
risk exposure. See “The mechanism on how it happened” to
understand the unsustainability of the derivatives.
There was also a culture of cronyism in Washington that
could facilitate business dealings with regulatory approval.
The financial sector buttressed its political strength by
placing Wall Street expatriates in top regulatory positions,
including the post of Treasury Secretary held by two former
Goldman Sachs chairs, Robert Rubin and Henry Paulson. Henry
Paulson was in the position from 2006-2009 under President
George W. Bush, and he was one of the main proponents for
deregulation and for increasing leverage when he was the CEO
of Goldman Sachs. His relationship with Wall Street was
subsequently called into question when Goldman Sachs turned
out to be the biggest beneficiary from the AIG bailout, and
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it was paid 100 cents on a dollar for the CDS that it
purchased when Paulson was the CEO.
Apart from having a too close relationship with Wall Street,
the government was to blame for having Alan Greenspan served
as the Federal Reserve chairman from 1987-2006. vii
Greenspan was instrumental in perpetuating the mortgage
market crisis by fueling the bubble with different policies
and statements. On February 23, 2004, Greenspan gave a
speech extolling the virtues of floating rate mortgages,
saying “many homeowners might have saved tens of thousands
of dollars had they held adjustable-rate mortgages….the
traditional fixed rate mortgages may be an expensive way of
financing a home.” In the subsequent two years, interest
rates quadrupled from 1 percent to 4.5 percent.
One of the most important features for the bubble was the
practice of mortgage equity withdrawal, or the “housing
ATM,” which enableed homeowners to routinely extract some
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portion of their home equity to spend. On November 13, 2002,
Greenspan explained: “besides sustaining the demand for new
construction, mortgage markets have also been a powerful
stabilizing force over the past two years of economic
distress by facilitating the extraction of some of the
equity that homeowners had built up over the years.”
Greenspan was a serial bubble-blower. His term saw the
market crash of 1987, the Savings and Loan crisis, the
crash of the Russian ruble and Long Term Capital Management,
the 2000 tech bubble, the supposed Y2K disaster, and last
but not least, the credit bubble and real estate crisis of
2008. Prior to Greenspan's arrival, excluding the brief
mania for commodities and precious metals in late '79 and
early '80, the U.S. had been bubble-free for over 50 years.
Conclusion:
From the discussions above, “intelligence hazard” and
avaricious culture in the banking industry, i.e. excessive
risk exposure in pursuit of higher returns and utilization
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of flawed financial models/ standard ratings, the corrosive
relationships that have developed between the government and
Wall Street, and the incompetence of the Federal Reserve
were the reasons that contributed to the financial meltdown
The meltdown has totally ruined the financial industry. The
TARP fund was mandated to be received by major banks, and
thus, blurred public’s ability in differentiating between
good and bad banks.
The crisis’s impact can still be felt today with
unemployment rate still is up at 7.7% and GDP growth below
the normal rate.
it remains to be seen when the United States can be back on
track for growth again. “Greed is good,” as popularized by
Gordon Gekko, turned out not to be so good after all.
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i 2008, September. "Financial crisis of 2007–2008 - Wikipedia, the free encyclopedia." Wikipedia, the free encyclopedia. N.p., n.d. Web. 5 Apr. 2013. <http://en.wikipedia.org/wiki/Financial_crisis_of_2007%E2%80%932008#US_stock_market>.
ii "Mortgage-Backed Securities I ." Mortgage-Backed Securities I . N.p., n.d. Web. 30 Aug.2007. <https://www.youtube.com/watch?v=oosYQHq2hwE>.
iii Viet-Nam, 1968 LBJ was dealing with, and bear much of the risk of loss implicitly. I do not like GSE&. "Another bailout that will cost the tax payers billions of dollars, post one | Fort Wayne Politics." Fort Wayne Politics. N.p., n.d. Web. 5 Apr. 2013. <http://fortwaynepolitics.com/2008/09/another-bailout-that-will-cost-the-tax-payers-billions-of-dollars-post-one/>.
iv Triana, Pablo. "VaR: The number that killed us." Futures: Stock, Commodity, Options, and Forex Strategies for the Serious Trader. N.p., n.d. Web. 5 Apr. 2013. <http://www.futuresmag.com/2010/12/01/var-the-number-that-killed-us?t=technology&page=2>.
v Hess, Alan. Finance 423, Banking Coursepack. Seattle: Foster School of Business, 2012. Print.
vi "What Drove Deregulation." zFacts on Controversial Topics. N.p., n.d. Web. 5 Apr. 2013. <http://zfacts.com/node/341>.
vii Fleckenstein, William A., and Frederick Sheehan. Greenspan's bubbles: the age of ignorance at the Federal Reserve. New York: McGraw-Hill, 2008. Print.
-before Freddie and fannie were the lead (required strong background checks), untiltheir reputation was hurt and bankers found way to structure the whole MBS market (that the world was flushed with cash was another extra carrot)> 2001 9/11 wanna customers to spend,2002 bush encouraged minority homeowers
Lier loans, home prices go up, people more money to spend, retail sales up, furtherpropped by Fed’s low interest rates