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1
Deciphering the 2007/8 Liquidity Deciphering the 2007/8 Liquidity and Credit Crunchand Credit Crunch
Markus K. BrunnermeierPrinceton University
Written notes will be available athttp://www.princeton.edu/~markus
2
Overview of TalkOverview of Talk1. Run-up
Creation of structured productsDemand for structured productsConsequences: Buy-out bonanza, house price frenzy
2. Unfolding of crisisSubprime, ABCP, banking crisisQuant crisis
3. Mechanisms at work4. Difference to previous crises
3
1.1 Creation of Structured Products1.1 Creation of Structured ProductsSecuritization I
Insuring CDS US$ ≈45tr (corporate debt ≈5tr)
PoolingTranching CDOs
CateringOpaqueness
Securitization IIShortening maturity SIVs et al.
Traditional business of banks“Ride yield curve”
Buy long-term assetsSell and roll over short-term assets (ABCP)
Opaqueness in off-balance sheet vehicles
Bond Tranches
Thickness “Loss Support”
AAA 80% 20%
AA 5% 15%
A 5% 10%
BBB+ 2% 8%
BBB 1% 7%
BBB- 2% 5%
BB 1% 4%Overcollateralization(Equity)
4% 0%
4
Conduits SIVs SIV-litesassets US$ ≈1,400bn
not tradable loansless risky
•≈11% RMBS•≈11% ABS/CDOs
US$ ≈400bn assets are tradedless risky
•≈ 43% fin. Inst. Debt•≈ 23% RMBS•≈ 11% CDOs
US$ ≈12bnassets are tradedrisky
• >95% US RMBS
liabilities 26% ABCP68% MTN
7% capital/mez.notes
capital structure non-structured structuredopen dynamic (change size/financing)
structured (aggressively)
closedstatic (like CDOs)
Credit enhancement
Some(sponsoring bank)
No (but overcollateralized) No
Liquidity enhanc. (credit line)
Contractual100%
Contractual< outstanding ABCPReputational
Contractualcredit line is subject to market value tests
1.2 Shortening Maturity 1.2 Shortening Maturity -- SIVsSIVs et al.et al.
5
1.3 Why Structured Products?1.3 Why Structured Products?Good reasons
Catering – transfer risk who can best bear it –stayed mostly within banking system
(complete markets)Bad reasons
Supply: Rating Arbitrage – Diluting existing bond holders
Transfer highly rated asset to SIV and issue AAA papersInstead of issuing A- minus rated papers+ banks’ rating was unaffected by this practice
Regulatory Arbitrage: Outmaneuver Basel I accord (SIVs)esp. reputational liquidity enhancements
Demand: Creative way to enhance portfolio returns
searching for yieldtrack record building - picking up nickels before the steamroller
Attraction of illiquidity (no price exists) + difficulty to value CDOs (correlation risk)
“mark-to-model”: Mark “up”, but not “down”smooth volatility and increase Sharpe ratiofraction of “level 3 assets” went up a lot
6
1.4 Consequences of 1.4 Consequences of ““originate and distribute banking modeloriginate and distribute banking model””
Banks focus only on ““pipeline riskpipeline risk””Distance between borrowers and lenders
Opaqueness - obfuscation
Deterioration of lending standardsMortgages
Mortgage brokersPiggyback mortgages, NINJA loans, …Housing Frenzy
Corporate bondsPik bondsCovenant-lite bondsPrivate equity bonanza – LBO acquisition spree
7
2. Unfolding of Crisis2. Unfolding of Crisis
1. Subprime2. ABCP, banking crisis3. Spillover to corporate credit4. Quant crisis
8
2.1 2.1 SubprimeSubprime crisis crisis –– envelope calculationenvelope calculationSubprime mortgage: 15% of US$ 10tr = US$ 1.5tr
Say: 50 % default, only recoup 50%Total loss: US$ 375bn, incl. Alt-A say, US$ 500bn2% change in stock market > US$ 500bn Amplifying mechanism
needed
9
2.2 ABCP 2.2 ABCP –– Banking CrisisBanking Crisis
ABCP dries up – no rolloverSIVs draw on credit lines of sponsoring bankLIBOR and flight to qualityBanking Crisis: IKB, SachenLB, Northern Rock
3
3.5
4
4.5
5
5.5
6
6.5
7/1/07
7/8/07
7/15/0
77/2
2/07
7/29/0
7
8/5/07
8/12/0
78/1
9/07
8/26/0
7
9/2/07
9/9/07
9/16/0
79/2
3/07
9/30/0
710
/7/07
ABCPLIBOR 3 monthsT-Bill 3 monthsFedFund
600
700
800
900
1000
1100
1200
1300
6/27
/07
7/11
/07
7/25
/07
8/8/
07
8/22
/07
9/5/
07
9/19
/07
10/3
/07
ABCPFinCP
Outstanding ABCP Rates
10
2.3 Spillover to Corporate Credit2.3 Spillover to Corporate Credit
Novelty effectLearning about structured products
0
100
200
300
400
500
600
1/1/07
2/1/07
3/1/07
4/1/07
5/1/07
6/1/07
7/1/07
8/1/07
9/1/07
10/1/
070
500
1000
1500
2000
2500
3000
CDX.HY.5y On the Run ABX.HE.BBB- On the Run
Note difference in scale!
11
2.4 Quant Crisis2.4 Quant Crisis1. High frequency stat arbs
High frequency, IT driven, short-term reversal strategiesAug 1st to Aug 9th - price declines seven days in a rowe.g. Renaissance’s Medallion fund
2. Low frequency quant fundsValue-growth (HML) strategy, momentum strategy FX carry tradese.g. Goldman Sachs’ Global Alpha, AQR, …
12
2.4 Quant Crisis2.4 Quant CrisisFunds’ assets in general
(Knowledge) Acquisition Cost
Market Liquidity
Order of Liquidation
Proprietary trading strategy (incl. credit)
High fixed costs Low/High
High
∞
Standard trading strategy(incl. carry trade, HML)
Low cost
3
2
Cash holding No cost 1
13
2.4 Quant Crisis2.4 Quant Crisis
Why? Many (not only quant) funds liquidate “relatively”liquid positions firstQuant funds are particularly loaded on these factors
HML Accumulative Returns
0.88
0.9
0.92
0.94
0.96
0.98
1
1.02
1/1/2
0072/1
/2007
3/1/2
0074/1
/2007
5/1/2
0076/1
/2007
7/1/2
0078/1
/2007
9/1/2
007
Date
Deutsche Bank Carry Trade ETF
0.98
1
1.02
1.04
1.06
1.08
1.1
1.12
1.14
1.16
1.18
1/1/2
0072/1
/2007
3/1/2
0074/1
/2007
5/1/2
0076/1
/2007
7/1/2
0078/1
/2007
9/1/2
007
Date
14
2.4 Quant Crisis2.4 Quant CrisisDaily HFR indexes
85
90
95
100
105
6/1/20
076/8
/2007
6/15/2
0076/2
2/2007
6/29/2
0077/6
/2007
7/13/2
0077/2
0/2007
7/27/2
0078/3
/2007
8/10/2
0078/1
7/2007
8/24/2
0078/3
1/2007
Cum
ulat
ive
Retu
rn
Equity Market Neutral Index Macro Index Global Index
HFR indexes
Stat arb crisis
15
3. Mechanisms3. Mechanisms
Market liquidityEase with which one can raise money by selling the asset
Funding liquidityEase with which one can raise money by borrowing using the asset as collateral
Each asset has two values/prices1. price2. collateral value
16
3. 3. The 3 Flavors of (the same)The 3 Flavors of (the same)Funding Liquidity RiskFunding Liquidity Risk
Margin funding risk Prime brokerMargin has to be covered by HF’s own capitalMargins increase at times of crisis
Rollover risk CPInability to roll over short-term commercial paper
Redemption risk Depositors, HF-investorsOutflow of funds for HFs and banks
Essentially the same!Maturity mismatch: Long-term assets but
short-term borrowing
17
3. Mechanism 13. Mechanism 1Collateral Crisis due to Collateral Crisis due to Increased Vol.Increased Vol. + Losses+ Losses
Permanent price shock is accompanied by higher future volatility (e.g. ARCH)
Realization how difficult it is to value structured products
estimate defaultcorrelations
Value-at-Risk shoots upMargins/haircuts increase Collateral value declinesFunding liquidity dries up
Rating Jan-May 2007 July-Aug 2007Bond
Investment grade 0-3 3-7
High yield 0-5 10+
Leveraged Loan
Senior 10-12 15-20
2nd lien 15-20 20-30
Mezzanine 18-25 30+
ABS and CDO
AAA 2-4 8-10
AA 4-7 20
A 8-15 30
BBB 10-20 50
Equity 50 100Source: Citigroup, IMF Stability report 2007
Liquidity/Margin Spiral
18
3. Mechanism 1 3. Mechanism 1 -- Margins for S&P 500 FuturesMargins for S&P 500 Futures
Collateral Crisis due to Collateral Crisis due to Increased Vol.Increased Vol. + Losses+ Losses
0%
2%
4%
6%
8%
10%
12%
14%
Jan-82 Jan-84 Jan-86 Jan-88 Jan-90 Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06
US/Iraq war LTCM
Asian crisis
Black Monday10/19/87
1989 mini crash
19
3. Mechanism 1 3. Mechanism 1 –– Why ARCH? Why ARCH?
Collateral Crisis due to Collateral Crisis due to Increased Vol.Increased Vol. + Losses+ Losses
t1 2
Λ
p1
m1
100
120
80 m1
Λ
vt = vt-1 + Δvt = vt-1 + σt εtσt+1= σ + θ |Δvt |
20
3. Mechanism 1 3. Mechanism 1 –– Hyperbolic Star Hyperbolic Star
Collateral Crisis due to Collateral Crisis due to Increased Vol.Increased Vol. + Losses+ Losses
x1 < W1/m1 = W1/(σ + θ|Δp1|)_
customers’supply
21
3. Mechanism 13. Mechanism 1Collateral Crisis due to Collateral Crisis due to Increased Vol.Increased Vol. + Losses+ Losses
Liquidity spiralMargin spiral (Redemption/roll-over spiral)Loss spiral
Both spirals reinforce each other
Source: Brunnermeier & Pedersen (2007)
22
3. Mechanism 23. Mechanism 2Collateral Crisis due to Collateral Crisis due to LemonLemon’’s Problems Problem
Financiers are concernedCollateral is more risky +Receive a particular bad selection of collateral
Issuer knows best what’s in the pool of assetsRecall CDOs are particularly difficult to price
As margins/ABCP rate increase, selection of collateral worsens
Leads to a further increase and hence worse selection ultimately leads to a market breakdown.
23
3. Mechanism 3 3. Mechanism 3 Expertise, Complexity and DiscretenessExpertise, Complexity and Discreteness
CP stops to be viewed as “cash substitute”Buyers of ABCP do not conduct a credit analysis.No expertise in credit quality evaluationDeterioration in fundamentals makes credit evaluation necessaryWithdrawal from ABCP market
Expertise is only slowly build up again
24
3. Mechanism 4 3. Mechanism 4 RunRun on Financial Institutionson Financial Institutions
Run before others run – DYNAMICDYNAMICFinancial Institutions
On Banks: Demand depositors, by withdrawing On HFs: Prime brokers, by increasing margins
Investors, by redeeming fundsOn SIVs: Investors, by not rolling over ABCP
Note: “Liquidation policy” of SIVs favors early withdrawals!
25
3. Mechanism 53. Mechanism 5GridlockGridlock RiskRisk
Interweaved network of financial obligationsLender and borrower at the same time
Example:
Gridlock, if A loses 30m – Deadlock, if A loses 55mOpaqueness makes matters worse
Regulator can’t interveneWarren Buffett is less likely to help out
B30m50m
40m
40m C30m
A60m
26
3. Mechanism 63. Mechanism 6Precautionary Precautionary HoardingHoarding
“Funding cushion” for adverse eventsincreases for 3 reasons
1. SIVs might draw on credit lines2. Borrowing at interbank lending market is more
volatile (since other banks might have SIV exposure)
3. Increased credit counterparty risk
27
3. Mechanism 73. Mechanism 7KnightianKnightian UncertaintyUncertainty
Market freezes up, sinceInvestors focus on worst-case analysisif it is difficult to assign probabilities to different outcomes (like value of CDOs)Investors/banks hoard because they fear the worst
28
4. Differences to Previous Crisis4. Differences to Previous CrisisCommon theme:Common theme:interaction between funding and market liquidity. 1987 crash: culprit was portfolio insurance trading1994 mortgage crisis: primarily prepayment risk1998 LTCM crisis: specific convergence spread arbitrage
trades were well knowne.g. on-the run and off-run spread (not much in 2007)
known main player which needed to be bailed out2000 Internet bubble – role of analysts2007 culprit:
rating agencies housing market correction maturity mismatch
29
5. Conclusion5. ConclusionCrisis with traditional elements: due to mismatch of maturities
Interaction between funding and market liquidityNew level of opaqueness
Structured products are difficult to valueoff-balance sheet vehicles (SIVs) (Basel accord)
Several mechanism/“liquidity spirals” are at workCollateral crisis due to increased volatility Run on financial institutions (dynamic)Gridlock riskHoarding