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1

Deciphering the Liquidity and Credit Crunch
What about is paper?

The paper attempts to explain economic mechanisms that caused losses in the mortgage market to amplify into turmoil in financial markets, and describes common economic threads that explain the plethora of market declines, liquidity, dry-ups, and bailouts that occurred after the crisis broke in 2007. The main concentration on the U.S. market.

2

Deciphering the Liquidity and Credit Crunch
Which Two trends in the banking industry laid the foundation of crisis:

1. „Originate and distribute“ model
2. Asset holdings were financed with short maturity instruments

3

Deciphering the Liquidity and Credit Crunch
„Originate and distribute“ model - describe

– NOT holding loans on bank’s balance sheet; repackaging loans and selling them to other financial investors; offloading risk => create structured products a.k.a. collateralized debt obligations – CDOs (tranches).

4

Deciphering the Liquidity and Credit Crunch
How the funding liquidity risk is related to „Originate and distribute“ model

• Off balance sheet strategy exposes banks to funding liquidity risk- investors might stop buying asset-backed commercial paper, preventing these vehicles rolling over the s-term debt.

5

Deciphering the Liquidity and Credit Crunch
Why most investors prefer assets with short maturities

• It allows them to withdraw funds on short notice;
• Can serve as a commitment device to discipline banks with the threat of possible withdrawals.
• The short term assets= “asset backed”, are backed by pool mortgages or other loan as collateral. In case of default, owners of asset-backed commercial paper have the power to seize and sell the underlying collateral.

6

Deciphering the Liquidity and Credit Crunch
How CDO is created:

• Form diversified portfolio of mortgages and other types of loans, corporate bonds, etc.
• Slice these portfolios into different tranches, which are sold to different investor groups according to their appetite to risk. (Senior tranche= the safest (AAA); low interest rate, first to be paid in case of default. The most junior/ equity tranche/toxic waste= will be paid only when other tranches are paid. Mezzanine tranches are between these two extremes.
• Buyers f these tranches can protect themselves by buying credit default swaps (CDS)- contract insuring against the default of a particular bond or tranche.

7

Deciphering the Liquidity and Credit Crunch
TWO types of liquidities:

Funding liquidity
Market liquidity

8

Deciphering the Liquidity and Credit Crunch
Funding liquidity

describes the ease with which expert investors and arbitrageurs can obtain funding from (possibly less informed) financiers. It is high- the markets are “awash with liquidity”- when it is easy to raise money.

9

Deciphering the Liquidity and Credit Crunch
Three risk forms for funding liquidity

• Margin/haircut funding risk- risk that margins/haircuts will change;
• Rollover risk- risk that it will be more costly to roll over short-term borrowing;
• Redemption- risk that depositors will withdraw funds.

10

Deciphering the Liquidity and Credit Crunch
Market liquidity

market liquidity is a market's ability to purchase or sell an asset without causing drastic change in the asset's price.

11

Deciphering the Liquidity and Credit Crunch
Three sub-forms of market liquidity

• Bid- ask spread- measures how much traders lose if they sell 1 unit of asset and then buy it back;
• Market depth- shows how many units traders can sell or buy at current bid or ask price without moving the price;
• Market resiliency- tells how long it will take for prices that have temporarily fallen to bounce back.

12

Deciphering the Liquidity and Credit Crunch
Benefits of structured financial products

• Shift the risk to those who want to bear it;
• Spread the risk among many market participants (lower interest & mortgage rates; certain institutional investors (e.g. pension funds) can directly hold assets that they were previously prevented from by regulation).

13

Deciphering the Liquidity and Credit Crunch
Four economic mechanisms through which the mortgage crisis amplified into a severe financial crisis

1. Borrowers’ balance sheet effects cause two “liquidity spirals”
2. Lending channel can dry up when banks become concerned about their future access to capital markets and start hoarding funds
3. Runs on financial institutions e.g. (Lehman brothers)
4. Network effects

14

Deciphering the Liquidity and Credit Crunch
Asset-backed commercial paper

a pool of assets (mortgages, loans) and in case of default, owners can sell the underlying asset (super senior tranche the safest > mezzanine > subordinate)

15

Deciphering the Liquidity and Credit Crunch
Collateralized Debt Obligation

pool of asset backed commercial papers (same sequence)

16

Deciphering the Liquidity and Credit Crunch
CDS (Credit Default Swap)

contract insuring against the default of particular bond or tranche. The buyer pays a periodic fixed fee in exchange for a contingent payment in the event of credit default

17

Deciphering the Liquidity and Credit Crunch
“Margin run”

faced by AIG, when counterparties requested additional collateral for its CDS positions.

18

Deciphering the Liquidity and Credit Crunch
Conclusion

An increase in mortgage delinquencies due to a national wide decline in housing price was triggered by a liquidity crisis. The current crisis can be characterized by a “classical banking crisis”. The particularity of this crisis is was the level of securitization which led to a strong level of interconnection. This paper outlined several amplification mechanisms that help explain the causes of the financial turmoil.

While it is individually beneficial for firms to have higher leverage, losses for a group of investors can initiate fire-sales by other investors via loss and margin spirals  which lead to reduced liquidity and uncertainty in counterparty positions Need for regulations of financial markets!!!

19

Deciphering the Liquidity and Credit Crunch
Macro-factors

a. Low interest rate (fear of deflation)
b. Capital inflows from abroad
c. Increased popularity of structured products

20

Deciphering the Liquidity and Credit Crunch
Micro factors

a. Originate-to-hold (Hold loans on banks BS) -> originate-to-distribute model (pool, tranche and resolve loans via securitization).
Security is riskier than loan.

21

Deciphering the Liquidity and Credit Crunch
Main problems

a. Moral hazard
b. Profit seeking (institutions – banks wanted more mortgages)
i. Lending no ninjas even (credit lending standards decreased a lot)
c. Complexity of financial system
i. Very complexed, even investment bankers sometimes don’t understand what instruments they are trading
d. Rating agencies

22

Deciphering the Liquidity and Credit Crunch
Factors leading to housing bubble

Low interest rates in the U.S.
Decline in lending standards
Increased popularity of structured products

23

Deciphering the Liquidity and Credit Crunch
What were the reasons of Low interest rates in the U.S.

– Capital inflows (Asia)
- Lax interest rates by FED

24

Deciphering the Liquidity and Credit Crunch
Loss spiral

Risk associated with the reduction in the value of an asset, leading to losses and higher margin/haircut

25

Deciphering the Liquidity and Credit Crunch
margin spiral.

Prices of assets decline -­‐> margins rise -­‐> investors sell even more to reduce leverage ratio -­‐> increase margins further
Margins increase after large price drops because:
(i) volatility increases,
(ii) asymmetric information frictions emerge (financiers become more careful about accepting as collateral)

26

Moore’s Law versus Murphy’s Law: Algorithmic Trading and Its Discontents
Moore’s Law

growth of semiconductor industry which had profound impact on the financial system.

27

Moore’s Law versus Murphy’s Law: Algorithmic Trading and Its Discontents
Murphy’s law

“whatever can go wrong will go wrong” and it corollary “whatever can go wrong will go wrong faster and bigger when computers are involved”

28

Moore’s Law versus Murphy’s Law: Algorithmic Trading and Its Discontents
Algorithmic trading

the use of mathematical models, computers and telecommunication networks to automate the buying and selling of financial securities.

29

Moore’s Law versus Murphy’s Law: Algorithmic Trading and Its Discontents
Authors’ idea

A more systematic and adaptive approach to regulating this system is needed, one that fosters the technological advances of the industry while protecting these who are not as technologically advanced.”

30

Moore’s Law versus Murphy’s Law: Algorithmic Trading and Its Discontents
Good aspects of algorithmic trading

o Lower costs (bid ask-spread)
o Reducing human error (ex: broker doesn’t buy the needed stock)
o Increasing productivity