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					  The 2007-2008 crisis
Notes for Macrorisks course Università
          di Milano Bicocca
 Based on Brunnermeier 2009 - JEP
• The paper tries to explain the mechanisms that caused losses in the
  mortgage market and the threads that can explain the generalised
  market decline;
• The US were experiencing low interest rates, large capital inflows
  (especially from Asia):
• The FED did not counteract the build-up of the housing bubble,
  while the banking system went through an important evolution
  towards the “originate to distribute” model;
• The creation of new securities (new asset types) facilitated the large
  capital inflows from abroad (remember Caballero?).
              Banking industry trends
•   Instead of holding loans on their balance sheets, banks moved to an
    “originate and distribute” model, packaging loans and selling these
    packages to other financial investors, offloading risks;
•   Banks increasingly financed their assets with short maturity instruments,
    exposing themselves to maturity mismatch and liquidity risk;
•   To offload risks structured products were created (typically CDOs);
•   CDOs were sliced into different tranches and sold to investors with different
    risk appetite (super senior, senior, mezzanine, equity or toxic);
•   Buyers of these tranchescould protect themselves through CDS (also on
    indexes, e.g. CDX or Itraxx).
                     Maturity mismatch
•   Investors prefer assets with short maturity (focussing on short term
    performance), but mortgages and other investment projects have long
    maturities (years);
•   Often (unfortunately) this time mismatch was transferred to a “shadow”
    banking system, such as off-balance sheet vehicles and conduits, which
    raise funds by issuing 90-days notes backed by long term assets, which can
    be seized and sold by owners in case of default;
•   This practice exposes vehicles to funding liquidity risk, that is “solved” by
    banks granting credit lines to their sponsored vehicles;
•   At the end of the day, it is always banks which bear the risk which, however,
    is hidden away from the balance sheet of banks;
•   Regulatory advantages and infrequent portfolio revaluation.
             The unfolding of the crisis
•   The trigger for the liquidity crisis was an increase in subprime mortgage defaults, first
    noted in February 2007:
                  ABCP vs. non-ABCP
•   Initially, only the asset backed commercial paper market was affected by the
    unfolding of the crisis:
               LIBOR, Repo and TED
•   In addition to commercial paper, banks use repo markets, the Fed funds
    market and the interbank market to finance themselves
•   Repurchase agreements (Repos) allow collateral funding, Fed funds rate is
    the overnight rate at which banks lend reserves to each other to meet the
    central bank’s reserve requirement and LIBOR is the interbank rate at which
    commercial banks lend to each other: which is the highest rate?;
•   TED is the difference (spread) between the risky LIBOR (counterparty risk)
    and the risk free US Treasury bill rate: in times of liquidity crisis this spread
    widens for two reasons. Which reasons? Why?
•   The wider the TED, the worse the liquidity crisis.
The TED spread
           The unfolding of the crisis
•   As the default rates on mortgages started to increase and banks started to
    refrain from trusting each other, the crisis became extremely serious;
•   Various interventions of the Fed through rates cuts and rescue packages
    did not prevent the crisis from fully unfolding and causing various important
    defaults such as that of Bear Sterns, Lehman Brothers, etc…;
•   Banks, and their vehicles and conduits, could not finance themselves any
    more and the liquidity mismatch described above became unsustainable.
                       The risks at work
•   Funding liquidity risk can take three forms:
     – Margin or haircut funding risk
     – Rollover risk
     – Redemption risk (bank runs and funds withdrawals)
•   Low market liquidity:
     – Wide bid-ask spread
     – Shallow markets
     – Market resiliency
•   Network risk (all banks and financial institutions are lender and borrower at
    the same time)
The liquidity spiral
Conclusions and policy implications
•   An increase in mortgage delinquency precipitated the crisis;
•   The crisis, which is still going on, was exacerbated by the extensive use of
    securitization and interconnected obligations;
•   The issue of a new financial architecture and a new regulatory framework is
    a good starting point to address these problems of fire-sale externalities,
    network and domino effects.

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