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					        Capital Matters:
     Managing Labor’s Capital


   FOUR LESSONS FROM THE
FINANCIAL CRISIS


     Randall Dodd
     Senior Financial Sector Expert
     IMF

     April 17, 2008


     * Standard disclaimer: the views expressed in this presentation are those of the author
       and not the IMF.
                         ABCP               BUYERS:                              BUYERS: Hedge
                        issuers             Institutional                          Funds, other
                                             Investors,                         aggressive investors
                                               other
                    HOLDERS:
                                                                                         Mezzanine
                                                                   Senior
                                            CDO




                                                                                                                 Equity



                   Fannie, Freddie,
                    Banks, Thrifts,
                     institutional
                      investors
                                             MBS Issuers –
Market Structure




                                          Fannie, Freddie and
                      HOLD:             Ginnie – plus major Wall


                                                                                                     subprime, $0.9
                                                                                                     in RMBS, $0.6
                                                                                                     $1.2 trillion in
                      Fannie,           Street banks and broker-
                      Freddie                    dealers




                                                                                                     in CDOs
                                  Secondary Market:




                                                                            separately and becomes tailored


                                                                            by highly leveraged hedge funds
                                                                            Credit risk is segmented, priced


                                                                            segments are most often held
                          Originator
                       Underwrite and Hold




                                                                            to investors. The riskiest
                      ($10 trillion residential)




                                                                            plus some aggressive
                                                                            institutional investors
                                                        Risk Distribution
                          Mortgage
                                                               Crunch
                                                                                                                                          Issuers stop
                                                                                                                                             buying



                                                                                                                          Institutional
                            Underwrite and Hold




                                                                                                                                                              ABCDS
                                                                                                                                                              issuers
                                                                                                                        investors cease
                                                  Originator
           Mortgage




                                                                                                                             buying




                                                                 Secondary Market:




                                                                                     Ginnie – new private label
                                                                                       Fannie, Freddie and
                                                                                                                                    CDO




                                                                                        MBS grows rapidly




                                                                                                                                                                       BUYERS:
                                                                                                                                                     Institutional
                                                                                                                  MBS Issuers –




                                                                                                                                                      Investors,
                                                                                                                                                        other
  Originators cease
issuing new subprime
                                                                                                                                    Senior
    and other non-




                                                                                                                                                         aggressive investors
     conforming




                                                                                                                                                          BUYERS: Hedge
      mortgages




                                                                                                                                                            Funds, other
                                                                                                                                  Mezzanine

                                                  RELIEF                  CDO issuers
                       Fannie and Freddie                                 stop buying
                       increase their buying of
                       conforming mortgages                                                                                         Equity
                                                                                     Hedge funds
                                                                                     cease buying
Four Lessons
1. Although large complex financial institutions (i.e. major banks and
   broker-dealers) are in trouble, and they are regulated, their problems
   emerged from their dealing with unregulated financial institutions (e.g.
   originators, SIVs, hedge funds) and unregulated markets (e.g.
   derivatives, structured securities).
2. Although there is a credit crunch at the major banks and broker-
   dealers, it is the OTC markets for structured securities, derivatives,
   muni bonds, student loan backed securities,
3. Leverage. Archimedes as enemy. Banks are inherently leveraged
   and much of finance generally depends on leverage, but the
   prudential limits that governs risk taking on balance sheets is not
   adequately applied to off-balance sheet items and is void at hedge
   funds and SIVs and the like.
4. Complexity. While there is nothing wrong per se with complexity, it is
   imperative that transactions in complex securities and derivatives be
   treated with high standards for transparency, competence and due
   diligence. The principle problem is pricing – getting the prices right –
   and it is challenging even in good times.
Total Mortgages:
  $14.4 trillion
 Subprime Debt:
   $1.2 trillion
Total Mortgages:
  $14.4 trillion
 Subprime Debt:
   $1.2 trillion
 Total Credit:
 $48.9 trillion
Subprime Debt:
  $1.2 trillion
 Total Capital:
 $70.4 trillion
Subprime Debt:
  $1.2 trillion
Subprime Crisis
-- catalyst
-- rise in delinquencies and foreclosures   •Kills many subprime mortgage originators
                                            •Pension Fund losses from Norway to
                                            Florida
                                            •Bank crises in UK and Germany
Price collapse in subprime MBS and CDOs     •Market liquidity dries up for MBS, CDOs
-- eliminates some market participants      and related credit derivatives
-- dries up most trading volume             •Hedge fund failures >> deleveraging and
                                            less trading volume
                                            •Banks hoard liquidity >> firms dependent
Funding Liquidity Crisis                    on short-term financing are crushed
-- credit crunch                            •LIBOR jumps up, T-bills dive down
                                            •Margin calls on Hedge Funds
                                            •SIVs fails as ABCP > LIBOR
                                            •Broker-dealers take steps to strengthen
                                            funding
                                            • SIVs assets taken onto balance sheet
Engorgement of Banks’ Balance Sheets        • Hedge fund assets/collateral taken on
-- worsening credit crunch                  • Accumulation of unwanted inventory
                                            • Aggravates banks’ own leverage – more
                                            assets require more capital to meet
                                            regulatory requirements
                                              • Problems at monoline insurers harms ABS
                                              they insured
                                              • Banks and broker-dealers cease acting as
Spreads to Muni and Student Loan Markets      dealers in auctions
-- more problems with short-term funding of   • ARS auctions fail in record number
long-term securities                          • Similar troubles at VRDO and TOB


                                              • Illiquid or weakened credit derivatives
Spreads to Agency Debt, Interest Rate         market leads to shorting of anything liquid
Swaps and other liquid instruments            but Treasury to hedge credit exposures
-- risk-free Treasury go to large premium     • Carlyle Capital and Peleton collapse


                                              • Bear Sterns fails and is bought by JPM –
New Meaning of Bear Market                    demonstrates concern for counterparty risk
-- credit crunch                              in OTC derivatives market
                                              • Low price sends price shock to market


Policy Responses
-- some late, some new, some ineffective
                                       Seriously Delinquent Loans
    14

    12

    10
Percent




          8

          6

          4

          2

          0
              1

                      3


                               1

                                       3

                                               1


                                                       3

                                                               1

                                                                       3


                                                                               1

                                                                                       3

                                                                                               1

                                                                                                       3


                                                                                                               1
          -Q

                  -Q


                          -Q

                                   -Q

                                            -Q


                                                   -Q

                                                           -Q

                                                                   -Q


                                                                            -Q

                                                                                   -Q

                                                                                           -Q

                                                                                                   -Q


                                                                                                           -Q
   01

                 01


                         02

                                  02

                                          03


                                                  03

                                                          04

                                                                  04


                                                                          05

                                                                                  05

                                                                                          06

                                                                                                  06


                                                                                                          07
20

              20


                      20

                               20

                                       20


                                               20

                                                       20

                                                               20


                                                                       20

                                                                               20

                                                                                       20

                                                                                               20


                                                                                                       20
                              Prime Fixed          Prime ARM               Subprime Fixed              Subprime ARM

  Chart from Jay Brinkmann, VP of Research and Economics, Mortgage Bankers Association
      Not all areas of nation are in trouble – in fact a minority of MSAs are
      Frequency of MSAs bracketed by home price changes of the past year
50
45          Freddie Mac data
               Dispersion of 382 MSAs
40
                 2007:4 over 2006:4
35
30
25
20
15
10
5
0
     -20
     -19
     -18
     -17
     -16
     -15
     -14
     -11
     -10
     -9
     -8
     -7
     -6
     -5
     -4
     -3
     -2
     -1
     0
     1
     2
     3
     4
     5
     6
     7
     8
     9
     10
     11
     12
     13
     14
     15
     16
     17
     18
* Freddie Mac Conforming Mortgage Home Price data
Title Case-Schiller Data shows for same quarter/quarter shows all but
three major cities shows declines over the period

 3
                                  Case Shiller Data
2.5
                                         Dispersion 20 cities
                                           2007:4/2006:4

 2



1.5



 1



0.5



 0
      -15%

             -14%

                    -13%

                           -12%

                                  -11%

                                         -10%

                                                -9%

                                                      -8%

                                                            -7%

                                                                  -6%

                                                                        -5%

                                                                              -4%

                                                                                    -3%

                                                                                          -2%

                                                                                                -1%

                                                                                                      0%

                                                                                                           1%

                                                                                                                2%

                                                                                                                     3%

                                                                                                                          4%
 * Case Shiller data from S&P
  Serious Delinquency and Foreclosure: small change in prime
                                              2006.2         2006.3    2006.4    2007.1 2007.2      2007.3   2007.4
   Prime - 87% of mortgage
   Delinquency                                      2.29       2.44       2.57     2.58    2.73       3.12       3.24
   Serious Del (NSA)                                0.75       0.79       0.86     0.89    0.98       1.31       1.67
   Foreclosure                                      0.41       0.44        0.5     0.54    0.59       0.79       0.96
   Subprime - 13% of mortgages
   Delinquency                                      11.7      12.56     13.33     13.77   14.82      16.31      17.31
   Serious Del (NSA)                                6.23       6.78      7.78      8.33    9.27      11.38      14.44
   Foreclosure                                      3.56       3.86      4.53       5.1    5.52       6.89       8.65
                                      16
* Mortgage Bankers Association data
                                                           Prime & Subprime
                                      14
                                                      Serious Del and Foreclosure
                                      12
                                                Foreclosure
                                                Serious Del (NSA)
                                      10
                                                Ser Del Subprime
                                                Subprime Foreclosure
                                       8

                                       6

                                       4

                                       2

                                       0
                                           2006.2          2006.3      2006.4    2007.1    2007.2      2007.3      2007.4
                                             1
                                                   1.5
                                                                  2
                                                                                 2.5
                                                                                       3
                                                                                           3.5
                                                                                                 4
                                                                                                     4.5
                                                                                                           5
                                                                                                               5.5
                                                                                                                     6
                                    2007-07-02
                                    2007-07-10
                                    2007-07-17
                                    2007-07-24




                                                 T-bill
                                    2007-07-31




                                                                  CP Fin
                                                          LIBOR
                                    2007-08-07




                                                                           Fed Funds
                                    2007-08-14
                                    2007-08-21
                                    2007-08-28
                                    2007-09-05
                                    2007-09-12




* U.S. Federal Reserve data, H.15
                                    2007-09-19
                                    2007-09-26
                                    2007-10-03
                                    2007-10-11
                                    2007-10-18
                                    2007-10-25
                                    2007-11-01
                                    2007-11-08
                                    2007-11-16
                                    2007-11-26
                                    2007-12-03
                                    2007-12-10
                                    2007-12-17
                                    2007-12-24
                                    2008-01-02
                                    2008-01-09
                                    2008-01-16
                                    2008-01-24
                                    2008-01-31
                                    2008-02-07
                                                                                                                         Credit Crunch: LIBOR jumps up, T-bills dive down




                                    2008-02-14
                                    2008-02-22
                                    2008-02-29
                                    2008-03-07
                                    2008-03-14
                                                                                       1
                                                                                           1.2
                                                                                                 1.4
                                                                                                       1.6
                                                                                                             1.8
                                                                                                                   2
                                                                                                                       2.2
                                                                                                                                                           2.4
                                                                                 2006-01
                                                                                 2006-02
                                                                                 2006-03
                                                                                 2006-04
                                                                                 2006-05
                                                                                 2006-06
                                                                                 2006-07
                                                                                 2006-08
                                                                                 2006-09
                                                                                 2006-10
                                                                                 2006-11
                                                                                 2006-12
                                                                                 2007-01
                                                                                 2007-02
                                                                                 2007-03
                                                                                 2007-04
                                                                                 2007-05
                                                                                 2007-06

* 30-year mortgage less 10-year Treasury; Freddie Mac; US Federal Reserve H.15   2007-07
                                                                                 2007-08
                                                                                                                             Mortgage Spread: Conforming




                                                                                 2007-09
                                                                                 2007-10
                                                                                                                                                                 Credit Crunch: Conforming mortgage spreads rise




                                                                                 2007-11
                                                                                 2007-12
                                                                                 2008-01
                                                                                 2008-02
Spreads for Jumbo prime over conforming loans jumps as private label issuers
suffer Credit Crunch




   Source: Bankrate.com
US Interest Rate Swaps (2-year) spread over Treasury – measures credit
exposure on counterparty risk in what is otherwise a AA market.




  * Bloomberg
How it spreads to Municipal Bond market
Over one-half of municipal bonds issuances are guaranteed by monoline
   insurers so that the bonds receive AAA credit rating.
Monoline insurers took a hit three ways
1. They insured some senior tranches of CDOs
2. They sold credit protection in credit derivatives markets
3. They invested their asset portfolios in CDOs – apparently so
   convinced that correlations would remain small and problems remote
   that they added to their underwriting exposure by investing in the
   securities.
    •   MBIA took losses of $3.5 billion on credit derivatives alone.
    •   Market estimates $23 billion losses for MBIA and Ambac on RMBS and
        CDOs.
Major monoline insurers were put on ratings review. FGIC, Ambac and
  ACA are downgraded. How can AA firm provide AAA guarantees?
The impact of such market doubts is first manifested in new issuances,
   refinance and in the variable rate portion of the market.
Markets for auction rate securities is roiled and funding costs spike.
300
                                                    Public Investment
250                                                               $2000 chained

200


150
                                                         Defense
                                                         Non-Def Federal
100
                                                         S&L

 50


   0
       Jan-90
                Jan-91
                         Jan-92
                                  Jan-93
                                           Jan-94
                                                    Jan-95
                                                             Jan-96
                                                                      Jan-97
                                                                               Jan-98
                                                                                        Jan-99
                                                                                                 Jan-00
                                                                                                          Jan-01
                                                                                                                   Jan-02
                                                                                                                            Jan-03
                                                                                                                                     Jan-04
                                                                                                                                              Jan-05
                                                                                                                                                       Jan-06
                                                                                                                                                                Jan-07
* U.S. Depart of Commerce, Bureau of Economic Analysis, NIPA series
Real State and Local investment spending is not cyclical like overall
muni budgets. Bond fund thus plays stabilizing macroeconomic role.
             ENGORGEMENT OF BALANCE SHEETS
       Assets*                            Liabilities*


+ $20 billion SIV/ conduit             + $64.4 billion in new
   assets                                 borrowing – sometimes
+ $20 billion unwanted                    strengthened through us
   inventory                              of longer-term notes
+ $20 billion hedge fund
   assets and collateral               + $5.6 billion new capital to
+ $10 billion muni securities             meeting capital
   bought to clear auctions               requirements and
                                          leverage ratios


  * Figures are hypothetical amounts chosen to
  illustrate the economic points
How it hits the muni market
1. Less funding and refinance – which would otherwise benefit from
   lower interest rate environment

Underwriting
Jan ’08                $19.6 billion
Jan ’07                $31.2 billion

Refunding
Jan ’08                $5.3 billion
Jan ’07                $17.9 billion

2. Roiling the variable rate market

This market segment has several sub-sectors
•    Auction Rate Securities
•    Tender Offer Bonds
•    Variable Rate Demand Obligations
•    Closed End Funds - Use leverage by issuing variable rate


* Bond Market Association at www.bondmarkets.com
                      Student Loan Market
Student Loan Market is heterogeneous
1. Direct student lending by government (administered by educational
   institutions). This is about $15 billion a year (amounts cut back by
   Republican Congress back in 1995).
2. Federal guarantees for private lenders such as banks and universities
    •   $115 billion borrowed last year by 8 million students
    •   2,000 lenders participate in program, although top 50 make 83%
       of loans
    •   The largest, Sallie Mae has 40% of new loans, and Citi is
       second
    •   Many lenders (at least 26) leaving program, e.g. Brazos of
       Texas that had a $15 billion portfolio. They have stopped making
       new loans.
•   State and fully private (no guarantees) provide another $18.5 billion
                      Student Loan Market
Auction Rate Securities
• SLARS – student loan-backed auction rate securitizations. Market
estimated by Moody’s to be $86 billion.
• Example from July 2006: The Vermont Student Assistance
Corporation issuance consisted of three series of ‘AAA’ rated tax-exempt
auction-rate securities totaling $175.3 million. The securities were issued
out of a master trust supported by a financial guarantee insurance policy
issued by Ambac, whose insurer financial strength is rated ‘AAA’ by
Fitch. The collateral securing the bonds consists of both FFELP and
private loans. They are often tranched.
• Problems became acute last fall. Broker-dealers who brought these to
market backed away from providing market liquidity and let the auctions
fail.
• Although rates are capped by formula or a ceiling, when the auction
rate or the cap exceed the interest rates on the underlying student loans
less fees, then the solvency and credit rating of the trust is brought into
question.
POLICY RESPONSES:
1. Initially, nothing
2. Super-SIV => D.O.A.
3. 30 day stay or freeze on foreclosures => does anyone still
remember? Court backlog is greater than 30 days.
4. Stimulus package: raising ceiling on GSE and FHA loans
5. Reduce capital surcharge on GSEs – will enable them to increase
lending and securitization activities.
6. Monetary policy easing – Fed funds goes from 5.25% to 2.25%
7. Municipal government are allowed to buy back their own debt
during auction of ARS
POLICY RESPONSES:
7. LOLR – Lender of Last Resort:
• Discount Window – traditional instrument for adding to borrowed
reserves (accepts collateral with haircut in exchange for loan)
• Term Auction Facility – banks bid for $50 billion in term loans (28
days) against collateral as required for discount window borrowing.
• Term Securities Lending Facility – lending general collateral US
Treasury securities against collateral (schedule I or II). Borrowers bid
for the use of the more liquid collateral. Schedule II includes discount
window eligible collateral plus AAA mortgage backed securities that
are not under ratings review.
• Primary Dealer Credit Facility – overnight loans like the discount
window for depository institutions, but for primary dealers. Eligible
collateral will include all collateral eligible for tri-party repurchase
agreements arranged by the Federal Reserve Open Market Trading
Desk, as well as all investment-grade corporate securities, municipal
securities, mortgage-backed securities, and asset-backed securities
for which a price is available.
• $30 billion loan to JPM for the purchase of Bear Stearns – JPM
holds first loss on $1 billion and Fed holds remaining risk.

				
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