Credit Crunch Central Banks by zoa72307

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									   Credit Crunch, Central Bank Actions
           and Market Integrity

               Suresh Sundaresan
               Columbia University




October 2008   Konstanz - Talk on Credit Crisis -   1
                Capitalization & Deleveraging
               Outline of Presentation


1. Overview of Credit Crunch – Magnitude of
   Crisis.
2. Actions Taken by Central Banks, Treasury
   and GSEs – Initially assumed to be a
   problem of illiquidity.
3. Welfare Costs Associated with Actions of
   Central Banks and Treasury.
4. Solvency rather just illiquidity:
   Recapitalizing and Selling Bad Assets -
   Thinking about de-leveraging strategies.

October 2008      Konstanz - Talk on Credit Crisis -   2
                   Capitalization & Deleveraging
               Overview of Credit Crunch




October 2008        Konstanz - Talk on Credit Crisis -   3
                     Capitalization & Deleveraging
      Stylized fact 1: Collapse in Housing Prices (beginning mid-2006)




                                                           Source: IMF – Global
                                                           Financial Stability Report.
                                                           April (2008).




October 2008          Konstanz - Talk on Credit Crisis -                      4
                       Capitalization & Deleveraging
      Stylized fact 2: Benign credit spreads until mid-2007




     CDS spreads on Banking institutions
October 2008              Konstanz - Talk on Credit Crisis -   5
                           Capitalization & Deleveraging
Stylized fact 3: Heavily levered financial institutions.




                                                         Heavily levered
                                                         going into August 2007.
                                                         Fannie and Freddie
                                                         were also heavily
                                                         levered during
                                                         this period.




                                                          Source: Economist
October 2008        Konstanz - Talk on Credit Crisis -                     6
                     Capitalization & Deleveraging
Stylized fact 4: Rapid Growth in CDS Markets -- BIS




                                                       CDS Markets have grown
                                                       without adequate safeguards
                                                       in marking to market, collateral
                                                       and clearing mechanisms.




October 2008      Konstanz - Talk on Credit Crisis -                          7
                   Capitalization & Deleveraging
      Stylized fact 5: CDO – backed by mortgage
                        collateral

CDO issuance activity




 October 2008           Konstanz - Talk on Credit Crisis -   8
                         Capitalization & Deleveraging
     Stylized fact 6: Steep increase in leveraged-loan
                              volumes.
Source: Morgan Stanley




 October 2008       Konstanz - Talk on Credit Crisis -   9
                     Capitalization & Deleveraging
        Early signs of troubles: Seizure of Money Markets




                                                  LIBOR to OIS
                                                  Spreads in basis
                                                  Points.




October 2008        Konstanz - Talk on Credit Crisis -               10
                     Capitalization & Deleveraging
       Early signs of troubles: Delinquencies and defaults




                                                         Defaults of regional
                                                         Banks and New Century
                                                         Federal




October 2008        Konstanz - Talk on Credit Crisis -                 11
                     Capitalization & Deleveraging
                        Magnitude of Crisis
             Some Estimates of Underlying Credit Markets

1.    Sub-prime loans outstanding:                           $ 300    billion.
2.    Alt-A loans outstanding:                               $ 600    billion.
3.    Prime loans outstanding:                               $3,800   billion.
4.    Commercial Real Estate:                                $2,400   billion.
5.    Consumer loans:                                        $1,400   billion.
6.    Corporate loans:                                       $3,700   billion.

TOTAL – about $12 trillion. Assuming an overall 5% loss,
  this yields a loss of $600 billion. Clearly, some sectors
  will lose more than others.



     October 2008       Konstanz - Talk on Credit Crisis -                       12
                         Capitalization & Deleveraging
                Magnitude of Crisis
      Some Estimates of Derivatives & Corporate

1.   ABS:                         $1,100          billion.
2.   ABS CDOs:                    $ 400           billion.
3.   PRIME MBS:                   $3,800          billion.
4.   CMBS:                        $ 940           billion.
5.   IG Corporate:                $3,000          billion.
6.   HY Corporate:                $ 600           billion.
7.    CLO:                        $ 350           billion.

TOTAL – about $11 trillion. Here the losses are likely to
  be higher on a mark-to-market basis. IMF estimates
  the losses here at $725 billion.

 October 2008        Konstanz - Talk on Credit Crisis -      13
                      Capitalization & Deleveraging
                   Magnitude of Crisis
                  Total Potential Losses

1. Total losses (potential):                              $ 1.350 trillion.

2. IMF’s estimate as of April 2008:                       $ 0.945 trillion.

What is the magnitude of aggregate write-offs?

Who can supply capital? In what quantities?

Is it a liquidity crisis or solvency crisis?




October 2008         Konstanz - Talk on Credit Crisis -                   14
                      Capitalization & Deleveraging
                                                    Asset sales and write-downs
                                                    have reached $550 billion by
                                                    the end of April 2008.




October 2008   Konstanz - Talk on Credit Crisis -                      15
                Capitalization & Deleveraging
          What agents in the economy can supply capital?
                - Institutions with “Deep Pockets”

1. Sovereign Wealth Funds (Supplied so far $40 to $50 billion)
   – It is unlikely to be a major future source.

2. “Buy” side real money investors: PIMCO, BLACKROCK,
   Pension Funds, Berkshire Hathaway, etc.

3.    Dedicated funds with “locked-up” capital – private equity.
     Fed has removed some constraints for PE firms to take
     stakes in regional banks.

4.    Hedge funds – subject to MTM and redemptions.


     October 2008       Konstanz - Talk on Credit Crisis -   16
                         Capitalization & Deleveraging
     Actions of Central Bank, Treasury & GSEs
          August 2007 to September 2008




October 2008     Konstanz - Talk on Credit Crisis -   17
                  Capitalization & Deleveraging
                Liquidity or Solvency Problem?
1. Initially, in August 2007, Central banks treated the
   crisis as one of illiquidity: free up “shadow banking
   system”: ABCP, repo markets, money market mutual
   funds, etc.

2. Fed took a number of actions:

   1. Cut discount rates -- from 100 basis points penalty to
      25 basis points (from June 2007 to March 2008) .
   2. Cut Target rates – from 5.25% to 2.00% -- from
      August 2007 to April 2008.
   3. Set up Term Lending facilities – monthly running
      balance of $150 billion; Act as a buyer of CP from
      financial institutions.
 October 2008         Konstanz - Talk on Credit Crisis -   18
                       Capitalization & Deleveraging
               Liquidity or Solvency Problem?


     4. Opened facilities to non-banking institutions –
        Primary dealer credit facility – more than $20
        billion drawn in September 2008.
     5. Supplied Treasury collateral in exchange for
        dodgy collateral – Steady demand for Treasury
        collateral.
     6. Extended direct term lending and loosened
        the menu of collateral.
     7. Opened the window for Fannie and Freddie
        (GSEs).



October 2008         Konstanz - Talk on Credit Crisis -   19
                      Capitalization & Deleveraging
        Fed cut the Target Rates and allowed the
           effective rates to fall below target.


               Effective vs. Target Fed Funds Rates
       5.5
        5
       4.5
        4
       3.5
        3
       2.5
        2
       1.5
      12/11/2006      6/29/2007                  1/15/2008         8/2/2008

                       DAILY EFFECTIVE               TARGET RATE


October 2008         Konstanz - Talk on Credit Crisis -                 20
                      Capitalization & Deleveraging
October 2008   Konstanz - Talk on Credit Crisis -   21
                Capitalization & Deleveraging
       Empirical Evidence - GSE Balance Sheet - FHLB
         provided even greater funding than the Fed!




October 2008       Konstanz - Talk on Credit Crisis -   22
                    Capitalization & Deleveraging
    Empirical Evidence - GSE Balance Sheet - Fannie and
      Freddie Bought Increasing Amounts of Loans




October 2008       Konstanz - Talk on Credit Crisis -     23
                    Capitalization & Deleveraging
 Empirical Evidence - Total Liquidity Provided by the Fed


      1. TAF                  $150 billion
      2. PCF                  $ 30 billion
      3. PDCF, TSLF
         Term Repo,
         & Others             $150 billion

Out of a balance sheet of $900 billion, the special
liquidity facilities take up about $330 billion, leaving
the Fed with considerable amount of mortgage
collateral, exceeding more than a third of its balance
sheet.
October 2008       Konstanz - Talk on Credit Crisis -      24
                    Capitalization & Deleveraging
           Welfare consequences – Fed’s balance sheet




    Source: Hilton (2008)
October 2008         Konstanz - Talk on Credit Crisis -   25
                      Capitalization & Deleveraging
           Welfare consequences – Fed’s balance sheet




    Source: Hilton (2008)
October 2008         Konstanz - Talk on Credit Crisis -   26
                      Capitalization & Deleveraging
October 2008   Konstanz - Talk on Credit Crisis -   27
                Capitalization & Deleveraging
            Welfare consequences - Perverse Incentives


Rather than liquidating mortgage collateral in an orderly
manner, financial institutions have found a way to post
nearly $330 billion to the Fed and get funding at target rate
plus 25 basis points, which is about 2.25%! Note that their
access to “market funding” is prohibitively expensive.

Given the low target rate and the low penalty, there is little
incentive for the institutions to shed these “problem assets”
to de-lever themselves.


 October 2008         Konstanz - Talk on Credit Crisis -   28
                       Capitalization & Deleveraging
        Recognition of Solvency Crisis (September 2008)

 Solvency versus illiquidity

 The failure of Lehman Brothers despite extended
 access to discount window suggests that the
 problem was one of solvency rather than just
 illiquidity alone.

 The problems faced by Fannie Mae and Freddie
 Mac and their placement under “conservatorship”
 also suggests that government is viewing the
 problem as increasingly a solvency issue.



October 2008         Konstanz - Talk on Credit Crisis -   29
                      Capitalization & Deleveraging
        Recognition of Solvency Crisis (September 2008)


 Solvency versus illiquidity

 In a solvency crisis the focus shifts to the following
 key issues:

 1.Debt write downs.
 2.Debt restructuring.
 3.Orderly asset sales.




October 2008         Konstanz - Talk on Credit Crisis -   30
                      Capitalization & Deleveraging
        Recognition of Solvency Crisis (September 2008)


 Solvency versus illiquidity

 How should “problem assets” be removed without
 inducing a further drop in housing prices?

 Government is proposing to take the “problem
 assets” and hold them until housing prices recover,
 and the “problem assets” increase in value.

 Treasury has already taken a similar step with
 GSEs

October 2008         Konstanz - Talk on Credit Crisis -   31
                      Capitalization & Deleveraging
            Recognition of Solvency Crisis (September 2008)
Solvency versus illiquidity – recapitalizing Fannie and
Freddie
The Treasury will provide up to $100 billion each to keep the
net worth of GSEs positive: this makes GSE debt issues
relatively safe and precludes bankruptcy. Treasury, in return,
will receive senior preferred stock and warrants on GSE’s
common stock.

As a part of this GSEs will be allowed to increase their
guaranteed mortgage portfolio with no limits and their
retained portfolios up to a maximum of $850 billion by
December 31, 2009 with no capital restrictions. In addition,
the GSEs can purchase $25 billion of MBS every month to
“replace” maturing MBS.
    October 2008         Konstanz - Talk on Credit Crisis -    32
                          Capitalization & Deleveraging
      Actions Taken By Treasury/Fed (September 2008)

    Solvency versus illiquidity

    Treasury has also indicated that it intends to buy
    MBS in the open market. The Treasury and the Fed
    have set up a new secured lending facility for Fannie
    Mae, Freddie Mac and FHLB. This GSE Credit facility
    (GSECF) will provide funding and liquidity at a
    penalty rate, similar to the primary credit facility under
    the discount window. This will eliminate the risk of
    rolling over short-term debt by the GSEs.




October 2008        Konstanz - Talk on Credit Crisis -      33
                     Capitalization & Deleveraging
      Actions Taken By Treasury/Fed – September 2008

Solvency versus illiquidity (CDS - mark to market)

Following the Chapter 11 filing by Lehman Brothers and
the merger of Bank of America and Merrill Lynch, the Fed
has significantly expanded the term auction lending
facility to the point of even accepting very risky collateral,
including common stock.

Fed has extended $85 billion bridge loan to AIG
insurance company as a loan facility under the following
terms. The facility will have a 24-month term, and the
interest will     accrue on the balance at three-month
LIBOR plus 850 basis points.
October 2008       Konstanz - Talk on Credit Crisis -     34
                    Capitalization & Deleveraging
               Actions Taken By Treasury/Fed

Solvency versus illiquidity
In a coordinated action, the U.S. Federal Reserve
announced a plan to pump $180 billion into markets
through swap agreements with other central banks. In
addition, the Fed added $110 billion via repurchase
agreements. This was in large part done to deal with the
lack of lending in inter-bank markets, as banks attempt to
hoard cash.

In a much broader move, the Federal government is
planning to set up a government entity to remove the
“problem mortgage-related assets” from the private
companies at a cost of $700 billion.

October 2008       Konstanz - Talk on Credit Crisis -   35
                    Capitalization & Deleveraging
    Welfare Costs of Bailouts, Lending Facilities, etc.

Treasury’s plan to buy bad assets from Banks at “hold to
maturity” prices will be a direct transfer of wealth from tax
payers to banks, unless several simultaneous steps are
enforced:

1.Treasury should first encourage capitalization by banks
(much the same way, Goldman Sachs capitalized by
common stock issuance worth $5 billion) by issuing
common stock.
2.     Treasury can make step 1 a pre-condition for
capitalizing banks with preferred stocks (convertible at the
option of Treasury into common stock). This way, Treasury
takes an equity stake and dilutes existing stockholders.
 October 2008        Konstanz - Talk on Credit Crisis -     36
                      Capitalization & Deleveraging
    Welfare Costs of Bailouts, Lending Facilities, etc.


3.     Treasury can further require (as a pre-condition)
banks to sell bad assets either by coordinating a reverse
auction or through private market channels. Specific targets
can be set, depending upon the extent of capitalization
provided by the Treasury.

4.      This way, existing stockholders are punished via
dilution, and Treasury takes an equity stake, which pays off
once the bad assets are sold off, and housing prices
stabilize.



 October 2008       Konstanz - Talk on Credit Crisis -   37
                     Capitalization & Deleveraging
      Welfare Costs Associated with Actions of
            Central Bank and Treasury.




October 2008     Konstanz - Talk on Credit Crisis -   38
                  Capitalization & Deleveraging
         Welfare Costs of Treasury’s Commitments


    Fannie & Freddie:                              $250 billion.
    Boost Fed’s Balance Sheet:                     $200 billion.
    Bailout funds:                                 $700 billion.
    Other guarantees &
    Commitments:                                   $250 billion (rough
                                                   guess).
    TOTAL:                                         $1.4 trillion.

Given the size $4 trillion of current Treasury debt, this
level of borrowing will likely deal a serious blow to a)
borrowing costs, b) inflation, and c) dollar.

 October 2008       Konstanz - Talk on Credit Crisis -               39
                     Capitalization & Deleveraging
       Welfare Costs of Bailouts, Lending Facilities, etc.

The institutions that have been set up by the Fed to
inject overnight and short-term lending to depository
institutions, primary dealers, and investment banks
have costs that must be ascertained, regardless of
the benefits that such institutions may be presumed
to deliver to the integrity of capital markets.

Likewise, the costs associated with contingent and
direct liabilities assumed by the United States
Treasury in the “conservatorship” of Fannie Mae and
Freddie Mac, and in its actions to extend either
implicit or explicit commitments to FHLB system and
FDIC system must be assessed.
October 2008         Konstanz - Talk on Credit Crisis -      40
                      Capitalization & Deleveraging
       Welfare Costs of Bailouts, Lending Facilities, etc.

Setting up standing facilities involves commitment of
time, qualified professionals and back-office systems.
The standing facility itself (as structured) is a free
option given to depository institutions and now
through PDCF to primary dealers as well.

For example, the right to borrow from the primary
credit facility at 25 basis points over the target Fed
funds rates is currently provided free of cost to
depository institutions, and through PDCF to
investment banks. In the Finance literature these
rights are properly viewed as options to borrow from
the Fed at a strike rate of 25 basis points over the
target rates.
October 2008         Konstanz - Talk on Credit Crisis -      41
                      Capitalization & Deleveraging
       Welfare Costs of Bailouts, Lending Facilities, etc.

Such options are not costless, especially under the
current volatile economic circumstances. These
options have been used by financial institutions to
borrow tens of billions of dollars as we have seen
from market data. Implicitly the costs of these options
are borne by the tax payers.

The existence of these options may also encourage
financial institutions to assume additional risks: one
such risk might be that they post as collateral
mortgage-related assets that they should be selling in
the market to deleverage. Such costs must be
balanced against the benefits provided by these
institutional arrangements.
October 2008         Konstanz - Talk on Credit Crisis -      42
                      Capitalization & Deleveraging
       Welfare Costs of Bailouts, Lending Facilities, etc.


How expensive are options to borrow from the Fed for overnight,
and term financing? Market data can be brought to bear on this
question. Loan commitments extended by syndicates of banks
are essentially options that firms have to borrow from the
syndicates. Evidence suggests that such loan commitments can
be fairly expensive.

One might argue that options extended by the Fed are much
more valuable for two reasons: first, Fed’s balance sheet is far
deeper than any syndicates. Second, Fed’s options come in
handy when there are aggregate liquidity shocks when bank
syndicates themselves may be unable to offer loans/credit.
Hence, the loan commitment prices provide a lower bound for
ascertaining the costs of standing facilities.

October 2008          Konstanz - Talk on Credit Crisis -           43
                       Capitalization & Deleveraging
         Welfare Costs of Bailouts, Lending Facilities, etc.


A more appropriate benchmark may be the values of catastrophe
insurance contracts, which offer liquidity conditional on some
measurable catastrophes that may occur during a specified period of
time. These facilities (offered in private sector) are rather expensive.
One must also factor into consideration that the special liquidity facilities
provide term credit against collateral for which there are very few takers
in private markets.

This has two components of costs: first, the cost of issuing ABCP with
mortgage-related collateral is rather high (if at all feasible in the current
market conditions), and certainly much higher than the rate at which the
Fed is extending credit (target fed funds rate plus 25 basis points).




  October 2008            Konstanz - Talk on Credit Crisis -            44
                           Capitalization & Deleveraging
        Welfare Costs of Bailouts, Lending Facilities, etc.

Banks instead of pursuing an orderly liquidation process for
their problem collateral may simply “put” their problem
collateral to the central bank and get significantly subsidized
funding. One may argue that if the central banks set their
haircuts judiciously, then the risk taken by the central bank
may be limited.

The specialized nature of the collateral imposes a very high
burden on central bank staff in figuring out what might be
the appropriate haircuts for different asset-backed securities
with mortgage-related underlying collateral. It may require
an investment in different type of human capital by the
central banks in addition to the ones that they currently
have.
 October 2008         Konstanz - Talk on Credit Crisis -      45
                       Capitalization & Deleveraging
                          Conclusions

1. Credit crisis was treated essentially as liquidity problem
   during the period August 2007 to August 2008.

2. Central Bank significantly extended its balance sheet to
   address the liquidity problem and the seizure of money
   markets. This led to perverse incentives -- “problem
   collateral” found its way to central banks.

3. Take over of Fannie and Freddie and the collapse of
   Lehman Brothers, and the near failure of others have
   demonstrated that the problem is one of solvency as
   well as illiquidity.


 October 2008       Konstanz - Talk on Credit Crisis -    46
                     Capitalization & Deleveraging
                          Conclusions

4. Government is approaching the problem by seeking to
   “nationalize” problem assets through a massive reverse
   auction and hold them until the housing prices stabilize.

5. This raises several questions: a) recapitalization
   requirements, b) equity stake for tax payers, c) auction
   design procedures, etc.

6. Continued seizure of money markets suggests that the
   economy needs a rapid resolution of the problem.




 October 2008       Konstanz - Talk on Credit Crisis -   47
                     Capitalization & Deleveraging

								
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