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Home , Shadow banking system

The Rise and Fall of the Shadow Banking System

Zoltan Pozsar

his article provides an overview change, and have led to the gradual and investors stretched for yield made for of the constellation of forces emergence of the originate-to-distribute a potent mix of inputs for trouble ahead. T that drove the emergence of the model of banking. Part I—CDO evolution. The 1988 network of highly levered off-balance- The originate-to-distribute model Basel Accord was the main catalyst for sheet vehicles—the shadow banking has deeply changed the way credit is the growth and development of credit system—that is at the heart of the credit intermediated and risk is absorbed in risk transfer instruments. Following the crisis. Part one of this four-part article the financial system, as these functions banking crises of the late 1980s, which presents the evolution of collateralized now occur less on balance sheets were triggered by loan defaults by Latin debt obligations and how they changed and more in capital markets. American governments, the accord from tools to manage to a no longer hold on to the loans they applied a minimum capital requirement source of credit risk in and of themselves. originate as investments, but instead to bank balance sheets and required Part two discusses the types of investors sell them to broker-dealers, who in more capital protection for riskier who ended up holding subprime turn pool the underlying cash flows assets. These rules prompted banks exposure through CDOs, and why the and credit risks and, using dedicated to reconfigure their assets using credit promise of risk dispersion through the securities, distribute them in bespoke risk transfer instruments such as credit originate-to-distribute model failed to live concentrations to a range of investors default swaps or CDOs. This was done up to expectations. Part three defines the with unique risk appetites. To properly either by purchasing against shadow banking system, discusses the function, the originate-to-distribute credit losses using CDSs (reducing causes and repercussions of its collapse, model needs liquid money and securities the gross risk of a loan portfolio) or by and contrasts it with the traditional markets to intermediate credit through removing the riskiest (first loss) portions banking system. An accompanying the daisy chain of asset originators, asset of a loan portfolio using CDOs. chart provides an exhaustive view of the packagers and asset managers. Initially, CDOs were applied to institutions, instruments and vehicles that The originate-to-distribute model corporate loans. A bank would pool make up the shadow banking system and and the of credit and its the corporate loans on its books (the depicts the asset and funding flows in it. transfer to investors through traded assets of a CDO) and carve up the pool’s Finally, part four discusses why it might instruments has been underlying cash flows into with still be too early to call an end to the part of the financial landscape since the varying risk profiles (the liabilities of a credit crisis. 1970s, when the first mortgage-backed CDO). Payouts from the pool were first Banking’s changed nature. The securities were issued. But this model paid to the least risky senior tranches, traditional model of banking—borrow has grown increasingly more complex then the mezzanine tranches, and short, lend long, and hold on to over the past decade, as securitization lastly to the most risky equity tranches. loans as an investment—has been expanded to riskier loans and came Conversely, losses were first allocated to fundamentally reshaped by competition, in increasingly more opaque and less equity tranches, then to the mezzanines, regulation and innovation. Everything liquid forms such as structured and only then to senior tranches. from the types of assets banks hold collateralized debt obligations. These Correspondingly, equity tranches offered to how they fund themselves to the developments were driven by loose the highest yields and senior tranches sources of their income have changed monetary policy and depressed yields in the lowest in CDOs’ capital structures. dramatically. Competition from finance recent years and became most apparent Tranching did not reduce the overall companies and broker-dealers in in subprime mortgage lending. Low amount of risk associated with the pool. lending to consumers, corporates and interest rates created an abundance of It merely skewed the distribution of risks sovereigns; changes in rules governing credit for borrowers and a scarcity of such that equity tranches ended up with capital requirements; and innovations yield for investors. With the housing a concentrated dose and senior tranches in securitization and credit risk transfer boom as the backdrop, exotic mortgages ended up with diluted ones. In this have been key facilitators of this to borrowers with spotty credit histories sense, equity tranches are overleveraged

Moody’s Economy.com • www.economy.com • [email protected] • Regional Financial Review / July 2008 13 Chart 1: ABS CDOs Drive Demand for Loans As the backed securities backed by credit card Global cash flow/hybrid arbitrage CDO issuance breakdown, % originate-to- receivables and auto loans (see Chart distribute 1). CDOs that invested in these new 140 Investment-grade bonds High-yield bonds model matured, collateral types came to be known as ABS 120 Structured finance (ABS) Leveraged loans arbitrage CDOs (or structured finance) CDOs. Through Emerging market and other debt Source: have become the use of riskier classes of debt, ABS 100 an integral part CDOs offered fat spread incomes and of the credit hence filled the vacuum created by the 80 intermediation narrowing of spreads on CDOs that process, with invested in investment-grade corporates. 60 their role Before 2004, the market for ABS 40 changing CDOs was small, and ABS CDOs had a from one of well-diversified pool of assets across the 20 repackaging ABS/MBS universe. Over the 2005-2007 existing loans period, however, ABS CDOs’ underlying 0 and bonds portfolios became increasingly 99 00 01 02 03 04 05 06 to one of concentrated in MBSs referencing facilitating the subprime mortgage pools. The typical creation of new ABS CDO issued during this period instruments, whereas senior tranches loans. Through the slicing, dicing and invested nearly 70% of its portfolio into are underleveraged instruments, and dispersion of credit risk, CDOs enabled subprime MBS according to Moody’s the of the entire CDO, similar the underwriting of some loans—subprime Economy.com estimates.3 to whole loans and bonds, is one by mortgages, for example—that would ABS CDOs have one crucial construction.1 This pooling and tranching never have been underwritten had banks difference from CDOs investing in of loans allowed banks to sell credit been required to hold on to them as corporate bonds. Traditional CDOs invest risk in concentrated forms using equity investments in the form of whole loans. in heterogeneous pools of corporate loans tranches and to hold on to credit risk in On the flip side, CDOs also helped expand and bonds, spanning a range of names diluted form through senior tranches, homeownership to those whose personal and industries, where diversification offers allowing them to set aside a much smaller should have precluded them from safety against company and industry amount of capital than for whole loans.2 buying a home in the first place. idiosyncratic events, while systematic risk This initial raison d’etre of CDOs At the very top of the housing and is controlled by having a mix of cyclical changed over time. They were no longer securitization boom, arbitrage CDOs’ role and countercyclical industries in the pool. used solely to fine-tune the risk profile of further morphed into one in which they ABS CDOs’ risk instead is driven by a bank’s loan portfolios to manage capital became a powerful source of demand economy-wide factors such as interest requirements (so-called balance sheet for loans in and of themselves, driving rates, house prices, and the job market. CDOs), but also to pool traded whole the spectacular collapse in underwriting These risks are systematic and cannot loans and corporate bonds, earning a standards that occurred from 2005 to be diversified away. However, such spread between the yield offered on these early 2007. a “diversification” was assumed to be assets and the payment made to various Wrong assumptions. The assets present, as ABS CDOs were pooled from tranches (arbitrage CDOs). that CDOs were investing in have also loans originated in different states with changed over time. The first generation separate local economies and, apart of arbitrage CDOs was backed by from the , the U.S. 1 The distribution of risks among tranches is achieved investment-grade corporate loans and never experienced falling house prices through overcollateralization and subordination. Overcollateralization is achieved by structuring CDOs such bonds. The widening of corporate credit or mortgage credit problems in multiple that value of the loan pool the CDO invests in exceeds the spreads in the wake of the tech bubble regions at the same time. total principal amount of rated securities issued by the CDO. The size of overcollateralization is by definition equal and corporate bankruptcies made it Due to the “diversified” nature of to the size of the CDO’s equity . The secondary form easy to structure CDOs, as wide spreads these pools, ABS CDOs were expected of credit enhancement in CDO structures is subordination. Subordination is the sequential application of losses to the provided sufficient spread income to to perform well in most circumstances, securities, starting with the equity tranche and then moving handsomely compensate the CDOs’ but could suffer steep losses during up the mezzanine, senior and super-senior tranches as originators, investors and managers. times of system-wide stress, exposing discussed above. 2 Basel II requires a 35% risk weight on residential However, as the economy began to investors to a “heads you win, tails mortgages, a 20% risk weight on AAA-rated residential improve in 2003, corporate spreads you loose” risk profile. This high- MBSs, and a mere 7% risk weight on AAA-rated tranches of ABS CDOs that invest in residential MBSs. The sizes of narrowed, which made it harder to correlation tail event could be driven by these risk weights are logical, as individual mortgages are structure CDOs using investment-grade everything from collapsing house prices, riskier than an MBS that invests in a pool of thousands of individual mortgages. Furthermore, the AAA-rated tranches credit as collateral. are protected by overcollateralization and subordination. In response, underwriters shifted Similarly, CDOs investing in a diversified pool of MBS to new collateral types, such as 3 Because ABS CDOs’ underlying portfolios became tranches have more credit enhancement built in through an concentrated in subprime MBS, the article henceforth extra layer of overcollateralization and subordination. The mortgage-backed securities backed by discusses the portfolios and performance of ABS CDOs as differences between individual loans, securitized loans and subprime mortgages, and other asset- if they were entirely made up of and driven by subprime CDOs is explained in more detailed throughout the article. mortgages.

14 Moody’s Economy.com • www.economy.com • [email protected] • Regional Financial Review / July 2008 payment shocks from ARM resets, or origination standards of the loans that above what was already present in the deteriorating underwriting standards. In the CDOs were investing in became form of cash securities. The comparable fact, it is the combination of all of these increasingly driven by dealmakers’ figure is 93% for 2006. factors that undid the low-correlation order books for CDOs and less by the As underwriting standards were assumptions, which were instrumental credit views of the firms (in-house or collapsing and yields on the underlying to the economics behind the structuring independent) that originated them. cash securities were getting compressed, of ABS CDOs. Underwriting standards deteriorated it became increasingly difficult for Collapsing standards. Growth through risk-layering, where lenders underwriters to offer attractive yields in the volume of CDOs outstanding offered nontraditional mortgages to risky on senior tranches. This pushed broker- was especially strong during 2005 and borrowers with extremely weak credit dealers to use ever more risky assets as 2006. The CDO market kept on growing controls, such as high combined loan-to- collateral. Riskier collateral, however, as their tranches offered fatter yields value ratios, reduced documentation, and made it more difficult to secure AAA than comparably rated sovereign or no down payment. ratings on senior tranches. Broker-dealers corporate securities, which was a sure Demand for CDOs got to the point found a solution by wrapping super- sell to investors such as pension funds that there were simply not enough cash senior tranches with cheap insurance that were struggling to match their fixed securities to fulfill demand.4 This is from monoline insurers. Insurance in obligations with low-yielding government when CDO managers and underwriters the form of CDS contracts was cheap, and corporate bonds. Meanwhile, broker- started to increasingly use credit default as the financial system was swimming dealers earned hefty fee incomes for swaps referencing MBSs to create so- in massive amounts of CDS protection originating and managing CDOs and called synthetic CDOs. Synthetic CDOs written as a byproduct of synthetic CDO trading their tranches. Demand for CDOs are designed such that the portfolio issuance. Cheap insurance was good for was so strong, in fact, that they ended up of the CDSs they invest in mimic the protection buyers, but proved disastrous driving demand for underlying mortgages performance and cash flow pattern for protection sellers, who were grossly in and of themselves. Due to this demand, of the MBSs that the CDSs reference. under compensated for the risks they prices of MBSs and mortgage loans Because they are synthetic replicas of took on. Similar to the synthetic CDO remained extremely buoyant, cheating MBS securities and their performance, investors, monoline insurers got exposed investors into a false sense of security as synthetic CDOs magnify the amount of to the worst loan vintages when deciding underwriting standards were collapsing. leverage and credit risks in the financial to wrap AAA tranches. As the prices of underlying MBSs/ system, and exponentially so, as the Matryoshka CDOlls. ABS CDOs mortgages rose and their yields fell mortgage pools the CDSs in synthetic were sold to investors in various forms correspondingly, some broker-dealers CDO portfolios primarily referenced and flavors. Their recent crop can be decided to outright purchase mortgage mortgages that were originated during divided into two groups based on the lenders so that they would have direct a period when underwriting standards quality of the CDOs’ collateral—high- access to the loans and would avoid were at their weakest. According to grade ABS CDOs and mezzanine ABS paying inflated market prices for them estimates, the system- CDOs. Both types were primarily and avoid paying fees to middlemen—this wide exposure to subprime mortgages investing in subprime MBS, with a was one avenue through which the roles through ABS CDOs referencing BBB-rated minority of their portfolios invested in of banks, finance companies and broker- subprime MBS was 60% more than BBB- other MBS/ABS and tranches of other dealers as credit intermediaries have rated subprime MBS issuance in 2005, CDOs. High-grade CDOs resecuritized been converging over time. Shrinking suggesting that synthetic CDOs issued MBS and CDO tranches rated AAA yield dynamics were similar to those that year added that much more subprime through A, while mezzanine CDOs that occurred in 2003 that made the exposure to the financial system over and resecuritized MBS and CDO tranches construction of CDOs from corporate rated BBB (see Table 1). loans less feasible and led to the increased Demand was strongest for the used of ABSs to structure CDOs. 4 Cash securities refer to individual mortgages and MBSs extreme ends of CDO capital structures backed by pools of mortgages. The cash flows of individual The purchase of wholesale loan mortgages and MBSs are coming from the monthly interest (AAA tranches offered safety, or so originators and finance companies and principal payments of homeowners. Cash securities investors believed, and above-market also include ABS backed by pools of auto loans, credit card by broker-dealers also meant that the receivables, and student loans. yields, while equity tranches offered lots

Table 1: Matryoshka CDOlls % values refer to tranches' share of a structure's capital structure

Subprime RMBS High-grade ABS CDO Mezzanine ABS CDO CDO-squared

Senior Senior AAA 88% Senior AAA 62% Senior AAA 60% 80% RMBS Senior (AAA) Mezzanine Subprime (AAA) Junior AAA 5%RMBS Junior AAA 14% Junior AAA 27% ABS CDO mortgages Mezzanine Mezzanine (BBB) Mezzanine Mezzanine 18% 6% 20% (AA-A) 10% Mezzanine (AA-BBB) RMBS (AA-BBB) (AA-BBB) (AA-BBB) Equity 2%(AA-A) Equity 1% Equity 4% Equity 3% Equity

Unrated equity tranches provide overcollateralization. Overcollateralization means a structure holding more assets than the value of its rated tranches (AAA-BBB). Equity tranches get thicker and senior tranches get thinner as the quality of underlying collateral used to structure a CDO weakens.

Source: IMF, Moody's Economy.com

Moody’s Economy.com • www.economy.com • [email protected] • Regional Financial Review / July 2008 15 Chart 2: Breakdown of CDO Holdings by Tranche results, presumably banks, and could grow as they wished %, as of the first half of 2007 managed to absorb by issuing more debt. Unlike SIVs, 120 or hedge these however, which invested in structured Equity Mezzanine Senior Source: Citigroup exposures without a credits, conduits held whole loans and 100 material impact on receivables awaiting securitization. Thus, their operations. conduits were not an investment vehicle, 80 In contrast, but a part of banks’ securitization however, senior pipelines. At their peak, conduits and 60 exposures did not SIVs held $1.4 trillion and $400 billion end up dispersed worth of assets, respectively, according to 40 at all, as they the IMF. stayed with a small By design, these off-balance-sheet 20 group of banks and vehicles were motivated by regulatory

0 monoline insurers and tax arbitrage, and allowed banks Banks Insurance Hedge funds Asset (see Chart 2). to reduce the capital associated with companies managers Monoline insurers their super-senior investments, thereby have been providing supercharging their returns on book traditional financial equity. Their growth was to a large extent of risk, but also abundant return), with guarantees on municipal bonds, MBSs motivated by the 1988 Basel Accord, demand for the remaining tranches and ABSs for decades, and have primarily which required more capital protection relatively lukewarm. The AA, A and been guaranteeing securities that were against riskier assets, and as such, BBB tranches that banks could not sell investment-grade on a stand-alone basis. encouraged banks to shift risky activities were recycled into yet another CDO—a In recent years, monolines got into the off their balance sheet, hiding them CDO-squared—with the usual capital business of insuring senior tranches from regulators’ and investors’ scrutiny. structure of super-senior and lower- of CDOs as well. Financial guarantors Indeed, before the subprime financial rated tranches and an equity cushion have written about $125 billion worth crisis, few market participants knew that providing overcollateralization. of insurance in the form of CDSs SIVs even existed. At the very top of the securitization referencing ABS CDOs according to the While growing securitization boom, some broker-dealers issued Bank for International Settlements. pipelines represented a growing CDO-cubeds, which were CDOs Banks’ exposure was more opaque, exposure to subprime mortgages, their investing in the recycled tranches of as their super-senior investments were downsizing on prudential grounds and CDO-squareds—CDO-cubeds were predominantly held in off-balance- leaning against competition was nearly CDOs of CDOs of CDOs. The sole sheet structured investment vehicles, impossible, as rationalizing a pullback purpose of CDOs of higher power was avoiding the radar of regulators and even from the hottest, most profitable to recycle CDO tranches that could not investors. SIVs were leveraged entities, business around would have been hard be sold as they were unattractive on a typically borrowing $15 for each dollar to explain to shareholders. To paraphrase stand-alone basis. of equity. Citigroup’s former CEO, Charles Price, Part II—No risk dispersion. In addition to senior CDO tranches, as long as the music was playing, banks The main benefit of credit risk transfer banks also became exposed to subprime pretty much had to play along. instruments is that through the risks through their massive securitization To play as safe as possible, some tranching of risk, they help ensure that pipelines. The very first ABS CDO banks hedged their pipelines, but these those most willing and able to bear deals were underwritten first by lining hedges did not turn out to be as effective risk end up bearing it. Through the up investors and only then buying the as assumed at their inception. Hedges spreading of this risk across thousands collateral to structure the deal. As such, using the ABX5 index were not perfect of investors worldwide, no participant underwriters were only exposed to the because of basis risks6, and some proxy in the financial system was supposed risks of the CDO for the brief period to have an excessive exposure to risk. that it took to assemble the CDO and This enhanced the overall stability of place it with the investors who ordered 5 The ABX is an index derived from the price of credit the , so the them. However, as the CDO business default swaps referencing subprime MBSs. When concerns about the quality of subprime mortgages rise, the cost argument went. grew, banks began to build up massive of insuring against a default on these securities rises, Indeed, the losses associated warehouses of mortgage loans (some and the ABX falls. Shorting the ABX is a bet that defaults on subprime mortgages will rise and that the price of with mezzanine and equity tranches even bought smaller mortgage lenders subprime MBSs will fall. A broker-dealer with significant did end up being well-diversified. A to serve as feeders for their booming subprime exposure in its securitization pipeline would short the ABX index to protect itself from the falling price large number of financial institutions CDO business), to make sure they had of subprime mortgages. The ABX index was also used by worldwide have disclosed manageable raw collateral for future deals. These speculators, betting on a deterioration of the performance losses from mezzanine exposures, warehoused exposures were also stored of subprime mortgages. 6 The risk is that offsetting investments in a hedging and based on the dearth of headlines, off balance sheets, in so-called conduits. strategy will not experience price changes in entirely equity investors, who do not typically Similar to SIVs, conduits were opposite directions from each other. This imperfect correlation between the two investments creates the break out CDO losses in their trading treated as ongoing entities by sponsoring potential for excess gains or losses in a hedging strategy.

16 Moody’s Economy.com • www.economy.com • [email protected] • Regional Financial Review / July 2008 Chart 3: Nonbanks Start to Behave Like Banks More importantly, bonds.7 Together with the funding of Maturity transformation as of 2007Q2 SIVs and conduits finance companies’ operations and the relied on short- holdings of conduits and SIVs in the 10 $ tril ABCP Source: JPMorgan term financing in ABCP market, $6 trillion worth of credit 9 Repos the asset-backed was intermediated through the shadow 8 banking system as of the second quarter 7 market to invest in of 2007 according to JPMorgan 6 long-term assets. estimates, compared with the $10 HF repos In this way, they trillion intermediated through regulated 5 were exposed to banks funded primarily by deposits (see ARS/TOB/VRDO 4 Deposits the classic maturity Chart 3).8 3 ABCP issuers mismatch typical Stepping back for a moment, it is of banks. interesting to compare the traditional 2 BD deposits 1 By borrowing model of banking with the originate-to- BD repos short and lending distribute model. Under the traditional 0 long, conduits and model, short-term funding and long-term Regulated banking system Shadow banking system SIVs were involved lending occurred on banks’ balance in the classic bank sheets—under one roof, so to speak—and business of maturity loans were held on to as investments; hedges were completely off. One bank, transformation. In this sense, conduits loan portfolios were kept diversified and for example, reportedly took out short and SIVs were an alternative form of those systemic risks that were impossible positions on emerging markets that traditional banking, the crucial difference to diversify away were hedged by building it thought would retreat if subprime being that these alternative banks were up reserves of liquid and safe assets to be valuations collapsed. In fact, those asset not funded by depositors, but by investors used as cushions during bad times. classes rallied, further compounding in the wholesale funding market and that Contrast this to the new model where the bank’s losses. Credit protection maturity transformation did not occur on loans are sold after they are originated, purchased from monolines was also far bank balance sheets but through capital and then are securitized into ABSs; ABS from perfect and became most unreliable markets in off-balance-sheet vehicles tranches are resecuritized into CDOs, when they were needed the most. outside the purview of regulators (and which might even be resecuritized Part III—Shadow banking system. also investors, as prior to the crisis only further into other CDOs; and the senior The accumulation of massive amounts a few market participants had heard of tranches of CDOs (themselves long-term of senior and super-senior CDO tranches SIVs). Another crucial difference was that credit instruments) are held by banks as in SIVs and the buildup of enormous the safety net that is available to regulated investments in off-balance-sheet SIVs, securitization pipelines through conduits banks (the option to borrow at the Fed’s which rely on short-term funding in the formed a network of highly levered off- discount window and FDIC insurance ABCP market, where the bulk of funds balance-sheet vehicles that constituted a to keep depositors from running) were were provided by funds— shadow banking system. This part of the unavailable for the shadow banking the modern day equivalents of bank article defines the shadow banking system, system of SIVs and conduits, and no deposits. Thus, credit intermediation still discusses the causes and repercussions alternatives existed. means borrowing short and lending long, of its collapse, and contrasts it with Conduits and SIVs were not the even in the originate-to-distribute model the traditional banking system. An only entities whose lifeline was the (see Chart 4).9 accompanying map provides an exhaustive ABCP (wholesale funding) market. Other Moreover, while the originate-to- view of the institutions, instruments and entities included finance companies such distribute model allowed for credit risk vehicles that make up the shadow banking as Countrywide and Thornburg Mortgage to be sliced, diced and dispersed, it did system and depicts the asset and funding in the U.S., and Northern Rock in the not eliminate credit risk itself, and at flows in it (see Chart 4). U.K. By borrowing short in ABCP markets each step of the process, a myriad of Different investors fund their to underwrite loans that they then sold investments differently. Insurance to broker-dealers for securitization, these companies and pension funds use no institutions were essentially asset feeders 7 Tender option bonds are synthetic short-term floating rate tax exempt bonds. They are “synthetic” because they leverage when making investments in for the shadow banking system. combine highly rated long-term municipal bonds with an order to juice returns, and they fund In fact, any investor investing in long- interest rate swap, thereby creating a floating rate municipal bond portfolio. This portfolio is financed by a two-tier their long-term investments with funds term credit products using short-term debt structure, involving highly rated short-term floating that are committed to them for the funding formed a part of the shadow rate securities (the TOBs) and a smaller piece of junior long term. In contrast, both SIVs and banking system. Such maturity debt. Variable rate demand obligations differ from TOBs only in that the latter is structured as an off-balance-sheet conduits funded their assets with highly transformations include hedge funds and special purpose vehicle, whereas the latter is not. Auction leveraged structures. SIVs were typically broker-dealers funding investments in rate securities are another form of floating rate municipal securities with a coupon that is set every seven, 28 or 35 15 times levered, whereas conduits’ credit products in the repo market, as well days in a Dutch auction process. holdings were 100% debt-financed— as auction rate securities, variable rate 8 Margaret Cannella and Jan Loeys. “How will the crisis change markets?” JPMorgan. April 14, 2008. essentially being levered through infinity. demand obligations, and tender-option 9 A guide to how to read the map is available upon request.

Moody’s Economy.com • www.economy.com • [email protected] • Regional Financial Review / July 2008 17

LTD

Equity

h Cas FHLB System Run for the Exit... Mortgages Investors fear losses and refuse roll over short-term debt Depositors fear losses and withdraw deposits Traditional bank run: Shadow bank run: Shadow bank run: Investors fear losses and raise haircuts, forcing margin spiral "Patient" Funds Currency Capital account TSLF; PDCF backstop, post Cash Safety Net Federal Reserve Private Equity Funds TAF PCF TSLF Deposits Funds PDCF Repos Equity Equity Sovereign Wealth Funds Current account surpluses Treasuries Uninvested investments investments Glossary: ABCPABSARM asset-backed commercial paper ARSCDO asset-backed security CDO, ABS mortgage adjustable-rate CDO, Synthetic CDOs that invest in credit default swaps rate security auction CDOs that invest in asset-backed securities CDS collateralized debt obligation CLOCMBSCRE EBITDA collateralized loan obligation commercial mortgage-backed security LTDLTFA commercial real estate earnings before interest, tax, depreciation and amortization LTFLLTRA long-term debt OMO long-term financial asset PCF long-term financial liability PDCF long-term real asset RMBS open market operations SIV credit facility (discount window lending) primary Primary Dealer Credit Facility STFA residential mortgage-backed security STFLTAF structured investment vehicle TOB short-term financial asset TSLF short-term financial liability VRDO Term Auction Facility tender offer bonds Term Securities Lending Facility variable rate debt obligation Cash Repos Money Market Equity infusions RR Sources of Funds Triparty Repo System TOB ARS ABCP VRDO Reverse Treasuries repos (RR) TAF lending post OMO breakdown Open market operations (OMO) PCF (discount window) backstop Cash LTD LTD TOB ARS VRDO ABCP Equity Equity Equity Equity Repos Repos Repos Equity Equity Deposits Deposits PCF/TAF Term notes SIVs leverage: 5x leverage: 30x leverage: 15x leverage: 10x Hedge Funds Broker-Dealers Risk Bearers Asset Managers

Maturity Mismatch

Commercial Banks

ARSs/TOBs/VRDOs

s Repo Insurance Companies LTA LTL LTA LTL bonds Municipal See Chart 2 See Chart 2 See Chart 2 See Chart 2 See Chart 2 See Chart 2 Other assets Other assets Other assets Other assets Other assets Other assets Credit Equity protection Monolines "AAA, Guaranteed!" off-balance sheet leverage Premiums Credit Default Swaps Equity Equity Equity Senior Senior Senior Mezzanine Mezzanine Mezzanine Super Senior Super Senior Synthetic CDO Mezzanine ABS CDO High-grade ABS CDO ABS CDS CMBS RMBS adds to system-wide leverage Mezzanine Mezzanine Mezzanine Senior ABS Senior RMBS Senior CMBS Equity Equity Equity Equity Super Senior Equity Senior Senior Senior Senior Senior Mezzanine Mezzanine Mezzanine Mezzanine Mezzanine CLO ABS CDO CMBS RMBS Securitization Resecuritization loans Bonds mortgages mortgages Leveraged Auto loans Residential Commercial Credit cards Student loans Following the breakdown of securitization market, FHLB system starts buying mortgages from commercial banks for cash; the FHLB system issues federally guaranteed debt to finance these purchases Liquidity backstop: bank takes onto its balance sheet all conduit/SIV assets and assumes their liabilities for contractual/reputational reasons ABCP CDS bets on the performance of RMBS and ABS tranches, and corporate sovereign bonds leveraged loans Monoline losses make the AAA ratings on munis questionable, triggering a run ARS/TOB/VRDO market ABCP Conduits Maturity Mismatch Risk Warehouses Loans loans loans bonds bonds bonds Equity Equity Municipal Corporate Corporate Sovereign mortgages Auto loans mortgages Leveraged Residential Commercial Credit cards Student loans leverage: 10x (whole loans) (whole loans) (tranched loan pools) (tranched tranche pools) Corporate Loans Consumer Credit Municipal Bonds Corporate/EM Bonds Residential Mortgages Commercial Mortgages Rents Taxes Taxes Payrolls Payrolls Payrolls EBITDA EBITDA CRE prices ARM resets House prices Risks Originated for Sale Real Economy Early payment defaults: loans returned to the originator; originator returns cash Loans Loans for sale for sale for sale Securities Cash Broker-Dealers Maturity Mismatch Commercial Banks Finance Companies Risk Originators LTD LTD LTD STFL LTFA LTRA LTFA LTFA STFL LTFA LTFL LTFA LTFL LTFA LTFL LTFA STFL STFA STFL LTFA LTFL LTFA LTFL ABCP Repos Equity Repos Equity Equity Bank Holding Companies Deposits Deposits PCF/TAF Bank loans Cash Chart 4: The Shadow Banking System

18 Moody’s Economy.com • www.economy.com • [email protected] • Regional Financial Review / July 2008 Chart 5: The Rise and Fall of the Shadow Banking System that held these were eating away at bank capital. These Asset-backed commercial paper outstanding mortgages (see Chart developments pushed bank capital ratios 1.2 5). The falling value lower and forced banks to pull back on $ tril of subprime RMBS discretionary lending. 1.1 trickled through to To date, the pullback on discretionary the value of CDOs lending was most obvious in the 1.0 that referenced interbank market where spreads remain them. Investors who elevated, and among hedge funds and 0.9 held these CDOs private equity funds who now have to 0.8 such as SIVs and operate in a world where leverage is more the imploded hedge expensive and also harder to come by 0.7 funds at UBS and from banks than before. For hedge funds, Bear Stearns were the pullback in discretionary lending also 0.6 Source: Federal Reserve denied short-term came in the form of increased margins 0.5 funding in the ABCP on borrowed securities and haircuts on 01 02 03 04 05 06 07 08 and repo markets, securities pledged as collateral when respectively, borrowing short-term funds. Increased triggering the run margins and haircuts were the primary other risks emerged, which have probably on the shadow banking system. Conduits drivers of in the financial increased risks in the financial system on that held risky mortgages awaiting system and contagion across asset classes. an aggregate level. These risks include securitization also were denied funding, A pullback in discretionary lending (inability to roll over ABCP), as were finance companies such as to the real economy is also evident basis risk (on hedges using the ABX index Countrywide and Thornburg Mortgage in the drying up of the issuance of to protect against subprime exposure), whose lifeline was the ABCP market. commercial mortgage-backed securities, risks inherent in proxy hedging, and Finance companies’ troubles were further and the virtual disappearance of the concentration/wrong-way counterparty exacerbated by the fact that they were nonconforming mortgage market and risks with regard to monoline insurers, stuck with mortgages for which demand lending against home equity. The whose ability to perform turned out to evaporated as the performance of earlier possibility that this pullback will spread be the weakest when they were needed vintages deteriorated rapidly. Unable to other loan types as their credit quality most. Moreover, because the complexity to get funding and to recycle into cash weakens in tandem with the economy, of ABS CDOs and the originate-to- the mortgages they originated, finance together with the tightening in loan distribute model itself made it so hard to companies’ lifelines were cut off and they underwriting standards across all loan dissect what was happening and what will came dangerously close to bankruptcy, types, is a downside risk to the economy happen next during the crisis, the model with Northern Rock succumbing. that could keep growth well below also comes with a heavy dose of what one The increase in system-wide leverage potential once the near-term technical could call complexity risk. that made deleveraging during the crisis positives of the rebate checks and lean Similar to regulated banks that so painful did not build up in the hedge inventories fade going into 2009. need to be able to continuously roll over fund universe (the concern du jour prior Three lessons from the crisis are their deposits to be able to fund their to the credit crisis) or the regulated abundantly clear. First, as the associated loans and provide liquidity to those who banking system, but in the short-term write-downs to the tune of close to $450 needed it, the shadow banking system ABCP markets that were the lifeline of the billion10 and subsequent rounds of capital needed to be able to continuously roll shadow banking system. Indeed, regulated raising illustrate, through the originate- over its ABCP debt to perform the same banks’ capital ratios were quite stable to-distribute model the regulated banking functions. Banks’ ability to continuously through just before the subprime crisis, system created far more credit and offered roll over their deposits stemmed from but have fallen significantly since. Capital far more liquidity guarantees than what their reputations as prudent risk takers ratios fell as funding from the ABCP their capital bases were able to support. and the quality of the whole loans they market dried up and the shadow banking With only about $350 billion11 in capital carried on their books. The shadow system outright “collapsed” onto the raised to date, the banking system banking system’s ability to roll over ABCP regulated banking system and all the credit maintains a capital deficit compared with depended on the quality of the structured risk that was shoved off to off-balance- pre-crisis levels. Less bank capital and a credit products and warehoused loans sheet vehicles during the previous decades more careful handling of leverage raise the it held; any sign of trouble with their became reintermediated onto regulated risk that the reduced availability of credit assets could trigger ABCP investors (their banks’ balance sheets through the liquidity will hold back the economy’s rebound “depositors”) to dump and refuse to roll backstops provided to conduits and the from the currently unfolding . over their debt, and a run on the shadow reputational risks associated with SIVs. The Second, the originate-to-distribute banking system would ensue. forced reintermediation of these credits model and the strong demand for and Such a run was triggered by rising led to an involuntary expansion of bank delinquencies on subprime mortgages and balance sheets at a time when mark-to- 10 Write-down league table, FT.com. the associated decay in the value of RMBS market losses on reintermediated assets 11 GFSR Market Update, July 28, 2008, IMF.

Moody’s Economy.com • www.economy.com • [email protected] • Regional Financial Review / July 2008 19 Chart 6: The Run on Bear Stearns and its reflect strong performance, but rather lax Bear Stearns' liquidity pool, daily from 2/22 to 3/13 aftershocks—the covenants (see Chart 7). Problems with Russian debt leveraged loans and associated privately 22 $ bil default and the held firms will surface this year and next 20 LTCM crisis—was as the economy slows further, revenues 18 the real economy. weaken, and high leverage multiples 16 Similarly, create problems. This could lead to 14 the currently bankruptcies and layoffs in a wide 12 unfolding range of non-housing related industries 10 recession in the (housing-related industries have been 8 U.S. is a threat to the main source of layoffs to date), 6 the performance which could potentially exacerbate 4 of leveraged consumer credit woes over and beyond loans and a slew what is expected today. Concerns 2 Sources: SEC, BOE Financial Stability Report 0 of other types involving leveraged loans can be placed of credit, from into four groups. 2/22 2/24 2/26 2/28 3/1 3/3 3/5 3/7 3/9 3/11 3/13 nonmortgage First, similar to what has happened consumer credit in the subprime mortgage space, there has from CDOs also enabled and encouraged to commercial mortgages and land also been an increase in risk layering in the underwriting of some loans (subprime development loans. Just as it took one the leveraged loan space in recent years. mortgages and leveraged loans) that year to get from the Asian crisis to the High loan-to-value ratios, interest-only would never have been made if banks had LTCM crisis, credit aftershocks could and negative amortization loans, cash-out to hold on to them as whole loans. occur this summer and into 2009. refinancings and home equity loans, zero Third, the originate-to-distribute Some caveats are in order, however. down mortgages, and excessive house model empowered credit markets to Credit losses from commercial price gains all have their equivalents grow very large in size and significance mortgages and land development in the leveraged loan space, taking the relative to regulated banks in the credit loans will be smaller and easier to forms of high debt-to-EBITDA multiples, intermediation process, but without absorb than losses on subprime covenant-lite and payment-in-kind toggle access to a safety net that was available exposures because (individually) notes,13 dividend recapitalizations, equity for regulated banks in times of stress. their outstanding volume is smaller This safety net vacuum caused the demise than that of subprime mortgages, and of Carlyle Capital and Bear Stearns because their underwriting standards 13 Covenant-lite loans came with an option to stop paying in March 2008 (see Chart 6), which never collapsed as much as those on cash interest if companies ran into cash flow problems. eventually prompted the Fed to create the subprime mortgages. Further, because Payment-in-kind toggle notes, also known as piks, give companies the option to pay interest either in cash or in Term Securities Lending Facility and the these loans are far less often securitized kind by issuing investors more notes over a given period. Primary Dealer Credit Facility. than subprime mortgages, associated The ability to suspend interest payments—a drain on cash flows—was a significant factor in the willingness of private Part IV—The beginning of the losses will primarily be borne by the equity firms to buy companies in cyclical industries, end. With the financial crisis over a balance sheets of thousands of smaller because it gives them time to ride out an economic year old, hopes that the worst is already commercial banks, savings institutions downturn. Covenant-lite loans and piks are symptoms of the relaxation of lending standards during the private past are rising. It is important to note, and credit unions, as opposed to capital equity boom. however, that there are historical market participants. precedents for aftershocks following In contrast, financial crises with lags as long as 12 leveraged loans Chart 7: A False Sense of Security months. Securitized taxi cab loans in and credit default % of outstanding leveraged loans in default or bankruptcy Thailand were one trigger of the Asian swaps associated 12 financial crisis, leading to a series of with firms that 12 currency devaluations in Southeast Asia were taken private Source: S&P Leveraged Commentary and Data in August 1997, followed by a global at the height of 10 recession. The recession led to a collapse the private equity in crude oil prices, which in turn led to boom could haunt 8 falling tax revenues in Russia and the broker-dealers and subsequent Russian debt default; this, hedge funds as the 6 in turn, triggered the Long-Term Capital economy weakens. Management crisis in August 1998. The While default 4 link between the Asian financial crisis rates on leveraged loans are still near 2 historic lows, 12 Jamie Dimon, CEO, JPMorgan Chase, panel discussion these indicators 0 on Systemic Financial Risk at the 2008 World Economic Forum in Davos. do not necessarily YE979899000102030405060708Q1

20 Moody’s Economy.com • www.economy.com • [email protected] • Regional Financial Review / July 2008 Chart 8: Leverage Levels Got to Historical Highs Chart 9: Synthetic CDOs Mainly Reference Corporates... Average large LBO leverage multiples, debt/EBITDA Global synthetic CDO issuance

6.5 90 ABS Other Corporate $ bil 80 6.0 Source: Creditflux Data+ 70

5.5 60

50 5.0 40

4.5 30

20 4.0 Source: S&P Leveraged Buyout Review 10 3.5 0 97 98 99 00 01 02 03 04 05 06 07 05 06 07 08 bridge loans, and purchase multiple potentially reducing recovery rates and recession will be the first true test of CDSs expansions, respectively (see Chart 8). the chances of successful emergence from as a whole. Since a vast majority of CDSs Second, arguments that the covenant- bankruptcy. This, indeed, is a major are unfunded—that is, they are not backed lite and payment-in-kind loans should allow downside risk for the real economy. by collateral that eliminates the risk that firms to sail through the economy’s rough Fourth, according to the IMF, over a counterparty will be unable to meet its patch miss the importance of trade creditors. $600 billion in leveraged loans are set obligations—they represent a fault line Thus, while it is true that weaker covenants to mature from 2008 to 2010, posing in the financial system similar to the way mean that bank creditors can no longer exert significant refinancing risks. The terms of subprime ARMs did prior to their resets discipline over borrowers, the firms that make the refinanced loans will be significantly (see Chart 10). up the borrowers’ supply chain still can. stricter and their sizes smaller because Problems could develop if the recession Suppliers’ refusal to extend trade credit, or of recent bank losses; this could spell is deeper and longer than expected, and if difficulties in obtaining short-term funding in trouble for deals that only looked firms with significant amounts of debt the commercial paper market, can also push attractive when credit was abundant and outstanding and associated CDSs default. firms into bankruptcy. Indeed, several firms in loan terms lax. Maturity on leveraged That the deepest housing recession since the retail sector that were taken private (Linens loans is so short because most private the Great Depression would pass without ‘n Things, for example) have already filed for equity funds intended to keep their the bankruptcy of a major homebuilder, or bankruptcy, and several more are struggling. investments private for only a few years, that a larger, cyclically sensitive business Others are exercising their options not to pay and then exit them via an initial public that was taken private in recent years under interest on their debt, suggesting that they are offering into a buoyant market. a saddle of debt would survive the recession facing cash flow problems. Coming corporate bankruptcies as unharmed, is increasingly unlikely. Third, the flip side of delayed the downturn takes hold also will test Such credit events could cause bankruptcies is that firms are bleeding the CDS market (see Chart 9). Investors serious payment shocks to investors cash for a longer time than usual, have hedged and spread around much who have written unfunded protection of the for such events, as well as hedge shocks corporate for those who purchased unfunded Chart 10: ...And Only a Minority Have Real Money Behind Them credit risk protection for the same events. While Global synthetic CDO issuance through CDSs on financial institutions’ debt have 90 CDSs. been receding lately, interbank rates Funded Unfunded $ bil Moreover, remain elevated and banks keep hoarding 80 Source: Creditflux Data+ CDSs massive amounts of cash. One reason for 70 on debt caution and the buildup of cash reserves 60 involving could be to guard against payment and firms that hedge risks on CDSs. 50 have gone To paraphrase Churchill, in 40 private conclusion, now this is not the end, but it 30 have grown is, perhaps, the beginning of the end. As exponentially the economy slides further into recession 20 in recent and risks remain that the recovery will be 10 years. The hindered by reduced credit availability in 0 currently the banking system, there is plenty of bad 05 06 07 08 unfolding news that could potentially roll in.

Moody’s Economy.com • www.economy.com • [email protected] • Regional Financial Review / July 2008 21 Appendix: A Map of the Shadow Banking System

The map of the financial system New Century Financial, Thornburg market bonds into collateralized debt presented in The Rise and Fall of the Mortgage, Capital One and GMAC. obligations (CDOs). These credits Shadow Banking System tracks the In addition to the above loan are not channeled through conduits, creation, securitization and dissemination types, commercial banks also originate however. These are all of credit risk only. It does not track commercial mortgages and corporate one-layer securitizations, as they have the flow of corporate equities or the loans. Corporate loans include direct exposure to the underlying loans. securitization of conforming mortgages commercial and industrial loans, loans Corporate and emerging market are also by the GSEs. This appendix explains the to finance companies, land development sold in whole forms to investors. Asset map in six steps. First the institutions loans, as well as leveraged loans. flows are mapped with solid black lines. and instruments involved in creating Broker-dealers also underwrite In recent years, RMBSs (and loans and securities are discussed. leveraged loans, and also corporate, especially subprime RMBSs) and ABSs Second the flows of these securities sovereign and municipal bonds. were increasingly recycled into ABS within the shadow banking system Standalone broker-dealers include CDOs. ABS CDOs came in two flavors— is presented. Third, the institutions , , Lehman high-grade CDOs and mezzanine CDOs. investing in these securities is discussed. Brothers and Lynch. High-grade CDOs recycled the senior Fourth, the way these investments are Standalone commercial banks of any tranches of RMBSs and ABSs, while financed is discussed and the run on the real size are hard to find, as competition mezzanine tranches recycled mezzanine shadow banking system is traced. Fifth, from finance companies and broker- tranches of RMBSs and ABSs. Both issued the capital and liquidity injections into dealers for transactions that used to super-senior, senior, mezzanine and the financial system and steps taken to be structured as bank loans forced equity tranches against their portfolio. avoid a systemic meltdown are discussed. commercial banks do diversify their Synthetic CDOs were another Risk originators. In the originate- business lines. Such diversified financial form of two-layer securitization. to-distribute model, loans are sold and institutions are called bank holding Synthetic CDOs invest in CDSs and pooled with thousands of other loans. companies, which combine commercial are structured such that their cash Using structured credit instruments banks and broker-dealers under one flows and performance mimic those (ABSs and CDOs, broadly speaking), the roof. Examples include Citigroup and of the cash securities that the CDSs in underlying cash flows and credit risks JPMorgan Chase. their portfolio reference. Through the of loan pools are tranched, and then The performance of the loans these synthetic creation of credit exposure, distributed in bespoke concentrations to institutions originate depend on the CDOs add to the amount of leverage a broad group of investors with unique originators’ underwriting standards as well in the financial system. CDSs used to risk appetites. To properly function, as the performance of the real economy issue synthetic CDOs reference anything the originate-to-distribute model needs (black dotted line). The performance of from the tranches of RMBS, CMBS and liquid money and securities markets at each loan type is driven by a unique set of ABS securities, leveraged loans involving all times to intermediate credit through macroeconomic variables. companies that were taken private, and the daisy chain of asset originators Asset flows. Once originated, loans corporate and sovereign bonds (these (finance companies and commercial are sold. Sold loans are warehoused in linkages are represented by dashed banks), asset packagers (broker-dealers asset-backed commercial paper conduits, purple lines). The “raw material” for and some hedge funds) and asset where they await securitization. synthetic CDOs comes form the credit managers (hedge funds, SIVs, pension Securitization involves the pooling of default swap market where CDSs are funds and insurance companies). thousands of individual loans and carving written. Of the notional $1.4 trillion in Three types of institutions feed up their cash flows into senior, mezzanine synthetic CDOs issued between 2005 the originate-to-distribute model with and equity tranches. Residential and March 2008, some $1.3 trillion loans. These are finance companies, mortgages are packaged into residential invested in CDSs referencing corporates, commercial banks and broker-dealers. mortgage-backed securities (RMBS), with the remainder investing in CDSs The dotted lines linking these loan consumer credit receivables into asset- referencing ABSs, according to data from originators with loan types indicate backed securities (ABS) and commercial Creditflux (see Chart 9 in main article). what type of lending these institutions mortgages into commercial mortgage- Importantly, 85% of these synthetic are primarily engaged in. Thus, finance backed securities (CMBS). CDOs are unfunded (see Chart 10 in companies originate mortgages, auto Leveraged loans are packaged main article), meaning that they are not loans, credit card loans and student into collateralized loan obligations backed by collateral that eliminates the loans. Examples of such firms include(ed) (CLOs), while corporate and emerging risk that a counterparty will be unable

22 Moody’s Economy.com • www.economy.com • [email protected] • Regional Financial Review / July 2008 Chart 1: Filling the Void their investments were reinforced by a massive wave of Purchases of mortgages, two-quarter moving sum using ABCP; broker- downgrades of ABS CDOs by the ratings 400 dealers and hedge agencies. The new marks and downgrades Source: Federal Reserve $ bil funds financing triggered a loss of confidence in ABS 350 credit investments CDOs and structures exposed to them, 300 using repos; as well notably SIVs. 250 as ARSs/TOBs/ Money market funds quickly dumped 200 VRDOs investing in all their ABCP holdings, and with no other 150 municipal bonds. investor willing to step in, the lifeline of These short- conduits and SIVs was cut off (see Chart 5 100 term funding sources in main article; solid red lines marked with 50 are marked with explosion marks). A run on the shadow 0 yellow boxes. Any banking ensued (thick solid orange line -50 FHLB system sign of trouble with running off the map). Issuers of ABSs -100 these structures’ This is when conduits’ contractual 00 01 02 03 04 05 06 07 assets could trigger liquidity backstops provided by a run on the shadow commercial banks (or more precisely, the banking system. arms of bank holding to meet its obligations. Also note, that Funding flows. Such a run was companies) kicked in, leading to a synthetic CDOs discussed here are only a triggered by ARM resets in early 2007. As massive re-intermediation of loans back very small subset of the nearly $60 trillion resets triggered early payment defaults on on to regulated banks’ balance sheets (notional) CDS market. loans, conduits exercised their options (dashed blue lines leading from conduits The volume of CDSs written on ABSs to sell defaulted loans back to their to commercial banks). SIVs did not have to create synthetic ABS CDOs depressed originator (dashed green line). Originators contractual backstops with banks, but the price of credit protection in a classic were obliged to buy them back, shielding banks chose bring them onto their balance insurance cycle. Monoline insurers conduits from losses. This shield soon sheets nonetheless, due to reputational guaranteeing the performance of senior broke, however, when some finance reasons and to avoid the fire sale of SIVs’ and super-senior RMBS, ABS and ABS companies ran out of cash to buy back AAA rated assets at depressed prices. This CDO tranches had no choice but to offer loans. Such a cash crunch led to the involuntary expansion in bank balance these guarantees at depressed premiums bankruptcy of New Century Financial. sheets (and simultaneous realization of (dashed red lines leading from monolines With the performance of earlier loan mark-to-market losses as assets were to senior tranches). vintages deteriorating rapidly, conduits reintermediated at depressed prices) Risk bearers. ABSs, ABS CDOs, CLOs stopped buying new mortgages altogether depressed capital ratios and forced banks and traditional CDOs were disseminated and the securitization market froze. to pull back on discretionary lending. across a wide range of investors with varying Unable to recycle into cash the The pullback in discretionary lending risk appetites. These investors include mortgages they originated, some mortgage and heightened counterparty risk led to SIVs, commercial banks, broker-dealers, lenders came dangerously close to massive strains in interbank lending. hedge funds, asset managers, and insurance bankruptcy, with Northern Rock in the Capital and liquidity injections. companies (for a breakdown of each U.K. succumbing. That no U.S. lender Rate cuts did not help much to ease strains investors’ holding of these securities see suffered the same fate was largely due in the interbank market, as the primary Chart 2 in main article). to the Federal Home Loan Bank (FHLB) dealers (broker-dealers) through which Of these investors, only asset system, which by issuing federally the Fed injects liquidity into the interbank managers and insurance companies were guaranteed debt, stepped in to buy all market were hoarding the cash they received not exposed to maturity mismatch, as they the mortgages that banks originated for from the Fed (dashed green line with fund their assets with long-term liabilities. sale, but could not sell all of a sudden. explosion mark). Primary dealers had every All other investors were financing their The FHLB system (and indirectly the incentive to hoard cash, as many of them investments in these long-term credit government) scooped up mortgages to the were suffering from subprime exposure and/ instruments using short-term funds, tune of $240 billion during the second half or internal problems. exposing themselves to the classic maturity of 2007 (see Chart 1). An alternative that existed for banks mismatch of banks (maturity mismatches Soaring delinquencies and defaults was to borrow at the Fed’s discount in the financial system are marked with red also started to hit the value of RMBSs window (dashed green line). This, boxes at the bottom of the page). and ABSs CDOs, causing the demise however came with a stigma and the Any institution that was financing Dillon Read Capital Management at UBS public perception that a bank is having long-term credit assets with short-term and two hedge funds at Bear Stearns financial problems. Banks were trying funds formed a part of the shadow banking during the summer of 2007. As these to avoid such perceptions at all cost system. These institutions include finance hedge funds were forced to unwind in an environment where the fear of companies funding their loan originations their positions by their prime brokers, counterparties going under was running using ABPC; loan warehouses financing their assets were sold at fire-sale prices. high. Banks were unwilling to use the their inventories using ABCP; SIVs funding These fire-sale prices of these securities discount window even after repeated

Moody’s Economy.com • www.economy.com • [email protected] • Regional Financial Review / July 2008 23 Chart 2: TAF Borrowing regulators and This in turn led to an increase in Auctions held every other week on Mondays ratings agencies, correlation across asset classes (making monolines were it increasingly hard to remain hedged 80 Source: Federal Reserve forced to raise more as the turmoil unfolded) and increased capital to maintain volatility. The increase in volatility 70 their AAA-ratings. across all asset classes, together with Injections the massive losses at broker-dealers, 60 came from private prompted prime brokers to raise margins equity funds. Private and haircuts on securities lending to 50 equity funds went hedge funds. into the crisis with A dangerous margin spiral ensued, 40 a massive war chest where forced sales trigger plummeting of uncommitted prices, more forced liquidations, and 30 funds. Monolines still higher haircuts. This dynamic $ bil were not the only culminated in the Bear Stearns’ 20 firms hat in hand for liquidity crisis in March (see Chart 1/14 1/28 2/11 2/25 3/10 3/24 4/7 4/21 5/5 5/19 capital. Bank holding 6 in main article; solid red line with companies and explosion mark next to broker-dealers), reductions of the penalty margin that broker-dealers raised over $350 billion constituting another form of a run on applies to discount window loans. Banks in capital from Middle Eastern and Asian the shadow banking system (thick solid remained starved for funds. sovereign wealth funds (dashed blue lines orange line running off the map). In response, the Fed introduced from private equity funds and SWFs). To break this margin spiral, the Fed the Term Auction Facility (TAF; dashed Uncertainty about monolines’ AAA introduced two new liquidity facilities black line). TAF disseminates funds ratings destabilized the municipal bond lending against less liquid collateral; at an auction, where banks can bid market, where many securities were these facilities were the TSLF and the anonymously, solving the problem of wrapped by monolines to obtain AAA PDCF (dashed black line leading from stigma (see Chart 2). Furthermore, ratings (dashed red line with explosion the Federal Reserve through the triparty depository institutions could bid for mark going from monolines to municipal repo system to broker-dealers). The TSLF these funds directly at the Fed, which bonds). This in turn prompted money allows primary dealers (whose lifeline is solved the issue of primary dealers markets to withdraw from the short-term the repo market) to exchange AAA-rated hoarding cash and not letting it flow ARS/TOB/VRDO market. RMBS, CMBS and ABS in exchange for through to the interbank market. As the ABCP and short-term muni Treasury securities. The dealers then can As subprime losses were mounting markets were collapsing and bank take the Treasurys to the Treasury repo and the value of highly-rated securities balance sheets were hemorrhaging, market to raise cash. were plummeting, monoline insurers troubles were also running high in The TSLF did not only make came under increased pressure. Mark-to- the repo market. The falling price of dealers’ balance sheets more liquid, but market losses on the value of securities securities with an exposure to subprime also helped the liquidity of the above whose AAA-ratings they guaranteed mortgages forced deleveraging across the securities and hence the price of ABS threatened the AAA ratings of monolines board. With markets for problem assets CDOs that reference those securities. themselves. In a tug of war between frozen, investors were forced to sell their All this improved liquidity in the entire the monolines, short-sellers, banks, good assets. triparty repo system and also in the repo

Chart 3: TSLF Borrowing Chart 4: PDCF Borrowing Weekly auctions held on Thursdays Standby facility, average outstanding balance during week

90 40 Source: Federal Reserve Source: Federal Reserve $ bil $ bil 80 35 70 30 60 25 50 20 40 15 30 20 10

10 5

0 0 1/10 1/24 2/7 2/21 3/6 3/20 4/3 4/17 5/1 5/15 1/9 1/23 2/6 2/20 3/5 3/19 4/2 4/16 4/30 5/15

24 Moody’s Economy.com • www.economy.com • [email protected] • Regional Financial Review / July 2008 Chart 5: The Fed's Expanding Toolbox What the the $240 billion in mortgages scooped Assets of the Federal Reserve TSLF and PDCF up by the FHLB system, the federal accomplish is government assumed some $500 billion 1.0 Treasurys Repos TAF PDCF TSLF that by providing in credit risk on its balance sheet. Source: Federal Reserve liquidity against Only the FHLB system’s purchases 0.9 less liquid were financed by freshly issued debt; the collateral, they Fed’s purchases were financed through 0.8 allow deleveraging the sale of Treasurys (see Chart 5). to proceed in The inclusion of mortgages purchased 0.7 an orderly way by and and (as opposed to the $30 billion in mortgage assets that 0.6 the destructive collateralize the $29 billion credit line by manner that the New York Fed to grease JPMorgan’s 0.5 caused the demise takeover of Bear Stearns would further $ tril of Carlyle Capital inflate these figures. 0.4 and Bear Stearns), Pandora’s box? The black box of O'07 N D J'08 F M A M minimizing credit default swaps (CDS) has yet to be potential damages tested in a recession. Banks and broker- that it might pose dealers are net buyers of protection market that exists between hedge funds to systematically important broker- and hedge funds, asset managers and and broker-dealers (solid red and dealers, the financial system as a whole insurance companies are net sellers of black lines between hedge funds and and the real economy. All they do is to protection (dashed purple lines linking broker-dealers). smooth deleveraging, but not prevent it. to net buyers’ assets and net sellers’ The PDCF, is a standby borrowing With the introduction of the TAF, liabilities). The performance of the facility where primary dealers can obtain the TSLF and the PDCF, the Fed sold real economy and leveraged loans and funds (as opposed to Treasurys under over $260 billion in Treasurys from corporate bonds hold the key to the the TSLF) from the Fed in exchange for its balance sheet, and replaced it with severity of losses on CDSs and potential most major types of investment grade riskier assets that serve as collateral for aftershocks in the financial system in securities (see Charts 3 and 4). the new lending facilities. Together with 2008 and 2009.

Moody’s Economy.com • www.economy.com • [email protected] • Regional Financial Review / July 2008 25 © 2008, Moody’s Analytics, Inc. (“Moody’s”) and/or its licensors. All rights reserved. The information and materials contained herein are protected by United States copyright, trade secret, and/or trademark law, as well as other state, national, and international laws and regulations. Except and to the extent as otherwise expressly agreed to, such information and materials are for the exclusive use of Moody’s subscribers, and may not be copied, reproduced, repackaged, further transmitted, transferred, disseminated, redistributed or resold, or stored for subsequent use for any purpose, in whole or in part. Moody’s has obtained all information from sources believed to be reliable. Because of the possibility of human and mechanical error as well as other factors, however, all information contained herein is provided “AS IS” without warranty of any kind. UNDER NO CIRCUMSTANCES SHALL Moody’s OR ITS LICENSORS BE LIABLE TO YOU OR ANY OTHER PERSON IN ANY MANNER FOR ANY LOSS OR DAMAGE CAUSED BY, RESULTING FROM, OR RELATING TO, IN WHOLE OR IN PART, ERRORS OR DEFICIENCIES CONTAINED IN THE INFORMATION PROVIDED, INCLUDING BUT NOT LIMITED TO ANY INDIRECT, SPECIAL, INCIDENTAL, PUNITIVE, OR CONSEQUENTIAL DAMAGES HOWEVER THEY ARISE. The financial reporting, analysis, projections, observations, and other information contained herein are statements of opinion and not statements of fact or recommendations to purchase, sell, or hold any securities. Each opinion must be weighed solely as one factor in any investment decision made by or on behalf of any user of the information contained herein.

82 Moody’s Economy.com • www.economy.com • [email protected] • Regional Financial Review / July 2008