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Prof. Jayanth R. Varma, Indian Institute of Management, Ahmedabad (jrvarma@iimahd.ernet.in)

Two Years
of the
Global Financial Crisis
Prof. Jayanth R. Varma, Indian Institute of Management, Ahmedabad (jrvarma@iimahd.ernet.in)
Global Financial Crisis
The Real Estate Sector
The Financial Sector
The Real Economy
Implications for Investment
Management
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Prof. Jayanth R. Varma, Indian Institute of Management, Ahmedabad (jrvarma@iimahd.ernet.in)
Real Estate and its financing
Real estate is the largest asset class
in the world. Residential plus
commercial real estate typically
exceeds stock market capitalization.
High Levels of Leverage
US household mortgage debt was about 55% of
residential real estate value
Accounting for mortgage free homes, the
average loan to value ratio of mortgages was
about 73% or D/E ratio of 2.75.
Prof. Jayanth R. Varma, Indian Institute of Management, Ahmedabad (jrvarma@iimahd.ernet.in)
When do mortgages default
Negative home equity
Negative life event:
Death, Disability, Disease, Dismissal,
Divorce
Poor underwriting:
Loan to value
Debt to Income
Past credit history
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Prof. Jayanth R. Varma, Indian Institute of Management, Ahmedabad (jrvarma@iimahd.ernet.in)
Originate to Distribute Model
Mortgage company acquires customers,
evaluates them and originates the
mortgage, but does not fund most of it.
Within a short time, mortgages are pooled,
package and sold to investors.
In US, high quality mortgages below a
certain size are guaranteed by government
Agencies Fannie/Freddie.
Credit risk falls on taxpayer (implicit
government guarantee).
Interest rate (prepayment) risk borne by
investor
Prof. Jayanth R. Varma, Indian Institute of Management, Ahmedabad (jrvarma@iimahd.ernet.in)
Non conforming mortgages
Mortgages not eligible for Agency
guarantees:
Subprime (poor credit history) or unacceptable
LTV, income ratios
Alt-A (unacceptable documentation, eg liar
loans)
Jumbo loans (above size limit)
Credit risk borne by investor. Managed by
diversification pooling thousands of
mortgages from multiple geographies.
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Prof. Jayanth R. Varma, Indian Institute of Management, Ahmedabad (jrvarma@iimahd.ernet.in)
Growth of sub prime and MBS
In 2001, non Agency (subprime, Alt-A
and jumbo mortgages) were less than
half of Agency mortgages.
In 2006 non Agency were one and a
half times Agency mortgages.
In 2001, only a minority of non
Agency mortgages were securitized.
In 2006, the vast majority of non
Agency mortgages were securitized.
Prof. Jayanth R. Varma, Indian Institute of Management, Ahmedabad (jrvarma@iimahd.ernet.in)
Rating of subprime MBS
Large diversified pools of subprime
mortgages were tranched to create highly
rated securities:
Over 80% became AAA
Over 95% became A/AA/AAA
These ratings implied that almost all credit
risk was diversifiable
negative life event risk
In fact, significant risk is non diversifiable:
Home price risk
Underwriting risk
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S&P/Case-Shiller U.S. National Home Price Index
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1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009
Source for Data: Standard & Poor
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Prof. Jayanth R. Varma, Indian Institute of Management, Ahmedabad (jrvarma@iimahd.ernet.in)
Real home prices do NOT trend up!
http://ssrn.com/abstract=1439735
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Prof. Jayanth R. Varma, Indian Institute of Management, Ahmedabad (jrvarma@iimahd.ernet.in)
Underwriting standards
Underwriting standards varied over
time.
Became very loose in 2005-2007
Underwriting standards varied across
originators
Countrywide and Indymac were very bad
Well Fargo (before Wachovia
acquisition) were much better
Prof. Jayanth R. Varma, Indian Institute of Management, Ahmedabad (jrvarma@iimahd.ernet.in)
Default rates
Extremely high in subprime and Alt-A
of 2006 and 2007 vintages
High and rising even in prime
mortgages of these vintages
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Prof. Jayanth R. Varma, Indian Institute of Management, Ahmedabad (jrvarma@iimahd.ernet.in)
Financial Sector
Prof. Jayanth R. Varma, Indian Institute of Management, Ahmedabad (jrvarma@iimahd.ernet.in)
Early 2007: Onset of crisis
Real estate prices peaked in 2006. BBB tranches
of subprime MBS (ABX index) started falling in
early 2007. AAA tranches started to fall only in
July 2007.
When the music stops, in terms of liquidity,
things will be complicated. But as long as the
music is playing, youve got to get up and dance.
Were still dancing Citigroup Chairman, Chuck
Prince, July 10, 2007.
Severe dislocation in Libor: TED spread and
Libor-OIS spreads.
Hedge funds with subprime exposure closed
down. Bear Stearns bailed out its hedge funds.
Quant hedge fund crisis early August 2007
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Prof. Jayanth R. Varma, Indian Institute of Management, Ahmedabad (jrvarma@iimahd.ernet.in)
The Crisis Up to Bear Stearns
9 August 2007, BNP Paribas stopped redemption of funds
invested in subprime MBS. Huge liquidity injections by
ECB/Fed to backstop interbank funding markets.
SIVs unable to roll over ABCP
Worries about bank losses
AAA tranches of subprime MBS
Taking over assets of bank sponsored SIVs
Northern Rock nationalized in UK (September 2007)
In late 2007 and early 2008, credit markets continued to
deteriorate.
In March 2008, Bear Stearns was unable to roll over its short
term borrowings. JP Morgan Chase bought Bear at a
bargain price with Fed guaranteeing most of the bad assets
of Bear.
Bear Stearns rescue stabilized markets for some time.
Prof. Jayanth R. Varma, Indian Institute of Management, Ahmedabad (jrvarma@iimahd.ernet.in)
Lehman bankruptcy
In early and mid 2008, liquidity concerns changed
into solvency concerns about large banks, bond
insurers and the Agencies.
July 2008, Agencies taken into conservatorship.
September 15, 2008: Lehman was allowed to fail
and AIG was bailed out.
All financial markets froze. International trade
collapsed.
Massive government intervention (no more
Lehmans, guarantee of bank deposits,
recapitalization, asset guarantees propped up the
markets.
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Prof. Jayanth R. Varma, Indian Institute of Management, Ahmedabad (jrvarma@iimahd.ernet.in)
Returning to normalcy
Key market indicators returning to
normal
TED spread, volatility, OIS spread are
back to pre Lehman levels
Some large banks may still be
insolvent, but if central banks keep
them liquid, may be they can earn
their way out of the hole.
Prof. Jayanth R. Varma, Indian Institute of Management, Ahmedabad (jrvarma@iimahd.ernet.in)
Real Economy
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Prof. Jayanth R. Varma, Indian Institute of Management, Ahmedabad (jrvarma@iimahd.ernet.in)
Impact on real economy
Pre crisis, US consumption was supported
by debt the house as an ATM.
This ATM has now stopped. Moreover, US
consumer now wants to delever.
Deleveraging and non functional banking
system affects business investment as
well.
Yet, global economy has recovered from
the depths reached after Lehman.
Real economy supported at present by
huge fiscal support and ultra loose
monetary policy.
Prof. Jayanth R. Varma, Indian Institute of Management, Ahmedabad (jrvarma@iimahd.ernet.in)
Implications for
investment management
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Prof. Jayanth R. Varma, Indian Institute of Management, Ahmedabad (jrvarma@iimahd.ernet.in)
Liquidity Risk
Buy and hold investor needs very large
reserves of liquidity and lots of courage to
hold risk assets through a crisis.
When liquidity and leverage collapse, even
basic arbitrage relations break down:
Covered interest parity
OIS versus Libor
CDS versus bonds
Asset prices can undershoot fair values.
Prof. Jayanth R. Varma, Indian Institute of Management, Ahmedabad (jrvarma@iimahd.ernet.in)
Whither diversification?
Asset class returns in 2008:
US Equity: Large cap -38%;
Mid cap -37%; Small cap -32%
Non US developed equity:
Large cap -43%. Small Cap -50%
Emerging market equities -50%
Real estate: US -43%. Non US -52%
Commodity index: -46%
High yield corporate bond -25%
US investment grade bonds -5%
US Treasury inflation indexed -6%
US Treasury bonds: 1-3 year 3%;
3-7 year 9.7% 7-10 year 13.2%
Source:
http://www.portfoliomonkey.com/blog/2009/01/03/2008-asset-class-returns-2/
Even old fashioned 60:40 asset allocation has negative returns, but
better than equities.
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Robert Arnott, Bonds: Why Bother?, Journal of Indexing,
May-June, 2009.
Whither track record?