Kapish Kaushal http://in.linkedin.com/pub/kapish-kaushal/37/7a1/124

Introduction:

Homeowners (Mortgages) Investors (Money)

Investors are always looking for avenues to multiply their wealth. One of the safest source of return

for them was the US government backed T-Bill and T-Bonds.

Early 2000s: Dot Com Bubble Burst and 9/11

1% was too low a return for investors. For the banks on Wall Street, this was a blessing as the banks

can borrow funds by merely paying a 1% rate of interest.

Wall Street

Alan Greenspan, then Federal

Reserve chairman, in order to

provide a boost to the US Economy

lowered the interest rate to 1%.

Logic:

Decline in Interest Rate

Increase in Investment

More projects undertaken, more

employment, increase in output

Increase in Consumption Levels

With abundance of cheap credit, banks start to lever their balance sheets and grows tremendously

rich.

Now, investors (Pension Funds, Insurance Companies, Asset Management firms, Alternate

Investment Firms, Private Equity players etc.) by seeing this wanted a piece of action

Part 1:

All this was based on the premise that the collateral was the “house” and the housing prices were

rising. So, in case a mortgage borrower defaults, the bank will take possession of the house and sell

it off to recover its stake in it.

Basic CDOs (Collateralised debt obligations) are investment grade securities backed by a pool of

bonds, loans and other assets. A financial institution such as a bank will purchase these CDOs and

divide them into tranches, or pieces of CDO that are grouped according to risk and are available for

purchase. Tranches are then sold to investors based on their desired amount of risk, with a higher

risk tranche paying out a higher premium.

The purpose of these products is to create tiered cash flows from mortgages and other debt

obligations that ultimately make the entire cost of lending cheaper for the economy. The idea is that

if CDOs can break up the pool of debt repayments into streams of investments with different cash

flows, there will be a larger group of investors willing to buy in.

Thus, the intention of CDOs was to create products suitable for different kinds of investors. As the

investment banks sell of their CDOs to investors, they make a return much higher than 1% (at which

they borrowed).

Similarly, the passing game continues with investors selling CDOs to other investors at higher prices

thereby making return on the spread. However, the fundamental premise of this model is the

mortgage payments that are flowing from the mortgage borrowers.

Part 2:

As investment banks reached out to mortgage lenders for more borrowers, there were none left.

Thus, the focus shifted to sub-prime borrowers.

Sub-Prime: No down payment, No proof of income, free money

It was believed that if the sub-prime owners default, then the houses can be sold and the money can

be recovered. The house prices were on the rise.

And eventually, the sub prime borrowers defaulted

The investment banks which were receiving monthly payments stopped receiving them. With more

and more defaults, the banks got more and more houses

As the supply of houses increased with banks and were put up for sale, the prices started to drop.

Seeing the prices drop, the prime borrowers who could afford to pay the loan also defaulted

because the value of the loan became greater than the price of the house.

As things followed, banks had assets on balance sheet in the form of houses but little liquid cash and

this drying up of liquidity, inability to meet payments saw banks going bust.

Lehman Brothers Collapsed (European and Asian operations acquired by Nomura, American

operations by Barclays)

Bear Sterns acquired by JP Morgan Chase

Merrill Lynch acquired by Bank of America

Losses at various financial institutions. Even healthy banks stopped trusting one another and

avoided inter-bank lending as it was hard to discern which institution would be the next to

go out of business. Due to this widespread fear and distrust, the ability of the financial

system to make loans even to creditworthy customers was impaired

Most companies rely on the financial system to get the resources they need for business

expansion or to help manage their short-term cash flows. With the financial system less able

to perform its normal operations, the profitability of many companies was called into

question. This led to volatility in stock market

High volatility in turn led to a decline in consumer confidence. In the midst of all uncertainty,

households started shelving off all spending plans

Consumption decreased, Investment decreased (Large contractionary shift of the IS

curve).LM shifted leftward due to decline in the credit flow

The consequences led to a leftward shift of the IS curve and the LM curve thereby bring an acute

short-down in the income levels.

The government’s reaction to counter this was: Expansionary Fiscal and Expansionary Monetary

Policy

Target for the interest rate cut to 0% in December 2008

Congress appropriated $700bn for the treasury to rescue the financial system. Much of

these funds were used for equity injections into the banks. The treasury put funds into the

banking system, which the bank could use to make the loans; in exchange for these funds,

the US govt. became a part owner of these banks, at least temporarily. (Increase in Govt.

Spending)

The expansionary monetary policy works by increasing the money supply thereby causing a

decrease in interest rate and hence stimulating investment. However, if interest rates have

already fallen to zero, then the monetary policy is no longer effective. (Liquidity Trap)

Thus, when the interest rates are already zero, the increase in money supply will not have much

effect. Aggregate demand, production and employment may be “trapped” at low levels. People

are indifferent between holding money and holding bonds. The demand for money becomes

horizontal.

Thus, the expansionary monetary policy was not working and expansionary fiscal policy was

having a limited effect. Hence, the shift to Quantitative Easing

Part 3:

QE is an unconventional monetary policy used by central banks to stimulate the national

economy when conventional monetary policy has become ineffective.

A central bank implements QE by purchasing financial assets from banks & other private sector

businesses with new electronically created money. The action increases the excess reserves of

the bank and also raises the prices of financial assets they bought, which lowers their yield. QE is

thus used by monetary authorities to further stimulate the economy, by purchasing assets of

larger maturity than only short-term govt. bonds and thereby lowering interest rates further out

on the yield curve.

The Fed engaged in three successive rounds of QE since 2008, and each had its own unique

characteristics

QE1 (December 2008). In December 2008, the Fed started buying longer-term Treasury

securities as well as the debt and the mortgage-backed securities (MBS) of Fannie Mae and

Freddie Mac, two government-sponsored enterprises (GSEs). The Fed announced it would

purchase up to $100 billion of the GSEs’ debt and up to $500 billion of their MBS from both

banks and the GSEs themselves.

QE2 (November 2010). In November 2010, the Fed announced that it would purchase $75 billion

per month of longer-termed Treasuries, for a total of $600 billion. These purchases were to be

concentrated in Treasury securities with maturities of two to 10 years, though the Fed also

intended to purchase some shorter-term and some longer-term securities.

QE3 (September 2012). In September 2012, the Fed announced its third round of easing, now

referred to as QE3. Under QE3, the Fed’s combined securities purchases (long-term Treasuries,

GSE debt, and MBS) were increased to approximately $85 billion per month. Unlike its

counterparts, QE3 was an open-ended commitment. Rather than commit to purchasing a fixed

amount of securities by a certain date, the Fed declared that it would make purchases until it

decided that the labor market had sufficiently improved.

The Effects of Quantitative Easing

The primary effect of QE was the substantial increase in Fed’s balance sheet. As it continues to

purchase assets, its balance sheet continues to expand. In particular, the Fed now holds more

than five times the amount of securities it had prior to the 2008 crisis. The Fed’s balance sheet

expanded from about $850b to more than $4.4 trn.

The Fed holds approximately $2.3 trillion in long-term Treasuries, and $1.7 trillion in GSE

securities. According to Richard Fisher, president of the Dallas Federal Reserve Bank, the Fed

now holds more than 30 percent of the stock of outstanding MBS and nearly 25 percent of

outstanding Treasuries. All three rounds of the QEs, as well as the Fed’s “normal” open-market

purchases, were supposed to increase economic activity through additional lending.

Instead of creating new money through additional lending, the Fed’s QE policies have greatly

expanded the amount of excess reserves in the banking system. In other words, banks have

mostly decided to hold onto the cash that the Fed gave them when it executed all those

securities purchases. Consequently, it is rather difficult to argue that these Fed policies have

done much to expand the economy.

Banks earn profits when they create new money through lending, but they lose money when

they make bad loans. Many banks are likely waiting for economic conditions to improve, and

simply do not have many profitable lending opportunities. Similarly, banks are likely hesitant to

make too many loans given the regulatory uncertainties surrounding the 2010 Dodd–Frank Wall

Street Reform and Consumer Protection Act. There is strong reason to believe these regulatory

chokeholds on banks have slowed growth.

The fact that the Fed started paying interest on reserves in October 2008, something it had not

previously done, could also explain the buildup in (idle) excess reserves. This new policy lowered

banks’ incentive to create more money with new reserve balances because it reduced the cost of

holding excess reserves. On the surface, it makes little sense for the Fed to flood the market with

trillions in reserves and simultaneously induce banks to forgo using them to make new loans.

A large portion of these QE purchases, however, removed some of the riskiest assets—Fannie’s

and Freddie’s debt and MBS—from commercial banks’ balance sheets. This fact has led some to

argue that the Fed designed the QE programs as a way to bail out banks, not merely as a new

form of expansionary monetary policy. Regardless of the true intent, the QE programs have been

so controversial because they effectively exchanged cash—created out of thin air—for bank

assets that had dramatically declined in value. From the perspective of banks, the QEs could be

judged a success because the purchases strengthened their financial position.

Controversy arises because those assets—including the MBS frequently referred to as “toxic”

assets—have not simply disappeared. These assets are now on the Federal Reserve’s balance

sheet. Put differently, the Fed now holds trillions of dollars in debt of two insolvent companies

as well as the same securities that led to the 2008 financial crisis.

Tapering

Although the Fed has not announced an official end to the program, it began purchasing smaller

amounts of bonds, referred to as tapering, in January 2014. The Fed has been reducing its

purchases by approximately $10 billion per month. Beginning in July 2014, the Fed was set to

purchase only $35 billion of these securities ($15 billion in MBS and $20 billion in long-term

Treasuries) each month. The Fed is still expanding its balance sheet, merely at a slower rate than

in the past.

As the bond purchasing comes to an end, the Fed slowly will begin to increase interest rates

which will bring huge inflows of money to the US Economy and thereby strengthening the US

dollar.

Thus, to summarize as the monetary policy did not yield the desired outcome, QE’s intention

was to facilitate easy money for corporates via banks so as to create investment and hence jobs

and increase in productivity.

Part 4:

While we have discussed monetary policy, it’s now time to look at the other side of the

coin…The Fiscal Policy and the excessive govt. spending which led to the issue of fiscal cliff, debt

ceiling and govt. shutdown in the last 3 years

Fiscal Cliff

The United States fiscal cliff was a situation that came into existence in January 2013 whereby a

series of previously enacted laws would simultaneously come into effect. Primary amongst this

were the Bush tax cuts of 2001 which had been extended for two years back in 2010. The

bottomline was that the discretionary spending for federal agencies and cabinet departments

would have been reduced through broad cuts referred to as budget sequestration. (Mandatory

programs, such as Social Security, Medicaid, federal pay (including military pay and pensions)

and veterans' benefits would have been exempted from the spending cuts.) The fiscal cliff

would increase tax rates and decrease government spending through sequestration, and lead

to an operating deficit (the amount by which government spending exceeds its revenue) which

was projected to be reduced by roughly half in 2013. The Congressional Budget Office (CBO) had

estimated that the fiscal cliff would have likely led to a mild recession with higher

unemployment in 2013, followed by strengthening in the labor market with increased economic

growth.

The American Taxpayer Relief Act of 2012 (ATRA) addressed the revenue side of the fiscal cliff

by implementing smaller tax increases compared to the expiration of the Bush tax cuts.

Adjustments to spending were expected to be resolved in early 2013. Intense debate and media

coverage about the fiscal cliff drew widespread public attention during the end of 2012 because

of its projected short-term fiscal and economic impact. ATRA eliminated much of the tax side of

the fiscal cliff while the reduction in spending due to budget sequestration was delayed for

two months. With ATRA's passage, the CBO projected an 8.13% increase in revenue and 1.15%

increase in spending for fiscal year 2013. The act resulted in a projected $157 billion decline in

the 2013 deficit over 2012, rather than the sharp $487 billion decrease projected under the

fiscal cliff.

However, the budget sequestration was only delayed and the debt ceiling was not changed,

leading to the United States debt ceiling crisis of 2013.

Debt Ceiling Crisis of 2013

Debt ceiling is the legal limit on the total amount that the government can accrue. Once the

government reaches this legal limit, it can no longer issue its debt (bonds, notes etc.). With no

funds, govt. cannot pay day-to-day bills. If the govt. itself fails to pay the debt, the interest rate

will begin to rise. Since the govt. interest rate is used as a benchmark for other kinds of loans like

house, vehicle, education etc., it will lead to an increase in their interest rates as well.

The crisis began in January 2013 and ended on October 17, 2013 with the passing of the

Continuing Appropriations Act, 2014, though the debate continues.

After the passing in early January 2013 of the American Taxpayer Relief Act of 2012 to avert the

projected fiscal cliff, political attention shifted to the debt ceiling. The debt ceiling had

technically been reached on December 31, 2012, when the Treasury Department commenced

"extraordinary measures" to enable the continued financing of the government. The debt ceiling

is part of a law (Title 31 of the United States Code, section 3101) created by Congress. According

to the Government Accountability Office, "The debt limit does not control or limit the ability of

the federal government to run deficits or incur obligations. Rather, it is a limit on the ability to

pay obligations already incurred." It does not prohibit Congress from creating further obligations

upon the United States. The ceiling was last set at $16.4 trillion in 2011.

On January 15, 2013, Fitch Ratings warned that delays in raising the debt ceiling could result in a

formal review of its credit rating of the U.S., potentially leading to it being downgraded from

AAA. Fitch cautioned that a downgrade could also result from the absence of a plan to bring

down the deficit in the medium term. Additionally, the company stated that "In Fitch's opinion,

the debt ceiling is an ineffective and potentially dangerous mechanism for enforcing fiscal

discipline.

In a press conference held on January 14, 2013, President Obama stated that not raising the

debt ceiling would cause delays in payments including benefits and government employees'

salaries and lead to default on government debt. President Obama urged Congress to raise the

debt ceiling without conditions to avoid a default by the United States on government debt.

Raising the debt ceiling was also supported by Ben Bernanke, chairman of the Federal Reserve.

Republican Speaker of the House, John Boehner and the Senate Republican minority leader,

Mitch McConnell as well as other Republicans argued that the debt ceiling should not be raised

unless spending is cut by an amount equal to or greater than the debt ceiling increase.

Republicans also argued that the Treasury can avoid debt default by prioritizing interest

payments on government debt over other obligations. Heritage Action for America, the Family

Research Council and the Club for Growth argued that a rise in the debt ceiling should be

accompanied by a plan to balance the budget within ten years, through reduced spending in the

discretionary budget as well as for entitlements. Several Democratic House members, including

Peter Welch, proposed removing the debt ceiling altogether. This proposal found support from

some economists such as Jacob Funk Kirkegaard, a senior fellow at the Peterson Institute for

International Economics. A survey of 38 economists found that 84% agreed that a separate debt

ceiling that is periodically increased could lead to uncertainty and poor fiscal outcomes.

On February 4, 2013, President Obama signed into law the "No Budget, No Pay Act of 2013",

which suspended the U.S. debt ceiling through May 18, 2013. The bill was passed in the Senate

one week previously by a vote of 64-34, with all "no" votes from Republican senators, who were

critical of the lack of spending cuts that accompanied an increase in the limit. In the House, the

bill passed the week before by a vote of 285-144, with both parties voting in favor.

On May 19, the debt ceiling was reinstated at just under $16.7 trillion to reflect borrowing

during the suspension period. As there was no provision made for further commitments after

the ceiling's reinstatement, Treasury began applying extraordinary measures once again. Despite

earlier estimates of late July, Treasury announced that default would not happen "until

sometime after Labor Day". Other organizations, including the Congressional Budget Office

(CBO), projected exhaustion of the extraordinary measures in October or possibly November. On

August 26, 2013, Treasury informed Congress that if the debt ceiling was not raised in time, the

United States would be forced to default on its debt sometime in mid-October. On September

25, Treasury announced that extraordinary measures would be exhausted no later than October

17, leaving Treasury with about $30 billion in cash, plus incoming revenue, but no ability to

borrow money. The CBO estimated that the exact date on which Treasury would have had to

begin prioritizing/delaying bills and/or actually defaulting on some obligations would fall

between October 22 and November 1

The US Government went into a partial shutdown on October 1, 2013, with about 800,000

Federal employees being put on temporary leave. Treasury Secretary Jack Lew reiterated that

the debt ceiling would need to be raised by October 17

On October 16, the Senate passed the Continuing Appropriations Act, 2014, a continuing

resolution, to fund the government until January 15, 2014, and suspending the debt ceiling until

February 7, 2014, thus ending both the United States federal government shutdown of 2013 and

the United States debt-ceiling crisis of 2013.

On January 14, 2014, the House and the Senate Appropriations Committees agreed on a

spending plan that would fund the federal government for two years. A bill extending the

previous continuing resolution through January 18 was also passed. On January 16, 2014,

Congress passed a $1.1 trillion appropriations bill that will keep the federal government funded

until October 2014. President Obama signed the appropriations bill into law on January 18. On

February 7, 2014, the debt limit suspension expired and treasury began applying extraordinary

measures once again, warning that such measures would not last beyond February 27 due to

large tax refunds that would need to be paid during February. On February 11th, after finding

insufficient support for various conditions for increasing the debt ceiling, the house passed a

bill suspending the debt ceiling without conditions through March 15, 2015. The senate passed

the bill unamended on February 12, 2014, and it was signed by the president on February 15.

Conclusion

Thus, post the crisis, both expansionary fiscal policy and expansionary monetary policy were the

response of the government and the Fed to shift the IS and LM curves rightward.

Going forward, the interesting thing to look forward in the months to come is the interest rate

guidance by the Fed. Early signs tell us that the rise in interest rate would be in early 2015 and it

will have repercussions for the global economy.

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Appendix 1: Role of Fannie Mae and Freddie Mac in the Crisis

Fannie Mae and Freddie Mac are govt. sponsored enterprises (GSEs). This means that they are

privately owned, but receive support from the Federal government. The GSEs provide a

secondary market in mortgages from the lenders who originate them. They hold some of these

mortgages and some of them are securitised i.e. sold in form of securities which the GSEs

guarantee.

The purpose of Fannie Mae and Freddie Mac was to expand the secondary mortgage market.

(market for the sale of securities collateralised by the value of mortgage loans i.e. CMOs). The

idea was to allow lenders to reinvest their assets into more lending and in effect increasing the

number of lenders in the mortgage market and reducing reliance on thrifts. (a savings and loan

association that specialises in accepting and saving deposits and making mortgage and other

loans)

In 2008, Fannie Mae and Freddie Mac had owned or guaranteed about half of the $12trn

mortgage market. Their bonds were owned by everyone from the Chinese govt. to money

market funds to the retirement funds of hundreds of millions of people.

Thus, when the investment banks were buying from the mortgage lenders, it was under the

guarantee of GSEs whose prerogative was to expand the secondary mortgage market. Their

failure to identify and perhaps promote the loans being rolled out to sub-prime borrowers had a

significant impact.

Appendix 2: Credit Default Swap and Role of AIG

It is the most widely used type of credit derivative. A CDS contract involves the transfer of credit

risk of mortgage backed securities (MBS) or corporate debt between two parties. There are two

parties to any CDS contract.

The buyer of CDS who is looking for protection against some uncertain event. The seller of CDS

who assumes the credit risk in exchange for a fee. If a negative event occurs, then the buyer of

CDS benefits and the seller will deliver current cash value or some other form of repayment. If

“no” negative event occurs, the seller receives the periodic fee.

A CDS contract can be used as a hedge policy against the default of a bond or loan. However, it

can be a highly speculative instrument as well. An investor with a “positive” view on the credit

quality of a company can sell protection and collect the payments that go along with it. An

investor with a “negative” view on company’s credit can buy protection for a relatively small

periodic fee and receive a big payoff if the company defaults on its bonds.

CDS are regularly traded with the value of contract fluctuating on the increasing or decreasing

probability of credit quality. Pertaining to the 2008 crisis, CDS started to used as an instrument

to get exposure to certain asset classes, various bonds and loans.

E.g. if one thinks that XYZ Corp is in trouble and won’t be able to pay back, then one can

speculate by buying a CDS on their bonds, which pays the full face amount of the bond if they

actually default.

These CDS were written on sub-prime mortgage securities. AIG was the seller of CDS. It had sold

$441bn worth of swaps on corporate bonds and mortgage backed securities. As the value of

these insured-referenced entities fell, AIG had massive write-downs and eventually required a

govt. bail-out.

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Sources:

1. Articles from “The Economist”

2. Articles from “The Guardian”

3. Articles from “The Telegraph”

4. Wikipedia

5. Investopedia: The Credit Crisis Visualised Video