Decoding the Liquidity Conundrum of 2008: How the events played out.

To understand the liquidity conundrum of 2008, we need to understand the difference between banks and non banks. In U.S. banks are highly regulated and have to maintain capital requirements and adhere to reserve ratios. The deposits of banks are insured by FDIC, which means that depositors are not concerned what the bank is doing with the money as the deposit is secured by the government. Another features that distinguishes banks from non banks is that the banks can discount their assets with the central bank to repay the depositor when required be. On the flip side non banks or the shadow banking system consist of conduits like REIT, CLO, CDO etc. These are levered institutions which take a lot of risk and are loosely regulated. they don’t have access to fed Discount window and deposits are not secured by FDIC. Therefore non banks are more susceptible to change in the risk appetite of their deposit base. Two primary funding sources of their deposit base – reverse repo and asset backed commercial paper. When the market’s risk appetite is strong, the liabilities of shadow banking system look stable. Brokers MTM investor’s collateral at face value, requiring reasonable margins and never hassle the non banks for more collateral and the asset backed commercial paper is picking up 2-3 bps versus conventional commercial paper. Everything looks fine, every 45-90 days bankers roll over the asset backed commercial paper and effectively the shadow banks have the same stability in their liabilities as the traditional banks. Rating agencies act as quasi regulators in case of shadow banks. However the shadow banks are able to get better of credit rating agencies by securing desired rating for their products through external and internal credit enhancements.

Non banks were able to hold an asset at a tighter spread than the regular banking system because leverage allows a non bank to hold an asset at a tighter spread relative to its funding cost and still generate an acceptable return on equity. For example if one broker has levered 12 times and another has levered 50 times and they have the same return on equity objective , then the broker who is levered 50 times will buy all the assets. This was the reality at the beginning of 2007. Those who questioned the reasonableness of the spreads were told that it was all a result of an enormous pool of liquidity. But the game was coming to an end. The liquidity was in fact was leverage and non transparent pool of money. The first sign was that when structured investment began to issue asset backed commercial paper, which gave the issuer the option to extend the maturity for a fixed period of time. This made the buyer the lender of last resort for a mere 2 bps. In Feb 2007, a Bear Sterns HF revealed that its reverse repo lenders had asked for more collateral to ensure that it does not lose money on the investment. When Bear Sterns conceded that it did not have more collateral, the lenders decided to sell off the collateral that they had. This was a wakeup call that initiated a run on the shadow banking system and the disappearance of liquidity. Traditional banks could not experience bank runs because FDIC insurance makes the govt the lender of last resort. Shadow banks however did experience the modern day version of bank run in 2007. The combination of not having the protections of FDIC, being under pressure from reverse repo brokers to put up more collateral, and facing an asset backed commercial paper market that refused to refinance took the market from unlimited liquidity to liquidity crunch. The non banks could not sell their assets fast enough to satisfy the increased risk aversion of their lenders. The liquidity dissipated and volatility returned to the market because investors state of mind changed their risk appetite. Financial instability hypothesis – This hypothesis states that stability is inherently destabilizing because stability leads to the extrapolation of stability into infinity, which encourage more risk seeking financial structures, particularly with debt. Therefore the more stability a marker has and the longer it lasts, the more unstable the foundation of the stability becomes. Stability is destabilizing because it begets more unstable debt structures.

Problem with the housing market

In this situation a borrower who buys an asset, the income generated by the asset plus other income is insufficient for amortizing the principal or even playing all of the interest. At the maturity the borrower has a balloon payment bigger than the original loan as the interest was not paid. The borrower is betting that the value of the collateral will go up. Borrowers who take on a Ponzi debt are betting that if they can buy an overvalued asset, when the balloon payment comes due, another borrower will pay a higher overvalued price for the collateral. The collateral cannot just hold its value, it has to go up.

By 2006 the preponderance of debt creation at the margin was Ponzi unit finance. A classic example is the 2/28 subprime adjustable rate mortgage in which borrowers put no money down, get a teaser rate for two years, and can opt to pay less than the full amount of interest. The borrowers choose how much interest to pay, and the rest is put towards principal. After two years the interest rate goes up by 5%. The majority of the marginal borrowers for the year 2004-2006 made use of this mortgage structure.

No one defaulted as the property prices were going up and there was no gain in defaulting on the balloon payments. But by the first quarter of 2007, the subprime mortgages issued in 2006 had a surge of early payment defaults. The percentage of borrowers not making the first payment on their mortgages rose quickly which signalled that the property market had reached the ponzi stage. The value of the property was less than the value of the loan due, so there was no gain in paying up the loans hence the defaults.