Understanding the Credit crunch

As the sub prime crisis unfolded, linkages among different markets became evident. The uncertainty in the interbank market spilled over to the corporate market, especially for lower rated loans and bonds. Banks had been using junk bonds to finance leveraged buyouts. They had hoped to off-load them to investors quickly. But in the troubled environment, the junk bonds remained on the balance sheet.

Monolines briefly mentioned earlier, had been providing insurance on municipal bonds. This was widely considered a pretty safe business as state and local governments rarely defaulted. But many guarantors expanded beyond this business. They entered the CDS market in a big way. The rating agencies threatened to downgrade the ratings of the bond insurer. And as the bond insurers were downgraded, so too were the bond issuers. Even municipalities with stable finances found interest rates on their bonds going up.

As the mortgage market correction gained momentum, investors began to focus more closely on credit quality and valuation challenges in illiquid markets. The first signs of the impending liquidity squeeze came in the asset-backed commercial paper (ABCP) market, when issuers began to encounter difficulties rolling over outstanding volumes. When nervousness about funding needs and the liabilities of banks intensified, liquidity demand surged, causing a major disruption in the interbank money markets.

Mark Brunnermeier [ “Deciphering the liquidity and credit crunch 2007-2008,” Journal of Economic Perspectives.], has explained how liquidity problems amplified the sub prime crisis in various ways. When asset prices dropped, financial institutions’ capital eroded and, at the same time, lending standards and margins tightened. Both effects caused fire-sales, pushing down prices and tightening funding even further. Banks also became concerned about their future access to capital markets and started hoarding funds.

The nature of funding aggravated these problems. Most investors preferred assets with short maturities, such as short-term money market funds. It allowed them to withdraw funds at short notice to accommodate their own funding needs. It might also have served as a commitment device to discipline banks with the threat of possible withdrawals. On the other hand, most mortgages had maturities measured in decades.

In the traditional banking model, commercial banks financed these loans with deposits that could be withdrawn at short notice. In the build up to sub prime, the same maturity mismatch was transferred to a “shadow” banking system consisting of off-balance-sheet investment vehicles and conduits. These structured investment vehicles raised funds by selling short-term asset-backed commercial paper with an average maturity of 90 days and medium-term notes with an average maturity of just over one year, primarily to money market funds.

The strategy of off-balance-sheet vehicles—investing in long-term assets and borrowing with short-term paper—exposed the banks to funding liquidity risk. To ensure funding liquidity for the vehicle, the sponsoring bank had granted a credit line to the vehicle, called a “liquidity backstop.” As a result, the banking system still carried the liquidity risk. When investors suddenly stopped buying asset-backed commercial paper, preventing these vehicles from rolling over their short-term debt, the assets came back to the balance sheets of the banks.

Another important trend was an increase in the maturity mismatch on the balance sheet of investment banks, due to a growth on balance sheet financing with short-term repurchase agreements, or “repos.” Much of the growth in repo financing as a fraction of investment banks’ total assets was due to an increase in overnight repos. The fraction of total investment bank assets financed by overnight repos (as opposed to term repos with a maturity of upto three months) roughly doubled from 2000 to 2007. The excessive dependence on overnight repos caused serious liquidity problems as the crisis aggravated.