Mortgage and Financial Crisis

Harvard Kennedy MPA/MC Seminar SeriesWilliam Werkmeister

Brandon BarfordAshish Khanna

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Executive Summary• Structured Finance 101: The “Life Cycle” of a Mortgage, Structured Products, and the BankingCrisis (Werkmeister)

• The Crisis Goes Global: Effects on the Derivative Markets, Global Contagion, and India (Khanna)

• The Government Policy Response: A Look fromthe Inside Out at the Proposed Policy Responses (Barford)

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What is “Structured Finance”• “Structured finance is one of those elusive terms that mean different things to different people.”

• In its simplest form, structured finance is usinga DEFINED or PREDETERMINED set of PROMISED future cash flows to create securities of varying investment characteristics (maturity and risk) which are, overall, more appealing to investors than the underlying assets.

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Life Cycle of a Mortgage Loan

Chase Bank’s

Original $3B Loan Portfolio

Investment Bank

Bankruptcy Remote

Trust / SPE(Issuer)

Senior Bond

Classes (AAA-BBB-)

Mezzanine ClassesEquity

• I-Bank Buys Loans• May Use “Conduit” For Smaller Issuers

• Legal Ownership of Mortgage Loan Assets Transferred ToBankruptcy Remote Trust Lowering Risk and Increasing Value of Underlying Assets

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Advantages of This Structure• Clearing Banks Balance Sheets: Allows Banks to “Liquiditate” Mortgage Loans and Lend More. Now “Bond Buyers” Essentially Own the Mortgages in the Form of Bonds• Increasing Value of Assets: The Mortgages are Worth More (“Lower Risk”) Once Moved to the Trust / SPE and Removed from Corporate Risk• Targeting Investor Needs: A Typical Offering Consists of 15 or More Bonds of Varying Default Risk Levels, Fixed/Floating Payments, Maturities

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The On-Going Payment Structure

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Restructuring Risk

Chase Bank’s Original $3B

Loan Portfolio

Money Market (AAA)

Tranches

Investment Grade, Non-

Money Market

Tranches

Mezzanine Bonds

Equity

“CREDIT ENHANCEMENT”Bonds Inherently “Safer” Than Original Mortgages

- Overcollateralization: more mortgage principal than collateralized bonds issued- Excess Spread: weighted average interestrate of bonds < weighted average interest rate of mortgage pool- Government Guarantee of Mortgage or Pools

- Bond Subordination: bond tranches pay inpreferred order- Swap Agreements: a derivative (insurance) to match mortgage paymentmethod (fixed/floating) to bond paymentmethod (fixed/floating)- Credit Wraps: financial insurance on bonds- Reserve Accounts: catch excess spread in accounts available to pay bonds in caseof shortfalls- Others: Triggers, Credit Derivatives, Surety Overcollateralization

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Credit Ratings

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Primary Buyers by Asset ClassMoney

Market (AAA) Tranches

Investment Grade, Non-

Money Market

Tranches (AAA – BBB-)

Mezzanine Bonds

Equity

Pension Funds (CALPERs)Insurance Companies (AIG, Chubb, etc.)University Endowment (Harvard)

Hedge Funds (many partially funded by the i-banks)

Money Market FundsBanksBrokers For Brokerage Account “Cash”

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The On-Going Payment Structure

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Who Got Hurt and How?Investment Grade Tranches Mezzanine Bonds Equity

• Insurance companies and pension funds suffer few P&I losses

• BUT, insurance companies are forced to raise additional capital due to rating downgrades on existing structured holdings. This means, they do not currently have the capital to but more structured bonds

• Insurance companies suffer losses on credit default swaps and credit wraps offered to protect structured bonds

What Bear Stern’s 2 MBS Hedge FundsLooked Like – Leverage (Not Size)

Assets AssetsLiab. Liab.

1bnbankinvest

4bnbank“loans”fromupgrades

5bnsecurnotes &mbs equity

15bnsecurnotes &mbs equity

1bnbankinvest

14bnbank“loans”fromupgrades

The Net: I-Banks lose a little, other lending commercial banks

hammered … “bank contagion”

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The Infamous SIVSIVs were off balance sheet entities set up by banks which bought ABS and MBS, usually 70-80% AAA-rated, and issued ABCP of shorter maturity (usually 270 days or less) profiting off of spreads of about 25 bps.

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FFG.. Still Open For BusinessFreddie, Fannie, and Ginnie still pumping out guaranteed loan pools with your tax dollars funding the efforts and assumption of risk.

Helps to maintain “liquidity” in the mortgage markets.

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The Bailout and Moral Hazard• Insurance Companies and Pension Funds are Sophisticated Investors Who Can Assess Risk and Reward – Should They Be Receiptants of a Tax Payer Funded Bailout• Potential retirement losses (pension funds)• Potential illiquidity in insurance market• Systematic issues from failures in guarantees

• The untold story: Insurance company and pension fund lobbyists were, behind the scenes, raiding the capital…

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The Bailout and Moral Hazard• Banks took some SIVs back onto their balance sheet, the i-banks structured these deals, other sophisticated banks offered highly leveraged loans to the SIVs…who bears the responsibility (taxpayers?)• However, with interbank lending and bank

lending to SIVs, we risk bank contagion with the failure of one or two big SIVs or banks…

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The Bailout and Moral Hazard• Perhaps it can be argued large commercial banks should be saved to prevent a banking failure, but why save Bear (the inventor of CMBS) and not Lehman, another investment bank.

• Why save Freddie and Fannie, and help sure up their guarantees on old loans pools (saving the likes of insurance companies, hedge funds, and pension funds) with taxpayer money versus creating new guaranteeing entities with better standards?

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How This Lead to a Real Crisis• Without MBS and ABS investors, the mortgage, small business loan, and virtually all other loan markets tightened, restricting both investment and consumer spending…

• Banks, insurance companies, and pension funds suffered REAL LOSSES, reducing retirement savings and driving financial P/E multiples to all-time lows. Many small bank failures.

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The Feds Balance Sheet

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Future Concern…Inflation• A doubling of the money supply (or base money) without a corresponding doubling in output will, in the long run, create inflation, begging the question..• How does the Fed reign in the money supply

(reduce the size of its balance sheet) and how does it get rid of all the toxic structured notes it now holds?

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Impact of Global Financial Crisis on Developing Countries: Contagion Effect

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Case of Brazil – Robust growth..

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….. until it all came crashing in IV Quarter

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In what forms did Crisis impact the developing countries

Contagion from developed world to developing

countries occurred through following modes

1. Financial Channel

2. Real Channel

3. Confidence Channel

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Impact through Financial Channel

• Drying up of overseas financing (investment

– FDI as well as institutional flows – FIIs)

• Capital outflows as part of global

deleveraging (mainly FII money)

• Need for Central Bank’s intervention in the

foreign exchange markets

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Impact also felt directly on Real Economy

• Slump in demand for exports

• Reduced investments to impact future

growth and lead to higher unemployment

• Lower remittances from migrant workers

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In addition to short run effects, confidence and trust dried up..

• Tightened global liquidity eroded

confidence

• Fear overtook greed; where fear of defaults

took over even healthy financial institutions

• Timing was bad, as it coincided with fund

requirement in the credit cycle

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Evaluating Response to Crisis between Developed and Developing World

• Origins of crisis is common

• Evolution of crisis different

Advanced economies – financial to real sector

Emerging economies – real to financial sector

• Response to crisis – country-specific

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How did India Respond to Crisis? Central Bank, RBI’s response

RBI’s monetary policy response guided by three objectives:

• Ample rupee liquidity

• Comfortable foreign exchange liquidity

• Credit flow to productive sectors

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How did Government of India Respond to the Crisis? – Fiscal Stimulus

Limited fiscal space in India, but still

• Govt.-guaranteed infrastructure spending

• Cuts in indirect taxes

• Expanded guarantee cover for micro and small enterprises

• Additional support to exports

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Presenters’ BiosWilliam Werkmeister: Prior to Harvard, Bill Werkmeister was a structured finance investment banker with Salomon Smith Barney and a Founding Partner of Aegis Texas and New York Venture Funds, economic development funds. He currently works on capital raising projects for socially beneficial businesses and non-profits, and sits on the boards of several non-profits focused on women’s and children’s related charities. He graduated summa cum laude from Cornell University with a degree in Applied Economics and Management, studied structured finance at NYU, and is now, concurrently enrolled at the Harvard Kennedy School and Yale School of Management.

Brandon Barford: Mr. Barford is currently an MPP candidate at the Harvard Kennedy School. Prior to Harvard, Barford worked in the office of Theresa May, MP of the House of Commons, and as a senior staff member of the Senate Banking Committee, where he helped draft legislation and policy to address the banking crisis. Barford holds a second masters in political economy from the London School of Economics and bachelors in political history from Boston College. He has also conducted study and research at University College, at the University of London.

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Ashish Khanna: Mr. Khanna is an Economist and a Senior Energy Specialist at the World Bank, where he focuses primarily in the area of funding the development and expansion of energy infrastructure in impoverished and developing countries. Prior to the World Bank, Mr. Khanna was a consulting manager at KPMG and Arthur Anderson, and earlier in his career, worked as a consultant for PriceWaterHouseCoopers. He graduated from Xavier Institute of Management, Bhubaneswar

Presenters’ Bios