Summary of ‘deciphering the Liquidity and Credit Crunch 2007-2008'

The financial crisis in 2007 and 2008 specifically experienced two severe circumstances. On the one hand, the banks wrote down several hundred billion dollars bad loan caused by mortgage delinquencies, driven by the bursting housing bubble. On the other hand, the stock market of major banks fell dramatically. Both circumstances damaged the real economy severely. There are two key factors leading up to the housing bubble. First, the interest rate in U.S. was low because of foreign capital inflows and the lax interest rate policy adopted by the Federal Reserve. Meanwhile, the banking system applied an ‘originate and distribute’ model, rather than traditional model, in which the issuing banks hold loans on their balance sheets until repayment is made.

Two trends in the banking industry significantly had contributed to the lending boom and housing bubble that laid the bottom for the crisis. Firstly, the ‘originate and distribute’ model enabled the bank to repackage loans and pass them on to other financial investors, together with the risk. Secondly, banks used more and more shorter financing, leading to liquidity squeeze.

When move to the ‘originate and distribute’ model, banks create ‘structured’ products to reduce risk. These products are referred as collateralized debt obligations (CDO). The bank at first groups various mortgages and other types of loans, corporate bonds and other assets together to form diversified portfolios. Then these portfolios are divided into different tranches. These tranches are sold to invest groups with different attitude towards risk. The safest tranche provides a low interest rate while it’s the first to be paid. Each tranche will receive a rating to demonstrate its riskiness. Usually, the issuing bank will hold the least safe tranche. Another kind of product, credit default swap (CDS), is created to offer protection to buyers of tranches. Such buyers can contract with the bank and pay a periodic fixed fee in exchange for contingent payment in the event of credit default. It is believed that, a combination of an AAA-rated tranche and a CDS will actually have low risk since the probability of default of the CDS counterparty is small. One of the advantages of such kind of securitization is that, risk will be delivered to those who wish to bear it and allows for lower interest rate. Moreover, certain institutional investors can hold assets that they were not allowed to hold before by regulation. Besides, other factors also contribute to the rise in popularity of structured investment vehicles, for instance, regulatory and ratings arbitrage. The capital charge for loans required by the Basel I was much lower than that for contractual credit lines. Moving a pool of loans into off-balance-sheet vehicles and granting a credit line to that pool to ensure an AAA-rating, would allow banks to reduce capital to hold under same risk level. For the Basel II, the capital charges