A large number of “market-based” financing vehicles that developed in the years leading up the the 2007 crisis were designed to exploit the fact that some investors were only worried about AAA-ratings (or for commercial paper A1/P1-ratings) and didn’t bother to understand the products they were investing in. Several of these vehicles were literally designed to blow up — they had liquidation triggers that when breached in an adverse market could result in complete loss of the investment. Others were designed to draw down bank liquidity lines when the economic situation became more difficult. (The latter could only exist because of a reinterpretation of a 2004 final rule promulgated by the Joint Bank Regulators that had the effect of gutting the regulation. See here.) Others would expose investors in AAA rated assets to massive losses if mortgage default rates were significantly higher what was expected and/or exhibited more correlation than was expected.
None of these products was viable once investors and bank regulators had seen how they worked in practice. Thus, these products had a very short life and markets for them collapsed entirely in 2007-08. This post briefly reviews this history.
A. In 2007 the commercial paper segment of the shadow banking system collapsed.
The first commercial paper issuers to go were structured vehicles that didn’t have committed bank lines of liquidity support, but instead supported their commercial paper issues by contractual terms that could force liquidation in order to pay up on the commercial paper. Structured Investment Vehicles (SIVs) are examples. Shortly thereafter structured vehicles that did have bank lines of liquidity support, such as CDOs and MBS (only a small fraction of which were financed with commercial paper), drew down the bank liquidity lines with dramatic effects on the balance sheets of the banks involved. To protect the banks from catastrophe the Federal Reserve gave them special regulatory exemptions (see the Supervisory Letters to Citibank, Bank of America, and JP Morgan Chase dated August 20, 2007 and to other banks in subsequent months) and permitted banks to pledge at the discount window ABCP for which they provided back up lines of credit (WSJ Aug 27 2007). These exemptions together with the Term Auction Facility made it possible for the ABCP market to deflate slowly over the course of three years, rather than collapsing quickly and taking a few banks with it.
In short in 2007 the Federal Reserve let a variety of different shadow bank models collapse, while protecting the banks and stabilizing the money supply by keeping the ABCP market from collapsing too quickly. These decisions were classic lender of last resort decisions that had the effect of allowing some entities to fail and other to survive with central bank support. They are also fairly uncontroversial: just about everybody agrees that the Fed acted appropriately at this point in the crisis.
B. From 2007 to 2008 a huge number of structured finance vehicles went Boom
At the same time some of the more esoteric structured vehicles that issued longer term obligations but also relied on liquidation triggers to support their issues blew up. Examples of this category include Leveraged Super Senior CDOs and Constant Proportion Debt Obligations. In a leveraged super senior CDO investors pay, for example, $60 million to earn 1.5% per annum spread over safe assets by selling an insurance policy (that is, CDS protection) on the $750 million most senior tranche of a CDO. Because the investors are putting up so little money the LSS CDO has a liquidation trigger, so that if the insured tranche falls by, for example, 4% in value, the structured liquidates, and an alternate insurance policy is purchased on the market. The investors then get whatever is left after the insured party is protected. These structures all blew up in 2007.
The Constant Proportion Debt Obligation was an even crazier product. Instead of insuring only the senior most tranche of a CDO, it sold insurance on a high grade bond index, including 125 names. Because there were no subordinated tranches to protect it from losses, the insurance premium was higher. The CPDO was structured to take the excess insurance premium (i.e. that which was not paid out as a bond yield to the marks who “invested” in this AAA-rated product) and put it aside. If everything goes well in three years the CPDO can stop insuring debt and pay the promised yield by just investing in safe assets. Of course, if everything goes badly, liquidation triggers are hit and the investor loses. Guess what happened in 2007?
CDO squared and ABS CDO’s are similarly products that pay an investor a bond-like yield to take an equity-like risk. They, however, had tranches that were rated up to AAA by the rating agencies, and in some cases even the brokers selling the products appeared to believe that they were just another kind of bond. Cordell, Huang & Williams (2012) found that the AAA-rated ABS CDO bonds lost more than half their value. More specifically they found that median junior AAA-rated ABS CDO bond lost 100% of its value, and that senior AAA-rated ABS CDO bonds did better, but also lost more than half of their value. And virtually every bond rated below AAA lost all of its value (Table 12). Now that investors understand this product, they won’t touch it with a ten foot pole.
C. Private Label Mortgage Backed Securitization evaporates
Underlying the losses on ABS CDOs were losses on private label mortgage backed securities. 75% of ABS CDO issuance was in the years 2005-2007 and over these years 68-78% of the collateral in ABS CDOs was private label mortgage collateral
(again from the great paper by Cordell, Huang and Williams Figure 2).
Cordell, Huang and Williams also finds that the lower tranches of subprime MBS were apparently never sold in any significant numbers to investors. Instead they were placed into CDOs (p. 9). This inability to place the lower rated tranches as well as other structural problems with the treatment of investors may explain the complete collapse of the private label MBS market, which is documented in Goodman 2015.
In short, SIVs, CDOs, and private label MBS were all effectively shadow banks that provided financing to the real economy during their lifetimes, but were not structured in a way that made them viable long term products. Thus, they disappeared as soon as they were exposed to an adverse environment. When this happened, the funding they had provided to the real economy disappeared (see Mian and Sufi 2018). This showed up as funding stress on the market.
Despite the stress the failures of these vehicles put on markets, the consensus seems to be universal that the Federal Reserve’s job was to protect the regulated banks, not to worry about the disappearance of the “market-based” lending structures. On the other hand, the liquidation and deterioration of these products sent waves through financial markets from August 2007 on that the Federal Reserve and the other central banks had to navigate.