Speech by Governor Svein Gjedrem at the annual meeting of the Norwegian Savings Banks Association (1)
Financial markets in different countries have become more closely interwoven over the past few years. New participants have appeared and new and more complex products to diversify risk have been introduced--also across national borders. Some of these products were put to the test for the first time during this autumn's turbulence in credit and money markets. Triggered by problems in the subprime mortgage market in the US, the turbulence quickly spread to other parts of the financial markets.
In my remarks today, I will try to describe the driving forces behind these developments and the contagion effects on the Norwegian money and credit markets, with a discussion of the lessons to be drawn.
Turbulence in the financial sector
The US subprime mortgage market has expanded sharply in recent years. These mortgages often have low interest rates at the beginning of the loan term followed by higher interest rates after a period. Subprime mortgages are based on expectations of a rise in house prices. Borrowers can refinance their mortgage when house prices rise and thus maintain their debt-servicing capacity. Alternatively, they can sell their house at a profit.
In 2006, there was a turnaround in the US housing market and the rise in house prices began to slow (see Chart 1). This pulled the carpet from under many investments and resulted after a period in rising defaults on mortgages. These developments then triggered widespread turbulence in money and credit markets.
The US mortgage market has gradually developed into a complex structure with a large number of participants. The distance between borrower and investor can be considerable. Chart 2 shows possible interlinkages in the US subprime market. There is a long chain of intermediaries. On the one side is a borrower who wishes to take out a mortgage in order to buy a house. Between the borrower and the lender is an agent who functions as sales channel. The lender is a financial institution specialising in granting and following up these mortgages. The ABS special purpose vehicle buys the mortgage and packages it with other mortgages. The mortgages are financed by tranched securities. The mezzanine tranches are sold to another special purpose vehicle, which repackages them and issues CDOs. A conduit invests in the senior tranches and obtains its financing by issuing asset-backed commercial paper. The commercial paper is bought by a money market fund, which in turn has received its capital from savers.
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Banks can be involved in all stages of the chain. A bank may have an ownership share in and/or provide credit lines to both the lender and several other types of special purpose vehicles. If problems arise in one of more of the intermediaries, the responsibility easily falls on the bank. US and European banks have also invested in securities issued by special purpose vehicles.
An important part of the process is the packaging of mortgages by special purpose vehicles. The senior tranches have a high rating. The subprime mortgage market has thus gained access to funding from insurance companies and other asset managers that would not otherwise have invested in this market, and credit risk associated with these mortgages has been spread to international financial markets.
Rising defaults on subprime mortgages resulted in a sharp rise in the yield spread between securities backed by this type of loan and US government bonds (see Chart 3).
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The turmoil quickly spread to other parts of the financial markets.
Uncertainty arose in banks that were directly or indirectly exposed to losses on subprime mortgages. Banks' oversight of their own potential losses was poor. It was also unclear to what extent special purpose vehicles would draw on credit lines. A number of private equity companies had difficulty obtaining financing in bond markets for their leveraged buy-outs. As a result, banks that had guaranteed temporary funding for these companies were left holding these loans for longer than originally planned. For both these reasons, banks did not know how much their balance sheets would grow. This created uncertainty as to their own liquidity requirements.
Banks were also uncertain about the size of potential losses in other banks. Information was not available to indicate which banks were exposed to losses in the US subprime market. In addition, it was difficult to pin down the actual risk associated with subprime-related securities. Banks became highly reluctant to lend to each other, resulting in a marked increase in money market rates.
Several funds began to lose money on securities backed by US mortgages. As a result, customers wanted to redeem their investments. The funds were forced to sell securities in order to meet their customers' demands. Since a number of the securities they held were not easy to trade, the funds were pressured into selling highly rated paper. This led to a fall in prices even for highly rated securities.
Equity prices fell, and bond markets saw a pronounced rise in credit spreads (see Chart 4). In spite of high earnings and a low level of defaults, credit spreads have risen for both US and European corporate bonds with a BBB rating. Credit spreads have also increased for US bonds with speculative-grade ratings, i.e. ratings lower than BBB-, even though there are no signs of more widespread problems in these markets. For emerging markets, credit spreads have increased somewhat, but the impact of the turbulence on these markets seems so far to be moderate. Equity markets have also seen a turnaround and in a number of countries have now regained lost ground.
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The market for asset-backed commercial paper has been severely affected (see Chart 5). The amount of paper outstanding has fallen markedly, and the share of short-maturity paper has increased. This is in part due to the withdrawal of a number of money market funds from this market. Substantial losses in this type of fund would have resulted in customer flight and funds are therefore having to dispose of their investments in markets that are now considered uncertain.
The current turbulence differs from previous periods of turbulence. The impact on equity markets and emerging economies has been limited. This time, we are dealing with a credit and liquidity squeeze at the core of the financial system. This affects many participants, including large banks.
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Subprime mortgages account for more than 6 per cent of the total volume of mortgages in the US. However, the problems in this segment are spreading to other housing market segments. The housing supply increases because of the rise in the number of foreclosures, and housing demand declines as it becomes more difficult for new borrowers to obtain a mortgage. This may lead to a further decline in house prices. The resulting wealth effects may have a dampening impact on household consumption.
Banks' accountants and auditors are now working hard to...