Chicago Booth BUSF 35150 - The Evolution of a Financial Crisis

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Electronic copy available at: http://ssrn.com/abstract=1364576 1 The Evolution of a Financial Crisis: Panic in the Asset-Backed Commercial Paper Market by Daniel Covitz, Nellie Liang, and Gustavo Suarez August 24, 2009 Abstract The $350 billion contraction in the asset-backed commercial paper (ABCP) market in the last five months of 2007 played a central role in transforming concerns about the credit quality of mortgage-related assets into a global financial crisis. This paper attempts to better understand why the substantial contraction in ABCP occurred by measuring and analyzing runs on ABCP programs over the period from August 2007 through December 2007. While it has been suggested that commercial paper programs, like commercial banks, may be prone to runs, we are the first to conduct a comprehensive empirical analysis of runs in the ABCP market using a rich and novel issue-level data set for all ABCP programs in the U.S. market. A program is defined as being run when it does not issue new paper during a week despite having a substantial share of its outstandings scheduled to mature, and then continuing in a run until it issues. We find evidence of extensive runs: more than 100 programs (one-third of all ABCP programs) were in a run within weeks of the onset of the turmoil and the odds of subsequently leaving the run state were very low. We interpret this finding as an indication that the ABCP market was subject to a bank-like “panic.” We also find that while runs were linked to credit and liquidity exposures of individual programs, runs were also related importantly to non-program specific variables in the first several weeks of the turmoil, indicating that runs were relatively indiscriminate during the early part of the panic. Thus the ABCP market may be inherently unstable and a source of systemic risk. Keywords: Commercial paper, asset-backed commercial paper, bank runs, financial crisis, panics JEL Codes: G01, G10, G21  All authors are at the Federal Reserve Board. This paper represents the views of the authors and does not necessarily represent the views of the Board of Governors, the Federal Reserve System, or other Federal Reserve staff. We thank seminar participants at the Federal Reserve Bank of San Francisco and the Yale Conference on Financial Crisis Research, Franklin Allen, Adam Ashcraft, Markus Brunnermeier, William Dudley, Gary Gorton, Zhiguo He, Greg Nini, Peter Lupoff, Philipp Schnabl, Jeremy Stein, and Wei Xiong for useful comments, and Elisabeth Perlman and Landon Stroebel for excellent research assistance. Corresponding address: [email protected] copy available at: http://ssrn.com/abstract=1364576 2 The Evolution of a Financial Crisis: Panic in the Asset-Backed Commercial Paper Market 1. Introduction The U.S. asset-backed commercial paper (ABCP) market erupted in late summer of 2007 and played a pivotal role in the global financial crisis that would become increasingly severe. In the ABCP market, where investors expect to be able to access their funds on demand at par value, even limited concerns about risk can instigate flight from the market. A narrative of the turmoil begins with mounting delinquencies of subprime mortgages triggering a decline in investor confidence in mortgage financial intermediaries and ratings downgrades of structured mortgage securities. Reflecting these concerns, investors became reluctant to roll over ABCP, yields on new issues of ABCP soared, and outstanding ABCP plummeted $190 billion, almost 20 percent, in August, and fell by an additional $160 billion by the end of the year (see Figure 1). The steep contraction in ABCP, in turn, sparked concerns about whether banking institutions that explicitly provided program back-up liquidity support or implicitly provided liquidity as sponsors would be able to meet their obligations. As a result, banking institutions began to hoard their cash and became extremely hesitant to lend in inter-bank funding markets, and risk spreads for interbank funds even at overnight terms widened sharply. In addition, demand from ABCP programs for AAA-rated tranches of mortgage backed securities (MBS) declined, which made it difficult to structure new securitizations of mortgages. Thus the events in the ABCP market had far-reaching and long-lasting consequences for the broader financial markets and the economy. An open question with implications for the stability of the U.S. and other financial systems with sizable ABCP markets is whether a large number of ABCP programs were subject to investor runs and so entirely shut out of the market, consistent with a bank-like “panic.”1 Another important question is whether this “panic” can be entirely explained as runs on ABCP 1 The term “panic” is used in different ways in the academic literature. We follow Gorton (1988), where banking panics refer to periods with many bank runs. Runs can either be linked to deteriorating fundamental factors, or are not explainable by fundamental factors, in which case they are indiscriminate runs. Alternatively, Calomiris and Mason (2003) discuss periods of bank failures which could reflect “fundamental” deterioration in bank health, or alternatively “panics,” sudden crises of illiquidity that may force viable banks to fail. Thus, Calomiris and Mason use the word panic to describe unpredictable behavior, while Gorton uses the word panic to describe periods of multiple runs, which would include runs that are based on fundamental factors and those that are not.3programs with liquidity or credit impairment; the alternative is that runs were not explained by program risks and were, to some extent, indiscriminate. Indiscriminate runs can be thought of as equilibria in which investors refuse to rollover paper because they believe that other investors will do the same, perhaps forcing the programs to sell assets at fire sale prices. Knowing whether a market is prone to such behavior is important because it would suggest that shocks to asset prices are magnified in the ABCP market, and thus the ABCP market may pose significant risks for financial stability. The possibility that the ABCP market is prone to indiscriminate runs is suggested by the similarities between ABCP programs and banks. Like banks, ABCP programs issue liquid short-term debt to finance illiquid and long-term assets. Moreover, if we define banks as entities that create


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Chicago Booth BUSF 35150 - The Evolution of a Financial Crisis

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