18 2 Funding: Introduction
banks to set aside capital. Banks looked for ways around the minimum capital
rules by shifting assets off their balance-sheets. They did this by securitising their
loan portfolios, by using structured investment vehicles, and by transferring the
risk of borrowers defaulting to issuers of CDSs.^34
Mortgage securitisation played a big role. In the past, a local bank lent money
to people that it knew. The loans were kept in the bank’s books until they were re-
paid. Mortgage securitisation enabled banks to sell mortgages to SPVs that issued
securities to pay for the mortgages. Banks earned fees for originating loans with-
out the burden of holding them on their balance-sheets (which would have re-
stricted their ability to lend to others). What made this easier was the easy avail-
ability of AAA ratings for senior tranches.
Banks and financial institutions invested in the US subprime mortgage market
through “conduits” or “structured investment vehicles” (SIV). Conduits issued
short-term paper to buy collateralised debt products with a maturity of several
years. This exposed them to the mismatch between long-term assets and short-
term liabilities.
Bursting of the bubble. In 2006, rising interest rates and the bursting of the US
housing bubble began to cause an increasing number of defaults, seizures of col-
lateral, and foreclosures. Several major US subprime lenders filed for bankruptcy.
As mortgage-related products were downgraded, investors lost confidence and
refused to buy any type of mortgage-backed security. The illiquidity even spread
beyond housing.
Liquidity crisis. Banks now became more risk averse. Generally, high leverage
and banks’ reliance on short-term borrowing from the capital market combined
with falling asset prices led to a liquidity crisis.
Assets had to be sold, but there were few buyers because of falling prices and
the lack of funding. This caused asset prices to fall even more.
Solvency crisis. A liquidity crisis led to a solvency crisis, as it was unclear
whether banks, hedge funds, private-equity funds and other investors had enough
assets left to repay their debts.^35
Recession. Losses wiped out banks’ equity. Because of minimum capital re-
quirements, banks had to find fresh capital or scale down their lending activities.
Only states and sovereign wealth funds had large amounts of capital to invest, and
it became more difficult for non-financial firms and consumers to borrow money
from banks. This led to a global recession.
The case of IKB. The way the risks materialised can be illustrated by the fate of
IKB Deutsche Industriebank, a specialist industrial lender. IKB is a relatively
small bank lending money to the German Mittelstand.
IKB had participated in the US subprime mortgage market through a “conduit”
or “structured investment vehicle” (SIV). The conduit, Rhineland Funding, was a
special-purpose vehicle which borrowed in the short-term, commercial-paper
market to make acquisitions of highly rated paper in US asset-backed securities.
(^34) A short history of modern finance. Link by link, The Economist, October 2008.
(^35) See, for example, Fehr B, Ruhkamp S, Die dritte Welle der Finanzkrise, FAZ, 14 March
2008 p 29.