How the Investment banks were trapped

In mid-2007, SIVs held $1.4 trillion of sub prime MBSs and CDOs. Banks found SIVs attractive for more than one reason. Not only could sizable profits be generated for creating and managing SIVs, but also due to their off balance sheet nature, little capital was needed to back them.

SIVs issued commercial paper to finance much longer term investments. This was fine as long as money market funds were willing takers. But when the performance of the SIVs deteriorated, the money market funds withdrew. So, the SIVs turned to their parent companies for funding. In late 2007, when nearly all the SIVs looked like failing simultaneously, the big banks brought the SIV investments back to their balance sheets.

Conduits were similar to SIVs. They held the loans until they could be pooled into securities. Conduits were also funded with short term paper. Like the SIVs, the conduits also ran into trouble when the money market funds withdrew.

In hindsight, it is clear that one distorting force leading to the popularity of SIVs was regulatory and ratings arbitrage. The Basel norms required that banks hold capital of at least 8 percent of the loans on their balance sheets. This capital requirement was much lower for contractual credit lines. Moreover, there was no capital charge at all for “reputational” credit lines—noncontractual liquidity backstops that sponsoring banks provided to SIVs to maintain their reputation. Thus, moving a pool of loans into off-balance-sheet vehicles, and then granting a credit line to that pool to ensure a AAA-rating, allowed banks to reduce the amount of capital they needed to hold to conform with Basel regulations. While all this happened, the risk for the bank remained essentially unchanged.

Basel II implemented capital charges based on asset ratings, but banks were able to reduce their capital charges by pooling loans in off-balance-sheet vehicles. Because of the reduction of idiosyncratic risk through diversification, assets issued by these vehicles received a better rating than did the individual securities in the pool. In addition, issuing short-term assets improved the overall rating even further, since banks sponsoring these SIVs were not sufficiently downgraded for granting liquidity backstops.

Raghuram Rajan[1] has raised a very interesting point. Why did the originators of these complex securities—the financial institutions that should have understood the deterioration of the underlying quality of mortgages—hold on to so many of the mortgage-backed securities (MBS) in their own portfolios? Clearly, some people in the bank thought these securities were worthwhile investments, despite their risk. Investment in mortgage securities seemed to be part of a culture of excessive risk-taking that had overtaken many banks. A key factor contributing to this culture is that, over short periods of time, it is very hard, especially in the case of new products, to tell whether a financial manager is generating true alpha or whether the current returns are simply compensation for a risk that has not yet shown itself but will eventually materialize. In short, are the returns being measured after adjusting for the full cost, including the risk involved? A simple example illustrates this point. Consider credit insurance. If traders are given bonuses by treating the entire insurance premium as income, without setting apart a significant fraction as a reserve for an eventual payout, they have a strong incentive to get more of such business and earn more bonuses. Thus, the traders in AIG wrote credit default swaps, pocketed the premiums as bonuses, but did not bother to set aside reserves in case the bonds covered by the swaps actually defaulted. And the traders who bought AAA-rated mortgage backed securities (MBS) were essentially getting the additional spread on these instruments relative to corporate AAA securities (the spread being the insurance premium) while ignoring the additional default risk entailed in these untested securities.

Many investment banks fell unwittingly into the CDO trap, by moving heavily into super-senior debt, the tranche with the highest priority for receiving cash flows if the CDO defaulted. Rating agencies gave super-senior CDO debt a triple-A rating, irrespective of what constituted the CDO. Thanks to the triple-A tag, banks were only required to hold minimal capital against super senior debt. This debt typically offered a spread of about 10 basis points over risk-free bonds. Some banks kept tens of billions of dollars of super-senior debt on their balance sheet and looked at the spread as an easy and continuing source of profit.

Looking back, it is clear that the triple A rating given to the super senior tranche was completely illusory.

Joseph R Mason[2], has dealt in detail with the rating discrepancies Corporate bonds rated Baa, the lowest Moody's investment grade rating, had an average 2.2 per cent default rate over five-year periods from 1983 to 2005. From 1993 to 2005, CDOs with the same Baa grade suffered five-year default rates of 24 per cent. In other words, Baa CDO securities were 10 times as risky as its Baa corporate bonds. Similarly, over time horizons of both five years and seven years, S&P attached a higher default probability to a CDO rated AA than to an ABS rated A. Over a three year time horizon, a CDO rated AA had a higher probability of default than an ABS rated A-.

Such data created some intriguing possibilities. A seven-year ABS rated AA+had an idealized default probability of 0.168%. If the security (all by itself) had been repackaged and called a CDO, it might have got a rating of AAA because the idealized default rate for the AAA rated CDOs was 0.285% over seven years. As Mason put it, “Municipal bond insurance for an Al state general obligation bond therefore merely translates the Al municipal rating to the Aaa corporate (global) rating of the monoline guarantor without any reduction in risk.”

As Anna J Schwartz mentioned[3], “The design of mortgage-backed securities collateralized by a pool of mortgages assumed that the pool would give the securities value. The pool, however, was an assortment of mortgages of varying quality.” The designers left it to the rating agencies to determine the price of the security. But the rating agencies had no formula for this task. They assigned ratings to complex securities as if they were ordinary corporate bonds. And these ratings overstated the value of the securities and were fundamentally arbitrary.

According to Brunnermeier “rating at the edge” might also have contributed to favorable ratings of structured products versus corporate bonds. While a AAA-rated bond represented a band of risk ranging from a near-zero default risk to a risk that just made it into the AAA-rated group, banks worked closely with the rating agencies to ensure that AAA tranches were always sliced in such a way that they just crossed the dividing line to reach the AAA rating.

Fund managers, “searching for yield,” were attracted to buying structured products because they promised high expected returns with a small probability of catastrophic loss. In addition, some fund managers may have favored the relatively illiquid junior tranches precisely because they traded so infrequently and were therefore hard to value. These managers could make their monthly returns appear attractively smooth over time because they had some flexibility with regard to when they could revalue their portfolios.

As information flowed about the poor quality of the underlying assets, the markets became increasingly weary about CDOs and their tranches. The prices of some tranches of debt fell by 30 per cent in a few months. Instead of booking profits, banks were faced with the possibility of write downs. Yet few anticipated the quantum of the write downs. Only as banks like UBS, Citigroup and Morgan Stanley started to announce big losses during the second half of 2007, the magnitude of the crisis became more evident.

[1] Federal Reserve Bank of St. Louis Review September/October, Part 1 2009. Pp. 397-402.
[2] “The (continuing) Information problems in structured Finance” Journal of Applied Finance, The Journal of Structured Finance, Spring 2008.
[3] “Origins of the financial market crisis of 2008” Cato Journal, Winter 2009.