German immigrants to the US set up Lehman Brothers in 1850. Capitalizing on cotton's high market value, the brothers who owned the firm, accepted raw cotton from customers as payment for merchandise. They then started trading in cotton. Within a few years, this business grew to become the most significant part of the operation. Lehman gradually evolved into a repected investment bank. Managment problems and internal tensions led to the firm being sold to Shearson, an American Express-backed electronic transaction company, in 1984, for $360 million. In 1993, under newly appointed CEO, Harvey Golub, American Express began to divest itself of its banking and brokerage operations. In 1994, it spun off Lehman Brothers Kuhn Loeb as Lehman Brothers Holdings, Inc. through an IPO.
Lehman performed quite well under CEO Richard S. Fuld, Jr.. In 2001, the firm acquired the private-client services, or (PCS), business of Cowen & Co. In 2003, Lehman aggressively re-entered the asset-management business, which it had exited in 1989. Beginning with $2 billion in assets under management, the firm acquired the Crossroads Group, the fixed-income division of Lincoln Capital Management and Neuberger Berman These businesses, together with the PCS business and Lehman's private-equity business, comprised the Investment Management Division. This division generated approximately $3.1 billion in net revenue and almost $800 million in pre-tax income in 2007. Prior to going bankrupt, Lehman had in excess of $275 billion in assets under management. Altogether, since going public in 1994, the firm had increased net revenues from $2.73 billion to $19.2 billion and had increased employee headcount from 8,500 to almost 28,600.
In August 2007, Lehman closed its subprime lender, BNC Mortgage, and took an after-tax charge of $25 million and a $27 million reduction in goodwill. The problems only aggravated in 2008 Lehman faced an unprecedented loss, since it had held on to large positions in subprime and other lower-rated mortgage tranches when securitizing the underlying mortgages. In the second quarter, Lehman reported losses of $2.8 billion and was forced to sell off $6 billion in assets. In the first half of 2008, Lehman stock lost 73% of its value as the credit market continued to tighten.
On August 22, 2008, shares in Lehman closed up 5% (16% for the week) on reports that the state-controlled Korea Development Bank (KDB) was considering buying the bank. But the gains quickly disappeared on reports KDB was facing difficulties in getting the approval of regulators and in attracting partners for the deal. It culminated on September 9, when Lehman's shares plunged 45% to $7.79, after it was reported that KDB had put talks on hold.
Investor confidence continued to erode as Lehman's stock lost roughly half its value and pushed the S&P 500 down 3.4% on September 9. The Dow Jones lost 300 points the same day on investors' concerns about the security of the bank. The next day, Lehman announced a loss of $3.9 billion and indicated it would to sell off a majority stake in the investment-management business, which included Neuberger Berman. The stock slid seven percent that day. Market rumours were strong that Lehman was reportedly searching for a buyer as its stock price dropped another 40 percent on September 11, 2008.
On Saturday September 13, 2008, Tim Geithner, the president of the Federal Reserve Bank of New York called a meeting to discuss the future of Lehman. Lehman reported that it had been in talks with Bank of America and Barclays for the company's possible sale. However, both Barclays and Bank of America ultimately declined to purchase the entire company.
The International Swaps and Derivatives Association (ISDA) arranged an exceptional trading session on Sunday, September 14, 2008, to allow market participants to offset positions in various derivatives.
In New York, shortly before 1 a.m. the next morning, Lehman announced it would file for Chapter 11 bankruptcy protection citing bank debt of $613 billion, $155 billion in bond debt, and assets worth $639 billion. It further announced that its subsidiaries would continue to operate as normal. A group of Wall Street firms agreed to provide capital and financial assistance for the bank's orderly liquidation. The Federal Reserve, in turn, agreed to a swap of lower-quality assets in exchange for loans and other assistance from the government.
On September 16, 2008, Barclays announced it would acquire a "stripped clean" portion of Lehman for $1.75 billion, including most of Lehman's North America operations. On September 20, the transaction was approved. On September 17, 2008, the New York Stock Exchange delisted Lehman Brothers.
Nomura, Japan's top brokerage firm, agreed to buy the Asian division of Lehman for $225 million and parts of the European division for a nominal fee of $2. It would not take on any trading assets or liabilities in the European units. Nomura decided to acquire only Lehman's employees in the regions, and not its stocks, bonds or other assets.
Did the US government make a big blunder, by not bailing out Lehman? After all, following the bankruptcy there were major upheavals in the financial markets. By October, it was evident that the credit markets had seized up. Companies found it difficult to raise working capital. Trade finance was becoming scarce. Investment decisions were postponed, industrial production shrank and world trade collapsed. By the end of 2008, the world economy was shrinking for the first time since World War II. G7 economies contracted at an annualised rate of 8.4% in the first quarter of 2009.
Former US Treasury secretary, Hank Paulson and Tim Giethner, the incumbent one recently justified their actions stating that the regulators did not have sufficient authority to do a quick bailout. The Fed had tried to broker a deal, but no buyer could be found for Lehman. Barclays which showed interest did not get approval from UK regulators. Bank of America, a potential bidder had already paired up with Merrill.
The collapse of Lehman had some unintended consequences. As Niall Ferguson mentioned[1], Paulson might have taken the right decision without being fully aware: “By showing Americans and particularly their legislators in Congress, just what could happen if even the fourth largest investment bank failed, he created what had hitherto been lacking: the political will for a wholesale bailout of the financial system” If Lehman had been bailed out, there would have been a hue and cry in congress. The TARP bailout would never have been possible. In that case, Citigroup, a bank three times bigger than Lehman would have collapsed.
An editorial in the Financial Times was more emphatic[2], that the US authorities had been right to allow Lehman Brothers to fail. “They could not know how awful it would prove to be and when it comes to saving failing companies, governments should err on the side of inaction. Capitalism relies on the discipline provided by the lure of wealth and the fear of bankruptcy.”
[1] Financial Times, September 15, 2009.
[2] Financial Times, September 14, 2009.
Showing posts with label Sub Prime Crisis. Show all posts
Showing posts with label Sub Prime Crisis. Show all posts
Sunday, 3 January 2010
Black September 2008
Many thought that the collapse of Bear Stearns in March 2008 signalled an end to the banking crisis. But it only proved to be a lull in the storm. It was in August that the action again started to pick up. Fannie and Freddie announced their fourth consecutive quarterly loss. On September 7, the US Treasury was forced to bail out the two agencies. Meanwhile, the fortunes of Lehman Brothers, another investment banking icon on Wall Street, had fluctuated wildly in the past few months. Lehman came close to bankruptcy, a couple of times but was saved at the last moment by some desperate measures. On September 15, Lehman threw in the towel and filed for bankruptcy. A big surprise followed the next day when the US Treasury announced a $85 billion bailout of AIG, the respected, global insurance company. AIG had taken huge positions in CDS without realising that credit default insurance was a completely different business compared to its traditional insurance activities. Meanwhile, Merril Lynch, realising it would be difficult to survive as an independent entity, decided to merge with Bank of America. Many of the deeper problems plaguing Merril would become evident only later. At the same time, Goldman Sachs and Morgan Stanley accepted a proposal from the US Treasury to convert themselves from pure play investment banks into bank holding companies. In short, the complexion of Wall Street changed completely in a week.
Saturday, 2 January 2010
The collapse of Bear Stearns
Bear Stearns was founded as an equity trading house on May Day 1923 by Joseph Bear, Robert Stearns, and Harold Mayer with $500,000 in capital. By 1933, Bear had opened its first branch office in Chicago. In 1985, Bear Stearns became a publicly traded company. In 2005-2007, Bear was recognized as the "Most Admired" securities by Fortune.
The sub prime crisis changed the fortunes of Bear dramatically. On June 22, 2007, Bear Stearns pledged a collateralized loan of up to $3.2 billion to "bail out" one of its funds, the High-Grade Structured Credit Fund, while negotiating with other banks to loan money against collateral to another fund, the High-Grade Structured Credit Enhanced Leveraged Fund.
During the week of July 16, 2007, Bear disclosed that the two subprime hedge funds had lost nearly all of their value amid a rapid decline in the market for subprime mortgages.On August 1, 2007, investors in the two funds took action against Bear and its top board and risk management managers and officers. Two law firms filed arbitration claims with the National Association of Securities Dealers alleging that Bear had misled investors about its exposure to the funds. As a result of the huge hedge fund write downs and its first loss in 83 years, Standard & Poor's downgraded Bear’s credit rating from AA to A.
Co-President Warren Spector was asked to resign on August 5, 2007. Matthew Tannin and Ralph R. Cioffi, both former managers of hedge funds at Bear Stearns Companies, were arrested June 19, 2008, on criminal charges and for misleading investors about the risks involved in the subprime market. Tannin and Cioffi were also named in lawsuits brought forth by Barclays Bank, who claimed they were one of the many investors misled by the executives. They were also named in civil lawsuits brought in 2007 by investors, including Barclays, who claimed they had been misled. Barclays claimed that Bear knew that certain assets in the High-Grade Structured Credit Strategies Enhanced Leverage Master Fund were worth much less than their professed values. The suit claimed that Bear’s managers devised "a plan to make more money for themselves and further to use the Enhanced Fund as a repository for risky, poor-quality investments." Bear had apparently told Barclays that the enhanced fund was up almost 6% through June 2007 — when "in reality, the portfolio's asset values were plummeting."
As of November 30, 2007, Bear had notional contract amounts of approximately $13.40 trillion in derivative financial instruments. In addition, the investment bank was carrying more than $28 billion in 'level 3' assets on its books at the end of fiscal 2007 versus a net equity position of only $11.1 billion. This $11.1 billion supported $395 billion in assets, implying a leverage ratio of 35.5 to 1. This highly leveraged balance sheet, consisting of many illiquid and potentially worthless assets, led to the rapid dilution of investor and lender confidence.
In early 2007, the typical price of a credit default swap, (cost of credit protection) tied to the debt of an investment bank like Bear had been about 25 basis points. By March 14 2008, the cost of buying protection on Bear’s debt had increased to 850 basis points[ “Bloomberg Markets”, July 2008].The widening spread predicted a high probability of default. Doubts about the very existence of Bear mounted.
On March 14, 2008, JP Morgan Chase, backed by the Federal Reserve Bank of New York, agreed to provide a 28-day emergency loan to Bear Stearns. Despite this, belief in Bear's ability to repay its obligations rapidly diminished among counterparties and traders. The Fed sensed that the terms of the emergency loan were not enough to bolster Bear. Worried about the possibility of systemic losses if allowed to open in the markets on the following Monday, the US authorities told CEO Alan Schwartz that he had to sell the firm over the weekend, in time for the opening of the Asian market. Two days later, on March 16, 2008, Bear Stearns finalized its agreement with JP Morgan Chase in the form of a stock swap worth $2 a share. This was a huge climb-down for a stock that had traded at $172 a share as late as January 2007 and $93 a share as late as February 2008. In addition, the Fed agreed to issue a non-recourse loan of $29 billion to JP Morgan Chase, thereby assuming the risk of Bear Stearns's less liquid assets. Bernanke, defended the bailout by stating that Bear’s bankruptcy would have affected the real economy and could have caused a "chaotic unwinding" of investments across the US markets.
The collapse of Bear Stearns was as much due to a lack of confidence as a lack of capital. On March 20, Securities and Exchange Commission Chairman Christopher Cox noted that the bank’s problems escalated when rumors spread about its liquidity crisis which in turn eroded investor confidence in the firm. Bear’s liquidity pool started at $18.1 billion on March 10 and then plummeted to $2 billion on March 13. Ultimately, market rumors about Bear Stearns' difficulties became self-fulfilling.
On March 24, 2008, a new agreement raised JPMorgan Chase's offer to $10 a share, up from the initial $2 offer, that meant an offer of $1.2 billion. The revised deal was meant to quiet upset investors and any subsequent legal action brought against JP Morgan Chase as a result of the deal. The higher price was also meant to prevent employees, whose compensation consisted of Bear Stearns stock, from leaving for other firms.
The sub prime crisis changed the fortunes of Bear dramatically. On June 22, 2007, Bear Stearns pledged a collateralized loan of up to $3.2 billion to "bail out" one of its funds, the High-Grade Structured Credit Fund, while negotiating with other banks to loan money against collateral to another fund, the High-Grade Structured Credit Enhanced Leveraged Fund.
During the week of July 16, 2007, Bear disclosed that the two subprime hedge funds had lost nearly all of their value amid a rapid decline in the market for subprime mortgages.On August 1, 2007, investors in the two funds took action against Bear and its top board and risk management managers and officers. Two law firms filed arbitration claims with the National Association of Securities Dealers alleging that Bear had misled investors about its exposure to the funds. As a result of the huge hedge fund write downs and its first loss in 83 years, Standard & Poor's downgraded Bear’s credit rating from AA to A.
Co-President Warren Spector was asked to resign on August 5, 2007. Matthew Tannin and Ralph R. Cioffi, both former managers of hedge funds at Bear Stearns Companies, were arrested June 19, 2008, on criminal charges and for misleading investors about the risks involved in the subprime market. Tannin and Cioffi were also named in lawsuits brought forth by Barclays Bank, who claimed they were one of the many investors misled by the executives. They were also named in civil lawsuits brought in 2007 by investors, including Barclays, who claimed they had been misled. Barclays claimed that Bear knew that certain assets in the High-Grade Structured Credit Strategies Enhanced Leverage Master Fund were worth much less than their professed values. The suit claimed that Bear’s managers devised "a plan to make more money for themselves and further to use the Enhanced Fund as a repository for risky, poor-quality investments." Bear had apparently told Barclays that the enhanced fund was up almost 6% through June 2007 — when "in reality, the portfolio's asset values were plummeting."
As of November 30, 2007, Bear had notional contract amounts of approximately $13.40 trillion in derivative financial instruments. In addition, the investment bank was carrying more than $28 billion in 'level 3' assets on its books at the end of fiscal 2007 versus a net equity position of only $11.1 billion. This $11.1 billion supported $395 billion in assets, implying a leverage ratio of 35.5 to 1. This highly leveraged balance sheet, consisting of many illiquid and potentially worthless assets, led to the rapid dilution of investor and lender confidence.
In early 2007, the typical price of a credit default swap, (cost of credit protection) tied to the debt of an investment bank like Bear had been about 25 basis points. By March 14 2008, the cost of buying protection on Bear’s debt had increased to 850 basis points[ “Bloomberg Markets”, July 2008].The widening spread predicted a high probability of default. Doubts about the very existence of Bear mounted.
On March 14, 2008, JP Morgan Chase, backed by the Federal Reserve Bank of New York, agreed to provide a 28-day emergency loan to Bear Stearns. Despite this, belief in Bear's ability to repay its obligations rapidly diminished among counterparties and traders. The Fed sensed that the terms of the emergency loan were not enough to bolster Bear. Worried about the possibility of systemic losses if allowed to open in the markets on the following Monday, the US authorities told CEO Alan Schwartz that he had to sell the firm over the weekend, in time for the opening of the Asian market. Two days later, on March 16, 2008, Bear Stearns finalized its agreement with JP Morgan Chase in the form of a stock swap worth $2 a share. This was a huge climb-down for a stock that had traded at $172 a share as late as January 2007 and $93 a share as late as February 2008. In addition, the Fed agreed to issue a non-recourse loan of $29 billion to JP Morgan Chase, thereby assuming the risk of Bear Stearns's less liquid assets. Bernanke, defended the bailout by stating that Bear’s bankruptcy would have affected the real economy and could have caused a "chaotic unwinding" of investments across the US markets.
The collapse of Bear Stearns was as much due to a lack of confidence as a lack of capital. On March 20, Securities and Exchange Commission Chairman Christopher Cox noted that the bank’s problems escalated when rumors spread about its liquidity crisis which in turn eroded investor confidence in the firm. Bear’s liquidity pool started at $18.1 billion on March 10 and then plummeted to $2 billion on March 13. Ultimately, market rumors about Bear Stearns' difficulties became self-fulfilling.
On March 24, 2008, a new agreement raised JPMorgan Chase's offer to $10 a share, up from the initial $2 offer, that meant an offer of $1.2 billion. The revised deal was meant to quiet upset investors and any subsequent legal action brought against JP Morgan Chase as a result of the deal. The higher price was also meant to prevent employees, whose compensation consisted of Bear Stearns stock, from leaving for other firms.
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.
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.
Understanding the Credit crunch
As the sub prime crisis unfolded, linkages among different markets became evident. The uncertainty in the interbank market spilled over to the corporate market, especially for lower rated loans and bonds. Banks had been using junk bonds to finance leveraged buyouts. They had hoped to off-load them to investors quickly. But in the troubled environment, the junk bonds remained on the balance sheet.
Monolines briefly mentioned earlier, had been providing insurance on municipal bonds. This was widely considered a pretty safe business as state and local governments rarely defaulted. But many guarantors expanded beyond this business. They entered the CDS market in a big way. The rating agencies threatened to downgrade the ratings of the bond insurer. And as the bond insurers were downgraded, so too were the bond issuers. Even municipalities with stable finances found interest rates on their bonds going up.
As the mortgage market correction gained momentum, investors began to focus more closely on credit quality and valuation challenges in illiquid markets. The first signs of the impending liquidity squeeze came in the asset-backed commercial paper (ABCP) market, when issuers began to encounter difficulties rolling over outstanding volumes. When nervousness about funding needs and the liabilities of banks intensified, liquidity demand surged, causing a major disruption in the interbank money markets.
Mark Brunnermeier [ “Deciphering the liquidity and credit crunch 2007-2008,” Journal of Economic Perspectives.], has explained how liquidity problems amplified the sub prime crisis in various ways. When asset prices dropped, financial institutions’ capital eroded and, at the same time, lending standards and margins tightened. Both effects caused fire-sales, pushing down prices and tightening funding even further. Banks also became concerned about their future access to capital markets and started hoarding funds.
The nature of funding aggravated these problems. Most investors preferred assets with short maturities, such as short-term money market funds. It allowed them to withdraw funds at short notice to accommodate their own funding needs. It might also have served as a commitment device to discipline banks with the threat of possible withdrawals. On the other hand, most mortgages had maturities measured in decades.
In the traditional banking model, commercial banks financed these loans with deposits that could be withdrawn at short notice. In the build up to sub prime, the same maturity mismatch was transferred to a “shadow” banking system consisting of off-balance-sheet investment vehicles and conduits. These structured investment vehicles raised funds by selling short-term asset-backed commercial paper with an average maturity of 90 days and medium-term notes with an average maturity of just over one year, primarily to money market funds.
The strategy of off-balance-sheet vehicles—investing in long-term assets and borrowing with short-term paper—exposed the banks to funding liquidity risk. To ensure funding liquidity for the vehicle, the sponsoring bank had granted a credit line to the vehicle, called a “liquidity backstop.” As a result, the banking system still carried the liquidity risk. When investors suddenly stopped buying asset-backed commercial paper, preventing these vehicles from rolling over their short-term debt, the assets came back to the balance sheets of the banks.
Another important trend was an increase in the maturity mismatch on the balance sheet of investment banks, due to a growth on balance sheet financing with short-term repurchase agreements, or “repos.” Much of the growth in repo financing as a fraction of investment banks’ total assets was due to an increase in overnight repos. The fraction of total investment bank assets financed by overnight repos (as opposed to term repos with a maturity of upto three months) roughly doubled from 2000 to 2007. The excessive dependence on overnight repos caused serious liquidity problems as the crisis aggravated.
Monolines briefly mentioned earlier, had been providing insurance on municipal bonds. This was widely considered a pretty safe business as state and local governments rarely defaulted. But many guarantors expanded beyond this business. They entered the CDS market in a big way. The rating agencies threatened to downgrade the ratings of the bond insurer. And as the bond insurers were downgraded, so too were the bond issuers. Even municipalities with stable finances found interest rates on their bonds going up.
As the mortgage market correction gained momentum, investors began to focus more closely on credit quality and valuation challenges in illiquid markets. The first signs of the impending liquidity squeeze came in the asset-backed commercial paper (ABCP) market, when issuers began to encounter difficulties rolling over outstanding volumes. When nervousness about funding needs and the liabilities of banks intensified, liquidity demand surged, causing a major disruption in the interbank money markets.
Mark Brunnermeier [ “Deciphering the liquidity and credit crunch 2007-2008,” Journal of Economic Perspectives.], has explained how liquidity problems amplified the sub prime crisis in various ways. When asset prices dropped, financial institutions’ capital eroded and, at the same time, lending standards and margins tightened. Both effects caused fire-sales, pushing down prices and tightening funding even further. Banks also became concerned about their future access to capital markets and started hoarding funds.
The nature of funding aggravated these problems. Most investors preferred assets with short maturities, such as short-term money market funds. It allowed them to withdraw funds at short notice to accommodate their own funding needs. It might also have served as a commitment device to discipline banks with the threat of possible withdrawals. On the other hand, most mortgages had maturities measured in decades.
In the traditional banking model, commercial banks financed these loans with deposits that could be withdrawn at short notice. In the build up to sub prime, the same maturity mismatch was transferred to a “shadow” banking system consisting of off-balance-sheet investment vehicles and conduits. These structured investment vehicles raised funds by selling short-term asset-backed commercial paper with an average maturity of 90 days and medium-term notes with an average maturity of just over one year, primarily to money market funds.
The strategy of off-balance-sheet vehicles—investing in long-term assets and borrowing with short-term paper—exposed the banks to funding liquidity risk. To ensure funding liquidity for the vehicle, the sponsoring bank had granted a credit line to the vehicle, called a “liquidity backstop.” As a result, the banking system still carried the liquidity risk. When investors suddenly stopped buying asset-backed commercial paper, preventing these vehicles from rolling over their short-term debt, the assets came back to the balance sheets of the banks.
Another important trend was an increase in the maturity mismatch on the balance sheet of investment banks, due to a growth on balance sheet financing with short-term repurchase agreements, or “repos.” Much of the growth in repo financing as a fraction of investment banks’ total assets was due to an increase in overnight repos. The fraction of total investment bank assets financed by overnight repos (as opposed to term repos with a maturity of upto three months) roughly doubled from 2000 to 2007. The excessive dependence on overnight repos caused serious liquidity problems as the crisis aggravated.
CDOs and the Sub Prime Crisis
One of the fascinating aspects of the sub prime crisis has been the degree of opaqueness created in the financial system by securitisation. The vehicle which has made this possible is the Collateralised Debt Obligation (CDO). CDOs allow asset backed securities to be mixed with subprime mortgage loans and placed into different risk classes, or tranches, each with its own repayment schedule. Upper tranches receive 'AAA' ratings as they are promised the first cash flows that come into the security. Lower tranches have lower priority but carry higher coupon rates to compensate for the increased default risk. Finally at the bottom, lies the "equity" tranche. Its cash flows may be wiped out if the default rate on the entire ABS creeps above 5 to 7%.
A simple illustration will explain how a CDO operates. Say a bank has granted 1000 subprime mortgage loans with an overall principal value of $ 300 million.
Based on the historical delinquency rates of 4% and average losses for defaulted sub prime mortgages of 25%, the expected loss for the pool would be 4% of 25%, i.e., 1%, or USD 3mn. This loss rate would be too high for the instrument to achieve a AAA credit rating.
So the bank redistributes the cash flows of the underlying mortgages to four different tranches. Tranche 1, the "AAA"-rated tranche, has a senior claim on all interest and principal payments of the mortgage pool. No other tranche may receive any cash-flows till all payments on the AAA tranche are met. Its size equals say 80% of the overall volume of the mortgage pool, or 0.8 x 300 million, i.e., $240 million.
Tranche 2, the "A"-rated tranche, is subordinated to the AAA tranche, but remains senior to all remaining tranches. Its size is 12% of the over-all volume, or 0.12 x 300 million i.e., 36 million.
Tranche 3, the "BB"-rated or High Yield tranche represents another 5% of the overall volume, i.e., $15 million and is subordinated to both higher-rated tranches.
The “Equity tranche” equals 3% of the pool volume, ie., $9 million and receives anything that is left over, after all other tranches are fully serviced.
If the losses remain within $3 million, the equity tranche takes all losses while all other tranches receive the full amount of interest and principal payments. Even with a cyclical rise in default rates, the AAA tranche would be well protected from losses.
Let us assume that if delinquency rates rise to 25%, losses on defaulted subprime mortgages will rise to 50%. This may result in a loss rate of 0.25 x 0.5 = 12.5% i.e., (.125) (300) = $37.5 million. This would erase the Equity tranche (3%, 9 million) and the BB tranche (5%, 15 million) entirely. The remaining losses ($13.5 million) would be absorbed by the A tranche which would lose 37.5% of principal (13.5/36). The AAA tranche would not carry losses, but its buffer for further losses would largely disappear. It would be living at the edge, so to say!
Through the process of tranching, the subprime mortgage lenders found a way to sell their risky debt. Nearly 80% of these bundled securities were rated investment grade ('A' rated or higher), by the rating agencies, who earned lucrative fees for their work in rating the ABSs.
Having found a way to originate and distribute risky mortgages, banks moved into subprime lending very aggressively. Basic requirements like proof-of-income and down payment were waived off by some mortgage lenders. By using teaser rates within adjustable-rate mortgages (ARM), borrowers were enticed into an initially affordable mortgage in which payments would skyrocket in a few years. The CDO market ballooned to more than $600 billion in issuance during 2006 alone - more than 10 times the amount issued just a decade earlier.
A simple illustration will explain how a CDO operates. Say a bank has granted 1000 subprime mortgage loans with an overall principal value of $ 300 million.
Based on the historical delinquency rates of 4% and average losses for defaulted sub prime mortgages of 25%, the expected loss for the pool would be 4% of 25%, i.e., 1%, or USD 3mn. This loss rate would be too high for the instrument to achieve a AAA credit rating.
So the bank redistributes the cash flows of the underlying mortgages to four different tranches. Tranche 1, the "AAA"-rated tranche, has a senior claim on all interest and principal payments of the mortgage pool. No other tranche may receive any cash-flows till all payments on the AAA tranche are met. Its size equals say 80% of the overall volume of the mortgage pool, or 0.8 x 300 million, i.e., $240 million.
Tranche 2, the "A"-rated tranche, is subordinated to the AAA tranche, but remains senior to all remaining tranches. Its size is 12% of the over-all volume, or 0.12 x 300 million i.e., 36 million.
Tranche 3, the "BB"-rated or High Yield tranche represents another 5% of the overall volume, i.e., $15 million and is subordinated to both higher-rated tranches.
The “Equity tranche” equals 3% of the pool volume, ie., $9 million and receives anything that is left over, after all other tranches are fully serviced.
If the losses remain within $3 million, the equity tranche takes all losses while all other tranches receive the full amount of interest and principal payments. Even with a cyclical rise in default rates, the AAA tranche would be well protected from losses.
Let us assume that if delinquency rates rise to 25%, losses on defaulted subprime mortgages will rise to 50%. This may result in a loss rate of 0.25 x 0.5 = 12.5% i.e., (.125) (300) = $37.5 million. This would erase the Equity tranche (3%, 9 million) and the BB tranche (5%, 15 million) entirely. The remaining losses ($13.5 million) would be absorbed by the A tranche which would lose 37.5% of principal (13.5/36). The AAA tranche would not carry losses, but its buffer for further losses would largely disappear. It would be living at the edge, so to say!
Through the process of tranching, the subprime mortgage lenders found a way to sell their risky debt. Nearly 80% of these bundled securities were rated investment grade ('A' rated or higher), by the rating agencies, who earned lucrative fees for their work in rating the ABSs.
Having found a way to originate and distribute risky mortgages, banks moved into subprime lending very aggressively. Basic requirements like proof-of-income and down payment were waived off by some mortgage lenders. By using teaser rates within adjustable-rate mortgages (ARM), borrowers were enticed into an initially affordable mortgage in which payments would skyrocket in a few years. The CDO market ballooned to more than $600 billion in issuance during 2006 alone - more than 10 times the amount issued just a decade earlier.
Securitisation and the sub prime crisis
Securitisation as a concept was introduced by Lewis S Ranieri in 1977, but has gained currency only in recent years. The securitized share of subprime mortgages (i.e., those passed to third-party investors) increased from 54% in 2001, to 75% in 2006. Of the $10.7 trillion worth of residential mortgage debt, $6.3 trillion had been securitised by mid-2007. A brief account of how securitisation works, follows.
Securitisation as the name suggests converts loans into tradable securities. Illiquid loans are packaged into a special purpose vehicle and sold in parcels to investors who are happy to receive payments from the underlying mortgages over time. Effectively, securitisation aims at generating cash out of relatively illiquid instruments. Lenders can free up capital for more lending. On the other hand, investors receive returns higher than they would have got in case of equivalent traditional investments. In the early 2000s, as the housing market boomed, securitisation seemed to create a win-win situation for lenders and investors.
As the market boomed, financial engineering and increased trading went hand in hand. Many investment banks bought the mortgages from lenders and securitized these mortgages into bonds, which were sold to investors in various forms. This “plain vanilla” securitisation soon gave way to more sophisticated structured products. Assets of different risk characteristics were combined. The cash flows expected from these assets were tranched and traded in the extremely large and very liquid secondary mortgage market. This is how Collaterised Debt Obligations (CDOs) were born.
The originate-to-distribute model of securitisation ensured that the identity of the original instruments was completely lost. Indeed, the instruments were transformed beyond recognition. Simple instruments became “exotic” ones.
In hte process, a huge shadow banking system was created. Banks did not want to keep mortgages and loans on their balance sheet as they needed more capital backing. Instead, they held mortgage backed securities with low risk weights as per the Basle framework. The funding for the loans increasingly came from non banking institutions. These included investment banks, hedge funds, money market funds, finance companies, asset backed conduits and SIVs.
According to Mark Zandy of Economy.com, the shadow banking system provided credit to the tune of $6 trillion by the second quarter of 2007. The shadow banking system was subject to minimal regulatory oversight and did not have to make significant public disclosures. The use of leverage amplified the problem. At the peak of the frenzy in 2005-06, hedge funds were leveraging their investments as many as 50 times.
Securitisation as the name suggests converts loans into tradable securities. Illiquid loans are packaged into a special purpose vehicle and sold in parcels to investors who are happy to receive payments from the underlying mortgages over time. Effectively, securitisation aims at generating cash out of relatively illiquid instruments. Lenders can free up capital for more lending. On the other hand, investors receive returns higher than they would have got in case of equivalent traditional investments. In the early 2000s, as the housing market boomed, securitisation seemed to create a win-win situation for lenders and investors.
As the market boomed, financial engineering and increased trading went hand in hand. Many investment banks bought the mortgages from lenders and securitized these mortgages into bonds, which were sold to investors in various forms. This “plain vanilla” securitisation soon gave way to more sophisticated structured products. Assets of different risk characteristics were combined. The cash flows expected from these assets were tranched and traded in the extremely large and very liquid secondary mortgage market. This is how Collaterised Debt Obligations (CDOs) were born.
The originate-to-distribute model of securitisation ensured that the identity of the original instruments was completely lost. Indeed, the instruments were transformed beyond recognition. Simple instruments became “exotic” ones.
In hte process, a huge shadow banking system was created. Banks did not want to keep mortgages and loans on their balance sheet as they needed more capital backing. Instead, they held mortgage backed securities with low risk weights as per the Basle framework. The funding for the loans increasingly came from non banking institutions. These included investment banks, hedge funds, money market funds, finance companies, asset backed conduits and SIVs.
According to Mark Zandy of Economy.com, the shadow banking system provided credit to the tune of $6 trillion by the second quarter of 2007. The shadow banking system was subject to minimal regulatory oversight and did not have to make significant public disclosures. The use of leverage amplified the problem. At the peak of the frenzy in 2005-06, hedge funds were leveraging their investments as many as 50 times.
The genesis of the sub prime crisis
The sub prime crisis assumed monstrous proportions thanks to a combination of factors. These included:
v low interest rates,
v political intervention,
v a laissez-faire attitude on the part of government officials and regulators,
v lax and predatory lending practices,
v a false belief that the housing boom would go on forever,
v a originate-to-distribute securitization process that separated origination from ultimate credit risk,
v imbalances in the global financial system,
v new derivatives like credit default swaps that fuelled speculation in segments of the mortgage market.
Let us explore these themes in a little more detail in the following paragraphs.
Many economists and market analysts believe the roots of the current financial melt down go back at least eight years in time. The US economy had been facing the risk of a deep recession after the dotcom bubble burst in early 2000. This situation was worsened by the 9/11 terrorist attacks, which created a great deal of panic and uncertainty among Americans. In response, the US Central bank, the Federal Reserve (Fed) under the leadership of Alan Greenspan tried to stimulate the economy by reducing interest rates aggressively. In particular, Greenspan hoped housing would get the momentum back into the US economy. Between New Year’s Day 2001 and mid-2003, the Fed cut the Federal Funds rate from 6.5% to 1%. The rate remained at 1% for 12 months from July 2003 to July 2004. Naturally people got an opportunity to borrow much more money than they otherwise would have been able to afford.
owning a house is part of the American dream. And the housing market, which is huge as mentioned earlier, has a big impact on the business cycle in the US. Not surprisingly, American politicians have strongly supported the cause of home ownership. Over the years, various pieces of legislation have been introduced in the US to make mortgages affordable to more people.
· The Federal Housing Administration (FHA) was set up in 1934 to insure mortgage loans provided given by private firms. Initially, a borrower had to make a 20% down payment to qualify for the loan. Later, this requirement was reduced. By 2004, the required down payment for FHA’s most popular program was 3%.
· The Home Mortgage Disclosure Act, 1975 asked lending institutions to report their loan data so that the underserved segments could be targeted for special attention.
· The Community Reinvestment Act (CRA), 1977 required institutions to provide loans to people in low and moderate income neighbourhoods. Congress amended CRA in 1989 to make banks’ CRA ratings public information. In 1995, the regulators got the power to deny approval for a merger to a bank with low CRA rating.
· The Depository Institutions Deregulatory and Monetary Control Act (DIDMCA), 1980 eliminated restrictions on home loan interest rates. Financial institutions could charge borrowers a premium interest rate.
· The Alternative Mortgage Transaction Parity Act (AMTPA) allowed lenders to charge variable interest rates and use balloon payments.
In 1992, Congress directed Fannie Mae and Freddie Mac to increase their purchases of mortgages going to low and moderate income borrowers. In 1996, Fannie and Freddie were told to allocate 42% of this financing to such borrowers. The target increased to 50% in 2000 and 52% in 2005. Fannie and Freddie were also directed to support “special affordable” loans to borrowers with low income. Fannie and Freddie could sustain this aggressive lending as the markets believed there was an implicit guarantee from the government. So the cost of funds was only slightly more than that of Treasury securities. In September 2003, during House Financial Services Committee proceedings, suggestions were made to rein in Fannie and Freddie. But people like Barney Frank who is leading the efforts to restore the health of the American banking system today, fought hard to maintain the status quo.
President Bush personally championed the cause of housing when he articulated his vision of an “ownership society.” In 2003, he signed the American Dream Down payment Act, a program offering money to lower income households to help with down payments. The Bush administration also put pressure on Fannie Mae and Freddie Mac to provide more mortgage loans to low income groups. By the time of the sub prime crisis, these two pillars of the American housing system had become heavy investors in the triple A rated, senior tranches of CDOs, which lay at the heart of the crisis.
At some points of time, Congress did raise some concerns about predatory lending, i.e., aggressive lending in which borrowers are not fully aware of the long term implications of the loan. In 1994, Congress passed the Home Ownership and Equity Protection Act (HOEPA) which authorised the Fed to prohibit predatory lending practices by any lender, irrespective of who regulated the lender. The Fed however used these powers only sparingly.
By mid-2004, fears about deflation had diminished while those about inflation had increased. When the Fed got into a tightening act, the benchmark interest rate went up to 5.25%. People who had borrowed when rates were 1% did not have time to adjust to the pressures of larger interest payments. With traditional profit making opportunities drying up, lenders became willing to take greater risks and entered the subprime segment in a big way. They did this by introducing adjustable rate mortgages, which came with several options:
v Low introductory interest rate that adjusted after a few years.
v Payment of only interest on the loan for a specified period of time.
v Payment of less interest than was due, the balance being added to the mortgage.
v Balloon payments in which the borrower could pay off the loan at the end of a specified period of time.
Adjustable Rate Mortgages (ARMs) had been around for the past 25 years. But in the past, they were offered to creditworthy borrowers with stable incomes and who could make bigger down payments. In 2006, 90% of the sub prime loans involved ARMs.
Traditionally, as a risk mitigation measure, lenders insisted that borrowers making small down payments must buy mortgage insurance. But insurance was costly. To allow home buyers to avoid buying mortgage insurance, generally required for large loans with low down payments, lenders counselled borrowers to take out two mortgages. This way, they circumvented the system and made it easier than ever for people to get a mortgage loan. In short, borrowers and lenders collaborated to beat the system!
As homes became more and more unaffordable, lenders became even more aggressive. Loans were offered without the need for borrowers to prove their income. “Stated income” loans went mainstream. They came to be known as liars’ loans. By 2006, well over half of the subprime loans were stated income loans. Some builders even set up their own mortgage lending affiliates to ensure that credit kept flowing even if traditional lenders refused to lend.
Home equity played a big role in fuelling the boom. As real estate prices continued to rise, sub prime borrowers were able to roll over their mortgages after a specified number of years. They paid the outstanding loan with funds from a new larger loan based on the higher valuation of the property. Thus, borrowers could immediately spend the gain they booked on the property. From 1997 through 2006, consumers drew more than $9 trillion in cash out of their home equity. In the 2000s, home equity withdrawals were financing 3% of all personal consumption in the US.
Even with soaring house prices, the market could not have expanded so much without securitization. Previously, mortgages appeared directly on a bank's balance sheet and had to be backed by equity capital. Securitization allowed banks to bundle many loans into tradable securities and thereby free up capital. Banks were also able to issue more mortgage loans for a given amount of underlying capital.
For securitisation to take off, clever marketing was required. Few investors would have looked seriously at sub prime mortgage securities considered alone. To make subprime mortgages more palatable to investors, they were mixed with higher rated instruments. In the products so created, different groups of investors were entitled to different streams of cash flows based on the risk return disposition of the investors. These products came to be known as Collateralised Debt Obligations (CDOs). We shall cover CDOs in more detail a little later in the chapter.
As mentioned in Chapter 2, the imbalances in the global financial system also played a crucial role in helping securitisation take off. Many countries in the Asia Pacific and the Middle East had registered huge trade surpluses with the US and accumulated huge amounts of foreign exchange reserves. Traditionally, these countries had invested their excess dollars in US treasury bills and bonds. To generate more returns, they began to look at other US instruments including those related to mortgage, more seriously.
Complex, opaque instruments and heavy speculation transformed the market conditions dramatically. The basic principles of risk pricing were conveniently ignored. Indeed, the risk pricing mechanism broke down. A study by the Fed indicated that the average difference in mortgage interest rates between subprime and prime mortgages declined from 2.8 percentage points (280 basis points) in 2001, to 1.3 percentage points in 2007. This happened even as subprime borrower and loan characteristics deteriorated overall during the 2001–2006 period. The more investors started to buy mortgage backed securities, the more the yields fell. Eventually a high rated security fetched barely more than a sub prime mortgage loan. But investors, having succumbed to the temptation, failed to back off. Rather than trying to reduce their positions, they tried to generate greater returns, using leverage.
As mentioned earlier, the payment burden for subprime mortgage borrowers increased sharply after an initial period. Borrowers were betting on rising home prices to refinance their mortgages at lower rates of interest and use the capital gains for other spending. Unfortunately, this bet did not pay off. Real estate prices started to drop in 2006 while interest rates rose. So the easy gains from refinancing mortgages evaporated. Many of the sub prime mortgages had an adjustable interest rate. The interest rate was low for an initial period of two to five years. Then it was reset. These reset rates were significantly higher than the initial fixed "teaser rate" and proved to be beyond what most subprime borrowers could pay. This double whammy, fall in home value and higher reset rates, proved to be too much for many borrowers.
To get an idea of the magnitude of the problem, the value of U.S. subprime mortgages had risen to about $1.3 trillion as of March 2007. Of this amount, the estimated value of subprime adjustable-rate mortgages (ARM) resetting at higher interest rates was $400 billion for 2007 and $500 billion for 2008. Approximately 16% of subprime loans with adjustable rate mortgages (ARM) were 90-days delinquent or in foreclosure proceedings as of October 2007, about three times the rate of 2005. By January 2008, the delinquency rate had risen to 21% and by May 2008 it was 25%. Subprime ARMs only represented 6.8% of the home loans outstanding in the US. But they accounted for 43.0% of the foreclosures started during the third quarter of 2007.
The number of home loan of defaults arose from an annualised 775,000 at the end of 2005 to nearly 1 million by the end of 2006. A second wave of defaults and foreclosures began in the spring of 2007. A third wave of loan defaults and disclosures happened when home equity turned negative for many borrowers. As many as 446,726 U.S. household properties were subject to some sort of foreclosure action from July to September 2007. The number increased to 527,740 during the fourth quarter of 2007. For all of 2007, nearly 1.3 million properties were subject to 2.2 million foreclosure filings, up 79% and 75% respectively compared to 2006. These developments forced a crash in the housing market. At the start of 2007, new and existing home sales were running close to 7.5 million units per year. By the end of the year, the number had fallen below 5.5 million.
Total home equity was valued (in the US) at its peak at $13 trillion in 2006. This dropped to $8.8 trillion by mid-2008. Total retirement assets fell from $10.3 trillion to $8 trillion during the same period. At the same time, savings and investment assets lost $1.2 trillion and pension assets $1.3 trillion during the same period.
v low interest rates,
v political intervention,
v a laissez-faire attitude on the part of government officials and regulators,
v lax and predatory lending practices,
v a false belief that the housing boom would go on forever,
v a originate-to-distribute securitization process that separated origination from ultimate credit risk,
v imbalances in the global financial system,
v new derivatives like credit default swaps that fuelled speculation in segments of the mortgage market.
Let us explore these themes in a little more detail in the following paragraphs.
Many economists and market analysts believe the roots of the current financial melt down go back at least eight years in time. The US economy had been facing the risk of a deep recession after the dotcom bubble burst in early 2000. This situation was worsened by the 9/11 terrorist attacks, which created a great deal of panic and uncertainty among Americans. In response, the US Central bank, the Federal Reserve (Fed) under the leadership of Alan Greenspan tried to stimulate the economy by reducing interest rates aggressively. In particular, Greenspan hoped housing would get the momentum back into the US economy. Between New Year’s Day 2001 and mid-2003, the Fed cut the Federal Funds rate from 6.5% to 1%. The rate remained at 1% for 12 months from July 2003 to July 2004. Naturally people got an opportunity to borrow much more money than they otherwise would have been able to afford.
owning a house is part of the American dream. And the housing market, which is huge as mentioned earlier, has a big impact on the business cycle in the US. Not surprisingly, American politicians have strongly supported the cause of home ownership. Over the years, various pieces of legislation have been introduced in the US to make mortgages affordable to more people.
· The Federal Housing Administration (FHA) was set up in 1934 to insure mortgage loans provided given by private firms. Initially, a borrower had to make a 20% down payment to qualify for the loan. Later, this requirement was reduced. By 2004, the required down payment for FHA’s most popular program was 3%.
· The Home Mortgage Disclosure Act, 1975 asked lending institutions to report their loan data so that the underserved segments could be targeted for special attention.
· The Community Reinvestment Act (CRA), 1977 required institutions to provide loans to people in low and moderate income neighbourhoods. Congress amended CRA in 1989 to make banks’ CRA ratings public information. In 1995, the regulators got the power to deny approval for a merger to a bank with low CRA rating.
· The Depository Institutions Deregulatory and Monetary Control Act (DIDMCA), 1980 eliminated restrictions on home loan interest rates. Financial institutions could charge borrowers a premium interest rate.
· The Alternative Mortgage Transaction Parity Act (AMTPA) allowed lenders to charge variable interest rates and use balloon payments.
In 1992, Congress directed Fannie Mae and Freddie Mac to increase their purchases of mortgages going to low and moderate income borrowers. In 1996, Fannie and Freddie were told to allocate 42% of this financing to such borrowers. The target increased to 50% in 2000 and 52% in 2005. Fannie and Freddie were also directed to support “special affordable” loans to borrowers with low income. Fannie and Freddie could sustain this aggressive lending as the markets believed there was an implicit guarantee from the government. So the cost of funds was only slightly more than that of Treasury securities. In September 2003, during House Financial Services Committee proceedings, suggestions were made to rein in Fannie and Freddie. But people like Barney Frank who is leading the efforts to restore the health of the American banking system today, fought hard to maintain the status quo.
President Bush personally championed the cause of housing when he articulated his vision of an “ownership society.” In 2003, he signed the American Dream Down payment Act, a program offering money to lower income households to help with down payments. The Bush administration also put pressure on Fannie Mae and Freddie Mac to provide more mortgage loans to low income groups. By the time of the sub prime crisis, these two pillars of the American housing system had become heavy investors in the triple A rated, senior tranches of CDOs, which lay at the heart of the crisis.
At some points of time, Congress did raise some concerns about predatory lending, i.e., aggressive lending in which borrowers are not fully aware of the long term implications of the loan. In 1994, Congress passed the Home Ownership and Equity Protection Act (HOEPA) which authorised the Fed to prohibit predatory lending practices by any lender, irrespective of who regulated the lender. The Fed however used these powers only sparingly.
By mid-2004, fears about deflation had diminished while those about inflation had increased. When the Fed got into a tightening act, the benchmark interest rate went up to 5.25%. People who had borrowed when rates were 1% did not have time to adjust to the pressures of larger interest payments. With traditional profit making opportunities drying up, lenders became willing to take greater risks and entered the subprime segment in a big way. They did this by introducing adjustable rate mortgages, which came with several options:
v Low introductory interest rate that adjusted after a few years.
v Payment of only interest on the loan for a specified period of time.
v Payment of less interest than was due, the balance being added to the mortgage.
v Balloon payments in which the borrower could pay off the loan at the end of a specified period of time.
Adjustable Rate Mortgages (ARMs) had been around for the past 25 years. But in the past, they were offered to creditworthy borrowers with stable incomes and who could make bigger down payments. In 2006, 90% of the sub prime loans involved ARMs.
Traditionally, as a risk mitigation measure, lenders insisted that borrowers making small down payments must buy mortgage insurance. But insurance was costly. To allow home buyers to avoid buying mortgage insurance, generally required for large loans with low down payments, lenders counselled borrowers to take out two mortgages. This way, they circumvented the system and made it easier than ever for people to get a mortgage loan. In short, borrowers and lenders collaborated to beat the system!
As homes became more and more unaffordable, lenders became even more aggressive. Loans were offered without the need for borrowers to prove their income. “Stated income” loans went mainstream. They came to be known as liars’ loans. By 2006, well over half of the subprime loans were stated income loans. Some builders even set up their own mortgage lending affiliates to ensure that credit kept flowing even if traditional lenders refused to lend.
Home equity played a big role in fuelling the boom. As real estate prices continued to rise, sub prime borrowers were able to roll over their mortgages after a specified number of years. They paid the outstanding loan with funds from a new larger loan based on the higher valuation of the property. Thus, borrowers could immediately spend the gain they booked on the property. From 1997 through 2006, consumers drew more than $9 trillion in cash out of their home equity. In the 2000s, home equity withdrawals were financing 3% of all personal consumption in the US.
Even with soaring house prices, the market could not have expanded so much without securitization. Previously, mortgages appeared directly on a bank's balance sheet and had to be backed by equity capital. Securitization allowed banks to bundle many loans into tradable securities and thereby free up capital. Banks were also able to issue more mortgage loans for a given amount of underlying capital.
For securitisation to take off, clever marketing was required. Few investors would have looked seriously at sub prime mortgage securities considered alone. To make subprime mortgages more palatable to investors, they were mixed with higher rated instruments. In the products so created, different groups of investors were entitled to different streams of cash flows based on the risk return disposition of the investors. These products came to be known as Collateralised Debt Obligations (CDOs). We shall cover CDOs in more detail a little later in the chapter.
As mentioned in Chapter 2, the imbalances in the global financial system also played a crucial role in helping securitisation take off. Many countries in the Asia Pacific and the Middle East had registered huge trade surpluses with the US and accumulated huge amounts of foreign exchange reserves. Traditionally, these countries had invested their excess dollars in US treasury bills and bonds. To generate more returns, they began to look at other US instruments including those related to mortgage, more seriously.
Complex, opaque instruments and heavy speculation transformed the market conditions dramatically. The basic principles of risk pricing were conveniently ignored. Indeed, the risk pricing mechanism broke down. A study by the Fed indicated that the average difference in mortgage interest rates between subprime and prime mortgages declined from 2.8 percentage points (280 basis points) in 2001, to 1.3 percentage points in 2007. This happened even as subprime borrower and loan characteristics deteriorated overall during the 2001–2006 period. The more investors started to buy mortgage backed securities, the more the yields fell. Eventually a high rated security fetched barely more than a sub prime mortgage loan. But investors, having succumbed to the temptation, failed to back off. Rather than trying to reduce their positions, they tried to generate greater returns, using leverage.
As mentioned earlier, the payment burden for subprime mortgage borrowers increased sharply after an initial period. Borrowers were betting on rising home prices to refinance their mortgages at lower rates of interest and use the capital gains for other spending. Unfortunately, this bet did not pay off. Real estate prices started to drop in 2006 while interest rates rose. So the easy gains from refinancing mortgages evaporated. Many of the sub prime mortgages had an adjustable interest rate. The interest rate was low for an initial period of two to five years. Then it was reset. These reset rates were significantly higher than the initial fixed "teaser rate" and proved to be beyond what most subprime borrowers could pay. This double whammy, fall in home value and higher reset rates, proved to be too much for many borrowers.
To get an idea of the magnitude of the problem, the value of U.S. subprime mortgages had risen to about $1.3 trillion as of March 2007. Of this amount, the estimated value of subprime adjustable-rate mortgages (ARM) resetting at higher interest rates was $400 billion for 2007 and $500 billion for 2008. Approximately 16% of subprime loans with adjustable rate mortgages (ARM) were 90-days delinquent or in foreclosure proceedings as of October 2007, about three times the rate of 2005. By January 2008, the delinquency rate had risen to 21% and by May 2008 it was 25%. Subprime ARMs only represented 6.8% of the home loans outstanding in the US. But they accounted for 43.0% of the foreclosures started during the third quarter of 2007.
The number of home loan of defaults arose from an annualised 775,000 at the end of 2005 to nearly 1 million by the end of 2006. A second wave of defaults and foreclosures began in the spring of 2007. A third wave of loan defaults and disclosures happened when home equity turned negative for many borrowers. As many as 446,726 U.S. household properties were subject to some sort of foreclosure action from July to September 2007. The number increased to 527,740 during the fourth quarter of 2007. For all of 2007, nearly 1.3 million properties were subject to 2.2 million foreclosure filings, up 79% and 75% respectively compared to 2006. These developments forced a crash in the housing market. At the start of 2007, new and existing home sales were running close to 7.5 million units per year. By the end of the year, the number had fallen below 5.5 million.
Total home equity was valued (in the US) at its peak at $13 trillion in 2006. This dropped to $8.8 trillion by mid-2008. Total retirement assets fell from $10.3 trillion to $8 trillion during the same period. At the same time, savings and investment assets lost $1.2 trillion and pension assets $1.3 trillion during the same period.
Deregulation and innovation and the sub prime crisis
Rapid deregulation and financial innovation combined to set the stage for the sub prime crisis. This blog provides a brief hsitorical perspective.
After the economic turmoil of the 1970s, the market economy found passionate champions in Ronald Reagan and Margaret Thatcher. Believing that freer markets would bring economic gains, they took the plunge and abolished various controls. Both Reagan and Thatcher had a lot of fan following. And they commanded respect in many countries. Liberalisation of the financial system soon became a major theme in many developed countries.
In London, the Big Bang of 1986 abolished the distinction between brokers and jobbers and allowed foreign firms, with more capital, into the market. These firms could handle larger transactions, more cheaply. The Big Bang undoubtedly played a big role in the emergence of London as a preeminent global financial centre. Meanwhile, the No.1 financial centre in the world, New York had already introduced a similar reform in 1975, following pressure from institutional investors.
These reforms had major implications for the business models of market participants. The fall in commissions contributed to the long-term decline of broking as a source of revenue. The effect was disguised for a while by a higher volume of transactions. But the broker-dealers (the then popular name for investment bankers) increasingly had to commit their own capital to deals. In turn, this made trading on their own account, or proprietary trading, a potentially attractive source of revenue. No bank made more impressive strides in this area, than Goldman Sachs.
Meanwhile, commercial banks faced intense competition in corporate lending. At the same time, retail banking required expensive branch networks. Naturally, commercial banks wanted to diversify into more lucrative “fee based” businesses. With their strong balance-sheets, they started to compete with investment banks for the underwriting of securities. Investment banks responded by getting bigger. As banks became more diversified, they also became more complex.
As the same time, there were major advances in risk management thanks to innovative financial instruments and sophisticated quantitative techniques. Option contracts have been known since ancient times but the 1970s saw an explosion in their use. The development of the Black Scholes Merton Option Pricing Model, for which Myron Scholes and Robert Merton later won the Nobel Prize, no doubt played an important role. While Black Scholes enabled options trading to take off, other derivatives also became rapidly popular. Currency swaps and interest-rate swaps enabled hedging and speculation in currency and interest rate risk respectively. More recently, credit derivatives have made possible the slicing and dicing of credit risk in ways which would have been unimaginable about 40 years back.
The concept of securitisation rapidly became popular. Securitisation was projected as a mechanism for spreading risk and creating new growth opportunities for banks by freeing up capital. Commercial banks did not have to depend on the slow and costly business of attracting retail deposits to fund their transactions. Of course, securitisation was also misused by some market participants. That is how the sub prime crisis was fuelled.
As deregulation gathered momentum, the global financial system faced crises from time to time. These included the failures of Drexel Burnham Lambert, which dominated the junk-bond market and the collapse of Barings. But these crises were regarded as individual instances of mismanagement or fraud, rather than evidence of any systemic problem. The American savings-and-loan crisis, (mentioned earlier) which was a systemic failure was resolved with the help of a bail-out plan and easy monetary policy, and dismissed as an aberration. Even the Long Term Capital Management crisis of 1998 did not create any serious problems. A Fed sponsored bailout ensured that the markets continued to function normally.
But the recent financial meltdown has resulted in a lot of soul searching about the merits of aggressive deregulation. The melt down has been unprecedented in terms of magnitude and impact. The long drawn out crisis is a reflection of how complex and inter connected the world of finance has become. An array of financial instruments has emerged that make it possible to bundle, unbundle and rebundle risk in various ways. Deregulation, technology and globalization have transformed the world of finance beyond recognition. At the end of 2007, the notional value of all derivative contracts globally was estimated at $600 trillion or 11 times the world GDP. Ten years back, it had been $75 trillion or 2.5 times the world GDP.
Clearly, finance has grown much more rapidly than the underlying, “real” economy. That probably explains why regulation has become so difficult.
After the economic turmoil of the 1970s, the market economy found passionate champions in Ronald Reagan and Margaret Thatcher. Believing that freer markets would bring economic gains, they took the plunge and abolished various controls. Both Reagan and Thatcher had a lot of fan following. And they commanded respect in many countries. Liberalisation of the financial system soon became a major theme in many developed countries.
In London, the Big Bang of 1986 abolished the distinction between brokers and jobbers and allowed foreign firms, with more capital, into the market. These firms could handle larger transactions, more cheaply. The Big Bang undoubtedly played a big role in the emergence of London as a preeminent global financial centre. Meanwhile, the No.1 financial centre in the world, New York had already introduced a similar reform in 1975, following pressure from institutional investors.
These reforms had major implications for the business models of market participants. The fall in commissions contributed to the long-term decline of broking as a source of revenue. The effect was disguised for a while by a higher volume of transactions. But the broker-dealers (the then popular name for investment bankers) increasingly had to commit their own capital to deals. In turn, this made trading on their own account, or proprietary trading, a potentially attractive source of revenue. No bank made more impressive strides in this area, than Goldman Sachs.
Meanwhile, commercial banks faced intense competition in corporate lending. At the same time, retail banking required expensive branch networks. Naturally, commercial banks wanted to diversify into more lucrative “fee based” businesses. With their strong balance-sheets, they started to compete with investment banks for the underwriting of securities. Investment banks responded by getting bigger. As banks became more diversified, they also became more complex.
As the same time, there were major advances in risk management thanks to innovative financial instruments and sophisticated quantitative techniques. Option contracts have been known since ancient times but the 1970s saw an explosion in their use. The development of the Black Scholes Merton Option Pricing Model, for which Myron Scholes and Robert Merton later won the Nobel Prize, no doubt played an important role. While Black Scholes enabled options trading to take off, other derivatives also became rapidly popular. Currency swaps and interest-rate swaps enabled hedging and speculation in currency and interest rate risk respectively. More recently, credit derivatives have made possible the slicing and dicing of credit risk in ways which would have been unimaginable about 40 years back.
The concept of securitisation rapidly became popular. Securitisation was projected as a mechanism for spreading risk and creating new growth opportunities for banks by freeing up capital. Commercial banks did not have to depend on the slow and costly business of attracting retail deposits to fund their transactions. Of course, securitisation was also misused by some market participants. That is how the sub prime crisis was fuelled.
As deregulation gathered momentum, the global financial system faced crises from time to time. These included the failures of Drexel Burnham Lambert, which dominated the junk-bond market and the collapse of Barings. But these crises were regarded as individual instances of mismanagement or fraud, rather than evidence of any systemic problem. The American savings-and-loan crisis, (mentioned earlier) which was a systemic failure was resolved with the help of a bail-out plan and easy monetary policy, and dismissed as an aberration. Even the Long Term Capital Management crisis of 1998 did not create any serious problems. A Fed sponsored bailout ensured that the markets continued to function normally.
But the recent financial meltdown has resulted in a lot of soul searching about the merits of aggressive deregulation. The melt down has been unprecedented in terms of magnitude and impact. The long drawn out crisis is a reflection of how complex and inter connected the world of finance has become. An array of financial instruments has emerged that make it possible to bundle, unbundle and rebundle risk in various ways. Deregulation, technology and globalization have transformed the world of finance beyond recognition. At the end of 2007, the notional value of all derivative contracts globally was estimated at $600 trillion or 11 times the world GDP. Ten years back, it had been $75 trillion or 2.5 times the world GDP.
Clearly, finance has grown much more rapidly than the underlying, “real” economy. That probably explains why regulation has become so difficult.
The Sub prime crisis and Liquidity Risk
The sub prime crisis was as much about liquidity as about insolvency. Many banks suffered during the sub prime crisis because of a capital structure that relied too heavily on debt.
Markus Brunnermeir[1] points out that a loss spiral arises for leveraged investors because a decline in the value of assets erodes the investors’ net worth much faster than their gross worth. The amount that they can borrow falls sharply. For example, consider an investor with a leverage ratio of 1:10, who buys $100 million worth of assets on 10 percent margin. This investor finances only $10 million with his own capital and borrows $90 million. Say the value of the acquired asset declines temporarily to $95 million. The investor, who started out with $10 million in capital, now has lost $5 million. So there is only $5 million of capital remaining. To prevent the leverage ratio from going up, this investor must reduce the overall position to $50 million. In other words, $45 million of assets must be sold. And this sale will happen exactly when the price is low. These sales will depress the price further, inducing more selling and so on. This loss spiral will get aggravated if some other potential buyers with expertise may face similar constraints at the same time. The spiral will also get amplified if other potential buyers find it more profitable to wait out the loss spiral before reentering the market. Indeed, traders might even engage in “predatory trading,” deliberately forcing others to liquidate their positions at fire-sale prices.
The margin/haircut spiral reinforces the loss spiral. As margins or haircuts rise, the investor has to sell assets to reduce the leverage ratio. Margins and haircuts spike in times of large price drops, leading to a general tightening of lending. A vicious cycle emerges, where higher margins and haircuts force de-leveraging and more sales, which increase margins further and force more sales, leading to the possibility of multiple equilibria.
An increase in counterparty credit risk can create additional funding needs and potential systemic risk. Brunnermeir has illustrated this by an example related to the Bear Stearns crisis in March 2008. Imagine a hedge fund that had an interest rate swap agreement with Goldman Sachs. Say the hedge fund offset its obligation through another swap with Bear Stearns. In the absence of counterparty credit risk, the two swap agreements would together be viewed essentially as a single one between Goldman and Bear Stearns. However, it would be unwise for Goldman to renew the contract if it feared that Bear might default on its commitment. Goldman was asked to increase its direct exposure to Bear after the trading hours on March 11, 2008 when Bear was approaching bankruptcy. Goldman did renew the contract in the morning of March 12. But the delay in response was mistakenly interpreted as a hesitation on Goldman’s behalf and fear that Bear Stearns might be in trouble. This misinterpretation was leaked to the media and seems to have contributed to the run on Bear Stearns.
Indeed, an increase in perceived counterparty credit risk can be self-fulfilling and create additional funding needs. Suppose that Bear Stearns had an offsetting swap agreement with a private equity fund, which in turn offset its exposure with Goldman Sachs. All parties, taken together, are fully hedged. However, each party is aware only of its own contractual agreements. So it may not know the full situation and therefore become concerned about counterparty credit risk. If the investment banks refuse to let the hedge fund and private equity fund net their offsetting positions, both funds have to either put up additional liquidity, or insure each other against counterparty credit risk by buying credit default swaps. This happened in the week after Lehman’s bankruptcy. All major investment banks were worried that their counterparties might default. So they bought credit default swap protection against each other. The already high prices on credit default swaps of the major investment banks almost doubled. The price of credit default swaps for AIG was hit the worst. It more than doubled within two trading days. Such problems are more easily overcome if there is a central clearinghouse which knows who owes what to whom. Indeed, many economists have argued strongly in favour of moving away from OTC to central clearing arrangements for most if not all derivatives.
[1] “Deciphering the liquidity and credit crunch 2007-2008” Journal of Economic Perspectives, Winter 2009, pp. 77-100.
Markus Brunnermeir[1] points out that a loss spiral arises for leveraged investors because a decline in the value of assets erodes the investors’ net worth much faster than their gross worth. The amount that they can borrow falls sharply. For example, consider an investor with a leverage ratio of 1:10, who buys $100 million worth of assets on 10 percent margin. This investor finances only $10 million with his own capital and borrows $90 million. Say the value of the acquired asset declines temporarily to $95 million. The investor, who started out with $10 million in capital, now has lost $5 million. So there is only $5 million of capital remaining. To prevent the leverage ratio from going up, this investor must reduce the overall position to $50 million. In other words, $45 million of assets must be sold. And this sale will happen exactly when the price is low. These sales will depress the price further, inducing more selling and so on. This loss spiral will get aggravated if some other potential buyers with expertise may face similar constraints at the same time. The spiral will also get amplified if other potential buyers find it more profitable to wait out the loss spiral before reentering the market. Indeed, traders might even engage in “predatory trading,” deliberately forcing others to liquidate their positions at fire-sale prices.
The margin/haircut spiral reinforces the loss spiral. As margins or haircuts rise, the investor has to sell assets to reduce the leverage ratio. Margins and haircuts spike in times of large price drops, leading to a general tightening of lending. A vicious cycle emerges, where higher margins and haircuts force de-leveraging and more sales, which increase margins further and force more sales, leading to the possibility of multiple equilibria.
An increase in counterparty credit risk can create additional funding needs and potential systemic risk. Brunnermeir has illustrated this by an example related to the Bear Stearns crisis in March 2008. Imagine a hedge fund that had an interest rate swap agreement with Goldman Sachs. Say the hedge fund offset its obligation through another swap with Bear Stearns. In the absence of counterparty credit risk, the two swap agreements would together be viewed essentially as a single one between Goldman and Bear Stearns. However, it would be unwise for Goldman to renew the contract if it feared that Bear might default on its commitment. Goldman was asked to increase its direct exposure to Bear after the trading hours on March 11, 2008 when Bear was approaching bankruptcy. Goldman did renew the contract in the morning of March 12. But the delay in response was mistakenly interpreted as a hesitation on Goldman’s behalf and fear that Bear Stearns might be in trouble. This misinterpretation was leaked to the media and seems to have contributed to the run on Bear Stearns.
Indeed, an increase in perceived counterparty credit risk can be self-fulfilling and create additional funding needs. Suppose that Bear Stearns had an offsetting swap agreement with a private equity fund, which in turn offset its exposure with Goldman Sachs. All parties, taken together, are fully hedged. However, each party is aware only of its own contractual agreements. So it may not know the full situation and therefore become concerned about counterparty credit risk. If the investment banks refuse to let the hedge fund and private equity fund net their offsetting positions, both funds have to either put up additional liquidity, or insure each other against counterparty credit risk by buying credit default swaps. This happened in the week after Lehman’s bankruptcy. All major investment banks were worried that their counterparties might default. So they bought credit default swap protection against each other. The already high prices on credit default swaps of the major investment banks almost doubled. The price of credit default swaps for AIG was hit the worst. It more than doubled within two trading days. Such problems are more easily overcome if there is a central clearinghouse which knows who owes what to whom. Indeed, many economists have argued strongly in favour of moving away from OTC to central clearing arrangements for most if not all derivatives.
[1] “Deciphering the liquidity and credit crunch 2007-2008” Journal of Economic Perspectives, Winter 2009, pp. 77-100.
Wednesday, 30 December 2009
Why risk management failed
No society can thrive without taking risk. We should not respond to the sub prime crisis by swearing solemnly. “Never again shall we take risk.” Rather, the efforts must be channelized towards finding loopholes in the current risk management framework, and strengthening systems and processes. Such efforts will encourage companies to take risk once again and pave the way for the return of the animal spirits.
But before we gaze into the future, it is a good idea to look at the recent past. In the months before the crisis, many banks claimed to have put in place sophisticated risk management systems. Yet these systems failed to deliver and many a bank landed in a mess after the sub prime crisis started to unfold. Why did this happen?
Risks went out of control for various reasons. To start with, mechanical approaches were followed by many banks with human judgment and intuition being completely ignored. For example, credit ratings were used to justify heavy investments in the super senior tranches of CDOs. In some cases, the top management did not become sufficiently involved while dealing with risk. In the name of delegation, they abdicated their responsibility. We saw this in some detail in the case of UBS in Chapter 10. Sometimes, the top management did raise the right questions. But they did not follow through with appropriate actions. In other cases, traders fooled risk managers into believing that all the rules were being followed. To a large extent they were able to do this by hiding behind technical jargon and sophisticated quantitative models. Only banks like Goldman Sachs, JP Morgan and Toronto Dominion (of Canada) where the top management asked the right questions at the right time and took principled decisions, escaped relatively unscathed.
In short, the ability of the top management to get involved and ask the right questions at the right time will have a crucial influence on the quality of risk management in an organization.
But before we gaze into the future, it is a good idea to look at the recent past. In the months before the crisis, many banks claimed to have put in place sophisticated risk management systems. Yet these systems failed to deliver and many a bank landed in a mess after the sub prime crisis started to unfold. Why did this happen?
Risks went out of control for various reasons. To start with, mechanical approaches were followed by many banks with human judgment and intuition being completely ignored. For example, credit ratings were used to justify heavy investments in the super senior tranches of CDOs. In some cases, the top management did not become sufficiently involved while dealing with risk. In the name of delegation, they abdicated their responsibility. We saw this in some detail in the case of UBS in Chapter 10. Sometimes, the top management did raise the right questions. But they did not follow through with appropriate actions. In other cases, traders fooled risk managers into believing that all the rules were being followed. To a large extent they were able to do this by hiding behind technical jargon and sophisticated quantitative models. Only banks like Goldman Sachs, JP Morgan and Toronto Dominion (of Canada) where the top management asked the right questions at the right time and took principled decisions, escaped relatively unscathed.
In short, the ability of the top management to get involved and ask the right questions at the right time will have a crucial influence on the quality of risk management in an organization.
The future of investment banking
After all the mauling they received, what is the future of banking? Plain vanilla commercial banks can be expected to operate as before. They provide basic functions like mobilizing savings, providing fixed deposits, etc. In many cases, they also provide letters of credit and other forms of trade financing. These functions are well understood. Indeed, these “non glamorous functions,” may regain their importance.
But what about investment banks? A few like Goldman Sachs already seem to have recovered. But many others are still struggling. With the collapse of Bear Stearns and Lehmann and the acquisition of Merrill by Bank of America, the air of invincibility about large financial institutions no longer exists.
Till recently, investment banks remained the dream employers for graduates of most leading Business Schools. The cowboy approach of the investment bankers received admiration and respect from society, even though of a grudging type. They came to be known as “Masters of the Universe.” Under the guise of financial innovation and various quantitative models, the investment bankers succeeded in convincing regulators that they had found ingenious ways to package and disperse risk. But it is now clear that many of these strategies were undesirable from the systemic risk point of view.
Thanks to the sub prime melt down, investment banking will undoubtedly undergo some structural changes in the coming years. Many banks are examining their product lines to determine whether the returns generated justify the risks taken. We saw this in great detail in the case of the investment banking division of the global Swiss bank, UBS in Chapter 13. Banks are also reducing leverage dramatically.
Leverage has traditionally been an integral part of the business model of most investment banks. Indeed, investment banks thrived on leverage to generate adequate returns for shareholders. The leverage ratio (Total assets to equity) for Wall Street banks was in the range 25-30 before the bubble burst. The great thing about leverage is that even a small rise in the value of investments results in a phenomenal return on capital. But the downside is that a small drop in the value of investments can wipe out the equity and raise fundamental concerns about a bank’s viability causing the stock price to plunge. That is why investment banks are reducing leverage. But as leverage reduces and capital goes up, the returns to shareholders are bound to reduce. So investment banks will have to get used to much lower returns on equity than they have been used to delivering in the past. In the early part of 2009, some banks such as Goldman have shown record profits. But that seems to be more due to government support. It is unlikely that these profits can be sustained in the long run.
Investment banks will also have to diversify their fund base. They will have to reduce their dependence on wholesale short term funding. During the sub prime crisis, when this funding dried up, it became difficult to roll over positions. That is how the Structured Investment Vehicles (SIVs) got into trouble. Liquidity dried up and many of the sub prime assets came back to the balance sheets of banks. In future, investment banks are likely to depend on “stickier,” retail deposits for their funding needs.
What kind of shakeout can we expect in the investment banking industry? It is too early to make predictions but already there are some doubts about the future of bulge bracket investment banks. Advisory boutiques with a “partnership,” culture that also give clients good, independent advice, seem to be doing well after the meltdown. These boutiques also have less conflict of interest. For example, they are generally not involved in proprietary trading or market making.
But what about investment banks? A few like Goldman Sachs already seem to have recovered. But many others are still struggling. With the collapse of Bear Stearns and Lehmann and the acquisition of Merrill by Bank of America, the air of invincibility about large financial institutions no longer exists.
Till recently, investment banks remained the dream employers for graduates of most leading Business Schools. The cowboy approach of the investment bankers received admiration and respect from society, even though of a grudging type. They came to be known as “Masters of the Universe.” Under the guise of financial innovation and various quantitative models, the investment bankers succeeded in convincing regulators that they had found ingenious ways to package and disperse risk. But it is now clear that many of these strategies were undesirable from the systemic risk point of view.
Thanks to the sub prime melt down, investment banking will undoubtedly undergo some structural changes in the coming years. Many banks are examining their product lines to determine whether the returns generated justify the risks taken. We saw this in great detail in the case of the investment banking division of the global Swiss bank, UBS in Chapter 13. Banks are also reducing leverage dramatically.
Leverage has traditionally been an integral part of the business model of most investment banks. Indeed, investment banks thrived on leverage to generate adequate returns for shareholders. The leverage ratio (Total assets to equity) for Wall Street banks was in the range 25-30 before the bubble burst. The great thing about leverage is that even a small rise in the value of investments results in a phenomenal return on capital. But the downside is that a small drop in the value of investments can wipe out the equity and raise fundamental concerns about a bank’s viability causing the stock price to plunge. That is why investment banks are reducing leverage. But as leverage reduces and capital goes up, the returns to shareholders are bound to reduce. So investment banks will have to get used to much lower returns on equity than they have been used to delivering in the past. In the early part of 2009, some banks such as Goldman have shown record profits. But that seems to be more due to government support. It is unlikely that these profits can be sustained in the long run.
Investment banks will also have to diversify their fund base. They will have to reduce their dependence on wholesale short term funding. During the sub prime crisis, when this funding dried up, it became difficult to roll over positions. That is how the Structured Investment Vehicles (SIVs) got into trouble. Liquidity dried up and many of the sub prime assets came back to the balance sheets of banks. In future, investment banks are likely to depend on “stickier,” retail deposits for their funding needs.
What kind of shakeout can we expect in the investment banking industry? It is too early to make predictions but already there are some doubts about the future of bulge bracket investment banks. Advisory boutiques with a “partnership,” culture that also give clients good, independent advice, seem to be doing well after the meltdown. These boutiques also have less conflict of interest. For example, they are generally not involved in proprietary trading or market making.
The price of the sub prime crisis
The overarching purpose of a sound financial system is to channelise effectively savings into productive investments. When the financial system is characterized by fear and panic, this function cannot be discharged. Investment spending falls and GDP shrinks. This more than anything else, is the real cost of a financial crisis.
Towards the end of 2008, as the crisis peaked, the markets for corporate bonds and commercial paper all but dried up. The spreads between risky and risk free instruments rose to phenomenal heights. Banks stopped lending and instead preferred to hoard cash. Economy after economy began to shrink in size with some countries showing double digit negative growth.
In the past six months, however, things have improved remarkably. The markets seem to be recovering. And global trade is gaining momentum. As we approach the end of 2009, the worst seems to be over, though we still do not know whether the recovery that began in early 2009 will be sustained. During the peak of the crisis, the governments and central banks were the only source of liquidity. Unless this perception goes away completely, recovery will be muted and halting.
Whatever be the nature of the recovery, we do know that we are paying a huge cost for the sub prime crisis and the bill is rising each day. The magnitude of the crisis is reflected in the scale of the government intervention. The value of sovereign credit and guarantees put in place during the crisis, already exceeds $7 trillion. (Estimates of course vary) There is hardly any major country in the world which has not announced a fiscal stimulus to boost spending and restore confidence. And obviously, central banks have been in the thick of things to provide liquidity to the financial system. The US Federal Reserve provided a bailout loan of $30 billion in case of Bear Stearns, a $85 billion credit facility for AIG and guaranteed $424 bn of losses on bad assets in case of Citibank and Bank of America. As of June 2009, the Fed’s total assets had risen to over $2 trillion compared with $852 billion in 2006. Only 29% of these assets were Treasury securities, compared with 91% in 2006.
Towards the end of 2008, as the crisis peaked, the markets for corporate bonds and commercial paper all but dried up. The spreads between risky and risk free instruments rose to phenomenal heights. Banks stopped lending and instead preferred to hoard cash. Economy after economy began to shrink in size with some countries showing double digit negative growth.
In the past six months, however, things have improved remarkably. The markets seem to be recovering. And global trade is gaining momentum. As we approach the end of 2009, the worst seems to be over, though we still do not know whether the recovery that began in early 2009 will be sustained. During the peak of the crisis, the governments and central banks were the only source of liquidity. Unless this perception goes away completely, recovery will be muted and halting.
Whatever be the nature of the recovery, we do know that we are paying a huge cost for the sub prime crisis and the bill is rising each day. The magnitude of the crisis is reflected in the scale of the government intervention. The value of sovereign credit and guarantees put in place during the crisis, already exceeds $7 trillion. (Estimates of course vary) There is hardly any major country in the world which has not announced a fiscal stimulus to boost spending and restore confidence. And obviously, central banks have been in the thick of things to provide liquidity to the financial system. The US Federal Reserve provided a bailout loan of $30 billion in case of Bear Stearns, a $85 billion credit facility for AIG and guaranteed $424 bn of losses on bad assets in case of Citibank and Bank of America. As of June 2009, the Fed’s total assets had risen to over $2 trillion compared with $852 billion in 2006. Only 29% of these assets were Treasury securities, compared with 91% in 2006.
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