1

Subprime Loans: How to improve Transparency

Toshihiko Sasaki

Japan Securities Dealers Association

September 24 , 2008

Interbanking Conference in Almaty, Kazakhstan

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1.Matters in Question1.Matters in Question

Structure of Subprime Mortgage Loans

Housing loan borrow

ers

Housing loan brokers (interm

ediaries)

Housing loan lenders

housing loan finance com

panies, comm

ercial banks,（

etc.）

sales・ credit・evaluationrequired・

documentation

lending

fees

GSEs

Fannie Mae,（Freddie Mac）

Investment Banks（ＳＰＣ）

transfer ofhousing loansconforming（

loans）

transfer ofhousing loansnon-confirming（

loans subprime＜loans, etc.＞）

mortgage-backedsecurities

Investorsinvesting in（

securities with highcredit rating）

, ＲＭＢＳ ＣＤＯwith low credit（

rating）

Investorsinvesting in（

securities with lowcredit rating）

,ＲＭＢＳＣＤＯwith high credit（

rating）

Credit RatingAgencies

rating

rating

rating

Short- termfunding throughrepo transactions

Short- term fundingthrough ABCP

Banks provideback-up linesfor ABCP

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Matters in QuestionMatters in Question US Economy and Financial Market before

Subprime Crisis　　・ Continued booming economy　・ Prolonged loose monetary policy　・ Ample liquidity　・ Rise in housing prices　・ Reduction in credit and liquidity risk

premiums

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Matters in QuestionMatters in Question Investors

・　 preferred high-risk-high-return investing under the afore-mentioned economic and financial circumstances

　← invested in high-yield subprime products (particularly secondary securitized products) aggressively taking interest-rate, liquidity and credit risks

・　 meanwhile, lacked awareness and management of risks (credit and liquidity risks)

　← lacked firm-wide risk management, sometimes without top management’s involvement　← overlooked risks that should be recognized and managed, e.g. liquidity risk arising from off-balance-

sheet vehicles　← followed conventional risk management practices and lacked awareness of their limitations　← used risk models that did not properly perceive risks of underlying assets of securitized products

・　 made investment relying excessively on credit rating

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Matters in QuestionMatters in Question Housing Loan Lenders

・　 made loans under substantially relaxed lending criteria ← failed to conduct due examination of loans in the originate-to-distribute process

・　 after securitization, provided insufficient disclosure on performance of housing loans which were underlying assets of securitized products

Government Authorities

・　 kept regulations to protect the privacy of borrowers and may have eventually hindered adequate information disclosure

　← Loan-by-loan information has not been disclosed to all market participants

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Matters in QuestionMatters in Question Credit Rating Agencies・　 failed to duly investigate rating methods and accuracy

of information・　 did not exercise due diligence to credit capability of

housing loan borrowers・　 failed to make reviews periodically by independent

groups from those originally made ratings・　 had organizational structure apt to cause conflict of

interests (acquisition of customers vs. accuracy of ratings) Originators・　 did “rating shopping” where they selected rating

agencies to get higher ratings they wanted・　 purchased housing loans without due diligence based

on the subsequent sales just after securitization

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2. US and European Initiatives to Redress the Issues2. US and European Initiatives to Redress the Issues

・　 CEO and top management should be wholly responsible for risk management. In particular, CRO has a critical role.

・　 When taking risks, all kinds of risks including off-balance-sheet vehicles should be managed.

・　 Risk management methods should be revised flexibly depending on the amount of risks taken and on changes in external economic environment.

・　 Limitations of risk management models and logics like VAR model should be recognized.

・　 For securitized products, risk management models that directly measure underlying assets’ risks and sensitivity to market should be employed.

・　 Methods for stress test should be improved by expanding its coverage of risks including liquidity risks.

Enhanced risk management

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US and European Initiatives to Redress the Issues US and European Initiatives to Redress the Issues

・　 CRAs should constantly make internal reviewing of their ratings done by an independent monitoring department.

・　 CRAs should build systems for external review of the afore-mentioned internal monitoring.

・　 CRAs should distinguish ratings of securitized products from those of corporate bonds.

・　 To prevent “rating shopping”, issuers should provide enough disclosure so that third parties can make alternative analysis.

Restoration of Confidence in CRAs

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US and European Initiatives to Redress the IssuesUS and European Initiatives to Redress the Issues

・　“ Too much ” information means “too little” .Proper transparency of information matching the needs of each market player is imperative.

　← For investors to easily understand schemes of securitized products, well-focused and comprehensive summary of prospectus should be provided.

・　 Key countries should take concerted approach for better transparency and disclosure principles for securitized products.

・　 A common platform that provides database of securitized products would improve transparency.

・　 As well as private sector’s efforts, support from regulatory and accounting fields (i.e. ensuring consistency between both fields) is essential.

A. Improvement in Transparency

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US and European Initiatives to Redress the Issues US and European Initiatives to Redress the Issues

・　 Investors should expand and enhance disclosure on securitized products that they hold.

・　 Investors should provide sufficient disclosure both in quality and in quantity as for valuation process for securitized products.

・　 Investors should provide proper disclosure on liquidity risk management and potential obligations for funding guarantee for off-balance-sheet vehicles.

　 B. Improvement in Transparency

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３．３． Recent US Financial Market and EconomyRecent US Financial Market and Economy

→ Witnessed a small pick up after the Treasury’s announcement of rescue measures for GSEs on Sep. 7 but traced downward path with Lehman’s bankruptcy

Stock Price

10,500

11,000

11,500

12,000

12,500

13,000

13,500

14,000

14,500

3-J an

3-Feb

3-Mar

3-Apr

3-May

3-J un

3-J ul

3-Aug

3-Sep

3-Oct

3-Nov

3-Dec

3-J an

3-Feb

3-Mar

3-Apr

3-May

3-J un

3-J ul

3-Aug

3-Sep

(US$)

07/08/

(Dow J ones Industrial Average)

11-Aug

14-Aug

17-Aug

20-Aug

23-Aug

26-Aug

29-Aug

1-Sep

4-Sep

7-Sep

10-Sep

13-Sep

16-Sep

GSEs Rescue Announcement(7 Sep.)

Lehman Brothers Holdings Inc. announced that itintends to file a petition under Chapter 11 of the

U.S.Bankruptcy Code( 15 Sep.)

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Recent US Financial Market and EconomyRecent US Financial Market and Economy

　

Corporate Bonds’ Spread

→ 　 Still continues to widen

(source) Morgan Stanley

40

80

120

160

200

240

280

320

360

3-J an

3-Mar

3-May

3-J ul

3-Sep

3-Nov

3-J an

3-Mar

3-May

3-J ul

3-Sep

3-Nov

3-J an

3-Mar

3-May

3-J ul

3-Sep

BBB Rated

A Rated

AA Rated

AAA Rated

(bp)

06/ 07/ 08/

Spread between corporate and government bonds（ ）

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Recent US Financial Market and Economy Recent US Financial Market and Economy

　

Real GDP→ During 2Q in 2008, recorded 3.3% annual growth compared with the previous period,

but its main driving force was external demands. Meanwhile, the trend of domestic demands keeps weaker.

Annual rate compared to previous period (%)

CY

Private consumption

Inventory Investment Net export

Residential Investment Capital investment

Real GDP

Government Expenditure

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Recent US Financial Market and EconomyRecent US Financial Market and Economy

（ Breakdown of Private Consumption ） （ Saving Ratio of

Household sector ）

Private Consumption

CY

CYDurable goods

Nondurable goods

ServicesAll goods

and services

/2Q

Real change, annual rate compared to previous period, contributing rate (%)

→ Already consumed tax reduction effect, private consumption could be much weaker, due to sharp increase in energy prices and jobless rates combined with negative-wealth effects triggered by sharp falls of real estate prices and stock prices.

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Recent US Financial Market and Economy Recent US Financial Market and Economy

(10 thousand)

Employment

CY

US: Number of employees and unemployment rate

Number of employees ( right scale)

Unemployment rate (left scale)

→ Continues to show decrease in number of employees and increase in unemployment rate

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Recent US Finance Market and EconomyRecent US Finance Market and Economy

　 （ Residential Investment ）

（ New Privately-owned Housing Units Started ）

Residential Investment

→Facing sharp reduction and keeps falling

Real base, annual rate compared to previous period, contributing rate (%)

Housing Units Started (left scale)

Average fixed interest rate of 30 year mortgage

others residential investment

/2Q

CY

10 thousand units

single family

houses

CYcollective housing

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Recent US Financial Market and EconomyRecent US Financial Market and Economy

　 　　 A. When would the private consumption hit the bottom? 　 B. When would the sharp construction of liquidity in the

financial markets get loose? 　 C. When would the stock prices hit the bottom?

　⇒ Vicious circle between weaker real economy and dry-up of liquidity in the U.S. should be avoided at any cost.

At the same time, a balance between “bail-out” and ”moral hazard” should be perused.

Future Prospects － key items

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4.Japan’s Situation4.Japan’s Situation

　 Subprime-related Losses in Japanese Financial Institutions

→Very limited compared with their business capacity and periodic income.

→Japanese financial institutions have limited exposure to subprime-related products.→Most securities firms’ subprime-related business is also a small portion.

billion US$

Tier Capital１end-March,（

2008）

OperatingProfits end-（March, 2008）

Subprime- relatedvaluation

profits/ losses(- )end- J une, 2008（ ）

Subprime- relatedrealized

profits/ losses(- )(total fromApr.2007 toJ un.2008)

475 57 -1 -7(source) Financial Services Agency

Subprime- related losses of J apanese deposit- taking institutions（ ）

billion US$

Book valueProducts whose

underlying assets wereoriginated abroad

Subprime- relatedproducts

223 134 9source Financial Service Agency（ ）

Exposures of J apanese deposit- taking institutions to（subprime- related products）

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Japan’s Situation Japan’s Situation

0

2

4

6

8

10

12

2006 2007 2008

J uly- Dec.J an.- J une

\ trillion（ ） J apan

▲ ３１．９％

Japanese financial sector hold bonds issued by 　 Fannie Mae and Freddie Mac 　amounting 　 142 billion US dollars, second largest figures in Asia next to China.

In addition, losses triggered by the bankruptcy of Lehman Brothers should be handled. Assuming all the negative elements are taken into account so far, our efforts have

focused on establishing preventive methods to avoid the same problem to occur in the future.

A. Responses in Japan

Recent Issuance of Securitized Products

0

200

400

600

800

1000

1200

1400

2006 2007 2008

Aug.- Dec.J an.- J uly

Billion US$（ ） United States

▲ ７８．２％

(source) Survey by Securitized Product Research Dept. of Deutsche Securities (source) Debt Capital Markets Review, Thompson Reuters

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Japan’s SituationJapan’s Situation

“Risk Management”　・　 Japanese authorities are taking steps to strengthen risk management of investors.　・　 Market-related bodies at the same time, started working to strengthen risk managem

ent on their part.

“Avoidance of Moral Hazard”　・　 In Japan, the lenders of housing loans, such as banks and others, rarely sell the as

sets because the conditions are relatively good enough for most banks. As a result, there are relatively few loans extended to later securitization.

　・　 Overall loan screening is carried out more prudently because of Japan’s experience suffered by NPLs in the last decade. Inspections by authorities have also been strengthened.

“Restoration of Confidence in CRAs”　・　 Authorities and rating agencies are planning to take actions based on the discussion

s in international bodies, such as the FSF and IOSCO.　・　 Investors are also reinforcing their risk management and revising their excessive de

pendence on ratings.

B. Preventive measures in Japan

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Japan’s SituationJapan’s Situation

“Accounting Valuation”←Enhancing Transparency　・ Actions will be taken based on the discussions in international bodies such as

the FSF and IOSCO

“Traceability of Underlying Assets”←Enhancing Transparency　・　 Authorities made a revision of the supervision guidelines for Financial

Instrument Businesses Operators requiring distributors to establish procedures that ensure traceability of underlying assets of securitized products for investors.

The JSDA set up a Working Group on Distributions of Securitized Products to formulate self-regulatory rules.

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Japan’s SituationJapan’s Situation

（ Towards formulation of self-regulatory rules ）　 A. 　 A Unified Information Disclosure Format will be created to

indicate the detailed contents of information provision. → see Appendix 2

　 B. 　 Distributors will have to properly provide information on the details and risks of the underlying assets in securitized products to investors taking fully into account the instructions described in the supervision guidelines (The use of the Unified Information Disclosure Format will be decided depending on individual transactions.).

Initiative by JSDA〇　 In its interim report announced July 24 of this year, JSDA’s Wor

king Group on Distributions of Securitized Products indicated the intention to formulate self-regulatory rules.

〇　 Following further detailed analysis in terms of practicality based on the above, JSDA is planning to compete formulation of the self-regulatory rules by February next year.

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US Government and Financial Authorities’ ResponsesUS Government and Financial Authorities’ Responses

A. Policy rate reduction and liquidity supply → 　 From August 2007 to April 2008, FRB cut the Federal Funds (FF) Target Rate and offici

al discount rate several times (FF Target Rate: 5.25 ％→ 2.00 ％ , official discount rate:6.25 ％→ 2.25 ％ )

　→　 In July 2007, FRB supplied huge amounts of funds and, in December, started the Term Auction Facility (TAF) Program which allows to collateralize a wide range of assets including RMBS.

　→　 In March 2008, FRB extended lending to Bear Stearns (BS) facing difficulty in its management through JP Morgan Chase, who eventually acquired BS.

　→　 In December 2007, five central banks in the US and Europe announced measures to ease pressure toward rising interest rates in short money markets. In March 2008, their second collaborative approach was carried out.

→ Major Central Banks declared to provide ample liquidity to financial markets triggered by the bankruptcy of Lehman Brothers (18,Sep).

B. Announcement of relief measures for GSEs　→　 On September 7, the US Treasury Secretary Paulson announced that, in order to bail o

ut the two ailing GSEs (Fannie Mae and Freddie Mac), the government would put them under its government control in the meantime and inject public money amounting to 2 bil. dollars (approx. 220 bil. yen) .

C. Rescue of AIG by US Government (16,Sep)

　 Urgent measures (to avert negative impacts between financial markets and the real economy)

(Appendix 1)(Appendix 1)

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US Government and Financial Authorities’ ResponsesUS Government and Financial Authorities’ Responses

・ Measures to avoid foreclosure　→　 In August 2007, President Bush announced countermeasures to subprime

housing loan problem including review of the Federal Housing Loan Insurance, budgetary support to avoid foreclosure, etc.).

　→　 The Bush administration expressed its support to “Hope Now” Plan, the framework initiated by the American Securitization Forum (ASF) to bail out subprime loan borrowers.

Protection of Housing Loan Borrowers

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(Appendix 2)(Appendix 2)

Ⅰ Information on Special Features of Product and Outline of Issue． Ⅳ Performance of core pool, etc., and asset pools used as comparative reference．I-1 Product name IV-1 Delinquency rateI-2 Product type IV-2 Default rateI-3 Main applicable laws IV-3 Advance repaymentsI-4 Issuance total, ussance amount of each tranche IV-4 Collection or loss rateI-5 Arrangers, underwriters and distributors IV-5 OthersI-6 Issue date IV-6 Grouping of comparison poolsI-7 Issue amount Ⅴ Surveillance following issue．I-8 Interest rate and planned dividend rate V-1 Issue amountI-9 Interest payment date V-2 Interest rate (dividend rate)I-10 Repayment method V-3 RatingsI-11 Final legal repayment date V-4 Current credit and liquidity enhancementI-12 Planned repayment date or schedule V-5 Trigger indicatorsI-13 Forecast repayment schedule, etc. V-6 Occurrence or non-occurrence of eventsI-14 Ratings V-7 Allocation of paymentsⅡ Information on structure and parties involved． V-8 Balance of subordinated portionII-1 Basic scheme Ⅵ Payments on Underlying Assets．II-2 Originator VI-1 Balance of debt involved with underlying assetsII-3 Servicer VI-2 WACII-4 Issuer VI-3 WAMII-5 Other major parties involved VI-4 Other pool groupingsII-6 Scheme-related risk VI-5 Grouping allotment of debt or debtors behind underlying assetsII-7 Credit and liquidity enhancements VI-6 Delinquency amount and rateII-8 Location of risk in structure VI-7 Amount of incurred default and rateII-9 Structure of trigger VI-8 Cumulative default or amount of incurred loss and rateII-10 Waterfall VI-9 Advanced repayment rateⅢ Information on Underlying Assets． VI-10 Collection rate or loss rateIII-1 Outline of underlying assets VI-11 Buyback rateIII-2 Outline of origin of underlying assets VI-12 OthersIII-3 Eligibility requirementsIII-4 Grouping of underlying asset poolsIII-5 Cash flow from underlying assets (planned)III-6 Weighted average coupon (WAC)III-7 Weighted average maturity (WAM)III-8 Group distribution of debts or debtors for assets

Items on the Common Information Item List For s（ ＲＭＢＳ ）