a recipe for disaster? credit derivatives, structured credit products, and the subprime debacle

All views expressed in this paper are strictly personal and do not necessarily coincide with those of my employer

A Recipe for Disaster?

Credit Derivatives, Structured Credit Products, and the

Subprime Debacle

Dr Sikandar Siddiqui

Konstanz, October 13th, 2008


Contents

1. Motivation

2. The Subprime Crisis: Causes

3. Instruments of Credit Risk Transfer

- Asset Backed Securities

- Asset Backed Commercial Papers, SIVs and Conduits

- Credit Derivatives

4. The Rôle of the Rating Agencies

5. Conclusions



In early 2008, the market for U.S. Subprime mortgages virtually collapsed.

Consequences:

•Insolvency or emergency nationalisation of some creditors, including renowned organisations (AIG, Lehman Bros.)

•Severe crisis in much of the financial sector, not limited

to the U.S.

• Downward pressure on asset prices extending to seemingly remote market segments, including structured credit, corporate bond, and equity markets worldwide.

Purpose of this talk:

• Identify causes of the the subprime meltdown

• Clarify how it could develop into a systemic crisis

• Infer conclusions on required changes in the behaviour

of market participants

Motivation



Timeline


Dow Jones Industrial Average, 01/2007 - present

Ownit Mortgage Solutions Inc. files for Chapter 11

Subprime industry collapse; >25 lenders declare bankruptcy

2 of Bear Stearns‘ Structured Credit funds

halt redemptions

Bonds collateralised by subprime mortgages are discovered in several several bank and

hedge fund portfolios worldwide

Fed cuts discount rate by 0.5%

Run on UKs Northern Rock

Bear Stearns acquired for $2 a share by JPMorgan Chase in a fire

sale avoiding bankruptcy

Sep 7: Federal takeover of Fannie Mae and Freddie MacSep 14: Merrill Lynch sold to Bank of America amidst fears of a liquidity crisis Sep 15: Lehman Brothers files for bankruptcy protectionSep 17: Fed loans $85 bn to AIG to avoid bankruptcy. Sep25: Wa Mu seized by FDIC, banking assets sold to JP MOct 3: $ 700bn U.S. bailout plan passedOct 6: BNP Paribas takes over Fortis from the Belgian government for €14.5 bn.Oct 6: Iceland prepares nationalisation of banks


Growing Mutual Distrust among Banks


Source: http://en.wikipedia.org/wiki/Subprime_mortgage_crisis


…due to a succession of defaults


The succession of government bailouts and emergency takeovers is likely place a heavy burden on public sector budgets in the next decade(s).


Contents

1. Motivation







5. Conclusions



• Early roots of the current crisis: Stock market turmoil of 2001f.

• To counter fears of a protracted recession, the Fed followed a strongly expansive monetary policy → several pronounced interest rate cuts.

• Over-abundant supply of liquidity + continuing uncertainty in stock and bond markets drew large amounts of investable funds into the seemingly undervalued U.S. Residential Real Estate markets.

• After some years, in the established „prime“ segment of this market, saturation set in.

The Subprime Crisis: Causes



Together, the beginning market saturation and continuing pressure to earn a high return on investments motivated creditors to target new customer groups.

Means employed:

• Significant relaxation of eligibility criteria

• Predatory lending: “Teaser” rates + deferred amortisation made mortgages look more affordable than they were.

Poor credit quality assessment + collateral valuation procedures, lax documentation / verification standards encouraged customers to lie on their loan applications(„predatory borrowing”).

The subprime segment of the residential mortgage market thus underwent a rapid expansion.


Market share of different product groups in % of newly originated

mortgages

conventional

conven-tional

Source: National Association of Realtors



•After 2001, low short-run interest rates made debt-financed home purchases look affordable even for low-income households

•The seemingly endless increase in home prices created the impression that in the case of borrower default, proceeds from the sale of the collateral would suffice to satisfy the lender’s claims.

•Result: Mutual reinforcement of a lowering of credit standards + rising home prices

•Since Q3, 2006: Trend reversal in house prices, accompanied by higher short-term interest rate put an end to the boom

•Foreclosures strengthen the downward pressure on home prices; low creditor confidence makes affordable refinancing unavailable to debtors → an avalanching succession of further defaults and declining home prices has begun.


Source:



Contents

1. Motivation







5. Conclusions



Credit Risk Transfer: Credit Default Swaps

• A Credit Default Swap is a contract by which the default risk of a given reference entity is transferred from the protection buyer to the protection buyer in exchange for a series of premium payments.

• If the reference debtor defaults during the life of the contract, the protection seller must grant the protection buyer a compensatory payment that equals the face value of the contract.

• In exchange, a claim on the reference entity is transferred to the protection seller. Its face value equals the one of the swap contract. However, due to the default event, its market value is far lower.

• Benefits:

- By buying credit protection for some debtors and selling credit protection for others, banks can diversify their credit portfolio

- Net sellers of credit protection can generate additional revenues.

• BUT credit default swaps increase the risk of conta- gion in the event of unexpectedly high credit losses.

Basic Structure of a Credit Default Swap

Exemplary Cash Flow Pattern

0 1 3 4 5

100% – Recovery rate Loss compensation:

Premia paid to protection seller

2



Contents

1. Motivation







5. Conclusions



Credit Risk Transfer: Asset Backed Securities

Mortgage debtors

Loans

Interest + Principal

Original lender

Special Purpose Vehicle

Purchase priceSale of claims

Investors

Libor + 25

Libor + 70

Libor + 400 Remainder

Securitisation of mortgages: A (simplified) description

AAA A BB Equity

Servicer Trustee

Admin.

Rating-Agency

Credit quality assessment

•For refinancing purposes and to create capa-cities for new business, banks can sell existing loan pools to a „Special Purpose Vehicle“ unaffected by a possible default of the original lender

•The SPV funds this purchase by issuing “asset backed securities” (ABS) = bonds collateral-ised by future cash inflows from the loan pool.

•These bonds are split into “tranches” of different rank.

•Tranche of rank r receives cash from the pool only if claims of tranches 1 to r-1 can be completely satisfied.

•Losses from defaults are first absorbed by the most junior “equity” tranche.

•Higher tranches only suffer losses if the capa-city of all lower classes has been exhausted.

• As a compensation for their higher default risk, holders of the junior tranches receive a much higher risk premium (credit spread). Dr Sikandar Siddiqui



• With regard to the creditworthiness of the debtors, the original lender has a considerable informational advantage over potential bondholders.

• In order to render an ABS issue marketable, this informational asymmetry has to be mitigated.

• Issuers thus entrust independent rating agencies with measuring the risk of losses for the individual tranches.

• On the grounds of proprietary statistical models + expert judgments, these agencies estimate

the likelihood and the statistically expected values of losses, for each tranche.

• The outcome of these investigations translate into grades from AAA (=excellent credit quality)

to C (= maximum danger of default).


Example:



•ABS tranches can themselves become part of newly created asset pools which, in turn serve as collateral for new tranches of bonds to be issued.

•Bonds backed by ABS tranches are often named CDOs on ABS, where the acronym CDO stands for “Collateralised Debt Obligation”. Subprime

Mortgage Pool

Placement of Subprime ABS from different tranches

(simplified example)

on

Risk-averse

investors

Risk-seeking

investors




• Implications of the tranching mechanism:

- The thicker the protective layer constituted by subordinate tranches, the lower likelihood of losses for bondholders of a given class.

- The risk of losses for a tranche increases with the default probabilities of the debtors in the pool.

•Debtor-specific default probabilities can vary over time due to

- individual factors,

- changes in the macroeconomic environment (wages, prices, interest rates, …)

• The more similarly individual debtors react to adverse macroeconomic shocks, the more vulnerable even the most senior tranche becomes.

• However, the magnitude of such “correlation” effects sometimes cannot be quantified with the required accuracy, particularly in the case of rather new-fashioned loan or transaction types.




• The subprime debacle has shown: Underestimation of the sensitivity of borrower solvency to common factors can even subject seemingly riskless assets – namely AAA-rated Subprime ABS tranches - to significant losses

• Here, the macroeconomic trigger event was the the joint occurrence of short-term interest rate hikes and a downward trend in home prices.

• In the sequel, many other sub-segments of the ABS market suffered from a growing mistrust by investors and incurred unexpectedly high losses.

• The fact that these products had also been bought on an extraordinarily large scale by banks and institutional investors outside the U.S. caused the Subprime debacle to develop into an international financial crisis.



Contents

1. Motivation







5. Conclusions



Credit Risk Transfer: SIVs and Conduits

•The extent of the subprime-related losses took most observers by surprise because in many banks, the true extent of the related risks could not be inferred from the balance sheet.

•A key role in this context was played so-called „Asset Backed Commercial Papers“ (ABCP):

- Short-term (30-90 day) notes

- backed by assets with longer lives

- issued by specialised entities on behalf of their

sponsors

- Purpose: Sponsors seek to capitalise on the interest rate gap between long-term assets and

short-term liabilities.

•(Seemingly) beneficial side effect: Assets held in the specialised entities do not have to be displayed on the sponsor’s balance sheet. Only the less voluminous & less capital-intensive shareholdings or subordinate debt positions in these companies have to be declared. Dr Sikandar Siddiqui

(Source: Asset Backed Alert)



Types of issuers for ABCP Notes:

• Conduits

- Ø maturity of notes: 45 days

- well-diversified portfolio (mainly of long-term bonds)

• Structured Investment Vehicles (SIVs)

- issue ABCPs in different tranches

- may also issue supplementary medium-term bonds

- Income notes confer claim on residual profits

Common feature: Assets bought have an excellent (usually AAA) credit rating. Subprime AAA tranch-es were included on a large scale.

Consequence: Notes they issued also earned a AAA grade at the time of sale.

Comprehensive lending commitments by sponsor-ing banks give support if demand for ABCPs drops.





Conduits set up by German Banks

Conduit BankSize ($ bn), Oct 2006

Source: Moody‘s, FTJune 2007: $bn 17.5



ABCP appeared to be risk-free and thus gained a lot of acceptance.

Many sponsors thus took a frictionless functioning of the related funding mechanism for granted.

This belief was drastically refuted in the course of the subprime crisis:

- The rapid rise in credit defaults among subprime mortgage pools led to significant downward pressure even on the prices of the seemingly risk-free AAA tranche

- Drastic downgrades soon followed.

- Investors withdrew from the ABCP market, because the value of the collateral provided by the issuers became doubtful.

- Asset sales became impossible due to the flight of potential buyers.

Some banks found themselves unable to fulfill the commitments related to their ABCP programmes, which brought them to the brink of bankruptcy.

Asset Pool

ABCP (senior)

Îf the asset pool suffers losses…

… they first accrue to the capital notes …

… but also lower the value of the

ABCP (diminished loss protection)

CapitalNotes

Losses



Contents

1. Motivation







5. Conclusions



The Rating Process for ABS

Rating grade

..

.

+70

+45

+110

Default probabilities of loans in the pool

Correlation assumptions

Aggregation

Estimated loss density

Steps in the Rating Process

Tranche-specific expected loss

Tranche-spe-cific loss rate

Loss rate in pool

0%

100%p.a.

Ø=10bpTranslation

Deduction

The credit quality assessment of ABS products usually proceeds in 4 steps:

(1) Individual debtor ratings are determined + translated into default probabilities. Correla- tion assumptions are introduced to mirror the dependency on macroeconomic factors.

(2) The loss frequency distribution for the entire pool is estimated.

(3) Tranche-specific estimates of loss probability and severity are deduced from (2).

(4) The outcomes of (3) are translated back into rating grades

If the rating grade of a tranche thus obtained does not match the target specified by the issuer, additional credit enhancements – e.g. external guarantees – are demanded.

Tranche-specific credit rating



The Rating Process for ABS


Source: Puzanova and Siddiqui, 2005

Loss density in pool with individual default probabilities set to p = 0.01

= 0.01

= 0.20The correlation parameter serves as a proxy for the sensitivity of individual credit quality to changes in the macroeconomic environment.

The higher its value, the greater the likelihood of extremely large losses.

Even a slight underestimation of can create a false impression of (near-)safety for highly ranked tranches.

= 0.10


Specific Difficulties for ABS Ratings

Three specific pitfalls in the ABS rating process:

(1) Agencies must rely largely on the trustworthi-

ness of credit quality assessments by the ori-

ginal creditor. It is doubtful whether the rating agencies have, in the past, tested the reliability of this information sufficiently well.

(2) A decisive factor for the credit quality of ABS tranches is the sensitivity of the individual debtors to adverse macroeconomic shocks.

If the pool is constituted by well-established asset classes (e.g. corporate bonds), the quantification of this sensitivity is facilitated

by availability of rich datasets. Yet in some cases, e.g. with sub-prime mortgages, this require-ment is not met.

(3) The effectiveness of external guarantees as credit enhancements depends on the solvency of the guarantors. If the guarantor itself has sold protection on many highly complex + heterogeneous products, this can be difficult to verify. Dr Sikandar Siddiqui


Specific Difficulties for ABS Ratings

• After the initial of credit quality assessment, rating agencies monitor further development of the underlying loan pool. This is done on the grounds of data on payment arrears + credit losses within the pool provided by specialised servicers

• The main measure for the credit quality of an ABS tranche is the so-called loss coverage ratio:

If LCR drops below a minimum target value a rating downgrade is likely to follow.

• Since July 2007, the rating agencies have been forced to undertake hundreds of rating downgrades, many of which have been drastic. The confidence of investors in the reliability of agency ratings has therefore been severely shattered since.

ranklowerwithtranchesofvolumeCumulated

loansdefaultednonlossesExpected:LCR



Contents

1. Motivation






4. The Rôle of Rating Agencies

5. Conclusions



Main findings

So far, the history of the subprime debacle has shown how a combination of

- lax lending standards due to insufficient quality incentives

- biased and incomplete information on the solvency of debtors and the value of collateral,

- inadequate credit quality assessment models,

- over-reliance on third-party credit ratings by investors, and

- the interconnectedness of market participants through a network of loans, credit derivative exposures, and ABS investments

worked together to cause what many observers believe to be the worst international financial market crisis since the end of the Great Depression.



Recommendations (1/2) In order to avoid future crises of this kind, and to restore confidence in the ABS markets, the following measures are recommended:

I. Extended risk participation of original lender

- Original creditor should buy e.g. 10% of all the securities issued by a SPV.

- Risk participation not limited the Equity Tranche only, but applies to all tranches of the transaction separately.

→ Reduced incentive for unreliable lending practices

II. Compulsory Supervisory Audit for ABS rating processes

- Regulators must be enabled to deny or withdraw the approval for certain rating processes if the data in use do not suffice to calibrate a model’s parameters adequately, or if the structure of the model fails to reflect the nature of a transaction adequately.

- Beneficial side effect: Supervisory audit might lead to a greater degree of standardisation and a less complex structuring of ABS transactions, because both tend to facilitate credit risk assessments.


Source: The New Yorker


Recommendations (2/2) III. Enhanced quality assurance as to the data provided by original lenders

- Trustworthiness of credit quality assessments for ABS crucially depends on whether the original creditor has provided unbiased and sufficient information about the debtors in the pool and the value of the collateral. Rating agencies should therefore be obliged to examine these data on a sampling basis, and to communicate the results to their addressees on demand.

IV. Stress testing and disclosure of results

- Virtually all of the statistical data and parameters used in a rating model are estimates, and thus susceptible to error.

- In addition to the baseline scenario, rating agencies should thus be bound to carry out “stress tests”. These are model runs carried out under alternative, less favourable assumptions. They enable the observer to make inferences about the impact of possible data or estimation errors on the outcome of the rating process, and thus provide more complete picture of the risks inherent in the product under investigation.


Stress Testing: Estimated Portfolio Loss Distribution under varying

correlation assumptions


What can public policy do?


Pay (valuable) taxpayers‘ money for essentially worthless assets (subprime mortgages / MBS) ??Bestow government guarantees on troubled banks

• Buys time, does not lead to an immediate cash outflow

• BUT: This is just another way of nationalising risks (and/or even actual losses) and privatising gains

?

Temporarily (!!) nationalise banks in immediate danger of failure, with a view to gaining from re-privatisation !

a recipe for disaster? credit derivatives, structured credit products, and the subprime debacle

Documents

subprime crisis

subprime mortgages

conduits credit derivatives

subprime segment

credit default swaps

asset prices

subprime meltdown

structured credit products