the credit crisis of 2007 notes

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Chapter 6The Credit Crisis of 2007

THE U.S. HOUSING MARKET

In about the year 2000, house prices started to rise much faster than they had in the

previous decade. The very low level of interest rates between 2002 and 2005 was an important contributory

factor, but the bubble in house prices was largely fuelled by mortgage lending practices.

The 2000 to 2006 period was characterised by a huge increase in what is termedsubprime mortgage lending.

o Subprime mortgages are mortgages that are considered to be significantly morerisky than average.

o Before 2000, most mortgages classified as subprime were second mortgages.o After 2000, this changes as financial institutions became more comfortable with

the notice of a subprime first mortgage.

The Relaxation of Lending Standards

Mortgage lenders started to relax their lending standards in about 2000.o This made house purchases possible for many families that had been previously

been considered to be not sufficiently creditworthy to qualify for a mortgage.o These families increased the demand for real estate, and prices rose.

To mortgage brokers and mortgage lenders, the combination of more lending and risinghouse prices was attractive.

o More lending meant bigger profits.o Rising house prices meant that the lending was well covered by the underlying

collateralif the borrower defaulted, the resulting foreclosure would lead to littleor no loss.

With rising house prices, it became more difficult for first-time buyers to afford a house.In order for mortgage brokers and lenders to continue to attract new entrants to the

housing market, they had to find ways to relax their lending standards even more.o Adjustable rate mortgages (ARMs) were developed where there was a low

teaserrate of interest that would last for two or three years, then followed by arate that was much higher.

o The applicants income and other information were frequently not checked.

The U.S. government did not regulate the behaviour of mortgage lenders because since

the 1990s, it has been trying to expand home ownership and has been applying pressure

to mortgage lenders to increase loans to low and moderate income households.

Some state legislators were concerned about what was going on and wanted to curtailpredatory lendinga situation where a lender deceptively convinces borrowers to agreeto an unfair and abusive loan terms.

While some analysts realised that the mortgages were risky, pricing in the market forsecurities created from the mortgages suggested that the full extent of the risks and theirpotential impact on markets was not appreciated until well into 2007.

Zimmerman (2007) provided some confirmation that mortgages made in 2006 were of alower quality than those made in 2005, which were in turn of lower quality than themortgages made in 2004.

o The lending criterion was relaxed progressively through time.


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The Bubble Bursts

The relaxation of lending standards was a bubble in house prices. Prices increased rapidlyduring the 2000 to 2006 period.

In the second half of 2006, house prices started to edge down.o

As house prices increased, demand for houses declined.o Borrowers with teaser rates found that they could no longer afford their

mortgages when the teaser rates endedthis led to foreclosures and an increasein the supply of houses for sale.

Individuals who had borrowed 100%, or close to 100%, of the cost of a house found thatthey had negative equity- the amount owed on the mortgage was greater than the valueof the house.

o Some of these individuals chose to defaultthis led to more foreclosures, afurther increase in the supply of houses for sale, and a further decline in houseprices.

One of the features of the U.S. housing market is that mortgages are non-recourse in somestates which means that when there is a default, the lender is able to take possession of

the house, but other assets of the borrower are off-limits.o The borrower effectively has a free American-style put optionhe/she can, at

any time, sell the house to the lender for the principal outstanding on themortgage.

o During the teaser rate period, this principal typically increased, making the optionmore valuable.

o Market participants realised how costly the put option could beif the borrowerhad negative equity, the optimal decision was to exchange the house for theoutstanding principal on the mortgage. The house was then sold, adding to thedownward pressure on house prices.

This presented an arbitrage opportunityinitially apply for a mortgage-> in the foreclosure, exercise the put option -> buy an identical house at

a lower cost (due to downward pressure on house prices). Real estate in the United Kingdom was also badly affected.

SECURITISATION

The originators of mortgages did not in many cases keep the mortgages themselves. Theysold portfolios of mortgages to companies that created products for investors from them. Thisprocess is known as securitisation.

Securitisation has been an important and useful tool for transferring riskin financialmarkets for many years.

o

It underlies the originate-to-distribute model that was widely used by banksprior to 2007.

Securitisation played a part in the creation of the housing bubblethe behaviour ofmortgage originators was influenced by their knowledge that mortgages would besecuritised.

When considering new mortgage applications, the question was not Is this a credit we wantto assume? but instead Is this a mortgage we can make money from by selling it to

someone else?

When mortgages were securitised, the only information received about the mortgages bythe buyers of the products that were created from them was the loan-to-value ratio (the

ratio of the size of the loan to the assessed value of the house) and the borrowers FICO(credit) score.


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The most important thing for the lender was whether the mortgage could be sold to othersand this depended primarily on the loan-to-value ration and the applicants FICO score.

o Both values were of doubtful quality.

Asset Backed Securities

An asset-backed security (ABS) is a security created from the cash flows of financialassets such as loans, bonds, and mortgages.

Fig. 6.2 on page 126 (Creation of an ABS from a Portfolio of Assets)

A portfolio of assets (such as subprime mortgages) is sold by the originators of the assetsto a special purpose vehicle (SPV)and the cash flows from the assets are allocated totranches.

A Special-Purpose Vehicle, orSPV is a subsidiary of a company which is

bankruptcy remote from the main organisation (i.e. protected even if the parent

organisation goes bankrupt). The actions of a SPV are usually very tightlycontrolled and they are only allowed to finance, buy and sell assets.

The purpose of a Special-Purpose Vehicleis to allow the parent company to

make highly leveraged or speculative investments without endangering the entire

company. If theSPV goes bankrupt, it will not affect the parent company.

The problem, as occurred in the 2007-2008 crisis is that often the parent

companies would have guaranteed liquidity lines to theirSPV and when

theSPV s started to lose money and lose access to credit, they would draw on

the funds of their parent company at a time when the parent was already low on

capital, thereby exacerbating the issues.

There tends to be three tranches:1. Senior tranche - gives the lowest return, but is the safest.2. Mezzanine tranche3. Equity tranchegives highest return, but is the most risky.

Cash flows are allocated to tranches by specifying what is known as a waterfall.

Fig. 6.3 on page 127 (The Waterfall in an ABS)

Cash flows go first to the senior tranche, then to the mezzanine tranche, and then to theequity tranche.

Losses of principal are first born by the equity tranche, then by the mezzanine tranche,and then by the senior tranche.

The ABS is designed so that the senior tranche is rated AAA, the mezzanine tranche istypically rated BBB, and the equity tranche is typically unrated.

Unlike the ratings assigned to bonds, the ratings assigned to the tranches of an ABS arewhat might be termed negotiated ratings.

o The objective of the creator of the ABS is to make the senior tranche as big aspossible without losing its AAA credit rating (since this maximises the

profitability of the structure).

The ABS creator examines information published by rating agencies for a preliminaryevaluation before choosing the final one.

The creator of the ABS makes a profit because the weighted average return on the assets

in the underlying portfolio is greater than the weighted average return offered to thetranches.
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A particular type of ABS is collateralised debt obligation (CDO). This is an ABS wherethe underlying assets are fixed-income securities.

ABS CDOs

Finding investors to buy the senior AAA-rated tranches created from subprime mortgageswas not difficult.o Equity tranches were typically retained by the originator of the mortgages or sold

to a hedge fund.o Finding investors for the mezzanine tranches was more difficultthis led to

financial engineersbeing creative. They created an ABS from the mezzanine

tranches of ABSs that were created from subprime mortgages. This is known asABS CDO.

Fig. 6.4 on page 128

In the second half of 2007, the AAA rated tranche of the ABS would have probably been

downgraded. However, it would receive the promised return if losses on the underlyingmortgage portfolios were less than 25% (senior tranche represents 75% of portfolio)because all losses of principal would then be absorbed by the more junior tranches.

Note that the AAA rated tranche of the ABS CDO is much more risky since it will getpaid the promised returns if losses on the underlying portfolios are 10% or less (refer tofig. 6.4).

CDOs and ABS CDOs in Practice

Fig. 6.5 on page 129

The risks in the AAA rated tranches of ABSs and ABS CDOs were higher than either

investors or rating agencies realised.o One of the reasons for this involves correlation.

The values of the tranches of ABSs depend on the default correlation of the underlyingmortgages.

o If mortgages exhibit a fairly low default correlation (as they do in normal times),there is very little chance of a high overall default rate and the AAA ratedtranches of both ABS and ABS CDOs are safe.

Many analysts, however, overlooked the fact that correlations always increase in stressedmarket conditions.

o It was a mistake to assume that the BBB rated tranches of an ABS had the samerisk as BBB rated bondsthere are important differences between the two and

these differences can have a big effect on the valuation of the tranches.

THE CRISIS

The defaults on mortgages in the United States had a number of consequences.o Financial institutions and other investors who had bought the tranches of ABSs

and ABS CBOs lost money.o Some mortgage originators also incurred losses because they had provided

guarantees as to the quality of the mortgages that were securitised and because

they faced lawsuits over their lending practices.

When losses are experienced in one segment of the debt market, there was flight toquality.

o Investors became reluctant to take any credit risk and preferred to buy Treasuryinstrument and similarly safe investments.


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Credit spreads(the extra return required for taking credit risks) increased sharply.

It was difficult for many nonfinancial companies to obtain loans from banks.

Banks themselves became reluctant to lend to each other and the interbank lending ratesconsequently increased sharply.

The tranches of ABSs and ABS CDOs were downgraded by rating agencies in the secondhalf of 2007.o The market for these tranches became very illiquid.o Too much reliance was placed on credit ratingsinvestors did not understand the

(complex) tranches well enoughthis highlights the importance of transparencyin financial markets.

Investors did not worry about the complexity associated with the products until problemsemergedthey found that the liquidity of the market was such that they could only tradeat fire saleprices.

Banks such as Citigroup, UBS, and Merrill Lynch suffered huge losses.

There were many government bailouts.

Lehmann Brothers was allowed to fail. Unemployment increased.

Parts of the world with no connection with U.S. financial institutions were affected.

Banks are now paying the price for the crisisthey are required to keep more capital thanbefore as well as maintaining certain liquidity ratios.

Legislations such as Dodd-Frankin the U.S. increases the oversight of financialinstitutions and restricts their activities in areas such as proprietary and derivativestrading.

WHAT WENT WRONG?

Irrational exuberancea phrase used by Alan Greenspan, Chairman of the FederalReserve Board, to describe the behaviour of investors during the bull markets of the 1990s.This can also be applied to the period leading up to the credit crisis.

Mortgage lenders, the investors in tranches of ABSs and ABS CDOs that were createdfrom residential mortgages, and the companies that sold protection on the tranchesassumed that the good times would last forever they thought that U.S. house priceswould continue to increase.

Many factors contributed to the crisis that started in 2007:

Mortgage originators used lax lending standards.

Products were developed to enable mortgage originator to profitably transfer credit risk to

investors. Rating agencies moved away from their traditional business of rating bonds (where they

had a great deal of experience) to a relatively new method with little historical data.

The products bought by investors were complex and in many instances, investors andrating agencies has inaccurate or incomplete information about the quality of theunderlying assets.

o Investors in the structured products relied on rating agencies rather than formingtheir own opinions about the underlying risks.

The return on the structured products rated AAA was high compared with the returnspromised on bonds rated AAA.

Regulatory Arbitrage


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Many of the mortgages were originated by banks and it was banks that were the maininvestors in the tranches that were created from the mortgages.

Why would banks choose to securitise mortgages and then buy the securitised products thatwere created?The answer concerns what is called regulatory arbitrage.

The regulatory capital banks were required to keep, for the tranches created from aportfolio of mortgages, was much less than the regulatory capital that would be requiredfor the mortgages themselves.

o This is because the mortgages were kept in what is referred to as bankingbook whereas the tranches were kept in the trading book.

o Capital requirements were different for the banking and trading book.

Incentives

Agency costsis a term used by economists to describe the situation where incentives aresuch that the interests of two parties in a business relationship are not perfectly aligned.

The process by which mortgages were originated, securitised, and sold to investors wasunfortunately riddled with agency costs.

The main concern of the creators of ABSs and ABS CDOs was the profitability of thestructures.

o They wanted the volume of AAA rated tranches that they created to be as high aspossible and found ways of using the published criteria of rating agencies toachieve this.

o Rating agencies were paid by the issuers of the securities they rated.

Employee compensation falls into three categories:1. Regular salary

2. The end-of-year bonus3. Stock or stock options.

Many employees at all levels of seniority in financial institutions (particularly traders)receive much of their compensation in the form of end-of-year bonuses.

o This form of compensation is focused on short-term performance.o If the employee generates huge profits one year and is responsible for severe

losses the next year, the employee will still receive a big bonus in the first yearand will not have to return it in the following year.

LESSONS FROM THE CRISIS

Some of the lessons for risk managers from the crisis:


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1. Risk managers should be watching for situations where there is irrational exuberanceand make sure that senior management recognise that the good times will not last

forever.2. Correlations always increase in stressed markets. Considering how bad things could

get, risk management should not use correlations that are estimated in normal markets.3. Recovery rates decline when default rates increase. This is true for almost all debt

instruments. Risk managers should thus not use recovery rates that are estimated innormal market conditions.

4. Risk managers should ensure that the incentives of traders and other personnelencourage them to make decisions that are in the interests of the organisationstheywork for. Financial institutions have revised their compensation policies.

a. Bonuses are now spread out over several years rather than all being paid at onceif good performance in one year is followed by bad performance in the next, partof the bonus for the good performance year that has not yet been paid may beclawed back.

5. If a deal seems to good to be true, it probably is. A sensible conclusion is for furtheranalysis to be conducted because there are likely to be risks that have not been identified

by credit agencies.6. Investors should not rely on ratings. They should understand the assumptions made byrating agencies and carry out their own analysis.

7. Transparency is important in financial markets.8. Re-securitisation, which led to the creation of ABS CDOs and CDOs of CDOs was a

badly flawed idea. The assets used to create ABS in the initial phase of securitisationshould be as well diversified as possible. There is nothing to gain from further

securitisation.

the credit crisis of 2007 notes

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