What Have We Learned from What Have We Learned from thethe

Sub Prime Crisis?Sub Prime Crisis?

Professor Anthony Professor Anthony SaundersSaunders

John M. Schiff Professor of FinanceJohn M. Schiff Professor of FinanceNew York University New York University

Stern School of BusinessStern School of Business

May 2008May 2008

22

How did we get here?How did we get here?

• Traditional BankingTraditional Banking– Banks as Delegated MonitorsBanks as Delegated Monitors

• DisintermediationDisintermediation– Securitization Securitization

• Traditional SPV-based (special purpose vehicle)Traditional SPV-based (special purpose vehicle)• SIV-based (special investment vehicle)SIV-based (special investment vehicle)

– SyndicationSyndication• Back to the FutureBack to the Future

– Off-Balance Sheet Proprietary InvestingOff-Balance Sheet Proprietary Investing– What happens when the delegated monitor What happens when the delegated monitor

delegates?delegates?

33

Getting here: Traditional Banks Getting here: Traditional Banks as Delegated Monitorsas Delegated Monitors

The Traditional Bank – Delegated The Traditional Bank – Delegated MonitoringMonitoring

BankBank

Assets LiabilitiesCash Assets Deposits

Purchased FundsLoans

Capital

44

Getting Here: Traditional Getting Here: Traditional SecuritizationSecuritization

• Securitization allowed banks to Securitization allowed banks to remove risk from their balance remove risk from their balance sheetssheets

• Securitization allowed banks to avoid Securitization allowed banks to avoid onerous capital requirementsonerous capital requirements

• Securitization turned banks into Securitization turned banks into underwriters – originate the loans underwriters – originate the loans and then sell them off.and then sell them off.

55

The Traditional Securitization ProcessThe Traditional Securitization Process

BankBank

Assets LiabilitiesCash Assets Deposits

Purchased Funds

Loans

SPV

Assets Liabilities

Loans Asset-Backed Securities

Investors

Cash

Loans

Cash

Capital

66

Getting Here: Asset-Backed Securities Getting Here: Asset-Backed Securities

(ABS) and Decline in(ABS) and Decline in Quality of Quality of Underlying AssetsUnderlying Assets• Mortgage-Backed Securities (MBS)Mortgage-Backed Securities (MBS)

– Residential MBSResidential MBS• Pass-throughs and Collateralized Mortgage Obligations (CMOs)Pass-throughs and Collateralized Mortgage Obligations (CMOs)• Subprime and No/Low DocumentationSubprime and No/Low Documentation

– Def. Subprime (2001 Def. Subprime (2001 Interagency Expanded Guidance)Interagency Expanded Guidance): : ≥ ≥Two 30-day delinquencies in last 12 mos. or ≥one 60-day Two 30-day delinquencies in last 12 mos. or ≥one 60-day

delinquency in last 24 mo.; ORdelinquency in last 24 mo.; OR Judgment, charge-off. foreclosure, repossession in last 24 mos.; Judgment, charge-off. foreclosure, repossession in last 24 mos.;

OR OR Bankruptcy in last 5 yrs; OR Bankruptcy in last 5 yrs; OR FICO score ≤660; OR FICO score ≤660; OR Debt service/income ratio ≥50%Debt service/income ratio ≥50%

• Second Lien Mortgages (High Loan/Value Ratios)Second Lien Mortgages (High Loan/Value Ratios)

• Collateralized Debt Obligations (CDOs)Collateralized Debt Obligations (CDOs)– Cash CDOs and Synthetic CDOsCash CDOs and Synthetic CDOs

• Collateralized Loan Obligations (CLOs)Collateralized Loan Obligations (CLOs)• Covenant Lite and PIK (payment in kind)Covenant Lite and PIK (payment in kind)

77Source: Bank of England, Financial Stability Report, October 2007, Issue 22, page 6

88

US and European CDO Issuance 2004-2007

0.00

10.00

20.00

30.00

40.00

50.00

60.00

2/28

/200

4

5/28

/200

4

8/28

/200

4

11/2

8/20

04

2/28

/200

5

5/28

/200

5

8/28

/200

5

11/2

8/20

05

2/28

/200

6

5/28

/200

6

8/28

/200

6

11/2

8/20

06

2/28

/200

7

5/28

/200

7

8/28

/200

7

Total Issues of US CDOs

Total Issues of European CDOs

.

Source: Loan Pricing Corporation website

99

Getting Here: Loan Getting Here: Loan SyndicationSyndication• Banks as underwritersBanks as underwriters

– Firm Commitment (Underwritten) deals: The lead bank commits to Firm Commitment (Underwritten) deals: The lead bank commits to making the loan in its entirety and then assembles participants to making the loan in its entirety and then assembles participants to reduce its own loan exposure. Thus, the borrower is guaranteed the reduce its own loan exposure. Thus, the borrower is guaranteed the full face value of the loan.full face value of the loan.

– Best Efforts deals: The size of the loan is determined by the Best Efforts deals: The size of the loan is determined by the commitments of banks that agree to participate in the syndication. commitments of banks that agree to participate in the syndication. The borrower is not guaranteed the full face value of the loan.The borrower is not guaranteed the full face value of the loan.

– Club deals: For small deals (usually $200 million or less), the loan is Club deals: For small deals (usually $200 million or less), the loan is shared among banks, each of which has had a prior lending shared among banks, each of which has had a prior lending relationship with the borrower.relationship with the borrower.

• Leveraged Loan SyndicationsLeveraged Loan Syndications– Below investment gradeBelow investment grade– Often, they will have debt to cash flow levels in excess of 4:1 (i.e., Often, they will have debt to cash flow levels in excess of 4:1 (i.e.,

their outstanding indebtedness (i.e., face value of debt) is more than their outstanding indebtedness (i.e., face value of debt) is more than four times the borrowing firm’s annual revenues) four times the borrowing firm’s annual revenues)

– Decline in Quality of Loan Syndications.Decline in Quality of Loan Syndications.

1010

Syndicated LendingSyndicated Lending

Borrower

Bank(Syndicate Lender)

Syndicate Member

SyndicateMember

SyndicateMember

1111

Syndicated Loan Volume 2000-2007

0.00

200.00

400.00

600.00

800.00

1000.00

1200.00

1400.00

1600.00

1800.00

2000 2001 2002 2003 2004 2005 2006 1-3Q07

Leveraged

Investment Grade

Other

Total

Source: Loan Pricing Corporation website.

1212

Getting Here: SIVsGetting Here: SIVs

• Banks as underwritersBanks as underwriters– Switching from spreads to feesSwitching from spreads to fees– Reduce risk, but reduce returnReduce risk, but reduce return– Response: A new form of intermediation Response: A new form of intermediation

– back to the future of SIVs.– back to the future of SIVs.– Formula for disaster:Formula for disaster:

•SIV = Traditional Bank – Regulatory SIV = Traditional Bank – Regulatory OversightOversight

•SIVs are exposed to traditional banking risks: SIVs are exposed to traditional banking risks: interest rate risk, liquidity risk, credit riskinterest rate risk, liquidity risk, credit risk

1313

A New Securitization ProcessA New Securitization Process

BankBank

Assets LiabilitiesCash Assets Deposits

Purchased Funds

Loans

SIV

Assets Liabilities

Loans Commercial Paper

Investors

Cash

Loans

Cash

Capital

ABCP

1414

Getting Here: Proprietary Getting Here: Proprietary InvestingInvesting

• Banks establish hedge funds, private Banks establish hedge funds, private equity funds, venture funds through equity funds, venture funds through equity investing and/or lending.equity investing and/or lending.

• Unregulated activities conducted off Unregulated activities conducted off the bank’s balance sheet.the bank’s balance sheet.

1515

Anatomy of the Storm and Anatomy of the Storm and Credit Risk ModelsCredit Risk Models

• Can we have higher return without Can we have higher return without higher risk?higher risk?– Why did Credit Risk Measurement Why did Credit Risk Measurement

Models fail? Models fail? – Which risks were underestimated?Which risks were underestimated?

1616

Anatomy of the Storm: The Anatomy of the Storm: The Phases of the Crisis – Bank of Phases of the Crisis – Bank of EnglandEngland

1717

Phase 1: Anatomy of the Storm: Phase 1: Anatomy of the Storm: Assumption of Perpetually Rising US Assumption of Perpetually Rising US House PricesHouse Prices

• Subprime and “teaser” rate mortgages depend on rising Subprime and “teaser” rate mortgages depend on rising housing prices to:housing prices to:– Refinance upon hitting expiration of introductory Refinance upon hitting expiration of introductory

teaser rate. But, there is a strong correlation between teaser rate. But, there is a strong correlation between PD and level of rates (see, Stiglitz and Weiss)PD and level of rates (see, Stiglitz and Weiss)

– Sale of property in the event of borrower’s inability to Sale of property in the event of borrower’s inability to make payments. If housing prices increase, Loss make payments. If housing prices increase, Loss Given Default = 0 Given Default = 0

– Both PD and LGD exhibit “procyclicality”Both PD and LGD exhibit “procyclicality”– Thus underestimate PD, LGD and Thus underestimate PD, LGD and ρρ (PD, interest (PD, interest

rates).rates).

1818

Phase II of the Storm: Rising Phase II of the Storm: Rising Spreads on RMBSSpreads on RMBS

Source: Bank of England, Financial Stability Report, October 2007, Issue 22, page 7.

• Underestimate ρ (RMBS vs. RMBS EUR

1919

Phase II: Higher spreads, lower Phase II: Higher spreads, lower prices, fewer MBS originationsprices, fewer MBS originations

• Underestimate ρ (AAA, BBB-)

2020

Phase III of the Storm: The Phase III of the Storm: The Crisis Spreads to Other ABS Crisis Spreads to Other ABS MarketsMarkets• CDO spreads increaseCDO spreads increase

• CDO issuance declinesCDO issuance declines

• Leveraged Loan prices fallLeveraged Loan prices fall

2121

CDO Spreads IncreaseCDO Spreads Increase

Source: Loan Pricing Corporation website.

• Underestimate ρ across debt markets, i.e., ρ (RMBS, CDOs)

2222

Leveraged Loan Prices FallLeveraged Loan Prices FallLeveraged Loan Index Prices 2004-2007

92.00%

93.00%

94.00%

95.00%

96.00%

97.00%

98.00%

99.00%

100.00%

101.00%

Index %

Source: Leveraged Loan Index is the CSFB Leveraged Loan Index Plus Average Price, expressed as a percentage of par, Bloomberg Ticker = DLJLPX

• Underestimate ρ (RMBS, HLT)

2323

Phase IV: Risk Flows Back to Phase IV: Risk Flows Back to Banks – ReintermediationBanks – Reintermediation• SIVs are unable to issue Asset-Backed Commercial SIVs are unable to issue Asset-Backed Commercial

PaperPaper• SIVs access their backup lines of liquidity and take SIVs access their backup lines of liquidity and take

down credit linesdown credit lines• Banks are unable to securitize or syndicate these Banks are unable to securitize or syndicate these

loans due to the decreased volume of new dealsloans due to the decreased volume of new deals• Even if they could sell off these unwanted loans, Even if they could sell off these unwanted loans,

the prices would be low as spreads increase.the prices would be low as spreads increase.• SO: Banks did not really remove the risks from their SO: Banks did not really remove the risks from their

balance sheets.balance sheets.• Underestimate correlation between on and off-Underestimate correlation between on and off-

balance sheet risk , i.e., balance sheet risk , i.e., ρρ (Risk on, Risk off) (Risk on, Risk off)

2424

Phase V: Liquidity Hoarding Phase V: Liquidity Hoarding and Flight to Quality Creates and Flight to Quality Creates MispricingsMispricings

3 Month LIBOR, 3 Month US T-Bill Rates and Federal Funds RatesJanuary 2007-October 2007

0.00000

1.00000

2.00000

3.00000

4.00000

5.00000

6.00000

7.00000

1/2

/2007

2/2

/2007

3/2

/2007

4/2

/2007

5/2

/2007

6/2

/2007

7/2

/2007

8/2

/2007

9/2

/2007

10/2

/2007

3 Mo. LIBOR

3 mo. T-Bills

Effective Federal Funds Rate

Source: St. Louis Federal Reserve Bank database, FRED website.

• Underestimate ρ (credit risk, liquidity risk)

2525

How do we steer out of the How do we steer out of the storm?storm?• Better Risk ModelingBetter Risk Modeling

– Price of risk was set too low in the mortgage market.Price of risk was set too low in the mortgage market.– Quantity of risk was underestimated – the pitfalls of Quantity of risk was underestimated – the pitfalls of

hidden leverage.hidden leverage.– Improve credit rating models PD and LGD.Improve credit rating models PD and LGD.– Analyze correlation across markets, risks and countriesAnalyze correlation across markets, risks and countries

• Align IncentivesAlign Incentives– What does it tell you when informed lenders treat their What does it tell you when informed lenders treat their

loans like hot potatoes?loans like hot potatoes?

• Avoid Regulatory MispricingsAvoid Regulatory Mispricings– Basel II implicationsBasel II implications

2626

If capital is required:If capital is required:• Standardized model risk weights:Standardized model risk weights:

• Credit Conversion Factor for Off-Balance Sheet Items:Credit Conversion Factor for Off-Balance Sheet Items:•100% unless “eligible liquidity facility” – limited draw-down privileges unrelated 100% unless “eligible liquidity facility” – limited draw-down privileges unrelated

to default – then 50% CCF for maturity > 1 year and 20% CCF for maturity ≤ 1 to default – then 50% CCF for maturity > 1 year and 20% CCF for maturity ≤ 1 yearyear

2727

Steering Out: Potential Pitfalls Steering Out: Potential Pitfalls of the Basel II Securitization of the Basel II Securitization Requirements Requirements • Places heavy reliance on external Places heavy reliance on external

credit ratings.credit ratings.– Standardized model uses credit ratingsStandardized model uses credit ratings– In the hierarchy of IRB approaches, RBA In the hierarchy of IRB approaches, RBA

is preferred – tied to credit ratingsis preferred – tied to credit ratings

• What happens when the credit What happens when the credit ratings are wrong?ratings are wrong?