Review of Subprime Crisis (Part 2) – The Causes

The crisis could be attributed to a number of factors. Most of these reasons are complex and varied, mostly persuasive in the housing and credit markets. Some of these factors are:

• 1. Some news and media commentary blame the crisis on the complexity of the CDO and the failure of risk and recovery models used by credit rating agencies to value these products.
  2. Institutions lacked the competency to monitor credit performance or estimate expected cash flows.
  3. Some academics maintain that because the products are not priced by open market, thus the risks are not priced into its cost.

Nevertheless, whatever the reasons there are, it all stem from the fundamental change in the way housing mortgages are funded. In recent years, banks have financed their mortgage lending where they sell on the mortgages to the bond markets. This made it easier to fund additional borrowing, but also led to abuse as well.

Rise of Mortgage Bond Market

In the past five years, the private sector has dramatically increased its share in the mortgage bond market which previously dominated by government-sponsored agencies. They specialized in new types of mortgages such as sub-prime lending or jumbo mortgages for limit over $417,000. This model proved extremely profitable for the banks as they earned a fee for each mortgage sold. Thus, they urged brokers to sell more and more of these mortgages, which is now worth $6 trillion and is the single largest part of US bond market (bigger even than Treasury Bonds).

A combination of low interest rates and large capital inflows from outside the US had created a surplus of loadable funds and easy credit for many years which led to boom in housing market. Housing prices were high and it was extremely difficult to own a house without moving the very edge of the metropolitan area. Mortgage brokers instead focused their efforts to sell sub-prime mortgages to these people. But these mortgages tend to have a higher rate of repossession than conventional mortgages because they were adjustable rate mortgage (ARMs) or considered to be high risk loans. These payments were fixed for two years, and then became both higher and dependent on the level of Fed interest rates, which rose substantially after the US economic recovery and stead rise in inflation rate.

Source: Trading Economics

Another contributing factor was the increased speculation in real estate market. It was estimated by end of 2005, nearly 40% were bought for this purpose. Eventually, overbuilding during boom period led to a surplus inventory of homes, causing the home prices to decline. Nevertheless, homeowners were unwilling to sell their houses, refinance becoming difficult and began to default on loans as their loans reset to higher interest rates and payment amounts. Thus, this led to further increase in housing inventory as shown below.

An estimated 8.8 million homeowners have zero or negative equity as of March 2008, meaning their homes are worth less than their mortgage, nearly 10.8% of total homeowners. (New York Times, 2008) As a result, these had a dramatic effect to the housing price with four million of unsold houses depressing the prices. In 2007, house prices are declining at an annual rate of 4.5% and it was expecting to fall by at least 10% by 2008 as shown below.

Bank Losses

As a result, the banking industry was facing huge losses. In 2007, the banks had announced $60bn worth of losses as many of the mortgage bonds backed by sub-prime mortgages had fallen in value. These losses could be much greater (as in 2007) as many banks might have concealed their

holdings in exotics, off-balance sheet instruments such as “structured investment vehicles” or SIVS. Although the banks did not own these SIVs and were not liable for their losses, but they were forced to cover any bad debts that they accrued. A good example would be Merrill Lynch in which the bank was addicted to the profit made from the “carry trade” – borrowing money at low rate and using it to buy CDO bonds paying higher rates.). Merrill Lynch might be optimistic that the credit market would be eased, thus leaving the bank to the large exposure of subprime paper remained unhedged, an estimated of $21 billion. (CNN, 2007)

Bond Market Collapse

These losses in terms had a dramatic impact to the bond market and bondholders, such as pension funds, which suffered huge losses. In the beginning of 2007, these bonds had fallen sharply in value and were worth between 20% and 40% of their original value.

Swap Market

With the troubles spilled out in the bond market, this had spread over to the Credit-Default Swaps – a private contracted that let firms trade bets on whether a borrower is going to default. The value of the swap rise and fall as market reassesses the risks that a company won’t be able to honor its obligations. Firms also use these instruments both as insurance – to hedge their exposures to risks and wager on the health of other companies. It was estimated there were more than $62 trillion in debt on credit-default swaps. (Wall Street Journal, 2008). One of the big new players in this game was AIG, the world’s largest insurer and a major seller of credit-default swaps to financial institutions and companies. Thus, with more firms defaulting, AIG’s strong credit ratings were affected and its balance sheet was thrown to turmoil by writing down on its derivative position. Its stock price was fallen dramatically and this had made it harder for the company to raise capital that it needed to maintain its credit rating. If its credit rating could not be maintained, this would mean a further drop in the value of its credit-default swap in which it was holding, thus having a great losses to its balance sheet and led to bankruptcy.

Hedge Fund

Hedge funds could be among the next problem areas as many had relied on borrowed money to amplify their returns. With banks under pressure and tightened their lending, many hedge funds’ returns would be pressurized. Furthermore, with the new rule and regulation planned to or passed from most central banks to stop taking short position, the funds would have to adjust their investment policy to limit tracking error in their portfolios.

Regulators’ Dilemmas

This crisis was also complicated by innovative financial instruments that Wall Street created and distributed. They were making it harder for officials and Wall Street executives to know where the next set of risks is hiding and contributing to the crisis’s spreading impact. The rules that the regulators devised in the past could not oversee the rapidly changing financial system. Investment banks were not as closely monitored by the Securities and Exchange Commission as commercial banks were by their regulators. With the runs happened in spheres, especially in the repurchase agreements or repo market, in which investment banks fund their day-to-day operations, regulators had no process to handle such failures and insurers like AIG which was not federally regulated.

BIBLIOGRAPHY

1. The New York Times (2008). Rescue of Home Owners in Debt Weighted. http://www.nytimes.com/2008/02/22/business/22homes. html?_r=1&oref=slogin, 28 Sep 2008

2. CNN (2007). Wall Street’s money machine breaks down. http://money.cnn.com/magazines /fortune/fortune_archive/2007/11/26 /101232838/index.htm, 28 Sep 2008

3. Wall Street Journal (2008). Worst Crisis Since ’30, with No end yet in sight. http://online.wsj.com/ article/SB122169431617549947.html, 28 Sep 2008.

4. BBC News (2007). The Turndown in Facts and Figures. http://news.bbc.co.uk/2/hi/business /7073131.stm, 28 Sep 2008.

5. News In Focus (2008). X-Trackers Bank ETF Stops Taking Shorts in Europe. http://www.indexuniverse.com/sections/newsinfocus/10-news-in-focus/4585-x-trackers-bank-etf-stops-taking-shorts-in-europe.html, 28 Sep 2008.

6. Wikipedia (2008). Subprime Mortgage Crisis. http://en.wikipedia.org /wiki/Subprime_mortgage_crisis, 28 Sep 2008

Review of Subprime Crisis (Part 1) – CDOs

The financial crisis had begun 13 months ago. Till date, the situation has not been improved but is worsening and taken a new turn which shake the financial world. With the latest fallout from AIG, consumers were losing confidence and every distress banks was asking for “bail out” from the U.S. government. Central banks from all over the world were pouring hundreds and billions of dollars into the global market. In order to understand the problems, it was worthwhile to examine the products that led to this subprime crisis – Collateralized Debt Obligation (CDO).

Collateralized debt obligation

Collateralized debt obligations (CDOs) are an unregulated type of asset-backed security and structured credit product. CDOs are constructed from a portfolio of fixed-income assets and rated by the rating firms to assess their value. Since 1987 (Black Monday), CDOs have become an important funding vehicle for fixed-income assets.

Structures

Generally, CDO is a broad term refers to several different types of products in which their usage categorizing in several ways as follow:

1. Source of fund

a. Cash flow CDOs pay interest and principal to tranche holders using the cash flows produced by the CDO’s assets

b. Market value CDOs attempt to enhance returns by realizing the capital gains on the trading and profitable sale of collateral assets.

2. Motivation

a. Arbitrage transactions attempt to capture for equity investors the spread between the relatively high yielding assets and lower yielding liabilities represented by the rated bonds. The majority of CDOs (86%) are arbitrage-motivated (SIFMA, 2007).

b. Balance sheet transactions are used by issuing institutions to remove loans and other assets from their balance sheets to reduce their regulatory capital requirements and improve their return on risk capital.

3. Funding

a. Cash CDOs involve a portfolio of cash assets such as loans, corporate bonds, asset-backed securities or mortgage-backed securities.

b. Synthetic CDOs gain credit exposure for the above assets without owning those with credit default swaps.

c. Hybrid CDOs are an intermediate instrument between cash CDOs and synthetic CDOs, therefore its portfolio includes both cash assets as well as swaps.

4. Single-tranche CDOs

a. Single-tranche CDOs are constructed from credit default swaps in which it is especially structured specifically for a single or small group of investors. The dealers hold the remaining tranches and their values are based on valuations from internal models.

Type of CDOs

A) Based on the underlying asset:

• Collateralized loan obligations (CLOs): CDOs backed primarily by leveraged bank loans.
• Collateralized bond obligations (CBOs): CDOs backed primarily by leveraged fixed income securities.
• Collateralized synthetic obligations (CSOs) : CDOs backed primarily by credit derivatives.
• Structured finance CDOs (SFCDOs) : CDOs backed primarily by structured products, e.g. asset-backed or mortgage-backed securities.

B) Other types of CDOs include:

• Commercial Real Estate CDOs (CRE CDOs) — backed primarily by commercial real estate assets

• Collateralized bond obligations (CBOs) — CDOs backed primarily by corporate bonds

• Collateralized Insurance Obligations (CIOs) — backed by insurance or, more usually, reinsurance contracts

• CDO-Squared — CDOs backed primarily by the tranches issued by other CDOs.

BIBLIOGRAPHY

1. Securities Industry and Financial Markets Association (2007). Global CDO Market Issuance Data: SIFMA : USA.

2. Wikipedia (2007). Collateralized Debt Obligations. http://en.wikipedia.org/wiki/Collateralized _debt_obligations, 21 Sep 2008.