How Subprime Lending Led to a Systemic Crisis

Transcription

1 The Darker Side of Securitization: How Subprime Lending Led to a Systemic Crisis Richard J. Herring The Wharton Finance Club The Wharton School, University of Pennsylvania herring@wharton.upenn.edu April 21, 2008

2 Overview Financial Alchemy: How subprime mortgages were transformed into investment grade debt The alphabet soup of securitization What went wrong Why it became a systemic threat Policy issues re: Accounting The Ratings Agencies Basel I & II Is the worst over?

3 Traditional Lending: Buy & Hold Bank originates loan Bank underwrites loan Bank k funds loan Bank services loan Bank holds loan on b/s until repaid Performs workout if necessary

4 New Model: Originate & Distribute Bank may originate (but so may another entity) Bank may underwrite (but so may another entity) Bank may assess credit risk and/or rating agency Bank may fund or may sell to a Trust Bank k may hold or may buy & sell a securitized tranche Bank may service (but so may another entity) If a workout is necessary, what happens?

5 Securitization Definition: Packaging and selling of loans and other assets backed by securities Rationale: the sum of the properly packaged parts is worth more than the whole Advantages to banks Risk management flexibility Interest rate Liquidity Credit risk Fees Reduction of capital requirements, reserve requirements and deposit insurance premiums Advantages to borrowers Lower cost Wider range of options

6 Securitizations Began with the GSEs Securitization of residential mortgages Improved transparency Enhanced diversification Increased liquidity Lowered costs Permitted banks to use capital more efficiently, in an originate and distribute approach Relied on guarantees from GSEs

7 Private Securitizations Replaced GSE guarantee with 1. Ratings 2. Statistical models to support credit tranching 3. Monoline insurance Alphabet soup of innovations RMBS CDOs, CDO 2 ABCP SIVs CLOs Became an off-balance sheet banking system Lost transparency of original model

8 Real Housing Prices, Source: U.S. Office of Housing Enterprise Oversight Ind dex 1975=

9 Technique applied even to nonprime mortgages Subprime: mortgages to borrowers with weak Credit histories Credit scores (repayment capacity) Or incomplete credit histories Low doc loans No doc loans Liar loans Alt-A: mortgages to borrowers w. non-standard features re: Borrower, Property or Loan

10 Helped Feed the Demand for High Quality Assets Demand for investment-grade assets, much higher than supply from investment grade issuers Portfolio regulations insurers, pensions funds and some mutual funds establish minimum acceptable ratings Banks could reduce capital requirements by holding higherrated debt Ability to synthesize investment grade securities helped fill the gap But how do you transform subprime mortgages into high-quality securities?

11 Where Did the Subprime Go? From to RMBS to CDO to CDO 2 to ABCP & SIVs Subprime loan originated Initially funded by warehouse lines of credit to mortgage brokers (about 90 days) Held briefly bifl on lender s b/s until seasoned, shows statistically predictable performance Sold to SPV and securitized e as RMBS Equity and risky debt may be difficult to sell Resecuritize equity and risk debt in CDOs Equity and risky debt may still be difficult to sell May securitize equity and risky debt tranches of CDO in CDO 2 Or may be purchased and pooled for ABCP

12 How CDOs Helped Transform Subprime Mortgage into AAA Credits Source: IMF Global Financial Stability Report (IMFGFSR), 4/08, Box 2.2.,p. 60

13 Conduits, SIVs & SIV-Lites Source: IMFGFSR, 4/08, p. 71

14 Credit Enhancements Excess servicing Over collateralization Subordination and residual tranching Performance triggers Monoline insurance Credit Default Swaps CDOs are Synthetic if backed by CDSs

15 Very Rapid Growth in Issuance of Structured Credit Increasing reliance on CDOs 2000: $150 billion 2007: $1.2 trillion Source: IMFGFSR, 4/08, Box 2.1, p. 56.

16 Became a dominant source of revenue for most LCFIs Growth in Trading Profits, Commissions & Fees Largely Reflects Growth in Structured Credits Source: Bank of England Financial Stability Review, October 2007, p. 38.

17 LCFI Issuance of RMBS backed by Sub-Prime Lending Source: Bank of England Financial Stability Review, October 2007, p. 37.

18 Deterioration in Subprimes Raised Alarm 60-Day Delinquencies by Mortgage Vintage Year (in % of Original Balance) Months after origination Source: IMF Global Financial Stability Review, April 2008, p. 6

19 7 Pitfalls in Subprime Mortgage Credit Securitization 1. Predatory lending: Subprime borrowers can be financially unsophisticated either unaware of all options available or unable to make the best choice between options. 2. Mortgage fraud: The originator, who sells a pool of mortgages to the arranger, has an information advantage over the arranger regarding quality of the borrower. An originator, collaborating with the borrower, may misrepresent the information on the application. MORTGAGOR ORIGINATOR ARRANGER 3. Adverse selection: The arranger has more information about the quality of the mortgage loans so, the arranger can choose to securitize the bad loans and retain the good ones. 6. Principal agent: While the investor provides funding for the mortgage backed security, the asset manager conducts the due diligence on the investments and findsthe best price for the trades the asset manager may not take sufficient effort on behalf of the investor. WAREHOUSE LENDER CREDIT RATING AGENCY ASSET MANAGER INVESTOR 4. Moral hazard: In order to maintain the value of the underlying asset (the house), the mortgagor has to pay insurance and maintain the property. In, or approaching delinquency, there is little incentive to do this. SERVICER 7. Model error: The rating agencies are paid by the arranger and not investors for their opinion. Their rating relies on models, which are susceptible to errors. 5. Moral hazard: Given that the servicer s income increases the longer the loan is serviced, keeping the loan on its books for as long as possible is preferred therefore, it has a preference to modify the terms of a delinquent loan to delay foreclosure. Source: Ashcraft and Schuermann (2007): Understanding the Securitization of Subprime Mortgage Credit

20 Losses Sustained by Leading Players Cast Doubt on Validity of Models After two Bear Stearns Hedge Funds Blew-Up in June 2007 Source: IMFGFSR, 4/08, Figure 2.2, p. 68.

21 Multi-Notch Downgrades Undermined Confidence in Ratings 68% 47% on Credit Watch* *As of 1/31/08 Source: IMFGFSR, 4/08, Box 2.3, p. 61.

22 CDS Market Took an Even More Pessimistic View Source: IMFGFSR, 4/08, Figure 1.3, p. 7.

23 Losses Threatened Solvency of Monoline Insurers At yearend 2006 Monoline insurers supported about $800 bn in structured finance obligations Source: IMFGFSR, 4/08, Figure 1.14, p.17.

24 The Damage Spread Rapidly Losses undermined 3 main supports for private sector securitization 1. Ratings 2. Statistical models 3. Monoline insurers Sharp decline in risk appetite Concerns about solvency of systemically important firms Flight to simplicity Flight to quality Pressures to deleverage financial system

25 Volatility Spread from Subprime in 07II to Emerging Markets in 07III Based on both the level and 1-month volatility of the spreads, prices and total returns of each asset class in terms of deviation relative to the average during Wider spreads, lower prices and total returns mean higher volatility. Focus on standard deviation. Green σ<1; yellow 1 σ 4; black σ>4

26 Performance of Alt-A A Deteriorated Source: IMFGFSR, 4/08, Figure 1.2, p.6. Months and percent of balance (60+ day delinquencies)

27 As Did Performance of Non-Agency Prime (Jumbo) Source: IMFGFSR, 4/08, Figure 1.2, p.6.

28 Looming Resets in 2008 $250 bn of Subprime Mortgages scheduled to reset $29 $ bn of Alt-A Mortgages gg scheduled to reset $82 bn in Prime Mortgages to reset Most ARMs have floors and caps, thus further monetary easing may not help Refinancing i will be difficult Tighter underwriting standards Fixed rates still elevated

29 Policy Issues: Role of Ratings Agencies

30 Ratings Agencies Crucial to securitization Link to ABX securities used to value illiquid structured product Use in regulatory process has led to grade inflation Portfolio regulations for banks, insurers, pension funds and some mutual funds establish minimum acceptable ratings Regulated entities want larger menu of highly-rated assets Ratings not consistent across instruments* Corporate bonds rated Baa, 2.2% 5-year default rate ( ) CDOs rated Baa, 24% 5-year default rate ( ) Market perceived differences as well 200 bp spread on AAA-rated CDOs vs. 10/20 bp spread on AAAtd corporates rated Source: Example cited by Calomiris (2007) from Bloomberg Markets (July 2007, p.56)

31 Market Perceived Differences As Well Source: IMFGFSR, 4/08, Box 2.3, p.62.

32 IMF highlighted 3 Flaws in Methodology 1. Underestimated PDs and LGDs 2. Underestimated correlations 3. Underestimated speed with which performance deteriorated t d and severity of loss Very slow to react to evidence of rising delinquencies in rating new issues Ratings of ABS CDOs based on default probabilities and loss severities associated with rated ABS rather than underlying mortgages CDO rating may be delayed for downgrade of ABS and analysis of complex cash flow dynamics Downgrades of ABS tend to compound

33 Undermined Credibility Old questions about conflicts of interest heightened Played active role in facilitating origination of structured products Revenue from securitizations accounts for roughly half of agencies fees Ratings slow to reflect deterioration in underlying pools of securities i Past errors individual corporates or sovereigns, not an entire, broad asset class

34 Would investors be better served By y disclosures of actual PDs and LGDs for each issue rather than letter grades? By y different scales for structured credits? By additional ratings for market, liquidity, and downgrade risk? By regulations that do not delegate judgments to the ratings agencies?

35 Policy Issues: Valuation of illiquid securities

36 Most CDOs held as Available for sale Source: IMF Global Financial Stability Report, April 2008, p. 65

37 Auditors require evidence that Sale price is not indicative of fair value before accepting a reclassification from level 2 to level 3 Forced sale by liquidator may not be indicative Similar sale by solvent entity may be indicative Meant to discourage cherry picking of valuations Post-SOX, auditors may be very cautious

38 Source: IMF Global Financial Stability Review, April 2008, p. 66.

39 Valuation Issues Reliance on models and judgment same security may have different values at different firms Loss of confidence in valuation models Bear Stearns ran two hedge funds that blew up Merrill Lynch announced $3.3 bn in losses and 3 weeks later, $7.9 bn Citicorp announced $2.2 bn in losses and 3 weeks later announced another $5-$7 bn It Internal models dl said to rely heavily on external credit ratings* Greater reliance on derivatives indices such as ABX which have continued to trade in liquid markets Wall St. Journal, November 5, 2007, p. C2

40 Fears that Fair Value Accounting May Contribute to Crisis Fair values intended to represent exit value If markets overshoot, so will fair values If fair values trigger asset sales, may contribute to further downward pressure on prices Could exacerbate downward liquidity spiral

41 Prices have continued to plummet in derivatives market Source: IMFGFSR, 4/08, Figure 1.3, p.7.

42 Spreads Continue to Widen on CMBS Source: IMFGFSR, 4/08, Figure 1.7, p.9.

43 As Do Spreads on Leveraged Loans Some banks have retained rather than accept loss As CLOs unwind, may be forced to take more leveraged loans on b/s Source: IMFGFSR, 4/08, Figure 1.10, p.10.

44 IMF Estimate of Losses on Structured Finance 3/08 (in billions of $s) Source: IMFGFSR, 4/08, Figure 1.13, p.13.

45 IMF Estimate of Financial Sector Losses 3/08 (in billions of $s) Source: IMFGFSR, 4/08, Table 1.1, p.12.

46 Policy Issues: Adequacy of Disclosure

47 The SEC & Disclosure Examined mortgage-related markets 4 times between 1998 & 2007, but found no significant concerns re: transparency Regulation AB requires collateral-level l l l performance reports, but allowed issuers to choose how to disclose Most chose to disclose only to First American Loan Performance Neither GAAP nor IFRS require instrument specific disclosures

48 Opaque Mitigation Practices Typical foreclosure costs are $60k and likely to increase as home prices decrease* Servicers use loan modifications to avoid classifying loans in default Post-modification default rate still 35-40% higher than non-modified loans Re-aging policy varies across servicers Some reclassify loan as performer as soon as 1 modified payment is made Others require several consecutive payments Practices mask true condition of subprime loans as they deteriorate and overstates performance of pool Tends to favor riskier tranches Improved performance ratios trigger release of cash flows to subordinated d tranches *Source: Joe Mason, Mortgage Loan Modifications: Promises & Pitfalls, October, 2007

49 Variations in disclosure across countries SEC requires quarterly disclosure Europe less prescriptive CFO can exercise professional judgment about scale and timing of loss recognitions Same asset may be valued differently in different institutions Piecemeal release of increasingly larger losses raises concerns about Integrity of financial reporting Management s grasp of its risk exposures

50 Uncertainty & Lack of Information Lack k of clarity about where these risks now reside overhangs markets Financial institutions are subject to an increasing opacity discount Skepticism re: assertions that Our exposures are highly rated or We have offsetting hedges or We have a rigorous risk management process Accurate t and timely information are critical for the market to differentiate among borrowers and price risk

51 Banks Pay an Opacity Premium 250 LIBOR spread over T-Bills from 5/1/07-4/1/ s Points Basi Date

52 Policy Issues: Basel I

53 Basel I Created Strong Incentives to Securitize On b/s mortgage had 50% risk weight Off b/s line of credit had 0% risk weight if less than 1 year Capital requirement against CP less than against mortgage Provides strong incentive to fund rather than dissolve ABCP Conduits

54 Basel I Did not Constrain Growth in Assets or Address Liquidity Risk Source: IMFGFSR, 4/08, Box 1.3, p.31.

55 Policy Issues: Basel II

56 Would Basel II have prevented problems? SIVs would still have been off/b/s Must only meet accounting criteria Would require some capital for back-up facilities of 364 days or less US already implemented such a rule in 2004 and did not restrain Citi More than 3x as much exposure as Bank of America & JP Morgan Chase combined** Exposure to subprime varied from actual loans to most highly-rated slices of CDOs Sponsored 7 SIVs **Call report data, 6/30/07, Outstanding principal balance of residential loans sold and securitized with servicing retained, or with recourse, or seller-provided credit enhancement: BofA = $73.6bn, JPMorgan Chase: $80.5 bn, Citibank: $584.9 bn. See Calomiris (2007)

57 When is off b/s really off b/s? Legal and accounting standards may not be sufficient for prudential purposes Reputational risk may override May feel obligated to support legally-separated ll entities financially i to maintain reputation in market SIVs, conduits, money market mutual funds, hedge funds New instruments & structures may contain contingent liabilities Under what circumstance might it be necessary to extend Under what circumstance might it be necessary to extend support to separate asset management companies, SPVs and conduits?

58 Basel II Standardized Approach relies heavily on external ratings If agencies get it wrong for entire categories of securities, a new source of systemic risk Internal a Ratings Based Approaches rely on internal models But even the most sophisticated players have found their internal models unreliable Basel II does not impose a capital charge for reputational risk Paulson has called for a review of treatment of off-b/s vehicles Others believe Pillar 2 is sufficient We may have a test of the pro-cyclicality of Basel II much sooner than anyone expected

59 Leverage ratio debate continues Well-capitalized US banks must have Tier 1 capital equal to at least 5% of total assets A deterrent to bring mortgages back onto b/s When binding, may encourage more off-b/s innovations But, ensures that t capital is available to absorb b risks that t are not well captured in Basel II framework

60 How Big is the Crisis?

61 IMF Comparison with Past Crises Source: IMFGFSR, 4/08, Figure 1.12, p.13.

62 Financial Policy Options

63 Forbearance In capital regulation But more difficult with Prompt corrective action measures and Post SOX and fair value accounting reforms GLBA requirements for Financial Service Holding Companies But Citi did not meet the 5% requirement at yearend o It would be ironic if the bank for which GLBA was written would be the first to lose its Financial Services Holding Company status In valuation standards

64 Provide liquidity Monetary policy Insure aggregate liquidity is sufficient Adjust monetary policy to compensate for crisis-induced credit crunch Swap high-quality liquid assets for risky securities Broadened access at discount window Term auction facilities Warehouse $30 bn of Bear Stearn s assets Major Concern: Increase rate of inflation to relieve burden on debtors and stop the decline in housing prices

65 Central Banks Have Broadened Range of Counterparties & Collateral Source: IMFGFSR, 4/08, Box 3.5, p.102.

66 Crisis has Decapitalized Banking System Loss of excess servicing from securitizations Direct losses from holdings of downgraded securities Losses from honoring implicit guarantees backing-up off b/s vehicles Extensions of liquidity Purchases of securities Losses from inventories i of assets that t can no longer be securitized Loss of important continuing source of bank revenue Capital challenge Replace lost capital Acquire new capital to bring much of off-balance sheet banking system back onto bank balance sheets Or reduce holdings of risky assets

67 Credit Default Swaps Spreads on Key Institutions Source: IMFGFSR, 4/08, Figure 1.2, p. 20.

68 Recapitalization Monetary authorities: Lower short-term rates relative to long-term rates to enable banks to increase spread earnings and rebuild capital Banks issue new capital, especially convertible debt Sovereign Wealth Funds

69 Sovereign Wealth Funds to the Rescue

70 Lessons for Risk Managers

71 Within the traditional silos Market risk Liquidity risk Credit risk Liquidity idi risk Operational risk Asset Liability Management Risk Liquidity risk Business risk Business risk Reputation risk

72 Across the silos Failure to realign risk management to deal with convergence of risk types Failure to anticipate correlations across assets and asset types Failure to understand consequences of reputation risk Need reassessment of KuU K, we knew less than we thought we did about models, ratings and insurance u, we must recognize that our knowledge of tail events is highly uncertain Basel may insistent on a 99.97% 97% level of confidence, but do delude yourself into thinking that you know it U, in large complex financial and economic systems, some dynamics, may simply be unknowable

73 How far will house prices fall? Average home equity has fallen to 50% May see a 3 rd wave of defaults on prime mortgages gg