A Recipe for Disaster? Credit Derivatives, Structured Credit Products, and the Subprime Debacle
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Slides relating to a talk i gave at the University of Konstanz in 2008
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A Recipe for Disaster? Credit Derivatives, Structured Credit Products, and the Subprime Debacle
- 1. A Recipe for Disaster? Credit Derivatives, Structured Credit Products, and the Subprime Debacle Dr Sikandar Siddiqui Konstanz, October 13 th , 2008
- 2. 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 Dr Sikandar Siddiqui
- 4. Timeline Dr Sikandar Siddiqui 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 Mac Sep 14: Merrill Lynch sold to Bank of America amidst fears of a liquidity crisis Sep 15: Lehman Brothers files for bankruptcy protection Sep 17: Fed loans $85 bn to AIG to avoid bankruptcy. Sep25: Wa Mu seized by FDIC, banking assets sold to JP M Oct 3: $ 700bn U.S. bailout plan passed Oct 6: BNP Paribas takes over Fortis from the Belgian government for €14.5 bn. Oct 6: Iceland prepares nationalisation of banks
- 5. Growing Mutual Distrust among Banks Dr Sikandar Siddiqui Source: http://en.wikipedia.org/wiki/Subprime_mortgage_crisis
- 6. … due to a succession of defaults Dr Sikandar Siddiqui The succession of government bailouts and emergency takeovers is likely place a heavy burden on public sector budgets in the next decade(s).
- 7. 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 Dr Sikandar Siddiqui
- 11. 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 Dr Sikandar Siddiqui
- 13. 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 Dr Sikandar Siddiqui
- 19. 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 Dr Sikandar Siddiqui
- 22. Credit Risk Transfer: SIVs and Conduits Dr Sikandar Siddiqui Conduits set up by German Banks Conduit Bank Size ($ bn), Oct 2006 Source: Moody‘s, FT June 2007: $bn 17.5
- 23. Credit Risk Transfer: SIVs and Conduits 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 Dr Sikandar Siddiqui
- 24. 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 Dr Sikandar Siddiqui
- 25. The Rating Process for ABS Rating grade 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 Dr Sikandar Siddiqui . . . +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=10bp Translation Deduction
- 29. 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 Rating Agencies 5. Conclusions Dr Sikandar Siddiqui
Notes de l'éditeur
- The collapse of the market for Subprime mortgages has plunged a substantial part of the financial sector in North America and Europe into a severe crisis and even led to the insolvency or emergency nationalisation of some creditors, including the renowned insurer AIG, and investment bank Lehman. The consequences of these developments were not limited to lenders directly involved in the US mortgage market. Rather, the shock waves sent out by the collapse of this segment also extended to the markets for structured credit products and can even be felt in the seemingly unsuspicious corporate bond market, as well as on stock markets worldwide. The purpose of this talk is to clarify which factors caused the subprime meltdown, and how it could develop form a local phenomenon to a systemic crisis of the international financial markets. From the results obtained, conclusions are to be inferred about changes in the behaviour of market participants which might help mitigate the likelihood and magnitude of such shocks in future.
- Jan 3, 2007: Ownit Mortgage Solutions Inc. files for Chapter 11. Feb 5, 2007: Mortgage Lenders Network USA Inc (subprime lender with $3.3 bn in loans funded) files for Chapter 11. February–March: Subprime industry collapse; more than 25 subprime lenders declaring bankruptcy June 7: Bear Stearns, Bear Stearns informs investors in two of its funds, the High-Grade Structured Credit Strategies Enhanced Leverage Fund and the High-Grade Structured Credit Fund that it was halting redemptions. August: worldwide "credit crunch" as subprime mortgage backed securities are discovered in portfolios of banks and hedge funds around the world, from BNP Paribas to Bank of China. Many lenders stop offering home equity loans and "stated income" loans. Federal Reserve injects about $100B into the money supply for banks to borrow at a low rate. Aug 17: Federal Reserve lowers the discount rate by 50 basis points to 5.75% from 6.25%. Sep 14: A run on the bank forms at the United Kingdom's Northern Rock bank precipitated by liquidity problems related to the subprime crisis. Sep 18: The Fed lowers interest rates by half a point (0.5%) Nov 1: Federal Reserve injects $41B into the money supply for banks to borrow at a low rate. The largest single expansion by the Fed since $50.35B on September 19, 2001. 2008: Mar 16: Bear Stearns gets acquired for $2 a share by JPMorgan Chase in a fire sale avoiding bankruptcy. The deal is backed by Federal Reserve providing up to $30B to cover possible Bear Stearn losses. Sep 7: Federal takeover of Fannie Mae and Freddie Mac Sep 14: Merrill Lynch sold to Bank of America amidst fears of a liquidity crisis Sep 15: Lehman Brothers files for bankruptcy protection Sep 17: The US Federal Reserve loans $85 billion to American International Group (AIG) to avoid bankruptcy. Sep 25: Washington Mutual was seized by the Federal Deposit Insurance Corporation, and its banking assets were sold to JP MorganChase for $1.9bn. Oct 6: The Danish government announces plan to guarantee all banking deposits and some inter-bank loans. In return for the guarantees, the country’s banks must establish a rescue fund of $6.5 billion. Oct 6: BNP Paribas agrees to takeover Fortis from the Belgian government for €14.5 billion. This deal makes BNP the largest bank operating in the Eurozone. Oct 6: Iceland passes legislation that allows the government to nationalize, merge, or force ailing banks into bankruptcy.
- Many market observers trace the causes of the current crisis back to as early as 2001, when the speculative outrage which had seized the technology segment of the stock markets between 1999 and mid-2000 gave way to a severe downward correction on the equity markets. The violent market turmoil following the Terrorist attacks on the World Trade Centre, and the subsequent fears of a protracted recession caused the U.S. Federal Exchange Bank to follow strongly expansive monetary policy, which which was mirrored by a succession of pronounced interest rate cuts. The over-abundant supply of liquidity, which coincided with an otherwise unfavourable market environment, turned the attention of institutional investors increasingly towards the U.S. residential real estate market, which, at that time, was in the reputation of being undervalued compared to asset classes with a similar risk profiles. After some years of increasing investment, however, saturation tendencies in the established „prime“ segment of this market became obvious.
- The combination of beginning market saturation and continuing pressure to earn a high return on investments motivated creditors to address new customer groups with innovative products. In order to achieve this end, lenders significantly relaxed the eligibility criteria for new residential mortgages. Moreover, creditors attracted customers by artificially low, so-called “teaser” interest rates and a deferral of amortisation payments during the first two years of the life of the mortgage. These practices made mortgages look more affordable for low-income households without actually lowering the contractually agreed amount owed in present value terms. They are thus often termed “predatory lending”. At the same time, the procedures employed for the credit quality assessment of debtors and the valuation of the collateral valuation were accelerated and greatly simplified. The same applies for the verification and documentation standards applied to these procedures. This provided potential debtors with the opportunity to obtain mortgages by deliberately falsifying their income- and wealth-related assertions in their credit applications. This practice is frequently referred to as „predatory borrowing”. Due to these developments, the subprime segment of the residential mortgage underwent a rapid expansion. In 1995, the total volume of subprime mortgage amounted to $50 bn; in 2001 it had grown to $ 190 bn, and in 2006 to $ 600 bn.
- Particularly after 2001, the low level of short-run interest rates made debt-financed home purchases look affordable even for households who would usally not have had a chance to be eligible for a mortgage. The steep increase in US home prices was another reason for the rapid growth of the subprime segment: It created the impression that in the case of borrower default, proceeds from the sale of the collateral would be more than sufficient to satisfy the remaining claims of the lender. This led to a mutual reinforcement process between the lowering of credit standards and the rise in home prices induced by the increases in demand thus created. This process peaked in 2006. Yet since then, the seemingly incessant trend towards rising home pr-ices has reversed. On the other hand, short-term interst rates, have risen compared to their historical low in 2004. The combined impact of these factors put an abrupt end to the boom in the subprime segment. Particularly among the floating rate subprime mortgages, the share of loans being more than 90 days in arrears has reached an unpreceden-ted peak. The fact that the corresponding quantity for fixed rate mort-gages is still low does not offer much comfort due to the tiny market share of this product group. Alarmingly, since mid-2007, the crisis has spread to the seemingly high-quality „prime“-segment. An avalanching succession of more defaults and further drops in home prices, due to the resulting foreclosures, has begun.
- In order to refinance the loans they extend to customers, banks - inclu-ding subprime lenders – often issue so-called Asset Backed Securities (ABS) to investors. These are bonds that are collateralised by the future cash flows from a pool of loans. In the context of such transactions, the loan pool is sold to a specialised company called a „Special Purpose Vehicle“, or SPV. This procedure ensures that the credit quality of the securities to be issued by the SPV is unaffected by a possible default of the original lender. The purchase of the loan pool is funded by the SPV through the issuance of bonds, for which the future cash flows from the loans serve as collateral. The entirety of these bonds is typically divided into distinct classes of different rank, the so-called tranches. When the cash flows from the pool are distributed, any specific tranche can only participate if all tranches of higher rank If defaults occur in the loan pool, at first only the lowest ranking class – temed the “equity trance” suffers losses. Each of the higher tranches only begins to suffer losses if the related capacity of all the less senior r classes has been exhausted. As a compensation for the higher default risk associated with them, holders of the junior tranches receive a much higher risk premium in addition to the baseline coupon than investors in the senior ones.
- Yet when setting up such a transaction, potential ABS issuers face the problem that the original creditor has a huge informational advantage over the potential bondholders with regard to the credit quality of the debtors in the loan pool is concerned. In order to mitigate this informational asymmetry, potential issuers by entrusting independent rating agencies with the measurement of the losses potential pertaining to the individual tranches. These agencies employ statistical models and expert judgments in order to estimate the likelihood of losses, as well as their statistical expectation, for each tranche about to be issued Based on the outcome of these investigations, they rate each tranche on a scale between AAA (=excellent credit quality) to C (= highest possible danger of default). By doing so, rating agencies set standards which serve as a benchmark for the individual risk-return calculations underlying the investment decisions of the bondholders.
- 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”.
- It follows from the structure of such transaction that the thicker the protective layer constituted by the totality of the subordinate tranches is, the lower likelihood of losses of a given tranche will be. If, on the other hand, the cumulative volume of the subordinate tranches is held constant, the risk of possible losses for a tranche increases with the default probabilities of the debtors in the pool. These debtor-specific default probabilities are not necessarily constant over time. Apart from individual causes, changes in the macroeconomic environment – e.g. in wages, prices, and interest rates - can alter in the credit quality of individual borrowers during the life of a a loan. The more similarly the debtors in the pool react to changes in the macroeconomic environment, the higher the fraction of total risk which accrues to the most senior tranches. In other words: If the loan pool mostly consists of debtors whose solvency will be severely impaired in the event of an adverse macroeconomic shock, there is considerable default risk even the most senior tranches of an ABS transaction. Yet the extent to which the solvency of an individual debtor will be affected by such external shocks often cannot be measured with sufficient accuracy. The uncertainty associated with such estimates is greatest in cases where the asset pool consists of rather new-fashioned loan types, for which sufficient historical data are unavailable.
- The subprime debacle is an exemplary case of how disregard of such uncertainties can even cause seemingly riskless assets – namely AAA-rated Subprime ABS tranches - to suffer significant market value losses or even default in the event of an unfavourable macroeconomic develoment. In this case, the macroeconomic shock that triggered historically unprecedented credit losses was the joint occurrence of short-term interest rate hikes and a downward trend in home prices. Due to these developments, many other sub-segments of the ABS market have subjected to a growing mistrust by investors and incurred unexpectedly high losses prevailing until today. Since the seemingly unsuspicious AAA tranches, in particular, had also been bought by banks and institutional investors outside the USA on an extraordinary scale, the Subprime problem managed to develop from the regionally and sectorally limited phenomenon to into an international financial crisis.
- One of the main reasons for the fact that the extent of the subprime-related losses took most observers by surprise is the fact that 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 by an asset class called „Asset Backed Commercial Papers“ (ABCP). These are short-term notes with a maturity of only 30 to 90 days which are backed by the cash flows from assets with longer lives They are issued in a revolving fashion by specialised entities in order to fund the acquisition of longer-term claims on behalf of their sponsors, which are usually banks. By doing so, their sponsors seek to capitalise on the interest rate differential between the long-term bonds acquired by the specialised entities and their short-term liabilities. From the viewpoint of the sponsoring bank, one of the perceived advantages of using such constructions is that often, the assets held in the specialised entities do not have to be displayed on the balance sheet. Instead, only the less voluminous and less capital-intensive shareholdings or subordinate debt positions in these companies have to be declared.
- There are two basic types of issuers for ABCP Notes: Conduits issue ABCPs with an average maturity of 45 days. They hold a well-diversified portfolio consisting mainly of long-term bonds. Structured Investment Vehicles, or SIVs, differ from conduits in that they issue ABCPs in different tranches bearing different amounts of credit risk. In addition, SIVs may fund their purchases by medium-term notes, maturing after around 3 years, and issue „Income Notes“ which confer claims on the residual profits to their holders. A common feature of nearly all these vehicles is that, upon purchase, all the assets acquired possess an excellent credit rating. As a conse-quence, AAA-rated tranches from subprime ABS transactions found their way into the asset pools of SIVs and conduits at a very large scale. Due to the apparently risk-adverse investment strategy of the vehicles, the notes they issued also earned the a AAA grade at the time of sale. In order to sustain the a conduit or SIV in cases where the notes to be issued do not meet sufficient demand, the sponsoring banks provide these vehicles with comprehensive lines of credit
- Due to their seemingly risk-free nature, ABCP investments gained a lot of acceptance. For some sponsors, this conveyed the impression that a frictionless functioning of the related funding mechanism could be ta-ken for granted independently of the prevailing economic environment. In the course of the subprime crisis, this assumption turned out to be a fatal fallacy: Within few months, the rapid increase in credit defaults experienced by subprime mortgage pools led to significant declines in the market value even of AAA tranches, which had previously been regarded as virtually risk-free. Drastic drowngrades by rating agencies followed suit. As a consequence, many investors withdrew from the ABCP market, because the value of the collateral provided by the issuers became doubtful. The sudden absence of buyers also defeated any attempts to unwind the vehicles’ investments through asset sales. Thus, SIVs and conduits suddenly had to draw on the sponsor-provided lines of credit to an extend that had never been experienced or expect-ed. Yet at some of the banks, the volume of these commitments had become so large that the attempt to fulfil their resulting duties was in danger of failing, which severely threatended solvency of the organisa-tion as a whole.
- The credit quality assessment of ABS products usually proceeds in 4 steps: At first, the individual ratings of the creditors in the loan pool are determined and translated into debtor-specific default probabilities. Also, assumptions about the degree of correlation between the behaviour of individual debtors are introduced. Secondly, the frequency distribution of potential losses in the pool is estimated on the grounds of a large number of simulated scenarios (which may easily exceed one million). Thirdly, this frequency distribution is used to derive loss probability and severity estimates for each of the tranches. These estimates, in turn, are translated back into rating grades. In cases where the rating grade of a tranche obtained in this way does not match the target rating desired by the issuer, additional credit enhancements – for example external guarantees by specialised credit insurers – are demanded.
- The credit quality assessment of ABS transactions is far more complicated than the conferment of ratings to corporations or governments. This is due to three main reasons: • When rating ABS issues, agencies must rely largely on the trustworthiness of credit quality assessments carried out by the original creditor with regard to the pool, and on the unbiased nature of the related results communicated to the agency. It is not known with certainty whether the rating agencies have, in the past, tested the quality of this information sufficiently. • The credit quality of ABS tranches depends crucially on the extent to which the individual debtors in the pool are affected by adverse macroeconomic shocks. Therefore, an adequate assessment of such sensitivities is vital for the quality of the rating outcome. If the pool is constituted by well-estab- lished asset classes, the availability of rich datasets from several decades facilitates this task. But if the collateral pool is made up of claims for which only little information is available – like in the case of subprime mortgages - severe estimation errors become more likely This increases the danger that the actually observed loss frequencies exceed their predicted values by far. • The use of external guarantees as credit enhancements effectively lowers credit risk if the ability of the external guarantors to fulfil their duties in case of emergency is beyond reasonable doubt. In cases where the insurer itself is engaged as protection seller for a large number of highly complex and heterogeneous products, it can be hard to verify whether this condition is indeed fulfilled
- After the initial of credit quality assessment for the tranches of an ABS transaction, the further development of the underlying loan pool is reviewed on by the rating agencies on a regular basis. To this end, data on payment arrears and effective credit losses within the pool, which have been measured and provided by specialised servicers, are examined statistically. The main measure for the credit quality of an ABS tranche is the so-called loss coverage ratio. The loss coverage ratio of a given tranche equals the statistically expected loss rate for non-defaulted loans, divided by the total volume of all tranches with lower rank. If this ratio drops below a minimum target value required for the maintenance of the current rating, a rating downgrade is a likely consequence. Since July 2007, the rating agencies have been forced to undertake hundreds of rating downgrades, many of which have been drastic. Apart form suprime ABS tranches, which were hit hardest by this wave, many other structured credit products indirectly related to this segment were afffected. Even tranches with the best possible grade, AAA, could often not withstand this downward pressure. Quite understandibly, the confidence of investors in the reliability of agency ratings has been severely shattered since.
- 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 The original creditor ought to be bound to buy a certain fraction (e.g. 10%) of the securities issued by a SPV. This rule should not apply to the Equity Tranche only, but to all tranches of the trans-action separately. This reduces the incentive for unreliable lending practices. II. Compulsory Supervisory Audit for ABS rating processes The models, methods and data sources applied by rating agencies in the course of ABS issuances ought to be subjected to a supervisory examination process. It should become possible for regulators to deny or withdraw the approval for certain rating processes if either 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 the transaction examined adequately. A beneficial side effect of such a rule is that it might lead to a greater degree of standardisation and a less complex structuring of ABS transactions
- 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.