Anatomy of  Subprime Crisis

1. Origins

Governments, particularly the US, were veering round to having more liberal environment in which the various economic entities, especially, the multinationals and financial organizations could operate unhindered.  This was inevitable as technology had compressed space and time resulting in increased integration of economies across the globe.  The resulting competitive pressures at the global level encouraged major importing and exporting economies of the world to adopt the ‘least common denominator’ as regards regulation and national restrictions.  The irony, however, was that the multilateral organizations that were created to support global trade and finance, neither had the wherewithal, not even a clear mandate to regulate or oversee the major players in international commerce and finance.

So the various checks and balances that were put in place in the US – the world’s major economy, after the depression of 1930s were over time either inadequate, diluted or repealed.  A typical instance was the repeal in 1999 of the Glass Stegall Act of 1993.  In fact, now that the contours of the sub-prime crisis are more or less clear and we are still contending with some of the debris left in its wake, we can discern that in the ultimate analysis, the crises is the result of what may be called ‘regulatory arbitrage’. This arbitrage is made up of a cocktail of securitization, search for low interest rates and funds flowing to less rigorously regulated entities such as merchant banks and their SPVs who with excessive leveraging and fractional reserves sought to maximize profits, albeit by assuming higher risks.

2. Anatomy

Subprime mortgages comprised loans that were issued with little or no down payment generally to households with low income and assets and often with troubled credit

histories.  The subprime crisis was triggered by a dramatic rise in mortgage delinquencies and foreclosures in the US, with major adverse consequences for banks and financial markets around the globe.  The nature and magnitude of the problem are indicated by the following developments and statistics.

• Defaults and foreclosures activity increased dramatically as easy initial terms expired, home prices failed to go up as anticipated and interest rates under adjustable rate mortgages (ARM) were reset higher.  In the US foreclosures accelerated in the late 2006 and triggered global financial crisis through 2007 and 2008.  During 2007, nearly 1.3 million US housing properties were subject to foreclosure activity, 79% higher than in 2006.

• The value US subprime mortgages was estimated at $ 1.3 trillion as of March 2007.

• Low interest rates and large inflow of foreign funds created easy credit conditions for a number of years.  Household debt grew from $ 705 billion at the end of 1974 from 60% of disposable personal income to $ 7.4 trillion by the end of 2000 and finally to $ 14.5 trillion in mid2008, which was 134% of disposable personal income.

• Financial products called Mortgage Backed Securities (MBSs) and  Collateralised Debt Obligations (CDOs) which derive their value from mortgage payments and housing prices, had enabled financial institutions and investors around the world to invest in the US housing market.  Major banks and financial institutions had borrowed and invested heavily in MBS and reported losses of approximately $ 435 billion as of 17th July, 2008.

• Financial institutions, particularly merchant banks were encouraged to lend to risky ventures, because of inadequate regulation and resultant fractional reserve regime. Investment banks were excessively leveraged. Lehman, for example, was leveraged 35 times which encouraged it to lend to high-risk ventures.  Naturally, only a few of these risky ventures succeeded.  But the fact that the successful ones included such iconic names like e-bay, Amazon and Google, postponed the day of reckoning for organizations that carried on such high-risk lending.

3.   Practices & Instruments that Precipitated the Crisis

The factors that caused the subprime crisis are many and complex.  But there are a few practices and instruments that readily come to mind when one talks of the crisis.  They are

• Securitization (MBSs/CDOs)
  • Credit Derivatives (CDSs)
  • Carry Trade
  • Role of Rating Agencies.

(i). Securitization: The traditional loan/mortgage model involved a bank originating a loan to the borrower/homeowner and retaining the credit (default) risk.  With the advent of securitization, the traditional model gave way to the ‘originate to distribute’ model in which the credit risk is transferred (distributed) to investors through MBSs/CDOs.  Securitization created a secondary – largely an Over the Counter (OTC) – market for mortgages which meant that those issuing mortgages were no longer required to hold them to maturity.   Finance companies and merchant banks often placed CDOs they originated or purchased into off balance sheet entities called Special Purpose Vehicles (SPVs).  Moving the debt off the balance sheet enabled financial institutions to circumvent capital adequacy requirements, thereby increasing profits but with increased levels of risk.  Such off balance sheet financing is sometimes referred to as shadow banking system and is thinly regulated.

CDOs explained

Let us assume that Company ‘A’ has substantial receivables on its balance sheet. It is the originator of the loans.  It chooses to float a subsidiary – a Special Purpose Vehicle (SPV) – with nominal capital and sell these receivables (assets/loans) to the SPV.  The SPV will issue tradable securities called Pass Through Certificates (PTCs) to fund the purchase.  In order to create a market for these PTCs, also called Structured Obligations (SOs), they are got rated by rating agencies.  Typically, the originator, here Company A, would like the SOs to have the highest credit rating so that they can be sold easily by the SPV.  If the SOs do not qualify for such high rating, the rating agency may require the originator to bring about suitable ‘credit enhancements’ like placing a percentage of the receivables as cash margin with the SPV.  For the investors the attraction of PTCs is that generally the return on PTCs is higher than similarly rated bonds.   But PTCs are illiquid since there is hardly any active secondary market for them.  Securitization can be further tweaked to arrive at a product called Collateralized Debt Obligation (CDO), wherein a variety of receivables such as vehicle loans, credit card receivables, mortgage loans and even future cash flows like property rentals, can be bundled and securitized separately. Thus the company has now created multiple layers of PTCs with varying ratings and coupons.

For example, company ‘A’ has receivables in property loans with varying risks of default. It creates an SPV with a pool of Rs500 crores, with average after tax return of 10 per cent. The SPV could have three tranches of investors. The First category – called the first loss tranche, comprises, say, Rs50 crores with coupon of 16 percent. Category two- called the second loss tranche, covers, say, Rs75 crores with 11 percent coupon. The third category – called the senior debt would cover 375 crores with 9 percent coupon. What this means is that the first Rs50 crores of bad debt will be borne by the first category, the next Rs75 crores of bad debts by the second category and bad debts beyond those amounts by third category. The first loss tranch which is a typical high risk reward instrument is one that would generally find favour with hedge funds, while senior debt which provides low risk low reward could find favour with pension funds.

(ii).  Credit Derivatives:     Credit derivatives emerged during 1995-96 and over a short span of time have grew into a business estimated in 2008, to be about $45 trillion. The massive growth in credit derivatives, as also news of banks and insurance companies writing off billions of dollars worth of credit derivatives exposure provoked heightened  interest in knowing these financial instruments. Credit derivatives are generally traded over the counter (OTC) unlike the exchange traded derivatives in equities and bonds. Although there are many and complex credit derivatives, the instrument that has become well known in the context of subprime crises is the Credit Default Swap (CDS) and it is best explained though an example.

• Bank A provides loans to a number of entities (possibly non A grade i.e. subprime categories) The size of the loan book is say, Rs 500 crores.
• Bank A wants to buy a cover against default on its loan portfolio which is called the CDS. Here Bank ‘A’ is regarded as protection buyer.
• A merchant banker or an insurance company provides such a risk cover for a fee/premium. The premium or cost of such a cover works out to say, 8 percent i.e. Rs 40 crores. Here the company providing the protection is the protection seller.
• After due diligence (may be with assistance from a rating agency) The protection seller decides there is a 3 percent chance of default on an exposure of Rs500 crores.
• Protection seller has to make a provision of 12 crores, resulting in an estimated profit of Rs 28 crores.
• However, in a euphoric growth environment marked by heightened competition, there could be more aggressive assumptions concerning default and the level of provisioning required, which could be progressively marked down, thereby reducing cost of CDS i.e. the protection against default.
• The ease with which banks could sell the risk clearly fuelled increased lending to subprime entities.
• AIG reportedly sold $440 billion worth of CDSs, which ended up in losses far greater than were estimated.

While the above discussion regards CDSs, essentially as a hedging instrument, CDSs could be traded like any credit derivative, purely for speculative purposes. In fact more than majority of the trades in CDS were not in the nature of hedges. Further, it was possible to trade indices of credit derivatives on asset backed securities, like ABX.HE (index of certain home equity securitizations), CMBX (index of certain commercial mortgage backed securitizations) and so on. There was also the idea of tranching in which it was possible to trade in tranches representing different risk levels as explained under the paragraph on CDOs above. The combination of tranching with indices which led to trades in tranches of indices, opens doors for a wide range of strategies or views, to take on credit risks. Traders could trade on the generic risk of default in the pool of names, or could trade on correlation   in the pool, or the way the different tranches are expected to behave with a generic upside or downside movement in the credit spreads, or the movement of the credit curve over time etc.

(iii)  Carry Trade :  It essentially means interest arbitrage between two currencies.  It is a strategy in which an investor sells a certain currency with a relatively low interest rate and uses the funds to purchase a different currency yielding a higher interest rate.  The gains from such arbitrage can be multiplied depending on the leverage the investor can or chooses to use.  In the context of financial meltdown during the subprime crisis, the yen carry trade deserves the greatest attention.  This is because during the past decade the most popular form of carry trade has been a strategy to exploit, the gap between US and Japanese yields or deploy funds borrowed at next to nothing in yen by multinational financial institutions in emerging markets such as China and India for superior returns. Japan was the world’s largest creditor and was the epicenter of carry trade bubble with its yield starved domestic investors having ploughed $ 6 trillion of their savings in overseas assets.  But plenty of yen carry trade money had flowed into risky cyclical assets including emerging capital markets and subprime mortgages.  With ongoing economic slowdown, these assets fell in value.  As a result, speculators in them cut their losses, bailed out and repaid their yen debts.  The flow back into yen boosted the yen’s exchange rate, regardless of Bank of Japan’s desire to keep the yen cheap to help its exporters.  A rising yen put remaining carry trade positions under further strain, as interest rate differentials are nullified by yen appreciation.  This caused more liquidation of carry trade positions with concomitant yen inflow and consequent strengthening of yen, and so on in a vicious cycle.  One estimate (by Global Money Trends) put yen carry trade at $ 5.9 trillion, with yen loans of another $ 1.2 trillion on top of it. In comparison Arabian oil wealth, or Chinese reserves looked small at $ 1.5 trillion and $ 1.9 trillion, respectively.  The effect of unwinding of carry trade was felt in India as well, which saw massive outflow of over $ 14 billion of FII investments.  The liquidity that drove up the capital markets till January 2008 became scarce and this drove the same markets down to unwarranted levels.

(iv). Role of Credit Rating Agencies  :  Now that one has the luxury of hindsight, after events such as the corporate governance crisis, exemplified among others, by the Enron fiasco, followed by the subprime crisis, the role of the rating agencies can be assessed more critically.  The first observation that one is inclined to make is that these agencies despite their ostensible experience and professional acumen, seem to be getting wise after the event, when much of the damage is done or has been already underway. It was only as late as Q3 2007 and Q2 2008, that rating agencies lowered the credit ratings on $1.9 trillion of MBSs. Financial institutions felt that they had to lower the value of their MBSs and acquire additional capital so as to maintain capital ratios. Where this involved the sale of new stock of shares, the value of the existing shares got reduced. Thus, ratings downgrades lowered the stock prices of many financial firms. The question then was, how do we evaluate the efficacy of these agencies.  Does it call for some kind of super rating agency to rate these agencies which could be funded by regulators like the SEC or by a fund to be created by collecting a cess from the rating industry? But in a free market, it will be argued that the best way eventually to discipline the rating agencies is for the investors to express their confidence in the products that these agencies rate.  But this is a long drawn-out process and as Keynes has said, ‘in the long run we are all dead’.

Empirical evidence suggests that high ratings encouraged investors to buy securities backed by the subprime mortgages, which helped finance the housing boom.  The reliance on agency ratings and the way these securities were tranched, innovatively bundled and rated, led many investors to treat securitized products – some based on subprime mortgages – as equivalent to high quality securities.  This also led to lower provisioning by ‘protection sellers’ who sold MBSs/CDSs. When borrower level defaults and delinquencies increased dramatically it triggered off a chain reaction in which a host of financial institutions, some of them icons of free market financial world, collapsed like a house of cards, threatening the entire global financial superstructure.

The investment grade ratings to CDOs and MBSs based on subprime mortgage loans were justified in part because of risk reducing practices, including over-collateralization (pledging collateral in excess of debt issued), credit default insurance and ‘equity’in the form of investors willing to bear the first losses.  However, indications have emerged that some of those who were involved in rating subprime related securities knew at the time, that rating process was faulty.  Emails exchanged between employees of rating agencies, dated before credit markets deteriorated and put in the public domain by US Congressional investigators, suggest that some rating agency employees suspected that lax standards for rating structured credit products would result in major problems.  For example, one 2006 internal email from Standard & Poor’s stated that “rating agencies continue to create an even bigger monster – the CDO market. Let’s hope we are all wealthy and retired by the time this house of cards falters”.

It is in this context that critics have alleged that the rating agencies suffered from conflicts of interest, as they were paid by investment banks and other firms which organize and sell structured securities to investors. On 11^th June, 2008 the SEC proposed rules designed to mitigate perceived conflicts of interest between rating agencies and issuers of structured securities. Since September, 2007, i.e. after it received the authority from Congress to register and oversee Nationally Recognized Statistical Rating Organizations (NRSROs), SEC has rigorously applied its new oversight to examine how credit ratings have been created and disseminated. The SEC proposed to bring out comprehensive rules to govern the conduct of rating agencies. For instance, credit rating agencies are required to make all their ratings and subsequent rating actions publicly available. Such data would be required to be provided in a way that will facilitate comparisons of each credit rating agency’s performance. Such a regulation, it is hoped, would provide a powerful check against providing ratings which are persistently overly optimistic, and further strengthen competition in the rating industry. But in the aftermath of subprime crises, one had little else to rely on other than hope!