How the credit tsunami of the century rose

The current crisis engulfing the world markets has been compared to a tsunami. The current crisis is also thought of as being more complex than any other in the world history.

The creation of complex financial products instead of diffusing risk and creating transparency wound up concentrating risk and creating opaqueness. This article explains in common man’s terms the origins of the crisis, its evolution in current times explaining the causes, concerns and insights.

Last month, I was visiting my parents for celebrating Diwali. I had missed celebrating the festival for the past 20 years as I was working and living in New York. As one would expect in family-related events with a larger share of intellectual retirees, the topic of discussion was the current “credit tsunami”.

Being a banking professional with supposedly Wall Street experience, I was in a quiz box at every “corner chat” with my relatives. My father growled in ex-military tone, “What have you bankers done? My uncle added cryptically those Ninja Loans in America caused the crisis. My brother-in-law supplemented in his scar-like voice (of the Lion King fame)—oh those greedy bankers caused it-did they not? 

I realised that if I were to have the remotest chance of winning the argument, I had to resort to use the strategy/consultant-type chart. I was confident that this would shift the focus from me to the chart (see chart), helping me avoid those penetrating stares. 

Stage 0 
This chart got them engaged—I explained one of the key factors that have caused the credit crisis of current magnitude were weak lending standards. I told my uncle “not all mortgage loans that were given were Ninja (no income no jobs no assets) loans”. Most of the commercial banks had and continue to have good credit appraisal mechanism and obtained appropriate documentation.

Generally, the loans given directly by the commercial banks were of sound credit standing. The subprime, or Ninja-type, loans were originated by mortgage brokers, who had these loans underwritten by a mortgage bank or savings and loan institution willing to assume risky assets.

The mortgage banks in turn pooled these assets and approached an investment bank/commercial bank to securitise these loans. While the crisis started with subprime loans it has spread to prime and better quality loans.

My brother-in-law interjected—what is that ABCP they talk about?
I told him the commercial and investment banks used an ABCP conduit (Asset-backed commercial paper conduit) to securitise the assets. ABCP conduit is a bankruptcy-remote legal entity that issues commercial paper (short-term borrowing) to finance purchase of longer-tenor assets.

My uncle asked, “The mortgage assets are of long tenor, doesn’t financing long-tenor assets with short-tenor commercial paper (CP) pose a risk?”

I agreed with my uncle and told him that these CPs were expected to be rolled over on maturity dates until the assets mature. The interest on the CPs issued by the conduit, and its principal on maturity is paid out of the cash flows on the assets purchased by the conduit.

To make the CPs issued from a conduit more appealing to investors (or to secure a particular credit rating) the bank will usually arrange some form of credit enhancement and/or back-up borrowing facility.  Back-up borrowing facility or liquidity support is separate from credit enhancement.

While credit enhancement facilities cover losses due to credit default, liquidity providers undertake to make available funds, should it be required for reasons other than credit default. The availability of a liquidity arrangement provides comfort to investors that CP will be repaid in full and on time, and is usually arranged with a commercial bank. In the current crisis, inabilities to place new CPs by the conduits led to the drawing of liquidity lines from banks and the need to enforce the guarantees due to credit defaults forced many banks to take these assets on their books. Taking these assets on the books required banks to provide for more capital.

My cousin, an MBA student at one of the top management schools, said, “Are not credit derivatives the cause for the crisis? What about credit default swaps, SIV, SIV-Lites and CDOs?”

I told him hey dude you are getting too technical here, but let me try to simplify and explain.

I told him credit derivatives do share some of the blame for the crisis. In the past 4-5 years, the credit derivative market had evolved in sophistication and complexity. The underlying logic of credit derivative is that if one had an asset with default risk paying a higher interest rate and an asset without default risk (e.g. government security) paying a lower rate, the difference between the two was the price of the credit risk.

This spread differential was separated and traded as credit default swap. Anyone who wanted protection paid the spread, and those willing to take the risk received the spread, for providing protection on the asset default.

This risk sharing idea was taken further in a CDO (collateral debt obligation) where a pool of loans, or debt and credit default swaps, was put together in a special purpose vehicle. The cash flows from the pool of assets were tested for robustness and based on the cash flows securities with different credit ratings were issued.

My cousin quizzed - How can you do that?
I told him that was very simple it involved basically slicing the cash flows for different levels of risk. Any financial instrument has cash flows and if you had a pool of cash flows - one can define the amount of cash flows that are certain to happen and the amount that are somewhat uncertain.

To the extent of certain cash flows, one could create a highly-rated security and create lower-rated security for less certain cash flows. The level of uncertainty can be defined by historical analysis of similar rated assets.

Technically, what is called the “default probabilities” is determined. The rating agencies had compiled data over the past several decades on what percentage of companies of particular credit rating would fail in one year and over longer-time period, say ten years. They also had data on how this probability changes over the period.

My cousin said—why is historical data relevant? History may not repeat?
I agreed that has been the problem in current times. Current defaults are a lot higher than the past and no one has an idea what the defaults will be in the future.  This has caused a serious problem for banks in valuing some of the assets based on default probabilities. Most banks have sizeable assets of this nature called the Level 3 assets.

These have no observable prices or even observable inputs in the market. In contrast Level 1 assets are liquid and easy to price and Level 2 assets can be priced with the benefit of “comparable assets”.

Even though they are hard to value, Level 3 assets are held at large investment and commercial banks by the billions. This classification was established by FASB, or the American Financial Accounting Standards Board.

What about SIV and SIV-Lites? He asked …
I mentioned that banks applying similar vehicles as ABCP were involved in two structured products-SIV and SIV-lites. Structured investment vehicles (SIV) was like virtual bank that borrows money using CPs, and then uses the money to purchase bonds.

SIVs were perpetual instruments they had no set maturity dates. SIV-Lites, a riskier cousin of SIVs, issues short-term commercial paper and medium-term notes to invest in longer-term securities. Unlike SIV, the SIV-Lites have fixed maturity dates and were also less restricted in terms of what they could invest.

Where also rating agencies to blame for proliferation of these complex structures?
One fault that is raised against the agencies is their pedantic approach. Ratings agencies used historical data and good rating seemed to give a stamp of credit approval for the investors. The structured credit transactions thus proliferated under the ratings umbrella as it provided comfort to the investor. The ratings in retrospect appear to be over optimistic and the agencies had the collateral benefit of revenues generated from the rating exercise.

I went on to explain the other stages of the evolving crisis.

Stage 1: The sub prime loans defaulted
In March 2007, HSBC Holdings Plc announced that the US subprime market is unstable and will affect their earnings. In April, New Century Financial Corp, which specialised in loans to people with poor credit, filed for bankruptcy protection after being overwhelmed by customer defaults. In June, investors in two Bear Stearns-promoted hedge funds that invested in CDOs backed by subprime mortgage loans were told that there is no value left in the funds, wiping out $1.6 billion originally invested. The evolution of the crisis increased the credit cost and slowly eroded the balance sheets of banks that had such exposure.

Stage 2
The cash-funded vehicles, ABCP, SIV and SIV-Lites faced two issues. They were not able to raise short-term CP in the money markets and the asset value on their books was depreciating due to increase in credit spreads. Banks exposed to subprime were asked to increase provisions for bad and doubtful debts by their auditors. This created a stress on the income and capital of banks.

Stage 3
Hedge funds that had invested on a leveraged basis faced margin pressure and were forced to sell the most liquid assets to meet the margin calls. The principle of leverage works favourably when the market goes up and exaggerates the losses when it goes down. At stage 2, I added the ABCP market dried up and banks were unwilling to lend to each other.

On August 22, 2007, Countrywide Financial Corp, the biggest US mortgage lender, sold $2 billion of preferred stock to Bank of America Corp to bolster its finances. On September 14, 2007, Bank of England agreed to provide emergency funds to Northern Rock to ease a “severe liquidity squeeze” sparked by US subprime mortgage defaults. On March 14, 2008, Bear Stearns Cos got emergency funding from the US Federal Reserve and JPMorgan Chase as a run on the bank depleted its cash reserves in three days. On March 16, 2008, JPMorgan Chase agrees to buy Bear Stearns for 7% of its market value in a sale brokered by the Fed and the US treasury.

Stage 4
The defaults increase in the non-subprime category. Equity and credit markets face pressure and the inter-bank market dried up. No bank was willing to trust the other. On July 11, 2008, Indy Mac Bancorp Inc, the second-biggest independent US mortgage lender, was seized by federal regulators after a run by depositors depleted its cash.

On August 12, 2008, UBS AG, Switzerland’s biggest bank, announces plans to separate its investment banking and wealth management units after mounting subprime writedowns prompted rich clients to withdraw funds. On September 26, 2008, Washington Mutual Inc was seized by government regulators and its branches and assets sold to JPMorgan Chase in the biggest US bank failure in history.  On September 27, Washington Mutual filed for bankruptcy protection.

Stage 5, 6 & 7
Central banks stepped in to pump liquidity. FED, ECB, and other central banks provided adequate liquidity support. Liquidity did not help as every institution was suspicious of each other’s real exposure. There was a massive shorting of banks stocks as a proxy credit hedge.

Lower stock prices impaired ability to raise further capital by banks. Inter-bank lending came to a standstill-crisis spread to Europe and Asia. Some the largest banks with inadequate capital were assured government support and capital infusion.

Governments realised the severity of the crisis-bailout plans were discussed and implemented. Banks in US, UK, Germany, and The Netherlands saw capital infusion by government.

RBS HBOS and Lloyds bank were bailed out by the UK government with 37 billion pounds package. Fed took control of AIG with $85 billion package. Hypo Real Estate received a euro 50 billion bail out from German government.

Major nations came together to cut rates and also with plans to shore up banks and the banking system. Guarantees for inter-bank lending were provided and deposit insurance guarantees for customer deposits were enhanced.  World leaders assured support in words and action to tide over the crisis.

Conclusion:
Like all crises one hopes this too will pass. The lessons learnt for the investors, governments and institutions are here to stay. We are already seeing increased risk aversion among the investors. Governments will have to rethink on the current regulatory framework and the role of free-market culture. We might see some slowdown in financial innovation from banks and a lot more cautiousness in approving and pricing credit.

(The author is senior vice-president, ABN Amro Bank. Views expressed herein are personal. E-mail: shiva.iyer@in.abnamro.com )