Subprime Mortgage Background (Optional)

• Subprime mortgages are residential home loans made to borrowers with poor credit. In the United States, consumer credit quality is measured with a FICO score. Factors that can drive down a FICO score include a limited credit history, a large amount of outstanding debt, or a history of delinquent payments. The exact definition of a subprime borrower can vary, and some lenders even consider borrowers with relatively high credit scores as subprime if their mortgages have low down payments. Broadly speaking, subprime mortgages have more default risk than prime mortgages and therefore pay higher interest rates.
• There is another category of borrowers termed Alt-A. These are borrowers that have reasonably strong credit ratings but lack essential documentation needed to verify their assets and income.
• Subprime mortgages became very popular in the United States in the years preceding the financial crisis. According to former Fed chairman Ben Bernanke, “From 1994 to 2006, subprime lending increased from an estimated USD 35 billion, or 4.5 percent of all one-to-four family mortgage originations, to USD 600 billion, or 20 percent of originations.” By early 2007, total outstanding subprime mortgage debt was estimated at USD 1.3 trillion.

Introduction And Overview

• The collection of events that were known as the Great Financial Crisis of 2007-2009 (GFC) began with a downturn in the U.S. subprime mortgage market in the summer of 2007. There was a massive boom in credit growth in the US in the years before the crisis along with a housing price bubble and excess leverage in the financial system. Also, there were financial innovations related to securitization, which expanded the capacity of the financial system to generate credit assets without proper development of risk management related to these assets.
• The GFC affected investors all over the world. Massive losses spread from subprime mortgages to other segments of the credit market. Banks began to experience large losses and liquidity problems and they stopped lending to one another. Many banks failed entirely or were taken over. In February 2008, U.K. mortgage lender Northern Rock was nationalized as it became a victim of the first bank run in UK in 140 years. Next month, U.S. investment bank Bear Stearns was absorbed by J.P. Morgan Chase.
• The crisis also brought the asset-back commercial paper (ABCP) and repo markets to a halt. Many hedge funds stopped redemptions or failed. Many special investment vehicles (SIVs) and conduits were also wound down. Credit losses worldwide exceeded USD 1 trillion.
• The peak of the subprime crisis came in September 2008, which saw a cascade of events.
  • Lehman Brothers declared bankruptcy, leading to an immediate acute reduction in the interbank borrowing market. Banks with excess cash were unwilling to lend money to banks looking for liquidity in the overnight repo markets.
  • The last two major investment banks in the United States, Morgan Stanley and Goldman Sachs, were converted to bank holding companies and became regulated by the Federal Reserve. This move gave them access to the Fed’s liquidity facilities.
  • Fannie Mae and Freddie Mac were nationalized. AIG was brought back from the brink of collapse via a USD 150 billion capital infusion by the U.S. Treasury and the Federal Reserve.
  • In Europe, many countries had to step in to provide massive support to their banks. Dutch financial conglomerate Fortis was broken up and sold. Iceland’s largest commercial bank, and subsequently the entire Icelandic banking system, collapsed.
  • Many government budgets in Europe were stretched thin due to the massive cost of the bank rescues, a situation that contributed to a subsequent European sovereign debt crisis in 2010.
  • There was a fundamental spillover from the financial crisis to the wider global economy. This resulted in a massive loss of wealth and high unemployment around the world.

How It All Started

• Growth in housing demand and mortgage financing was encouraged to some extent by the low interest rate environment of early 2000s. This led to considerable increase in housing prices. Low interest rates also stimulated the investors to find investments that offered higher yields, which they found in subprime mortgages, having premiums of up to 300-basis points over prime mortgages.
• Subprime loans also became increasingly in demand for securitization. Through this process, securitizers:
  • Created pools of below investment-grade assets;
  • Bifurcated the cashflows by model-driven certainty; and
  • Packaged the “safest” cashflows into investment-grade securities.
• Subprime mortgages became an increasingly large share of the overall mortgage market, rising from 7% of total mortgage originations in 2001 to 20% in 2006. Many subprime mortgages were structured with low teaser rates for the first few years (which were then followed by much higher rates once the teaser period ended). Many of these mortgages were interest-only over the teaser period as well, meaning that no principal payments were required.

• Some borrowers used subprime lending to purchase a house in which they intended to live, whereas others were merely speculating on rising home prices. For either type of borrower, a loan could typically be refinanced into another similar mortgage once the teaser rate period ended (as long as housing prices rose). If refinancing was not possible, a speculator could simply default on the mortgage.
• Originate-to-distribute (OTD) model allowed banks to lend more (or originate more loans) without violating lending limits (as they distribute the loans rather than hold them). Under the model, banks’ losses on subprime mortgages were borne not by the banks that initially made the loans, but by the investors that eventually owned them. This reduced the incentive for the originating banks to conduct the appropriate due diligence (e.g., proper credit assessments on the borrowers and rigorous collateral valuation) before extending credit since loans were taken off from their balance sheets and someone else was holding them.
• Many subprime mortgages were securitized into collateralized debt obligations (CDOs) during this time. These credit risk transfer instruments played a major role in the subsequent sub-prime mortgage meltdown.
• Delinquencies on adjustable-rate subprime mortgages approached 16% by August 2007 (roughly triple its level in mid-2005). By May 2008, this figure had risen to 25%, leading to a massive number of ratings downgrades for subprime mortgage securitized products. There were several reasons for the increase in delinquencies after mid-2005:
  • In a subprime mortgage transaction, the inherent credit quality of the borrower is typically weak and the mortgage often undercollateralized. Income and payment histories are inconsistent, and debt-to-income ratios are typically high for subprime borrowers.
  • Traditionally, first-time home mortgages required a 20% down payment. In 2005, 43% of first-time home buyers paid zero down payment, which reduced the collateral cushion.
  • Many subprime mortgages included teaser rates for initial 2 or 3 years, and after that, it would reset to a (potentially) much higher rate for the remaining years. This was not a problem if a borrower could refinance the mortgage before the reset date. But if the borrower could not refinance and if interest rates increased, the monthly mortgage costs could rise very quickly. Interest rates actually increased, with the rate on the three-month Treasury bill rising from less than 1.0% in April 2004 to over 4.0% in November 2005. Other mortgage features, such as interest-only teaser periods, made this issue even worse.

• The ability to refinance mortgages declined significantly when housing prices began to fall sharply in 2006. Furthermore, subprime mortgage balances quickly began to exceed the market value of the homes that collateralized the loans, increasing the incentive for borrowers to default.
• The heavy demand for subprime mortgage products encouraged questionable practices by some lenders.
• Some borrowers were deliberately pushed into subprime mortgages even though they qualified for mortgages with better terms.
• Other borrowers ended up with mortgages they were not qualified to hold and could not afford.
• Increasingly risky products entered the subprime market, including NINJA loans (i.e., no income, no job, and no assets) and liar loans (which required so little documentation that borrowers could safely lie on their applications).
• To take advantage of weak controls, some borrowers and mortgage brokers submitted false documentation that enabled some borrowers to receive funding under fraudulent terms.
• This situation was made worse by the compensation structure for most mortgage brokers, which gave incentive for the volume of loans rather than quality of the loans. Originating brokers therefore had very little incentive to conduct proper due diligence. In fact, some brokers were found to have encouraged the submission of fraudulent documentation to get applications approved.

The Role Of Financial Intermediaries

• Banks moved assets to be securitized off their balance sheets to structured investment vehicles (SIVs), also called conduits. A SIV is a limited-purpose, bankruptcy-remote company used by banks to purchase assets, funded with short-term commercial paper as well as some medium-term notes and capital. Securitization involved taking a portfolio of existing assets and repackaging their associated cash flows into claims on tranches. Bonds were issued against these tranches and the proceeds were used to purchase the collateral assets.
• Different tranches were typically structured having a desired credit rating, to cater to investor demands, with most tranches being rated as investment grade. A waterfall structure was introduced to differentiate the credit risk associated with the claims on the different tranches. The tranches were established in order of safety, beginning with Senior AAA debt (often referred to as super senior), Junior AAA, AA, A, BBB, BB, and so on. To ensure that the super senior tranche receives a AAA rating, a surety wrap was sometimes used.
• In theory, the OTD model, coupled with extensive use of securitization, would distribute risk more broadly throughout the financial system. This in turn would make banks less sensitive to credit crises, reduce systemic risk, and give banks additional funding sources to support their lending. But there were flaws in this theory, which were exposed by the crisis. Over the period from 2003 to 2007, banks appear to have used securitization to keep their credit exposures to AAA-rated tranches to generate extra yield without increasing their minimum regulatory capital requirements under Basel II. For example, a residential mortgage is subject to a risk-weighted asset (RWA) of 50%. But a AAA-rated tranche of securitization is only subject to an RWA of 20% (because an asset with such a rating is presumed to be at low risk of default). The AAA rating also reduced incentives for investors to investigate and perform proper due diligence on the pool.

Issues With The Rating Agencies

• As part of the CDO structuring process, equity holders (known as CDO trust partners) would pay credit rating agencies to rate the various liabilities of the CDO. CDO trusts were aware of the requirements and assumptions underlying these ratings, and they were able to structure the payment waterfalls and associated liabilities in such a way as to get a high percentage of AAA-rated bonds. The assumptions used in this rating process were based on historical data which did not reflect current changes in asset characteristics (e.g., growing number of NINJA loans, liar loans, and subprime mortgages with 100% loan-to-value ratios). Also, subprime mortgage loans were too new in the marketplace to offer long-term data that could inform risk analyses.
• Rating agencies also relied on data from issuers and arrangers, who performed due diligence. In spite of widespread knowledge of declining lending standards and increasing fraud, rating agencies themselves did not perform any additional due diligence or monitoring of the data.
• Despite these analytical flaws, there were strong incentives for agencies to provide the required ratings. These agencies are paid to monitor the CDO over its life. But if the CDO trust did not get formed because too few bonds were AAA-rated, the agency would miss out on this profitable and continual cash stream.

The Short-Term Wholesale Debt Market

• There are two main instruments that constitute the short-term wholesale debt market: repurchase agreements and commercial paper (CP). Both markets shut down early in the crisis as market participants started to doubt the quality of the collateral.
• Repurchase agreements (also known as repos) are used by many financial institutions, including banks, brokerage firms, and money market funds. A standard repo involves:
  • The sale of an asset; and
  • An agreement to buy the asset back at a slightly higher price at a later time.

The seller of the security receives cash at the outset of the repo and can thus be viewed as a borrower in a collateralized loan transaction (with the security serving as the collateral). The buyer of the security, who gives cash at the outset of the repo and then receives a higher sum at the end of the term of the repo, can be considered a lender (with the higher sum representing principal plus interest).

Repos are excluded from the bankruptcy process. Hence, if one counterparty fails, the other may terminate the transaction unilaterally and either keep the cash or sell the collateral.

Various types of securities can be used as collateral in repo transactions, like government bonds, high-quality corporate bonds or even tranches of securitizations. The quality of collateral greatly influences the size of the haircut (i.e., the percent reduction from the initial market value the lender is willing to give the borrower). For example, a haircut of 10% means that a borrower can borrow USD 90 for each USD 100 pledged collateral. A haircut is intended to protect the lender from recovering less than the full value of the loan amount if they ever need to sell the collateral. Higher (lower) quality collateral has smaller (larger) haircuts.

• In unsecured CP financing, short-term debt is issued but is not backed by any specific assets. Since there is no specific collateral, unsecured CP issuers generally have very high credit quality. If a CP issuer’s credit quality deteriorates, such as through a rating downgrade, there is usually an orderly exit through margin calls. Asset-back commercial paper (ABCP) is a special case of CP where the issuer finances the purchase of the assets by issuing CP, with the assets serving as collateral.
• The demand for collateral increased in the years preceding the crisis, driven by the growth of the OTC derivatives markets and an increasing reliance on short-term collateralization by financial institutions. This demand was (in part) satisfied by the issuance of AAA-rated securitization tranches.

The Liquidity Crunch Hits

• SIVs were typically funded short-term and relied on being able to regularly roll over short-term debt to finance their longer dated assets. As mortgage-backed securities lost value, the credit quality of many SIVs declined. This led to rapid downgrading of the credit ratings of the ABCP issued by these SIVs and doubts about pledged collateral value, because of which many SIVs could not roll over their ABCP. Simultaneously, liquidity in the subprime-related asset markets disappeared.

• Until the middle of 2007, counterparty credit risk was not priced by the market. There was hardly any difference (i.e., only 2 – to 5-basis points) between the unsecured OIS rate and the swap rates. Starting in June of that year, there was worry about the value of asset-backed securities but also about how much exposure banks and other financial institutions had to the subprime market. As a result, the OIS-swap spread exploded (as shown in this figure). It remained high during the crisis, jumped again when Lehman Brothers failed, and did not come back to pre-crisis levels.

• At the same time, credit spreads increased substantially, lowering the market price of the credit assets. This led to a systematic increase in haircuts, from 0 pre-crisis to more than 45% when Lehman failed in September 2008 (as shown in this figure).

• To understand the impact of increase in haircuts, consider an example. Suppose a bank has USD 100 in assets. In turn, these assets are backing USD 40 in long-term debt, USD 50 in repo financing, and USD 10 in equity. Suppose repo haircuts increase from zero to 20%, dropping repo financing from USD 50 to USD 40. The bank is now short of funding by USD 10. In a normal market, the bank could simply sell USD 10 in assets. Its new balance sheet would look like the following: USD 90 in assets backing USD 40 in long-term debt, USD 40 in repo financing, and USD 10 in equity. However, if there is a simultaneous sell-off in the markets, the market value of the assets can fall precipitously. If the value of the bank’s assets falls below USD 90, then the equity is wiped out and the bank becomes insolvent.

• By the summer of 2007, the short-term wholesale funding markets started to freeze, including both the ABCP market and the repo market. Investors stopped rolling maturing ABCP, forcing banks to bring back SIVs’ assets onto their balance sheets. With the significant increase in repo haircuts, institutions that relied on repo financing were unable to roll their short-term funding. At that point, there were only three outcomes:
  • bailout,
  • merger, or
  • bankruptcy
• This is exactly the scenario that unfolded in 2007 – 2008 that led to the failure of Bear Stearns, mortgage banks Northern Rock in the United Kingdom, IndyMac in California, and Lehman Brothers. All these institutions satisfied Basel minimum regulatory capital requirements before they failed.
• The lesson from this is that relying heavily on short-term wholesale funding can be dangerous. This source of financing can evaporate overnight.

Valuation Uncertainty And Transparency Issues

• Asset-backed structured products have liability structures and cashflow waterfalls which are complex and contain different types of collateral and interest rate triggers. Also, since each structured product is unique, the model(s) used to simulate the cashflows for each bond must be customized to fit the unique aspects of the structure.
• The assets in the collateral pool of ABS trusts can require the valuation of thousands of subprime mortgages, with a wide variety of borrower characteristics and loan terms. CDOs may contain securities issued by ABS trusts, while CDO-squared structures contain securities issued by other CDOs. Some asset pools contain synthetic ABS credit default swaps. All of these complex instruments must be valued.
• These products also had transparency issues. Many investors, even seemingly sophisticated investors, simply did not have the in-house expertise to understand the complex products they were buying. Furthermore, they did not understand the potential risks that might arise from the assumptions underlying the valuation and credit rating models. Investors simply did not foresee how these assumptions might fail under stressed conditions. As a result, they chose to be completely reliant on the rating agencies for risk measurement.

• At the same time, the valuation of illiquid assets was opaque. Since benchmark prices were not readily available, investors became highly skeptical of reported prices when assessing the credit risk of a counterparty. The lack of transparency extended to types of products within the SIVs, because banks may hold assets until they can be securitized and sold.
• The total volume of outstanding commitments that a financial institution had given was also hard to determine. Many banks also had profitable money market franchises and these relationships carried implicit commitments to these funds in the event they experienced significant difficulties and were threatened by a “run on the fund”.
  • In June 2007, Bear Sterns tried to rescue two hedge funds that were threatened by losses from subprime mortgages. The prime broker for one of the funds, Merrill Lynch, seized USD 850 million in collateral but could not selling them easily, because of illiquidity.

• In August 2007, BNP Paribas froze (i.e., barred investors from making withdrawals from) three funds with USD 2.2 billion in assets because it could not value their subprime assets.
• The significant exposure of large financial institutions to the subprime market created a lot of worry. Shortly after these events, markets for wholesale short-term funding shut down.

Central Banks To The Rescue

• In response to the crisis, the Federal Reserve and other central banks from around the world came up with innovative liquidity injection facilities. The Fed’s actions included:
  • Creating long-term lending facilities against high-quality collateral,
  • Opening the discount window to investment banks and securities firms,
  • Providing funds to be lent against high-quality illiquid asset-backed securities,
  • Providing funds to finance the purchase of unsecured CP and ABCP,
  • Providing liquidity to money market funds, and
  • Purchasing assets from Fannie Mae and Freddie Mac.
• The major government interventions in the United States during the crisis were the following:
  • Term Auction Facility (TAF), a program implemented in December 2007 and designed to provide funds to depository institutions by auctioning funds against collateral
  • Primary Dealer Credit Facility (PDCF), allowing the Fed to lend funds to primary dealers via repos
  • Economic Stimulus Act of February 2008
  • Government takeover of Fannie Mae and Freddie Mac in September 2008
  • TARP (Troubled Asset Relief Program) in October 2008

Systemic Risk In Action

• Systemic risk is the risk that events at one firm, or in one market, can extend to other firms or markets. In turn, this can put entire markets or economies at risk. Systemic risk played a large role in exacerbating the impact of the crisis.
• In the ABCP and repo markets, collateral quality is important in reducing the risk of a default by the borrower. As the ABCP and repo markets deteriorated, confidence was lost in the nature and value of the collateral assets. Lenders became increasingly concerned about whether the collateral contained subprime mortgages and about the reliability of the reported valuations. Due to the lack of transparency in these markets, even borrowers without subprime exposure simply could not roll over their debt.
• In the summer of 2007 it became impossible to estimate the price of illiquid assets. Managers of money market funds, typically large purchasers of ABCP and active participants in the repo markets, began to flee and to seek refuge in Treasury bills.
• The collapse of the ABCP and repo markets had numerous repercussions. Many hedge funds, unable to roll over their debt, were forced to sell assets. As hedge funds hold a wide variety of assets, this impacted many markets. One of the first to be hit was the CDO market, which came under significant selling pressure. Many funds liquidated other assets as they felt that prices were artificially low or they were unable to practically liquidate CDO holdings, To close out existing positions, some funds sold higher credit-rated assets and bought lower credit-rated assets that were shorted, pushing the prices of higher quality assets down and the prices of the lower quality assets up. Some quantitative hedge funds that traded on pricing patterns were adversely impacted by this type of price reversal. Institutional investors and hedge funds unwound carry trades at a loss in an effort to reduce leverage.
• At the same time, banks began to hoard cash (in part) due to the uncertainty around the magnitude of possible drawdowns on the backstop credit lines they had extended to SIVs. Adding to banks’ concerns were outstanding commitments to underwrite leveraged buyouts. During the first part of August 2007, the three-month Libor (London interbank offered rate) rose over 30-basis points. The reluctance to lend became widespread as credit standards tightened, negatively impacting hedge funds and other financial institutions, squeezing the availability of mortgages (both residential and commercial), and restricting business lending. Thus, a financial crisis became an economic crisis.