Chapter 4 the Credit Crisis of 2007

Risk Management and Financial Institutions 3e, Copyright John C. Hull 2012

4 - The Credit Crisis of

2007

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The credit crisis and its consequences

The worst financial crisis since the 1930s started in 2007 in the

United States.

The crisis spread rapidly to other countries, and from financial

markets to the real economy

Some financial institutions failed and much more had to be bailed

out by national governments

Risk management practices of financial institutions have been

subjected to a great deal of criticism

The crisis has led to a major overhaul of banking regulation


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U.S. Real Estate Prices, 1987 to 2011: S&P/Case-Shiller Composite-10 Index


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What happened

Starting in 2000, mortgage originators in the US relaxed their lending standards

and created large numbers of subprime first mortgages. This made house purchases

possible for many families that had previously been considered to be not sufficient

creditworthy to qualify for a mortgage.

This, combined with very low interest rates, increased the demand for real estate

and prices rose.

Rising house prices meant that the lending was well covered by the underlying

collateral. If the borrower defaulted, the foreclosure would lead to little or no loss.

To continue to attract first time buyers and keep prices increasing they relaxed

lending standards further


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What happened

Bad practices: Features of the market: 100% mortgages, ARMs, teaser rates,

NINJAs, liar loans, non-recourse borrowing

ARM Adjustable rate mortgages: they had a low rate of interest for two or three years and be

followed by a much higher rate.

NINJAs No income, No jobs, No assets. Sometimes, the applicant income reports were not even

checked.

Borrowing was only guaranteed by the underlying asset. The borrower had no legal responsibility

for the repayment of the loan. This encouraged free riding by borrowers as they had an implicit

PUT option on their investment. As long as they understood they had a negative equity, some of

them chose to default.

Political interference: The US government had since the 1990s been trying to

expand home ownership, and had been applying pressure to mortgage lenders to

increase loans to low and moderate income households.


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What happened...

Although some mortgage defaulters were unable (but willing) to meet

mortgage payments, many were speculators who bought multiple homes as

rental properties and chose to exercise their put options. They even bought

them a similar house at much lower prices.

This abuse by borrowers meant that while in normal crisis a lender can expect

to recover around 75% of the amount owing in a foreclosure, in 2008 and

2009 recovery rates were as low as 25%.

In 2007 the bubble burst. Some borrowers could not afford their payments

when the teaser rates ended. Others had negative equity and recognized that

it was optimal for them to exercise their put options.


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What happened...

Mortgages were packaged in financial products and sold to investors

(securitization). This had been an important and useful tool for transferring risk

in financial markets for many years.

However this time the quality of the underlying mortgages was often very low,

with key information lacking.

Banks found it profitable to invest in the AAA rated tranches because the

promised return was significantly higher than the cost of funds and capital

requirements were low (due to high ratings).

U.S. real estate prices fell and products, created from the mortgages, that were

previously thought to be safe began to be viewed as risky

There was a flight to quality and credit spreads increased to very high levels


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Asset Backed Securitization (Simplified)

A waterfall defines the precise

rules for allocating cash flows to

tranches

Asset 1

Asset 2

Asset 3

Asset n

Principal:

$100 million

SPV

Senior Tranche

Principal: $75 million

Return = 6%

Mezzanine Tranche

Principal:$20 million

Return = 10%

Equity Tranche

Principal: $5 million

Return =30%

ABS

An asset-backed security

(ABS) is a security created

from the cash flows of

financial assets such as loans,

bonds, credit card receivables,

mortgages, auto loans,

Tranches are subordinated to

each other


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The Waterfall

Equity Tranche

Senior

Tranche

Mezzanine Tranche

Asset

Cash

Flows


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ABS CDOs or Mezz CDOs (Simplified)

Subprime Mortgages Senior Tranches (75%)

AAA

Mezzanine Tranches (20%)

BBB

Equity Tranches (5%)

Not Rated and usually retained

or sold to a hedge fund

Senior Tranche (75%)

AAA

Mezzanine Tranche

(20%) BBB

Equity Tranche (5%)

How much of the original portfolio of subprime mortgages is AAA? For

the originator, making the senior tranche as big as possible without

losing its AAA credit rating maximizes the profitability of the structure

ABSs

ABS CDO

Different thicknesses

(25% vs. 10%) but

SAME AAA rating: is

this reasonable ?


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Losses to AAA Tranche of ABS CDO

Losses on

Subprime

portfolios

Losses on

Mezzanine

Tranche of

ABS

Losses on

Equity

Tranche of

ABS CDO

Losses on

Mezzanine

Tranche of

ABS CDO

Losses on

Senior

Tranche of

ABS CDO

10% 25% 100% 100% 0%

15% 50% 100% 100% 33.3%

20% 75% 100% 100% 66.7%

25% 100% 100% 100% 100%


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A More Realistic Structure (incredible

but true !)

Subprime

Mortgages

AAA

AA

A

BBB

BB, NR

Senior

AAA

Junior AAA

AA

A

BBB

NR

Senior AAA

Junior AAA

AA

A

BBB

NR

Senior AAA

Junior AAA

AA

A

BBB

NR

81%

11%

4%

3%

1%

ABS

High Grade ABS CDO

Mezz ABS CDO CDO of CDO

62%

14%

8%

6%

6%

4%

88%

5%

3%

2%

1%

1%

60%

27%

4%

3%

3%

2%


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BBB Tranches

BBB tranches of ABSs were often quite thin (1% wide)

This means that they have a quite different loss distribution from BBB

bonds and should not be treated as equivalent to BBB bonds

They tend to be either safe or completely wiped out (cliff risk). They

are much more BINARY, and its distribution is much less NORMAL

than a same-rated bond.

Correlation among the underlying mortgages was much higher than

expected by rating agencies and investors models (and we know that, the lower the correlation, the lower the expected risk of the

portfolio)

What does this mean for the tranches of the Mezz ABS CDO?


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Role of Incentives and regulatory

arbitrage

Arguably the incentives of valuers (provide as high a valuation as

possible to obtain low LTVs), the creators of ABSs and ABS CDOs

(making structures profitable), and rating agencies (which are paid

by the issuers) helped to create the crisis as there were hiding

agency costs embedded

Compensation plans of traders created short-term horizons for

decision making

Capital required for securities created from a portfolio of mortgages

was considerably less than capital that would be required if

mortgages had been kept on the balance sheet


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Importance of Transparency

ABSs and ABS CDOs were complex inter-related products

Once the AAA rated tranches were perceived as risky they became

very difficult to trade because investors realized they did not

understand the risks

ABSs and ABS CDOs tranches were heavily downgraded by rating

agencies in the second half of 2007.

The market became illiquid and credit spreads increased sharply for

every banking issue (short term interbank, senior, subordinated,

covered, ) and not just for ABSs or mortgage related bonds.

Other credit related products with simpler structures (eg, credit

default swaps) continued to trade during the crisis.


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Lessons from the Crisis

Beware irrational exuberance, overconfidence, herding instincts.

Black swans DO exist

Do not underestimate default correlations in stressed markets

Recovery rate depends on default rate (do not use RR of normal years).

Compensation structures did not create the right incentives (now bonuses are

usually spread out over several years)

If a deal seems too good to be true (eg, a AAA earning LIBOR plus 100 bp) it

probably is

Do not rely on ratings

Transparency is important in financial markets

Do not buy what you do not understand

Resecuritization was a badly flawed idea. It added no further diversification to the

structure, and hence it was only financial engineering.


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Lessons from the Crisis do not

blame the subprime episode !

The subprime crisis was not the cause of our problems, it was just

the first link to be broken because it was the weakest.

Financial markets do play a role in the crisis, but they reflect the

overall degree of debt in the economy and the different connections

among social groups (savers and borrowers).

The western world faces a great demographic challenge that requires

an ever increasing social spending that at least since the 80s is not

being matched neither by productivity gains nor by base increasing (i.e. more population or worked hours) GDP growth.

This fuelled the temptation to use debt as a way to replace real,

fundamental-justified increase of living standards.


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This increase in debt has been carried

out by citizens and companies (housing

bubble and corporate indebtedness) but

also by governments themselves. (As an

example, France has not had a budget

surplus since 1974 and its debt-to-GDP

ratio has gone up from 22% in 1975 to

82% in 2010).

Europe today accounts for just over 7% of the worlds population, produces

around 25% of global GDP but has to finance 50% of global social spending.

Debt allowed governments (and citizens) to avoid the usual choices between

reducing public spending versus increasing taxes, because debt was a way

to escape both choices.


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This crisis is then a DEBT crisis, originated in the public and private sector

of most western economies, and accumulated in banks balance sheets.

The housing bubble and the subprime mortgage disaster are specific

episodes, but they are only part of a wider and structural over-

indebtedness problem which helped (in good years) to hide the fact that

living standards were already stagnating in the west and that only debt

could keep on increasing such levels of welfare.

The social contract is at risk. Debt is a burden for future generations, (which do not even vote our deficit budgets). Pensions and health services

are at the center of a problem with demographic and social roots that

threatens the very core of our political system and intergenerational implicit

agreements.


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Practice questions and problems


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Homework Work in pairs to prepare up to 5 slides with a global overview of the

mortgage market in your home country:

-Which is the market share of home ownership vs. home rentals ?

-Which are the main features of mortgages? (fixed/floating, average

maturity, average cost, average household indebtedness)

-How has the housing market reacted to the global financial crisis:

increase/decrease in prices since 2007, non performing loans for banks,

-Were mortgage lending standards relaxed in the boom times? How?

-Which changes do you foresee in the way banks would assess in the

future credit risk arising from house mortgages?

Chapter 4 the Credit Crisis of 2007

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Transcript of Chapter 4 the Credit Crisis of 2007