The story of not so well-known crisis catalysts
Tuesday, 21 October 2008
Zahid Hussain
In my article published in this paper on October 20, I discussed the role of one simple financial derivative--credit default swaps (CDS)--in propagating the housing market crisis throughout the international financial system. Here, I attempt to flesh out the credit-crisis catalysts that have clandestinely caused havoc in this episode of the global financial crisis. These are structured collateralized debt obligations, CDS, and their most lethal offspring - CDS on structured collateralized debt obligations. I will focus on the structured collateralized debt obligations.
A brief digression on the concept of asset-backed security may be helpful. This is based on a simple investment principle: Take a bunch of assets that have predictable and similar cash flows (like an individual's home mortgage), combine them into one managed package that collects all of the individual payments (the amortisation and interest payments in case of mortgages), and use the money to pay investors a fixed amount of cash per unit of time (coupon) on the managed package. This creates an asset-backed security in which the underlying real estate acts as collateral. Credit rating agencies such as Moody's and Standard & Poor's stamped their 'AAA' or 'A+' approval on many of these securities, signaling their relative safety as an investment. The apparent attraction for the investor is that he or she can acquire a diversified portfolio of fixed-income assets that come as single coupon payment.
Suppose a mortgage company makes home loans. Then another party, say a bank, comes along and buys the mortgages from the mortgage company. Let's say it only wants to buy the mortgages made to prime borrowers who are paying X-percent interest on their mortgages. After acquiring those loans, the bank "securitizes" the mortgages, meaning it pools them into a tradable package that it can sell to investors. Because all the mortgage loans in this example are made to so-called prime borrowers with strong credit history - the package may have an investment grade (A+) that pays X- percent. This is because all the mortgage holders are paying X-percent and the payments are passed through to the investors.
The Wall Street financial wizards designed more complicated asset-based securities by slicing and dicing them into structured collateralized instruments. These generally fit into two categories: collateralized debt obligations (CDOs), which included various types of residential and commercial mortgage-backed securities; and collateralized loan obligations (CLOs), which pooled bank and investment-bank loan portfolios.
CDOs and CLOs, collateralized by the underlying assets, are also "structured." If you want to create higher-yielding securities, than in the simple X-percent example above, that you think you will be able to sell a lot more of, you can pool mortgages from subprime borrowers because these pay higher rates than prime borrowers. Mortgage companies and banks charge subprime borrowers higher rates of interest to offset the greater risk that they embody. If you pool only these mortgages, their ratings would be close to junk. This will be a problem as you try to sell these securities to investors.
Here is where financial engineering, better known as structuring, performed their magic. Subprime loans were placed into different risk classes, or tranches, each of which came with its own repayment schedule. Even though they contained subprime mortgages, the upper tranches were able to receive 'AAA' ratings because they were promised the first dollars that came into the security. Lower tranches carried higher coupon rates to compensate for the increased default risk.
Structuring allowed the subprime mortgage lenders to sell their risky debt. They marketed these debts very aggressively. Wall Street picked up their subprime loans, packaged them with other loans of varying quality, and sold them to investors. Nearly 80 per cent of these bundled securities magically became investment grade, thanks to the rating agencies, which earned handsome fees for their work. The profitability of originating mortgages-even risky ones-led these agencies and mortgage lenders to neglect even basic requirements like proof of income and a down payment.
With Wall Street, Main Street and others in between caught in the profit euphoria, who was going to be the party blooper by putting on the brakes? Low interest rates combined with lax lending standards fueled and nurtured real estate price bubbles to record highs across most of the United States. Homeowners indulged in refinancing in record numbers. Meanwhile, thanks to the liquidity in the market, investment banks and other large investors were able to increase leverage to create additional financial products, based among others on dubious subprime assets. They could sell a lot of these high-yielding securities because of their investment grade rating.
Many of the CDOs had been re-packaged so many times that it was almost impossible to gauge how much subprime exposure was actually in them. There were billions and trillions of these tranched securities on the balance sheets of banks, investment banks, insurance companies, hedge funds and all types of other gullible investment entities worldwide. When subprime borrowers began to default, the lower-tier tranches soon ran out of money to pay the so-called 1st- and 2nd-tier high rated securities.
The lowest-level tranches were "kyoties" to begin with because they not only pooled subprime mortgages but also made them "toxic" by taking out their cash flow to support other tranches. No one ever rated them. However, greedy hedge funds and wild speculators still bought them for their high yield.
The CDO market rose to more than $600 billion during 2006 alone. This was more than 10-times the amount issued a decade earlier. These securities, although illiquid, were picked up in the secondary markets, which merrily parked them into large institutional funds. Cracks began to appear by mid-2006 as new home sales slowed and the home price bubble began bursting. Interest rates were on the rise. Inflation fears threatened to raise them further. Default rates rose sharply. The entire castle of CDOs built on home mortgages began to crumble. The financial institutions took the first hit. They incurred massive losses and write-downs. Their liquidity was disrupted. The cascade began as not only did their immediate counterparties default but the counterparties of their immediate counterparties began defaulting. The rest, as you know, is history.
(The author is Senior Economist at the World Bank Dhaka office. The views expressed are he author's own, not that of the World Bank.)
In my article published in this paper on October 20, I discussed the role of one simple financial derivative--credit default swaps (CDS)--in propagating the housing market crisis throughout the international financial system. Here, I attempt to flesh out the credit-crisis catalysts that have clandestinely caused havoc in this episode of the global financial crisis. These are structured collateralized debt obligations, CDS, and their most lethal offspring - CDS on structured collateralized debt obligations. I will focus on the structured collateralized debt obligations.
A brief digression on the concept of asset-backed security may be helpful. This is based on a simple investment principle: Take a bunch of assets that have predictable and similar cash flows (like an individual's home mortgage), combine them into one managed package that collects all of the individual payments (the amortisation and interest payments in case of mortgages), and use the money to pay investors a fixed amount of cash per unit of time (coupon) on the managed package. This creates an asset-backed security in which the underlying real estate acts as collateral. Credit rating agencies such as Moody's and Standard & Poor's stamped their 'AAA' or 'A+' approval on many of these securities, signaling their relative safety as an investment. The apparent attraction for the investor is that he or she can acquire a diversified portfolio of fixed-income assets that come as single coupon payment.
Suppose a mortgage company makes home loans. Then another party, say a bank, comes along and buys the mortgages from the mortgage company. Let's say it only wants to buy the mortgages made to prime borrowers who are paying X-percent interest on their mortgages. After acquiring those loans, the bank "securitizes" the mortgages, meaning it pools them into a tradable package that it can sell to investors. Because all the mortgage loans in this example are made to so-called prime borrowers with strong credit history - the package may have an investment grade (A+) that pays X- percent. This is because all the mortgage holders are paying X-percent and the payments are passed through to the investors.
The Wall Street financial wizards designed more complicated asset-based securities by slicing and dicing them into structured collateralized instruments. These generally fit into two categories: collateralized debt obligations (CDOs), which included various types of residential and commercial mortgage-backed securities; and collateralized loan obligations (CLOs), which pooled bank and investment-bank loan portfolios.
CDOs and CLOs, collateralized by the underlying assets, are also "structured." If you want to create higher-yielding securities, than in the simple X-percent example above, that you think you will be able to sell a lot more of, you can pool mortgages from subprime borrowers because these pay higher rates than prime borrowers. Mortgage companies and banks charge subprime borrowers higher rates of interest to offset the greater risk that they embody. If you pool only these mortgages, their ratings would be close to junk. This will be a problem as you try to sell these securities to investors.
Here is where financial engineering, better known as structuring, performed their magic. Subprime loans were placed into different risk classes, or tranches, each of which came with its own repayment schedule. Even though they contained subprime mortgages, the upper tranches were able to receive 'AAA' ratings because they were promised the first dollars that came into the security. Lower tranches carried higher coupon rates to compensate for the increased default risk.
Structuring allowed the subprime mortgage lenders to sell their risky debt. They marketed these debts very aggressively. Wall Street picked up their subprime loans, packaged them with other loans of varying quality, and sold them to investors. Nearly 80 per cent of these bundled securities magically became investment grade, thanks to the rating agencies, which earned handsome fees for their work. The profitability of originating mortgages-even risky ones-led these agencies and mortgage lenders to neglect even basic requirements like proof of income and a down payment.
With Wall Street, Main Street and others in between caught in the profit euphoria, who was going to be the party blooper by putting on the brakes? Low interest rates combined with lax lending standards fueled and nurtured real estate price bubbles to record highs across most of the United States. Homeowners indulged in refinancing in record numbers. Meanwhile, thanks to the liquidity in the market, investment banks and other large investors were able to increase leverage to create additional financial products, based among others on dubious subprime assets. They could sell a lot of these high-yielding securities because of their investment grade rating.
Many of the CDOs had been re-packaged so many times that it was almost impossible to gauge how much subprime exposure was actually in them. There were billions and trillions of these tranched securities on the balance sheets of banks, investment banks, insurance companies, hedge funds and all types of other gullible investment entities worldwide. When subprime borrowers began to default, the lower-tier tranches soon ran out of money to pay the so-called 1st- and 2nd-tier high rated securities.
The lowest-level tranches were "kyoties" to begin with because they not only pooled subprime mortgages but also made them "toxic" by taking out their cash flow to support other tranches. No one ever rated them. However, greedy hedge funds and wild speculators still bought them for their high yield.
The CDO market rose to more than $600 billion during 2006 alone. This was more than 10-times the amount issued a decade earlier. These securities, although illiquid, were picked up in the secondary markets, which merrily parked them into large institutional funds. Cracks began to appear by mid-2006 as new home sales slowed and the home price bubble began bursting. Interest rates were on the rise. Inflation fears threatened to raise them further. Default rates rose sharply. The entire castle of CDOs built on home mortgages began to crumble. The financial institutions took the first hit. They incurred massive losses and write-downs. Their liquidity was disrupted. The cascade began as not only did their immediate counterparties default but the counterparties of their immediate counterparties began defaulting. The rest, as you know, is history.
(The author is Senior Economist at the World Bank Dhaka office. The views expressed are he author's own, not that of the World Bank.)