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The Subprime Credit Crisis of 2007
Banks and Insurers:Separate paths but a Common Destination
Michel CrouhyNATIXIS Corporate and Investment Bank
Chicago, April 14, 2008
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I. IntroductionII. How it all startedIII. The players and issues at the heart of
the crisisIV. Issues to be addressed to avoid a
repeat of the “subprime” crisisV. Concluding remarks
Agenda
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I. Introduction
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The credit crisis of 2007 started in the subprime mortgage market in the U.S. but has affected investors all over the world and shut down the ABCP market, securitization. Hedge funds have halted redemptions or failed, SIVs have been wound-down:
- The amount of write-off could for the financial institutions could reach $400 to 500 billion
- Banks have been taken over in Germany (Satchen and IKB). Great Britain had its first bank run in 140 years and ended up nationalizing the troubled bank (Northern Rock). Last month the US Treasury and the Fed helped to broker the bailout of Bear Stearns
- Libor and spreads over Libor for inter-bank lending has skyrocketed as banks don’t trust each other
- U.S. banks had to call global investors such as “sovereign funds” for capital infusions of 136 billion so far according to Bloomberg
- Contagion affects other segments of the credit market
- Credit crunch and fear of economic recession
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II. How it all started
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Economic environment since 2000:
- Low inflation, low interest rates, low volatility, low…
- Spurred increases in mortgage financing and substantial increase in
house prices
- Investors looked for instruments that offer yield enhancement
- Banks have been adopting a new business model: “originate to
distribute”
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Huge growth of the securitization business:- First, corporate loans and other retail credit assets
- Then, subprime mortgages: subprime loans grew from $160 billion in
2001 (7.2% of new mortgages) to $600 billion (20.6% of new
mortgages) in 2006
Unprecedented massive amount of senior tranches of subprime
CDOs were downgraded from triple-A to junk within a short period of
time:
- Delinquency rates on subprime mortgages started to significantly
increase after mid-2005 especially on loans originated in 2005-2006
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Four reasons why delinquencies on subprime loans started to
skyrocket after mid-2005:
- Subprime borrowers are not very creditworthy, highly levered with high
debt-to-income ratios, large loan-to-value ratios, no down payment
(second mortgage: “piggyback” loan)
- Subprime loans are “short-reset” loans: “2/28” or “3/27” hybrid ARMs
- In a market where housing prices kept rising, borrowers expected to
refinance before the reset and build some equity cushion
- Huge demand from investors for higher yielding assets, such as super
senior tranches of subprime CDOs, lead to lowering of lending
standards: low-documentation or no-documentation loans, “liar loans”
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The current crisis was thus an accident waiting to happen. The trigger
was a series of events:
- In June 2007, attempt by Bear Stearns to bail out two hedge funds
hurt by subprime mortgage losses – then, attempt by Merrill Lynch to
liquidate some of the funds’ assets revealed how illiquid the market
for such securities has become
- In July, first bailout by German regulators of IKB
- In July also, BNP Paribas, froze three investment funds with assets
of 2 billion euros because the bank could not value the subprime
assets in the funds
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III. The players and issues at the heart of the crisis
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Rating agencies- Many investors such as money market funds, pension funds are restricted
to investing in triple-A securities
- Monolines also rely on rating agencies
- Implicitly in investment decisions is that ratings are relatively stable and no
one was expecting a triple-A asset to be downgraded to junk within a few
days
Mortgage brokers and lenders- Securitization has created moral hazard: originating lenders had little
incentive to perform their due diligence and monitor borrowers’ credit worthiness
- By the end of 2006 mortgage lenders started to default (Ownit Mortgage
Solution, New Century,...)
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Special Investment Vehicles (SIVs)
- SIVs are limited purpose, bankrupt remote companies that purchase
mainly highly rated medium and long term assets and fund these assets
by mainly issuing short term asset backed commercial paper (ABCP)
- SIVs are capitalized such that there is no requirement to post collateral. In
addition, sponsor banks provide backup lines of credit.
- SIVs are structured such that senior debt is rated triple-A. To protect
senior debt holders, when a trigger event occurs the SIV is wind-down.
- During the third quarter of 2007, when rating agencies started to
massively downgrade subprime related structured credits, liquidity
evaporated and banks had no other alternative than taking back the
assets on their balance sheet.
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The Economy and Central Banks
- Last August, the ECB injected 95 billion euros, the Fed injected $5 billion in the MM
and another $12 billion in repo agreements
- Flight to quality: 3-month T-bill fell from 3.90% to 2.51% in one day during the third
week of August
- The Fed cut the Fed fund rate 3 percentage points to 2.25 % between September 2007
and March 2008
- The Fed has also taken the unprecedented measure of introducing a new lending
facility (PDCF: Primary Dealer Credit facility) for investment banks and securities
dealers
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Valuation Uncertainty- Fair value accounting framework:
Level 1: clear market prices
Level 2: valuation using prices of related instruments
Level 3: prices cannot be observed and model prices need to be used
- Structured credit products fall in level 3 category
- As investors were confused about the market value of these securities they remained on the sideline, not rolling ABCP… and as a consequence liquidity dried out
Bear Stearns: 2 hedge funds
BNP Paribas: froze three hedge funds stating it is impossible to value the assets due to the lack of
liquidity
Money market funds stopped investing in ABCP
Quantitative funds lost a significant percentage of their value during the summer
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Transparency
- Complex nature of the structured credit products
- Lack of transparency in the valuation of illiquid assets
- Detailed information about the quality of the collateral of the subprime CDOs
were not available to the investors
- Banks provided back stop lines of credit to SIVs, loan commitments to private
equity buyouts: the level of these commitments is not known to outside
investors
- Money market funds have invested in triple-A credit structures to enhance
yields: the amount and the nature of these investments was not fully disclosed
- Banks hold similar assets to those held by the SIVs: not fully disclosed to the
shareholders
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Monolines- Monolines started in the 1970s as insurers of municipal debt and debt issued
by hospitals, non-profit groups: a $2.6 trillion market, with half of the municipal
bonds being insured by monolines which guarantee a triple-A rating to the
bonds issued by U.S. municipalities: MBIA, AMBAC
- In recent years they entered the credit structured products market. Monolines
insured $127 billion of subprime related CDOs
- As mortgage delinquencies rose, monolines had to raise capital (CIFG: $1.5
billion, MBIA: $3billion) to maintain their triple-A rating or were downgraded
(FGIC, ACA…)
- Loss of the triple-A rating by the monolines could lead to additional write-off for
banks: $40 to $70 billion
- A bailout plan of the major monolines (MBIA, AMBAC and FGIC) is currently
being explored
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Systemic Risk
- Crisis of confidence and liquidity crisis has caused contagion to other
“unrelated” markets
- Lack of liquidity make it difficult to estimate prices: margin and collateral
calls amplify the problem
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IV. Issues to be addressed to avoid a repeat of the “subprime” crisis
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Rating agencies
- Rating of bonds vs. rating of structured credit products (close to half of their income
came from the rating of structured credit products)Rating of a corporate bond based largely on firm-specific risk and relies on analyst
judgment
Rating of a CDO tranche relies on quantitative models as it is a claim on cash flows
from a portfolio of correlated assets
- Ratings were based on expected loss: a bond and a CDO tranche with the same
expected loss have different unexpected losses that depend on the correlation
structure, prepayment behavior and the position in the capital structure of the CDO
- How to deal with the volatility of ratings? What is the usefulness a very volatile rating?
- Rating agencies did not perform any due diligence on the quality of the underlying
loans: took for granted the accuracy of the information provided to them by the
structurers
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Valuation- Better models are clearly needed to generate the loss distribution of
correlated credits
- Parameter estimation – forward looking: PDs, LGDs, prepayment
behavior, default correlations
Transparency- Disclosure: underlying assets of CDOs and SIVs, commitments
provided by banks
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Instrument design
- Going forward we can expect that investors will shy away from
complex structures: CDOs squared, CPPI, CPDOs and other
structures exposed to “gap risk”
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Regulators and Risk Management
- Lending standards
- Put options to allow banks to put back mortgages to originators
in the case of delinquency within a short period
- Need for several risk metrics to assess the risk of complex
exposures:VaR for “normal market conditions”
Stress testing and scenario analysis to account for liquidity risk and other
complexities (e.g., digital nature of the risk involved in holding a CDO
tranche) in extreme market conditions, very unlikely, but still realistic
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V. Concluding Remarks
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The Future of Securitization
- The objective of the business model “Originate to Distribute” is
to allow banks to focus on what they do best originate, structure
financial products and redistribute the risks to end-investors by
tailoring CRT instruments to their needs
- SIVs did not allow banks to redistribute the risks to the end-
investors as the securitized assets are coming back to the
balance sheet of the banks when liquidity evaporates
40“Dad was in subprime mortgage lending”
Conclusion
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700 pagesISBN: 0-07-135731-9$70.00
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ANNOUNCING
Risk ManagementMichel Crouhy, Dan Galai,and Robert Mark
The All-in-One Banker's andFinancial Manager's Guide for
Implementing ⎯ and Using ⎯ anEffective Risk Management Program
In today’s world of multibillion-dollar creditlosses and bailouts, it has become increasingly imperativefor corporate and banking leaders to monitor and manageon all fronts. Risk Management introduces andexplores the latest financial and hedging techniques in usearound the world, and provides the foundation for creatingan integrated, consistent, and effective risk managementstrategy.Risk Managementpresents a straightforward, no-nonsense examination of the modern risk managementfunction — and is today’s best risk management resourcefor bankers and financial managers. Its tested andcomprehensive analyses and insights will give you all theinformation you need for:
• Risk Management Overview —From the history of risk management to the newregulatory and trading environment, a look at riskmanagement past and present• Risk Management Program Design —Techniques to organize the risk managementfunction, and design a system to cover yourorganization’s many risk exposures• Risk Management Implementation —How to use the myriadsystems andproducts⎯value at risk (VaR), stress-testing,derivatives, and more⎯for measuring andhedging risk in today’s marketplace
In the financial world, the need for a dedicatedrisk management framework is a relatively recentphenomenon. But as the recent crises attest, lack of up-to-date knowledge concerning its many components can bedevastating. For financial managers in both the bankingand business environments, Risk Managementwillintroduce and illustrate the many aspects of modern riskmanagement⎯and strengthen every financial riskmanagement program.
Chapter 1: The Need for Risk Management Systems
Chapter 2: The New Regulatory and CorporateEnvironment
Chapter 3: Structuring and Managing the Risk ManagementFunction
Chapter 4: The New BIS Capital Requirements forFinancial Risks
Chapter 5: Measuring Market Risk: The VaR Approach
Chapter 6: Measuring Market Risk: Extensions of the VaRApproach and Testing the Models
Chapter 7: Credit Rating Systems
Chapter 8: Credit Migration Approach to Measuring CreditRisk
Chapter 9: The Contingent Claim Approach to MeasuringCredit Risk
Chapter 10: Other Approaches: The Actuarial andReduced-form Approaches to Measuring
Credit Risk
Chapter 11: Comparison of Industry-sponsored CreditModels and Associated Back-Testing Issues
Chapter 12: Hedging Credit Risk
Chapter 13: Managing Operational Risk
Chapter 14: Capital Allocation and PerformanceMeasurement
Chapter 15: Model Risk
Chapter 16: Risk Management in Nonbank Corporations
Chapter 17: Risk Management in the Future
Michel Crouhy,Ph.D., is senior vice president, GlobalAnalytics, Risk Management Division at Canadian ImperialBank of Commerce (CIBC), where he is in charge ofmarket and credit risk analytics. He has publishedextensively in academic journals, is currently associateeditor of both Journal of Derivativesand Journal ofBanking and Finance, and is on the editorial board ofJournal of Risk.
Dan Galai, Ph.D., is the Abe Gray Professor of Financeand Business Administration at Hebrew University and aprincipal of Sigma P.C.M. Dr. Galai has consulted for theChicago Board Options Exchange and the American StockExchange and published numerous articles in leadingjournals. He was the winner of the First Annual PomeranzePrize for excellence in options research presented by theCBOE.
Robert Mark,Ph.D., is senior executive vice president atthe Canadian Imperial Bank of Commerce. Dr. Mark is thechief risk officer at CIBC. He is a member of the seniorexecutive team of the bank and reports directly to thechairman. In 1998, Dr. Mark was named Financial RiskManager of the Year by the Global Association of RiskProfessionals (GARP).
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