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Chapter 5

Chapter 5. Current Multinational Financial Challenges: The Credit Crisis of 2007-2009. The Goals of Chapter 5. 0. Introduce the notions of subprime debt and securitization Introduce the crisis of 2007 and 2008: subprime crisis , financial tsunami , and credit crisis

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Chapter 5

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  1. Chapter 5 Current Multinational Financial Challenges: The Credit Crisis of 2007-2009

  2. The Goals of Chapter 5 0 • Introduce the notions of subprime debt and securitization • Introduce the crisis of 2007 and 2008: subprime crisis, financial tsunami, and credit crisis • Discuss several issues associated with the crisis • Market-to-market accounting rule • LIBOR • Collateralized Debt Obligations (CDOs) • Credit Default Swaps (CDSs) • Structured Investment Vehicles (SIVs) • Lessons learned from the crisis

  3. Subprime Debt and Securitization 5-3

  4. The Seeds of Crisis: Subprime Debt 0 • From 1995 to 2001, the Nasdaq index increased by a factor of more than 6, which is called the dot-com boom • After the collapse of the dot-com bubble in 2000 and 2001, capital tried to find a safer target and began to flow toward the real estate sectors in the United States • Some economists argued that much of the wealth accumulated from the equity markets during that period was now used to push the demand and prices of real estate upward • The U.S. banking sector found mortgage lending highly profitable and saw it as a rapidly expanding market • The mortgage lending business boomed due to the high demand • The bright prospect of the housing price enhanced the value of collaterals for the mortgage

  5. The Seeds of Crisis: Subprime Debt 0 • In 1999, the U.S. Congress pass the Gramm-Leach-Bliley Financial Services Modernization Act, which repealed the Glass-Steagall Act of 1933 and eliminated the barriers between commercial and investment banks • With the increase of the competition in the mortgage lending business, a growing number of the borrowers were with lower credit quality • These borrowers who previously should be unqualified to borrow mortgages, and their associated mortgage agreements (subprimedebt), carried higher debt obligations with lower income • In traditional financial management terms, the debt-service coverage ratio, defined as the ratio of income available for servicing interest and principal payments of the debt, was increasingly inadequate

  6. The Seeds of Crisis: Subprime Debt 0 • The competitiveness created various mortgage forms to attract borrowers, e.g., • Initially, borrowers pay floating rates, often priced at LIBOR, plus a small interest rate spread, and the loans would reset at much higher fixed rates within two to five years • Borrowers pay interest only in early years with a initial interest rates far below market rates, and have substantial step-ups in payments after the initial period of interest-only payments

  7. The Seeds of Crisis: Subprime Debt 0 • Mortgage loans in the U.S. marketplace are normally categorized (in increasing order of riskiness) as: • Prime (or A-paper) • A-prime mortgages are conforming or conventional loans, meaning it would meet the guarantee requirement and can be resale to government-sponsored institutions, e.g., Fannie Mae (Federal National Mortgage Association) or Freddie Mac (Federal Home Loan Mortgage Corporation) • Alt-A (Alternative A-paper) • The Alt-A loans are still with low risk, but for some reasons are not initially conforming, like borrowers with less than full documentation, higher loan-to-value (LTV) ratio, and more investment properties • Subprime • In principle, it reflects borrowers who do not meet underwriting criteria and have a higher perceived risk of default, normally as a result of some credit history, e.g., bankruptcy, loan delinquency, default, etc.

  8. The Seeds of Crisis: Subprime Debt 0 • Sub-prime mortgages are nearly exclusively floating-rate structures, and carry significantly higher interest rate spreads over the floating bases such as LIBOR • Sub-prime borrowers typically pay a 2% premium over the rate for the prime debt–the subprime differential, which depends on several factors, including the borrower’s credit score, the payment-income ratio, the mortgage loan-to-value (LTV) ratio • However, the low interest rate policy adopted by the U.S. Federal Reserve to aid the U.S. economy in its recovery from the 2000-2001 recession lower the overall interest rate paid by the subprime borrowers as well • Lower interest rates stimulate the growing demand for loans or mortgages from subprime borrowers, and subprime loans became a growing segment of the market during 2003-2005 • In fact, subprime mortgages had never exceeded 7% to 8% of all outstanding mortgage obligations by 2007, but by the end of 2008, they were the source of more than 65% of bankruptcy filings by homeowners in the U.S.

  9. Asset Values 0 • One of the key financial elements of this growing mortgages was the value of the assets collateralizing the mortgages–the houses and real estate itself • As the market demands pushed up prices, housing assets rose rapidly in market value since 2000 • The increased values were then used as collateral in re-financings or second mortgages • Many mortgage holders became more indebted and participated in more aggressively constructed loan agreements • Mortgage brokers or banks, driven by additional fee income, pushed for continued refinancing or second mortgages • Consequently, mortgage debt as a percentage of household disposable income continued to climb in the U.S. in the post-2000 business environment (from 80% in 1990 to 100% in 2000 and 140% in 2007)

  10. Asset Values and Interest Rates 0 Housing boom reversed and finally burst after 2007, but the interest rate continued to rise • The combination of the effect of decreasing asset values and the increasing interest rates ※ The data of housing price index is from Federal Housing Finance Agency ※ The data of U.S. 3-mon Treasury yield is from the Department of the Treasury in the U.S.

  11. Asset Values and Interest Rates 0 • After U.S. house prices peaked in mid-2006 and began their steep decline thereafter, refinancing became more difficult • As adjustable-rate mortgages began to reset at higher rates in the meanwhile, mortgage delinquencies soared • Consequently, securities backed with subprime mortgages, widely held by financial firms, lost most of their value • The result has been a large decline in the capital of many banks and U.S. government sponsored enterprises

  12. The Transmission Mechanism: Securitization 0 • The transport vehicle for the growing lower quality debt to spread worldwide was a combination of securitization and re-packaging provided by a series of new financial derivatives • Securitization: pooling loans and issuingstandardized securities backed by those loans • This process is able to turn illiquid loan assets into a liquid saleable asset • The loan sale market is illiquid due to the possible adverse selection or the moral hazard • Adverse selection: the customer who has a higher demand for borrowing is with a higher probability to default • Moral hazard: if a bank knows that a loan will be sold in the future, the motive to evaluate the credit rating of the customer carefully is weakened

  13. The Transmission Mechanism: Securitization 0 • Meanwhile, the credit risk of borrowers also transferred to holders of securitization securities • In the securitization process, the originating bank changes its role from a risk taker to a service provider • Securitized assets took two major forms, mortgage-backed securities and asset-backed securities • Asset-backed securities included second mortgages and home-equity loans based on mortgages, in addition to credit card receivables, auto loans, and a variety of others

  14. The Transmission Mechanism: Securitization 0 • By selling securitized securities to investing public or other financial institutions, the originating institutions can free up more capitals for conducting more lending business • Thus, more subprime mortgages and loans to be written, which is essentially not a bad thing because it provides lower-cost financing for home buyers and makes home ownership more affordable • Consequently, more low quality debt in the U.S. are spread all over the world via the securitization process, i.e., not only financial institutions in the U.S. but also financial institutions worldwide suffer serious losses as long as they possessed any kinds of mortgage-back securities

  15. The Transmission Mechanism: Securitization 0 • In addition, for the pass-through mortgage-backed securities which is the most common MBS in the market, if the originating bank does not hold any share of MBS, its incentive to continuously monitor borrower behavior over the life of the debt is weakened • Thus, the securitization process may degrade credit quality of MBSs comparing with the original mortgage loans • This moral hazard problem is viewed as another reason for the subprime crisis

  16. The crisis of 2007 and 2008 5-16

  17. The Crisis of 2007 and 2008 0 • The housing market began to falter in late 2005, withincreasing collapse throughout 2006, and the housing boom bubble finally burst in 2007 • Starting with the fail of two major hedge funds at Bear Stearns and the rescue of Northern Rock, the global financial markets slid toward near panic • The Bear Stearns Companies, Inc., based in New York City, was a global investment bank and securities trading and brokerage and lost its two major hedge funds in July 2007 • Northern Rock Bank moved into sub-prime lending via a deal with Lehman Brothers in 2006 • On 14 September 2007, Northern Rock Bank sought and received a liquidity support facility from the Bank of England, following problems in the credit markets caused by the U.S. subprime mortgage financial crisis • Both cases held a variety of collateralized debt obligations (CDOs) and other mortgage-based assets

  18. The Crisis of 2007 and 2008 0 • In 2008, with oil prices peaking in July, and the substantial increase of every other commodity prices, the subprime debt problem became more serious • In March 2008, Bear Stearns failed, and the Fed arranged the sale of Bear Stearns to JPMorgan Chase with the agreement to cover the lose of $29 billion • On August 10, 2008, the Fed purchased record-high $38 billion mortgage-backed securities to inject liquidity into the market • In September 2008, the U.S. government announced it was placing Fannie Mae and Freddie Mac into conservatorship • In essence, the government was taking over these institutions as result of their near insolvency

  19. The Crisis of 2007 and 2008 0 • Over the following week, Lehman Brothers, one of the oldest investment banks eventually filing for the largest single bankruptcy in American history on September 14 • Lehman Brothers was founded in 1850 by a pair of enterprising brothers • After moving the firm to NY following the American Civil War, the firm had long been considered one of the highest return, highest risk small investment banking firms on the Wall Street • Why did the U.S. government let it fail? • Although the “too big to fail” doctrine has long been a mainstay of the U.S. financial system, this doctrine, however, had largely been confined to commercial banks rather than investment banks which intentionally bear risk in exchange for profit

  20. The Crisis of 2007 and 2008 0 • The rescue loan from the Fed is limited by the amount of asset collateral specific institutions, but it is not enough to save Lehman • Due to the extensive holdings of mortgage-backed securities and dominant role to issue commercial papers, allowing Lehman to fail is to send shock waves worldwide through most common instruments in the banking system, and turn a financial tremor into a tsunami • On the next day, equity markets plummeted and the LIBOR rates of Eurodollars shot skywards as a result of the growing international perception of financial collapse of U.S. banking institutions

  21. The Crisis of 2007 and 2008 0 • On the following day, American International Group (AIG), who had extensive credit default swap (CDS) exposure, received an $85billion injection from the U.S. Federal Reserve in exchange for its 80% equity • The problems of Lehman and AIG caused many banks to question credit quality of other banks in not only U.S. but also international financial markets • Traditional commercial bank lending were squeezed out by the huge losses from the investment in mortgage-related instruments • E.g., working capital financing, automobile loans, student loans, and credit card debt are influenced • This problem deteriorated for small firms, which heavily depend on short-term debt for working capital financing

  22. The Crisis of 2007 and 2008 0 • All corporate borrowers were confronted by banks reducing their access to credit • Companies that did not have preexisting lines of credit could not access funds at any price • Companies with preexisting lines of credit were receiving notification that their lines were being reduced • The commercial paper (CP) market nearly ceased • Due to the default of Lehman, which was one of the largest CP issuers in the world, the market no longer trusted the credit quality of any counterparty • The Fed quickly announced that it would buy billions in CP issuances in order to add liquidity into the market • The subprime crisis finally became the worldwide credit crisis, during which the world’s credit markets–lending of all kinds–nearly stopped

  23. Global Contagion 0 • The rapid collapse of the mortgage-backed securities markets in the United States spread to the global marketplace • Equity markets fell worldwide from the summer of 2008 until the spring of 2009 (see Exhibit 5.11 for severe global contagion) • Capital invested in equity and debt instruments in all major financial markets fled not only for cash, but for cash in traditional safe-haven countries and markets • Currencies of the more financially open emerging markets felt a significant impact, e.g., Icelandic krona, South Korean won, Mexican peso, Brazilian real, etc.

  24. Exhibit 5.11 Selected Stock Markets during the Crisis

  25. Three Stages of the Credit Crisis 0 • Three stages of the credit crisis are summarized: 1. The failure of specific mortgage-backed securities started in the summer of 2007 (causing the fall of values of specific funds and instruments) 2. The crisis spread to the very foundations of the organizations at the core of the global financial system, the commercial and investment banks on all continents ※The financial tsunami from the U.S. causes the global credit crisis 3. A credit-induced global recession happened • Not only had lending stopped, but also in many cases, borrowing and investing had ceased • This is because prospects for investment returns of all types were dim; corporations failed to see returns on investments • As a result, there was widespread retrenchment among industrialized nations as corporations cut budgets and headcount ※In order to stimulate the economy, all countries adopted the expansionary monetary policy and lowered the interest rate

  26. Several Issues Associated with the Crisis 5-26

  27. Several Issues associated with the Crisis 0 • Some issues and financial products associated with the crisis will be discussed • Market-to-market accounting rule • LIBOR • Collateralized Debt Obligations (CDOs) • Credit Default Swaps(CDSs) • Structured Investment Vehicles (SIVs)

  28. Mark-to-Market Accounting 0 • One of the continuing debates about the global credit crisis is whether the use of mark-to-market accounting contributed significantly to the failure of financial institutions • Market-to-market rule is a long-term accounting practice to require that financial institutions re-value all financial assets and derivatives daily, even though there is no intention to liquidate the asset at that time • If there is not really a market value, the revaluation must follow a theoretical process to calculate the asset value, which is called mark-to-model method

  29. Mark-to-Market Accounting 0 • The problem in normal periods is that many instruments do not trade in markets, or trade only in very thin markets, so establishing a fair value can be a very difficult task • In panic-induced free fall of the crisis, the asset values are extremely low and may result in significant reduction in the organization’s equity • It thus causes insolvency results in accounting sense although the organization had no intention of liquidating the asset at that time

  30. LIBOR’s role 0 • The global financial markets have always depended upon banks’ services for their core business activity • The banks in turn have depended on the interbank borrowing and lending market for liquidity which had historically operated on a “no-names” basis • “No-names” basis meant that for the banks at the highest level of international credit quality, interbank transactions could be conducted without discriminating by name • In the summer of 2007, however, much of this changed, increasing focus on each individual institution and its particular credit risk profile • This is because even for traditionally highly-rated banks, they may suffered a lot of losses in the subprime crisis and be near to bankrupt

  31. LIBOR’s Role 0 • The British Bankers Association (BBA), the organization charged with the daily tabulation and publication of LIBOR Ratesfor 15 different maturities and 10 different currencies, became worried about the validity of its own published rate • Due to the cases of Lehman and AIG, many banks doubted the credit worthiness of other banks in the interbank market • It caused the U.S. LIBOR rate skyrocket and extremely volatile in September and October of 2008 (see Exhibit 5.10) • A skeptical attitude was about the quotations of BBA, even these LIBOR rates are based on the quotes from 16 major banks • These banks did not dictate the rate they quoted to conduct the lending business between themselves or to non-bank borrowers

  32. LIBOR’s Role 0 • The real borrowing rates and borrowing amount in the interbank market depended on the risk profile of each individual borrower ※ In fact, instead of asking the quoted rate only, the BBA already changed the survey wording–“at what rate could the bank borrow a reasonable amount?” • As the crisis deepened, many corporate borrowers began to publicly argue the LIBOR rates published were in fact underestimating their problems • Because many loan agreements have “market disruption clauses” that allow banks to actually charge corporate borrowers their “real cost of fund,” not just the published LIBOR • In its role as the basis for all floating rate debt instruments of all kinds, the LIBOR rate has the potential to cause significant disruptions due to its skyrocketed and volatile behavior and inability to reflect the true cost of fund

  33. Exhibit 5.10 USD & JPY LIBOR Rates (September–October 2008) ※ Comparing to the JPY LIBOR, the USD LIBOR was extremely volatile in the period of Sep.–Oct. 2008 ※ Wachovia, one of the largest providers of financial services in the U.S., provides a broad range of banking, asset management, wealth management, and corporate and investment banking services ※ On October 3, 2008, Wachovia agreed to be bought by Wells Fargo for about $14.8 billion in an all stock transaction

  34. LIBOR’s Role 0 • The larger, more creditworthy companies did not have to borrow exclusively from banks, but may issue debt directly to the market in the form of commercial paper • However, the CP market also quickly fell as many traditional buyers of CP–commercial banks, hedge funds, private equity funds, and even the SIVs discussed later–lost their confidence in the future condition of the economy and the creditworthiness of issuers of CPs • As the lending business of commercial banks froze, the LIBOR skyrocketed, and the CP market locked-up, the corporate borrowers almost lost all possibilities to access the short-term debt • The lending crisis is illustrated in Exhibit 5.12

  35. Exhibit 5.12 LIBOR and the Crisis in Lending 0

  36. LIBOR’s Elements 0 • During the credit crunch of 2007 and 2008, the Bank for International Settlements (BIS) in Basle, Switzerland, had published a study of the LIBOR market’s behavior of late • The study described the risk premium added to interbank quotes as: Risk Premium = Term Premium + Credit Premium + Bank Liquidity Premium + Market Liquidity Premium + Micro Premium • In this study, the interbank quotes are the LIBOR overnight interest rates • The term premium is a charge for longer maturities • The credit premium is a charge for the perceived risk of default by the borrowing bank

  37. LIBOR’s Elements 0 • Bank liquidity premium is the access of the individual lending bank to immediate funds • The market liquidity premium is a measure of general market liquidity • A micro premium is a charge representative of the market micro-structure of how banks conduct interbank lending • The microstructure research is about how market structures or rules affect trading costs, e.g., assets are traded through dealers who keep an inventory, while other markets are dominated by brokers who act as intermediaries • The BIS concluded that for the U.S., the Euro, and the U.K., although there seemed to be some evidence of a small increase of the credit premium, most of the total risk premium was explained by bank and market liquidity

  38. Collateralized Debt Obligations 0 • Banks originating mortgage or corporate loans could create a portfolio of these debt instruments and repackage them as asset-backed securities • One of the key instruments in the growing market of securitized products was the collateralized debt obligation(CDO) (see Exhibit 5.6) • During the securitization process, the bank passed this portfolio to a special purpose vehicle (SPV) (also known as special purpose entity (SPE)) • SPVs own this portfolio of debt instruments on behalf of the holders of CDOs and serve as the legal entity to issue CDOs • SPVs are typically used to isolate the transactions from the financial risk of the originating bank • Since SPVs are individually legal entities, different accounting or tax rules from that for the originating bank is applied

  39. Exhibit 5.6 Global CDO Issuance, 2004–2008 (billions of U.S. dollars) [Insert Exhibit 5.6] • ※ From 2004 to the second quarter of 2007, the amount of CDO issuance grew nine times, which is equivalent to 110% growth rate for each year

  40. Collateralized Debt Obligations 0 • Similar to all other securitized securities, the CDO was sold into the market through underwriters and freed up the bank’s financial resources to originate more and more loans, earning a variety of fees • The collateral for the CDO is the real estate, equipment, or property that the loan was used to purchase • The overall picture of the CDO arrangement is illustrated in Exhibit 5.5

  41. Exhibit 5.5 The Collateralized Debt Obligation 0 • ※ In addition to mortgage loans, corporate loans, and corporate bonds, the underlying assets of the CDO could be other asset-backed securities and mortgage-backed securities • ※In 2007, 47% of CDOs were backed by structured products, 45% of CDOs were backed by corporate loans, and only less than 10% of CDOs were backed by fixed income securities

  42. Collateralized Debt Obligations 0 • CDOs were sold to the market in categories representing different credit quality: senior tranche (rated AAA), mezzanine or middle tranches (AA down to BB), and equity tranche (usually unrated) • For the default and failure events in the portfolio, the equity tranche absorbs the principal loss first • After the principal of the equity tranche is used up, the losses from default events begin to undermine the principal of the mezzanine tranches (in decreasing order of riskiness) • The above rules gives the senior tranche most protection, so the senior tranche is with the lowest interest yield • In fact, the distribution of cash for different tranches follows the waterfall method, i.e., cash would fill from the top-down, from the senior tranche to the equity tranche (see the figure on the next slide)

  43. Illustration of a CDO Construction 0 • ※ Waterfall rule: Only once the senior class has been paid what its due, the junior class gets paid, i.e., for both interest income and principal repayment, tranche AAA gets first, then does the tranche A, tranche BBB, and finally equity tranche • ※ If the principal losses in the events of default represents 13% of the total amount, the equity tranche loses all its principal, tranche BBB loses 30% (=3%/10%) of its principal, and tranches A and AAA do not lose any principal

  44. Collateralized Debt Obligations 0 • The introduction of the equity tranche is to provide credit enhancement for other tranches • Similarly, the mezzanine tranches A and BBB are the subordinated debt to tranche AAA, providing further protection for the senior tranche AAA • CDOs would be rated by rating agencies, who often complete the analysis quickly based on the information provided by the underwriter, rather than undertake the typical ground-up credit analysis themselves • The false estimations of the credit risk of CDOs are also one of the reasons for the subprime crisis

  45. Collateralized Debt Obligations 0 • The determinant factors for the value of the CDO • The performance of the debt it holds, i.e., the ongoing payments being made by the original borrowers on their individual mortgages • The second driver, uncovered until the crisis occurred, was the willingness of the many institutions and traders of CDOs to continue to make a market for this kind derivative, i.e., the liquidity of the market • In the crisis of 2007-2008, the market prices of CDOs are far lower than their theoretical prices due to the lack of the liquidity • Other COD instruments • Synthetic CDOs: structures in which the CDO itself does not actually hold debt, but is constructed purely of derivative contracts combined to “mimic” the cash flow of other debt instruments (like CDSs introduced later)

  46. Collateralized Debt Obligations 0 • CDO-squared: a CDO that holds shares from other CDOs, which is created by Merrill Lynch in October 2006 • For example, a bank can collect some mezzanine tranches from different CDOs and use the same skill to arrange the sequence for different tranches to absorb the losses for the events of default, so CDO-squared still can generate another AAA tranche • The CDO-squared instruments not only holds lower and lower quality loans and bonds, but also they are typically highly subordinated CDOs to the original instruments that they supported • The experience from the crisis tells us the AAA tranche generated in this way cannot provide secure cash flows that should offer by a AAA debt instrument

  47. Credit Default Swaps 0 • The credit default swap (CDS) is a derivative instrument, which derives its value from the credit quality and performance of any specified asset • Invented by JPMorgan in 1997, the CDS was designed to shift the risk of default from protection buyer to protection seller (see Exhibit 5-7) • For protection buyer, CDS provides insurance against the possibility that a borrower might not pay • For protection seller, CDS makes the bet without ever holding or being directly exposed to the credit instrument itself • According to The Economist, the participants in the CDS market in 2007 were widespread across a variety of financial institutions: 44% banks, 32% hedge funds, 17% insurance companies, 4% pension funds, and 3% other investors

  48. Exhibit 5.7 Cash Flows under a Credit Default Swap

  49. Credit Default Swaps 0 • Concerns for CDSs • Participants in the market, protection buyers and protection sellers, do not need to have any actual credit exposure • Participants simply have to have a viewpoint • As a result, the CDS market, estimated at about $60 trillion at its peak in 2007, grew rapidly since 2000 and reached a size many times the size of the underlying credit instrument it was created to protect (see Exhibit 5.8) • CDSs actually allow banks to disconnect their links to their borrowers, reducing incentives to screen and monitor the ability of borrowers to repay–a moral hazard • There is no real record or registry of issuances for CDSs • No requirements on buyers and sellers that they had adequate capital to assure contractual fulfillment • Since CDSs depend on one-to-one counterparty settlement, there is no real market for assuring liquidity

  50. Exhibit 5.8 Credit Default Swap Market Growth

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