What caused the sub-prime problem will be discussed and debated for long time. Many blame the Sub-Prime crisis upon Greedy Wall Street Investment bankers, or on “Risky” Hedge Funds, or on Incompetent Regulators. But the fact is, such a massive problem can be hardly attributed to only one participant in the market. I believe it’s the whole marketplace (including regulators, investment banks, mortgage houses, credit agencies, as well as investors) that should share the blame.
Securitisation took off in the early 80s, and was an efficient tool to spread risk, and reduce costs of financing. Since the mid 1990s, mortgage issuers were encouraged to offer home loans to all Americans including the ones without a good credit history or a stable job. These were called SUBPRIME loans (whereas Prime loans are relatively “good” loans for people with good credit history, job, assets etc.) where the probability of default was quite high. They were also referred to as NINJA loans i.e. No Income No Job No Assets to back up the loan. The financial crisis that started in mid 2007 was initiated by rising defaults in Subprime loans and hence is called Subprime crisis. The banks and the mortgage houses were issuing rapidly these loans as a part of wider “American dream” that every American should have a house. But it was very risky for the banks to keep those risky loans on their books, so they worked with Investment Banks to pool such loans and securitise them into Bonds and sell them over to the end investors. Credit Rating agencies were rating them at levels which are highly questionable.
Securitisation worked on one assumption; not all loans would / should default at the same time, maybe some would but not all. Credit rating agencies used this assumption as a principal and rated such bonds as A grade or better. This made end-investors comfortable investing in such bonds. This way, Securitisation helped spread out the risk from the banks to the other investors (typically institutions) who received good returns on these A rated bonds. These loans worked well under the assumption that most subprime loan owners would be able to repay their mortgage, and / or the house prices would keep going up in which case even if there is a default the end investor would be able to get their money back by sale of the underlying house.
This held true for few years; subsequently we witnessed the Dotcom bubble burst in 2000. That triggered loads of Equity investors to flee the stock market and invest in Housing. Cheap financing by banks (because of Securitisation), coupled with several Equity investors coming to invest into Housing market and that the Interest rates were kept at an all-time low in US (1%), the house prices began to rise significantly. The demand for houses exceeded the supply and people started to consider buying second and third houses. For example, if somebody got a subprime loan for $100,000 in 2000, by 2002 their home value was over $130,000 and that person could use this $30,000 rise in house value to finance another subprime mortgage. And they did that. Let’s consider the illustration about the value chain of mortgage securitisation,
The mortgage issuers had the incentive to issue as many mortgages as possible. The practice became so unprofessional, that the loan applicants were asked to fill the form in pencil so that issuers could misrepresent certain details so as to meet the issuer’s lending criteria and get the loans issued. Low documentation lending exploded in US over the past decade. For example if an applicant put their annual salary over the last 5 years less than $20,000, the issuers could change that figure to $35,000, reaching any such desired threshold and get the loan approved. Since these were sub-prime loans, they were not typically required to show any proofs of their salaries etc.
The issuers would combine these loans and go to an Investment Bank to help securitise them. Since the foundation of the securitisation of these loans was based upon incorrect information, this would affect the whole value chain in the future if things went bad. And so they did. Investment banks would base their securitisation criteria on the facts about the loans presented to them (which were wrong in many instances). On top there would be assumptions that if the economy keeps growing, subprime loan owners would find ways to earn money and make their mortgage payments and hence the securitised bonds would keep paying their coupons. The Rating agencies would rate these bonds on similar assumption that not all of these loans combined would be as bad as they individually could be. Hence they would give them better ratings which would help investors get comfortable investing in such assets. The investors could include Institutions like Pension Funds who would trust the Investment Bank’s Sales teams with information around how great these bonds are, highly rated by Rating agencies, and they provide such high returns. The individual who contributes towards this Pension Fund would not even be aware where there retirement savings are being invested, and where the losses would be coming from. Also, the creation of bonds from such loans was divided into different tranches to create different types of risk associated with them. Such instruments are called CDOs.
CDOs divide the bonds into different categories as shown above, to give different levels of risk and return within each tranche. Senior tranche for example has lowest risk and lower return as compared to other tranches. Different tranches are rated by Rating Agencies (like AAA, B, etc.) As the creation of such Bonds and tranches grew, it became harder to sell the lower rated / tranches of these bonds. They were sizable enough for Investment Banks to hold on their own books. They used another derivative instrument Credit Default Swap, to sell such instruments. The Investment Banks were incentivised to create and sell more and securitised deals, and package them up as CDOs so they could make transaction fees in the process. And whenever they could not sell the CDO tranches, they ended up keeping them in their own books and hence taking incremental risk (which played important role in their demise in 2008).
The least risky of these were bought by investors such as Pension Funds and the probability of such bonds not paying interest only came after all the Bonds underneath defaulted. Since these bonds were traded Over the Counter (i.e. between 2 counterparties), it was harder to find out systematically how much exposure anyone has into such products. These subprime losses started to mount in 2007. House prices ceased to rise (due to fall in demand and overall economic slowdown) and the subprime loans started to default. This led to the losses being incurred by the investment banks and also by the investors. The losses mounted to hundreds of billions of dollars and the crisis was unfortunately not only contained within sub-prime, ended up expanding to many other asset classes.
Risk management in the New Securitised Model
The key change in the securitisation model compared to earlier was the risk management. This is how the loans used to be approved by banks (pre-securitisation era) and held by them. The bank would grant loan for a home once the risk officer evaluated and assured the credit background and repayment capability of the individual seeking loan. The risk officer’s job was important as the bank held the loan on its books until maturity.
Over time with securitisation, the model changed and the risk officer’s job got less relevant since the bank was not keeping the risk on its books. As can be seen below, end owner of the risk was probably the pension fund who got comfortable with the bond as it was well rated by the rating agency.
This was one of the reasons that led to the sub-prime and housing crisis. Also the Investment banks started to acquire the banks / mortgage issuers to generate more revenues by originating mortgages and then securitising them. This lack of risk supervision led to the weak foundation of housing societies and due to the leverage involved, it became such an big subprime crisis.
Double leverage equation in Investment Banks’ Mortgage Business
The leverage within the properties, and the banks leverage on top made this house financing operation double risky and hence the problems we witnessed with all Investment banks, subsequent to this housing crisis in US. How did this Subprime Mortgage Problem become such a big Crisis? Subprime mortgages had led to a bubble in the Housing market overall. Due to defaults on subprime loans the whole Housing bubble has burst and people without subprime loans (with normal loans called as Prime loans) also started losing out by the decrease in House prices. Housing is integral to any economy as it is one of the basic necessities in any part of the civilization. It is generally directly correlated to the economic growth of a country, as well as supply demand. Please note that supply of Housing is an important factor as we cannot produce land in densely populated regions with shortage of available land. Besides, when the mortgage houses, banks, investment banks and other financial institutions started to lose out on their loans, the rest of their operations which included giving loans to companies, short term lending to other banks, etc. were also reduced significantly.
The reason for the reduction in this lending was because of the astronomical amounts of losses the banks incurred due to the sub-prime crisis. The global financial institutions’ losses (investment banks, commercial banks, investment funds, etc.) due to sub-prime and related activities had topped $1 trillion by the end of 2008. These losses led the banks to reduce their leverage significantly, and their cheap financing in the capital markets became significantly higher. And one of the big factors that affected the financial world’s functioning is that banks had significantly reduced lending to each other as they were conscious that the other bank might or might not be able to survive this crisis. This led to the credit crunch across the economy. This credit loss spread from mortgages and start affecting commercial housing, to credit cards, to student loans, to leveraged loans, to company loans and so on. The deleveraging from Investment Banks to financial institutions rippled through companies to all across the world.