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					                       The
                     Subprime
                               Mess Tracing the
                                   Origins of the
                                   Panic of 2007




                                     By Gary Gorton



36   The Milken Institute Review
                     I
                     In 2005 and 2006, $6.1 trillion worth of home mortgages were orig-
                     inated in the United States, of which $1.25 trillion were subprime
                     mortgages – that is, mortgages extended to borrowers with less-
                     than-excellent credit. The total assets of the U.S. banking system
                     alone in 2007 were about $10 trillion, a figure that does not include
                     the vast assets of investment firms, foreign banks and insurance
                     companies. How, then, could subprime mortgages be the cause of
                     the near-collapse of the global financial system?
                        Two factors made the inconceivable quite possible. First, much
                     of what we now call the banking system lies outside the traditional,
                     relatively transparent commercial-banking sector. It belongs to the
                     less-regulated shadow banking system –
                     financial-services businesses that create
                     asset-backed securities, synthetic assets
                     called financial derivatives and off-
                     balance-sheet investment vehicles. For
                     example, 80 percent of subprime mort-
                     gages were financed by securitization,
                     with a large amount of that 80 percent re-
                     securitized into other forms. Second, sub-
                     prime mortgages – and thus the securities
                     backed by these mortgages – were de-
                     signed in ways that made their value very
                     sensitive to the market prices for houses.
                        By the third or fourth year of the long
                     housing boom, almost everyone (irratio-
                     nally) expected that house prices would
elwood smith (all)




                     always go up. When the market finally frustrated those expecta-
                     tions, the sheer complexity of both mortgage-backed securities and
                     the web of contracts allocating liability in mortgage losses made it



                                                                                     First Quarter 2009   37
     RISK PROFILE OF SUBPRIME                                                              High-Grade
                                                                                            ABS CDO
     MORTGAGE LOANS
                                                                                            Senior ‘AAA’           88%

                                                                                                Junior ‘AA’        5%
BORROWER DOWN PAYMENT




                                  Subprime                Subprime                                 ‘AA’            3%
                 low




                                  Mortgage                Mortgage
                                    Loan                   Bonds                                   ‘A’             2%
                                                            ‘AAA’        81%
                                                                                                  ‘BBB’            1%
                                                                         11%
                 high




                                                             ‘AA’
                                                                                                   NR              1%
                                                              ‘A’        4%
                        good         bad                                                                  Mezz
                         BORROWER CREDIT
                                                             ‘BBB’       3%                              ABS CDO                    CDOC

                                                            BB,NR        1%, not in all deals         Senior ‘AAA’       62%     Senior ‘AAA’   60%
     source: UBS Market Commentary
                                                       Other credit support:                             Junior ‘AA’     14%      Junior ‘AA’   27%
                                                       Excess Spread,
                                                       Overcollateralization                                ‘AA’         8%          ‘AA’       4%

                                                                                                            ‘A’          6%           ‘A’       3%
                        virtually impossible for investors to deter-
                                                                                                           ‘BBB’         6%         ‘BBB’       3%
                        mine who bore risk and how much. Faced
                                                                                                            NR           4%          NR         2%
                        with this lack of information, financial inter-
                                                                                                   Other credit support:       Other credit support:
                        mediaries refused to deal with one another                                 Excess Spread               Excess Spread
                        and began to hoard cash.
                           To get a better sense of what happened,
                        think of ground beef. Hamburger is made by                         product by “recalling” the portion that might
                        grinding steer carcasses and then mixing the                       be contaminated.
                        meat to obtain the desired fat content. If e-
                        coli bacteria are later discovered in one pack-                   housing and subprime mortgages
                        age in a supermarket – perhaps caused by                          – a financial innovation
                        contamination from a single carcass – the in-                      U.S. housing policy has focused on increasing
                        cident might lead to the recall of millions and                    homeownership ever since the Great Depres-
                        millions of pounds of possibly contaminated                        sion. To accomplish that, Washington created
                        meat. The problem we face today is that the                        two government-sponsored enterprises – the
                        subprime risks (the e-coli) have been spread                       Federal National Mortgage Association (Fan-
                        around, but there is no fast way to recall the                     nie Mae) and Federal Home Loan Mortgage
                        possibly contaminated mortgages. Because                           Corporation (Freddie Mac) – to provide low-
                        the subprime risks have been widely (though                        cost insurance against mortgage defaults and
                        hardly uniformly) distributed, investors fear                      to support a deep secondary market that al-
                        that all assets that could conceivably be af-                      lowed lenders to easily replenish their capital
                        fected have gone bad. The bailout is, in es-                       by selling the mortgages they originated.
                        sence, an attempt to restore confidence in the                     But until quite recently, the credit standards
                                                                                           that needed to be met to obtain a mortgage
                        Gary G orton is professor of finance at the yale School
                                                                                           blocked homeownership for millions of lower-
                        of Management. this article is a shorter, revised version of       middle-income households, a disproportion-
                        a paper delivered at a symposium sponsored by the Federal          ate number of which were minority house-
                        reserve Bank of Kansas City’s Jackson Hole conference in
                        august 2008. It can be downloaded free at http://papers.
                                                                                           holds. Enter the subprime mortgage, designed
                        ssrn.com/sol3/papers.cfm?abstract_id=1255362.                      to open the market to this struggling group.


    38                  The Milken Institute Review
   How could one structure a mortgage loan            is refinanced, the lender is due substantial
that would be affordable for people with mar-         prepayment penalties.
ginal credit, yet still be attractive to investors?      Consider the impact of this design. On the
The answer: by setting terms that would allow         one hand, the interest rate jumps very sub-
both debtor and creditor to benefit from the          stantially after the initial period, creating a
mutually anticipated appreciation in the              strong incentive to refinance at that point. A
value of the mortgaged houses. This assumed           $300,000 loan at these rates would begin with
appreciation would make it possible to refi-          a monthly payment of $1,685 and ratchet up
nance a mortgage every two or three years,            to a whopping $2,998. On the other, the pre-
generating cash to bridge the gap between the         payment penalty in the mortgage contract cre-
borrower’s limited capacity to pay and the            ates an incentive not to refinance early. If the
creditor’s demand for premium returns on              stepped-up rate and the prepayment penalty
risky loans.
   Most subprime mortgages are variants on
standard adjustable-rate mortgages (ARMs)
with structures known as a “2/28” or “3/27.”
Both typically have 30-year amortizations –
that is, they would be self-liquidating after 30
years. But with a 2/28, the interest rate re-
mains fixed for two years and then floats for
28 years, while with a 3/27 the initial fixed
rate lasts for three years. As with any adjust-
able-rate mortgage, the floating rate consists
of some reference index rate plus a premium
that reflects both market conditions and the
quality of the borrower’s credit.
   These mortgages are known as hybrids be-
cause they incorporate both fixed- and ad-
justable-rate features. The initial monthly
payment is based on the low teaser rate. On a
2/28 mortgage originated in 2006, for exam-           are both so high that, without refinancing from
ple, the initial interest rate might have been        the lender, the borrower will almost certainly
8.64 percent – remember, this is a loan to a          default, the lender is in a position to decide
household with marginal credit. On the step-          what happens at the end of the teaser period.
up date (two years after origination), the rate          Either the lender can foreclose, exposing it
resets to a floating (inevitably higher) rate –       directly to the risks of owning the house, or it
say the London Interbank Offer Rate (Libor)           can roll over the mortgage on terms the bor-
plus 6.22 percent. At the time of origination,        rower can better afford. It’s possible, of course,
Libor was, say, 5.4 percent. So, the new inter-       that rising house prices will make it possible
est rate at the reset (if Libor remained un-          to refinance the mortgage with another lender
changed) would be 11.62 percent. This inter-          and get enough cash out of the deal to cover
est rate is updated to reflect the change in the      the debt to the original lender (the principal
Libor rate every six months. If the mortgage          plus a stiff prepayment penalty). One way or


                                                                                     First Quarter 2009    39
     the subprime mess
                                                       ditional securitizations, legal entities called
      another, though, the original mortgage is al-    special purpose vehicles (SPVs) issue securi-
      most certain to be terminated. So a hybrid       ties backed by their assets. In these deals, the
      mortgage with a nominal 30-year term is ef-      seniority as well as the face value of the bonds
      fectively a short-term mortgage that will dis-   issued by the SPVs – called tranches – are
      appear at the reset date.                        pretty much fixed over the life of the transac-
         The subprime innovation was successful,       tion. Each tranche is protected against losses
      at least for a while. In total, subprime and     by the size of tranches that are “junior” to it –
     “Alt-A” mortgages (the name for a class of        the junior tranches absorb losses (associated
      mortgages between prime and subprime in          with the default of the underlying mortgages)
      risk) amounted to about one quarter of the       first. By the same token, the principal of the
                                                       most senior tranches is paid down first as the
                                                       mortgages are amortized or refinanced.
                                                             Subprime mortgaged-backed securities
                                                          are different because (in deference to their
                                                              inherently riskier nature) they have more
                                                             “excess spread” and “overcollateralization”
                                                              built in. Excess spread refers to the dif-
                                                             ference between the cash flow (assuming
                                                          all mortgage payments are made) and what,
                                                       under the terms of the deal, is owed to the
                                                       holders of the securities. Overcollateraliza-
                                                       tion refers to the difference between the debt
                                                       represented by the underlying mortgages and
                                                       the face value of the mortgage-backed securi-
                                                       ties. There is bound to be some overcollater-
     $6 trillion mortgage market between 2005          alization when the securities are issued, while
     and the first quarter of 2007. From 2000 to       excess spread is supposed to build further
     2007, the outstanding amount of “agency”          overcollateralization during the life of the se-
     mortgages (higher-quality mortgages eligible      curities. The allocation of the resulting “credit
     for insurance by Freddie and Fannie) dou-         enhancement” among the tranches depends
     bled, while subprime grew 800 percent! Be-        on a variety of contractual triggers that reflect
     tween 1998 and 2006, house prices rose            the credit quality of the underlying mortgages.
     briskly and mortgages were refinanced at a            The payback dynamic of subprime securi-
     furious pace. Indeed, the bulk of the origina-    tizations is thus very different from standard
     tions in the subprime market were refinanc-       securitizations. With securities collateralized
     ings of existing mortgages.                       by prime mortgages, little credit enhance-
                                                       ment builds up. Mostly, excess spread is paid
     financing subprime residential                    out to the originator while some is used to
     mortgage-backed security (rmbs)                   slowly (but surely) amortize the senior
     bonds                                             tranches. With subprime securitizations, by
     If this were the end of the story, we would not   contrast, credit enhancement depends on the
     be in the middle of a banking crisis. With tra-   rapid refinancing of the mortgages rather


40   The Milken Institute Review
than the steady, predictable accumulation of       deal go into a “mezz CDO.” What can be done
equity in the houses as the mortgages are am-      once can be done twice: If bonds issued by
ortized. So the repayment prospects for own-       mezz CDOs are put into another CDO port-
ers of the junior, riskier tranches depends        folio, then the new CDO – now holding mezz
critically on the prospects for refinancing the    CDO tranches – is called a “CDO squared.”
underlying mortgages – which, in turn, de-            Each CDO is governed by its own (often-
pends critically on rising house prices. To put    complex) contractual rules, with various trig-
it another way, if house prices rise at a brisk    gers that determine the conditions under
pace and refinancing is easy, the junior           which each tranche receives cash from mort-
tranches are very profitable. If housing prices    gage payments and refinancing. There is no
stagnate (or, heaven forbid, fall) the junior
tranches turn to dross when the teaser rates
of the underlying mortgages ratchet up and
the homeowner can neither make the pay-
ments nor refinance.

collateralized debt obligations
The story does not end there because Wall
Street raised the stakes even further by adding
another layer (or two) of securitization. Col-
lateralized debt obligations (CDOs) are secu-
rities created by raising capital (in risk-based
tranches) and investing it in
other securities. In investment-
banking parlance, CDO tranches
consist of senior tranches (rated
Aaa/AAA by the rating agen-
cies), mezzanine tranches (Aa/AA to Ba/BB),        straightforward template. So the risk profile
and equity tranches (unrated). CDO portfo-         of each CDO must be separately modeled – a
lios typically included securities backed by       major issue in the panic, when investors were
subprime and Alt-A mortgages, sometimes in         scrambling to figure out where they stood.
quite significant amounts.                            Why would CDOs buy subprime RMBS
    The linkage of subprime mortgages, sub-        bonds? The lower-rated RMBS tranches were,
prime residential mortgage-backed securities       in fact, initially difficult to sell. By 2005, how-
(RMBSs) and the CDOs built on the RMBSs            ever, the extra interest to be gained on sub-
is shown in the schematic on page 38. To the       prime BBB tranches appeared to be greater
left is a representation of a subprime RMBS        than on other structured products with the
deal. Some of the bonds issued in this securi-     same credit rating. CDO portfolios were thus
tization go into the portfolio of CDOs. In         increasingly dominated by subprime securi-
particular, as shown on the right-hand-side        ties, suggesting that the market was pricing
of the figure, RMBS bonds rated AAA, AA            this risk inconsistently with the ratings.
and A form part of a “high-grade” CDO port-            Issuance of asset-backed security CDOs
folio, while the BBB bonds from the RMBS           roughly tripled between 2005 and 2007, and


                                                                                   First Quarter 2009    41
     the subprime mess
                                                        kets of subprime bonds with specific ratings:
     portfolios became increasingly concentrated        AAA, AA, A, BBB and BBB-. Every six months
     in subprime residential mortgage-backed se-        the indexes are reconstituted, based on a pre-
     curities (RMBS). New CDO issues totaled            determined set of rules. The index is overseen
     $551 billion in 2006, with $314 billion in-        by Markit Partners, a financial-information-
     vested in CDOs that purchased subprime             services company based in London.
     RMBS tranches. As the volume of origination            For our purposes, the main point is that
     in the subprime mortgage market increased,         subprime risk can be traded “synthetically”
     subprime RMBS increased, and so did CDO            with credit derivatives. Since each derivative
     issuance.                                          contract matches parties on the two sides of
                                                        the risk, no net addition to subprime mort-
                                                        gage risk is generated by these derivatives.
                                                        However, data on the rapidly growing volume
                                                        of synthetic derivatives that were created sug-
                                                        gests that the demand for exposure to riskier
                                                        tranches of subprime RMBS exceeded supply
                                                        of the securities available by a wide margin in
                                                        2005 and 2006.
                                                            Before 2005, the portfolios of asset-backed
                                                        security CDOs were made up primarily of
                                                        cash securities – legal claims against real in-
                                                        come flows. After 2005, though, CDO manag-
                                                        ers and underwriters began creating synthetic
                                                        CDOs – derivatives that mimicked the real
                                                        thing – as well as “hybrid” CDOs that con-
                                                        sisted of a mix of cash positions and deriva-
                                                        tives. This gave them the flexibility to meet
                                                        the growing investor demand for CDOs and
                                                        to quickly meet investors’ preferences to carve
                                                        out particular risk exposures that may not
     synthetic subprime risk                            have been available in the cash market.
     There are other (and, it turns out, very im-
     portant) ways to slice and dice the risk associ-   where have all the tranches
     ated with securitized assets. Subprime risk        gone?
     can be assumed (or hedged against) by selling      So where are the CDO tranches now? We
     (or buying) credit derivatives tied to the fate    don’t know for sure. Investors around the
     of individual subprime cash bonds. Alterna-        world purchased tranches of CDOs backed by
     tively, the derivatives can be tied to an index    RMBSs and other securitized asset classes. In-
     based on a basket of such bonds. To do that,       vestors who bought the highest quality CDO
     dealer banks launched the ABX.HE index in          tranches (in both cash and synthetic form),
     January 2006, which was based on 20 equally        the ones rated Aaa/AAA or Aa/AA, included
     weighted RMBS tranches. There are also in-         pension funds, money managers and the big
     dexes comprising sub-indexes linked to bas-        insurance companies. Another significant


42   The Milken Institute Review
class of investors in CDOs was off-balance-       4.5 percent in the 12 months between the
sheet entities – notably, structured invest-      third quarter of 2006 and the third quarter of
ment vehicles (SIVs) and “SIV-lites.” A SIV is    2007 – the largest drop since the index started
a limited-purpose operating company that          recording data in 1988.
buys mostly highly rated medium- and long-           Home prices in the 20 largest metropoli-
term fixed-income assets, paying for them by      tan areas declined by 4.9 percent in that pe-
selling cheaper, mostly short-term commer-        riod (the biggest drop since the sub-indexes
cial paper and medium-term notes. The SIV-        were started in 2001) with 15 of the 20 cities
lites are typically more highly leveraged, and    showing depreciation over the course of the
seem to have invested almost exclusively in
U.S. residential mortgage-backed securities.
    The important point here is that these ve-
hicles are very different than the special pur-
pose vehicles (SPVs) used in securitization.
Standard securitization SPVs are not man-
aged funds; they are “robot” companies that
follow specified rules. SIVs and SIV-lites, by
contrast, are managed. They raise money by
issuing commercial paper and medium-term
notes, and they use the proceeds to buy high-
grade assets to form diversified portfolios.
They borrow short-term and purchase longer-
term assets. The credit-rating agencies re-
quire them to “mark-to-market” the value of
their assets on a daily or weekly basis, and to
use these valuations to determine how much
they may borrow.
    Another category of investors holding
CDOs was money market mutual funds,
which apparently not only purchased a vari-
ety of structured assets directly but also in-    year. The two largest declines were in Tampa
vested in SIVs. Later, some of these money        (11.12 percent) and Miami (9.96 percent).
market mutual funds had to be bailed out by          When house prices did not appreciate to
their parent-firm sponsors to keep them from      the same extent as in the past (or actually de-
returning less than one dollar on a dollar in-    preciated), the ability of borrowers to refi-
vested – known as “breaking the buck.”            nance was curtailed. Thus began a vicious
                                                  cycle: mortgage-underwriting standards be-
the panic                                         came tougher (for originators that did not go
From 2001 to 2005, home values rose an aver-      bankrupt) as the crisis unfolded, making it
age 54.4 percent, as measured by the Office of    impossible to refinance subprime mortgages.
Federal Housing Enterprise Oversight. Then           Problems in the Alt-A market are still
the worm turned. The S&P/Case-Shiller na-         mostly in the future, since their teaser-rate
tional quarterly home price index declined by     period generally is five years. But it is likely


                                                                                First Quarter 2009   43
         the subprime mess
                                                                were thinking – what is called the common
                                                                knowledge problem. But it didn’t help to un-
ABX BBB– IndeX PRICeS
                                                                derstand who bore subprime risk and how
100                                                             much.
                                           06-1 vIntAge
                06-2 vIntAge
                                                                     Entering into an ABX index contract is
 80                                                              analogous to buying or selling insurance on a
                                                                basket of the underlying RMBS tranches. An
                                                                investor wanting to hedge an existing posi-
 60
                                  07-1 vIntAge                  tion or otherwise establish a short credit po-
                                                                 sition using the index – the “protection buyer”
 40
                                                                – is required to pay a monthly fee to the other
                                                                party – the “protection seller.” In exchange for
                                        07-2 vIntAge
 20                                                             the payment, the protection buyer is compen-
                                                                 sated by the protection seller when any short-
   0
                                                                fall in interest or principal or any write-
                                                                downs on the underlying mortgages affect
   06


            6


                     6


                              6

                                   07


                                            7


                                                    7


                                                            7
          r0


                   l0


                            t0




                                          r0


                                                  l0


                                                          t0
   n




                                    n




                                                                the constituent RMBS. The index contract
                 Ju




                                                Ju
        Ap




                                        Ap
                          Oc




                                                        Oc
 Ja




                                  Ja




                                                                does not terminate when these credit events
source: Bank of America
                                                                occur; rather it continues with a reduced no-
         that this market, too, will shut down. (More-          tional amount until maturity. If credit events
         over, no one is originating subprime mort-              are subsequently reversed – for example, a
         gages, because it is no longer possible to secu-       principal shortfall is made up – the protection
                            ritize them).                       buyer must reimburse the protection seller.
                                The investment commu-                The first ABX.HE index contracts began
                            nity surely understood that         trading on January 19, 2006 with a new “vin-
                            the value of the investment         tage” issued every six months. So, unfortu-
                            structures along this chain         nately, there are no observations before that
                            were sensitive to house             date. No new vintages were introduced after
                            prices and that houses              2007. The graph shows the prices of the 2006-
         would stop appreciating some day. Not every-           1, 2006-2, 2007-1 and 2007-2 vintages of the
         one, though, had the same view on when they            index for the BBB- tranche, the only vintages
         would stop rising, or what the broader market           available. In the first three cases, the index
         impact would be. And individual players had             starts trading at par of 100. The 2007-2 index,
         no signposts to gauge the thinking of other            by contrast, opened at a price significantly
         market participants.                                   below par.
            This changed with the ABX.HE indexes                     The time pattern of prices is interesting.
         created at the start of 2006. They provided a          The first-vintage ABX (2006-01) initially
         price for subprime risk that everyone could            traded near par, as did the 2006-02 vintage.
         see. Second, the index derivatives made it             Thus, during 2006, there is little evidence of a
         cheap and easy to sell short the subprime              crisis in the making. But the 2007-01 BBB-
         market (or, of course, to hedge long posi-             index nosedives immediately upon issuance,
         tions). In sum, the ABX solved the problem of           and the 2007-02 vintage opens trading below
         figuring out what other market participants            60. The ABX indexes thus revealed previously


44       The Milken Institute Review
unknown information – namely, the market’s          on the risks to which firms were exposed to
view that subprime-backed securities were           be able to make informed decisions.
losing value. Some of the dealer banks, we
now know, were shorting the index to hedge          panic in the repo market
their long positions – as, of course, was every-    The panic also manifested itself in a scramble
one else.                                           for cash, causing one important form of lend-
   It is not clear whether the housing-price        ing, repurchase agreements (repos), to almost
bubble was burst by the new ability to short        disappear. Repos are essentially secured loans,
the subprime housing market or whether              so the credit of the borrower is not usually
house prices were going down and the impli-
cations were revealed by the ABX indexes.
One way or another, though, it seems the in-
dexes played a central role in spreading the
information that market players were bearish
on subprime.

 the run on the sivs
 The run began on asset-backed commercial
 paper conduits and SIVs. These vehicles were
 financed with short-maturity borrowing, so
 the run amounted to lenders refusing to
 roll over the loans. SIVs were absorbed
 back onto the balance sheets of their in-
 vestment-firm sponsors, who then typically
 sold the assets in the market, effectively trig-
 gering a fire sale. By December 2007, out-
 standing asset-backed commercial paper
 had declined by $404 billion from a peak of
 $1.2 trillion – a decline of about 34 percent!
    Were there runs on SIVs because they held
 massive amounts of subprime-related paper?         the issue. All general-collateral repos carry
 In August 2007, a few months prior to the          the same interest rate – the GC repo rate, or
 runs, Standard & Poor’s reported that SIV          simply the repo rate. Typically, repos can be
 portfolios “remain well-diversified” and that      rolled over easily and indefinitely, though the
“exposure to residential-mortgage assets and        repo rate may change. Repurchase agree-
 CDOs of ABS average [a modest] 24 percent.”        ments play a key role in financial intermedia-
And of the 24 percent, only a small fraction        tion by dealer banks because the assets they
 was in the subprime category.                      purchase for later resale are generally fi-
    Arguably, the more problematic exposure         nanced by repo.
 was to the liabilities of the companies in the         The repo market is huge: outstanding
 financial sector (about 41 percent), which         repos for primary dealers reporting to the
 was up to its eyeballs in subprime risk. And       New York Fed averaged $7.06 trillion in the
 here, investors could not shine enough light       first quarter of 2008. Extrapolating from


                                                                                  First Quarter 2009   45
     the subprime mess
                                                        playing speed chess – the sensible response
     other sources, total outstanding repos are in      was to refuse to accept any structured-asset
     the neighborhood of $11.5 trillion.                products as collateral.
        But the repo market evaporated in August           Without a functioning repo market, assets
     2007, and the drought lasted for months.           cannot change hands because the intermedi-
     Dealer banks would not accept standard repo        aries cannot do business. And in that envi-
     collateral because they rightly believed that if   ronment, the only way to sell assets is at ex-
     they were forced to seize it there would be no     tremely low prices. But fire sales create a
     market in which to sell it.                        feedback effect, lowering the market value of
                                                        similar assets used as collateral and making it
                                                        that much less likely that transactions in
                                                        repos can take place.

                                                              information and complexity
                                                               In the current crisis, information was
                                                                    lost due to the complexity of the
                                                                      chain of mortgages, securitiza-
                                                                      tions, CDOs, SIVs and so on. By
                                                                       “lost” I mean that it became im-
                                                                         possible to penetrate the chain
                                                                         from the front end and thereby
                                                                         estimate value based on the
                                                                         underlying mortgages. Nor
                                                                         was it possible for those at the
                                                                        other end to use their informa-
                                                                   tion to value the chain “upwards.”
                                                            Normally, investors do not see a need to
                                                        ferret out such information. These are debt
                                                        securities, not residual claims on assets like,
                                                        say, common stock. But, in a crisis, debt be-
                                                        comes equity-like because the assets backing
                                                        the value of the debt may well be worthless.
                                                            Before the introduction of the ABX index,
        That begs the question, though: why did         there was no liquid, publicly visible market
     the problem with subprime bonds spill over         where subprime risk was directly priced. Par-
     to this tenuously connected market? One can        ties to individual transactions knew what
     understand that dealers would not want to          they paid, but these prices were not widely
     take subprime RMBS as collateral in repo, but      seen and the parties had no incentive to make
     why not take better-quality asset-backed se-       them public. Moreover, parties wishing to
     curities? Repo traders report that there was       hedge or to short subprime-backed securities
     uncertainty about whether to believe the           had no easy way of doing it. When they did
     credit ratings on these complex products, and      manage it by shorting over the counter (that
     in a fast-paced market – repo trading is like      is, off organized exchanges), there was no


46   The Milken Institute Review
public forum in which the transaction was           efficiency of global capital markets.
transparent.                                           • Conventional financial accounting is not
   But the introduction of the ABX proved           up to the task of measuring the worth of
that a little knowledge could kill. The ABX         firms in a world in which value turns on the
started trading in 2006, and started drifting       allocation of risk through derivatives. The
downwards in the second half of that year. In       transparency of risk-management techniques,
2007, all the indexes reflected a distinctly neg-   not disclosure through double-entry book-
ative view of the subprime market. This nega-       keeping, is increasingly the key to financial
tive view became known, and it became               transparency.
known that everyone else knew it, too. But –           • Forcing financial intermediaries to bear
critically – the ABX didn’t offer a clue as to      less risk – for example, by raising bank capital
who bore the subprime risk, so everyone re-         requirements – is not an answer in itself be-
mained suspect.                                     cause those who wish to bear risk will seek fi-
                                                    nancing in less-regulated environments.
the crisis in perspective                              • Wealth that serves well as collateral in or-
It’s far too early to write the definitive analy-   dinary times may not be collateralizable dur-
sis of what went wrong. But the crisis has          ing a crisis. What is collateralizable is very in-
plainly tested some key assumptions of finan-       timately related to information. Thus there is
cial economics and has highlighted some of          no financial wealth that can serve as collateral
the contradictions in public policy toward fi-      in every conceivable state of the markets.
nancial markets. A few tentative thoughts:
    • The sorts of hybrid mortgages that domi-      what does the future hold?
nated the subprime market could only meet           How will this all end? Very painfully. Until
the expectations of everyone in the lending         the crisis spread beyond the mortgage market,
chain if housing prices rose ceaselessly, and       there was a straightforward way to recall
were thus not viable in the long run. But pol-      the metaphoric contaminated beef: Refinance
icymakers should bear in mind that they ini-        subprime mortgages,
tially welcomed these mortgages, and for a          allowing people to stay
good reason: subprime lending made it pos-          in their homes. For
sible for millions of lower-middle-income           example, Washington
households to buy houses without direct gov-        could have explicitly
ernment subsidies. Hence, there is a price to       guaranteed bonds used
be paid in simply turning back the clock to an      by Fannie Mae and
era of higher underwriting standards.               Freddie Mac to refinance subprime mortgages
    • The crisis illustrates the extent to which    at the initial teaser rates, with the losses – the
the real action in financial intermediation has     difference between the current market fixed
spread beyond the traditional banking system.       rate and the original teaser rate – being ab-
The spectacularly bad end to the housing            sorbed by the Treasury. This would, of course,
bubble should not obscure the reality that the      have been very costly, but probably not as
innovations that made this possible – the           costly as the cascade of bailouts that have
parsing of risk through the securitization of       since been necessary to contain the subprime
assets and the creation of credit derivatives –     crisis. And surely not as costly as the global re-
also have enormous potential to increase the        cession we are currently experiencing.          m




                                                                                   First Quarter 2009    47

				
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posted:5/5/2012
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