The Credit Crisis


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Essay on the causes of the 2008-09 credit crisis (Winter 2009)

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The Credit Crisis

  1. 1. ∑€βπμ£$¥¢ΫλξδαΣΦΘЏ∏℮∫∞≈ΫΨ∑ ℮∫∞≈ΫΨΔ πμ£∑€βπμ£$¥¢ΫλξδαΣΦ ΘЏ ∏℮∫∞ ≈ΫΨΔ∑€βπμ£ $¥¢Ϋλ ξδ£ $¥¢ΫλξδαΣΦΘЏ∏℮∫∞≈ΫΨ∑€βπμ£$¥ The Credit Crisis Applied Investment Management ¢ΫλξδαΣΦΘЏ∏℮∫∞≈ΫΨΔ πμ£∑ €βπ 1/12/2009 μ£$¥¢Ϋλξδ αΣΦΘЏ∏℮∫∞ ∑€βπμ£ $¥ Ryan D. Lazzeri ¢ΫλξδαΣΦΘЏ∏℮∫∞≈ΫΨ∑ ℮∫∞≈ ΫΨ Δ πμ£ ∑€βπμ£$¥¢Ϋλξδ αΣΦΘЏ∏℮∫∞ ≈ΫΨΔ∑€βπμ£¥¢Ϋλξδ£$¥¢ΫλξδαΣΦΘ Џ∏℮∫∞≈ΫΨ∑€βπμ£$¥¢ΫλξδαΣΦΘЏ ∏℮∫∞≈ΫΨΔ πμ£∑€βπμ£$¥¢Ϋλξδ αΣ ΦΘЏ∏℮∫∞∑€βπμ £$¥¢Ϋλξδα ΣΦΘЏ ∏℮∫∞≈ΫΨ∑℮∫∞≈ΫΨΔ πμ£∑€ βπμ£ $¥¢Ϋλξδ αΣΦΘЏ∏℮∫∞≈ ΫΨΔ∑€βπμ £$¥¢Ϋλξδ£$¥¢ΫλξδαΣΦΘЏ∏℮∫∞≈ΫΨ ∑€βπμ£$¥¢ΫλξδαΣΦΘЏ∏℮∫∞≈ΫΨ∑ ℮∫∞≈ΫΨΔ πμ£∑€βπμ£$¥¢ΫλξδαΣΦ ΘЏ ∏℮∫∞ ≈ΫΨΔ∑€βπμ£ $¥¢Ϋλ ξδ£
  2. 2. Fixed income investing and particularly mortgage investing has taken on a decidedly different look has in recent years. To be sure, the risks associated with investing in coupon-bearing investment securities have not changed. Funding markets, however, have enabled creative financial engineers and agile investors to change the nature of these risks by changing exposures to them and realigning interests. Gary Gorton, John Kiff, and Paul Mills explore these innovations by examining the genesis, evolution, and collapse of the subprime mortgage market. The collapse, government response, and alternative remedies are outlined in the writings of Lucian Bebchuk, University of Chicago finance faculty, and Campbell Harvey. I will summarize the markets and investment securities that are believed to have caused our current financial crisis, and conclude with experts’ remediation proposals. Since 2007, global financial markets have suffered near-cataclysmic damage, partially as a result of irrational exuberance in residential real estate and associated mortgage markets. Kiff and Mills define subprime mortgages as those loans with “a lower expected probability of full repayment”, determined by the borrower’s credit record and FICO score, debt service-to-income ratio, and/or the mortgage loan-to-value ratio. For its part, the government has, through passage of various laws since 1980, encouraged home ownership.1 In later years, financial intermediaries have created convoluted funding channels in a process called securitization, explained below, and conflicts inherent in subprime mortgage products misaligned the interests of borrowers, lenders, service providers, and investors. The design of a subprime mortgage required that borrowers should need to refinance periodically or risk distress, in order to avoid prohibitively high interest rates in the floating-rate period of the loan’s life. Gorton explains that refinancing was not necessarily problematic for the lender or the borrower, as long as home prices appreciated. The lender, however, owned greater exposure to the asset, because if home prices fell2 and the borrower could not refinance (risking default), the lender was still long the (depreciating) asset. (Gorton, 5) Another problem in refinancing: Unless the borrower’s credit had improved prior to refinancing, the subsequent mortgage(s) were likely to be subprime, as well. After origination, mortgages may have been held by the originator or securitized. A financial institution – Citi, for instance – would pay the originator cash in the amount of the present value of the mortgage; in turn, Citi would package that mortgage with others in a mortgage-backed security (MBS). The MBS would then be divided into tranches, each of which gave the investor rights to certain scheduled principal payments and/or prepayments. The theory went that packaging the mortgages would achieve risk dispersion while directing specific risk/return payoffs to investors who with different investment requirements. According to Gorton, “the amounts of credit enhancement for each tranche 1 Federal deregulation of interest rates (1980), legalization of floating-rate mortgages (1982), and tax-deductibility of mortgage interest (1986) went far to “facilitate the development of the modern subprime mortgage market.” (Kiff, Mills) 2 Residential housing prices did indeed fall; See Exhibit A
  3. 3. and the size of each tranche depend on the cash flow coming into the deal in a significant way. The cash flow comes largely from prepayment of the underlying mortgages through refinancing. What happens to the cash coming into the deal depends on triggers which measure (prepayment and default) performance of the underlying pools of subprime mortgages.”3 MBS were largely funded by another engineered vehicle, collateralized debt obligations (CDOs), which Gorton describes as “special purpose vehicles that issue long-dated liabilities in the form of rated tranches in the capital markets and use the proceeds to purchase structured products for assets.” CDOs further divided their portfolios (which included other fixed income products in addition to subprime MBS) into tranches, again prioritizing and allocating cash flows and losses by seniority. Some CDO managers apparently added subprime mortgages to take advantage of rating arbitrage.4 Finally, CDOs were funded by short-term commercial paper, medium-term notes, and money market funds. Valuation of these convoluted and disparate vehicles was (and remains) troublesome, exacerbated by less stringent marking requirements for MBS and CDOs. Each dealer bank would mark these investments using proprietary information and conventions – that is until ABX indices were introduced in 2006. The indices not only improved the transparency of subprime pricing, they allowed investors to express an opinion on the subprime market. Investors’ views were not kind.5 Despite the obvious difficulties in valuing each the underlying mortgages and then MBS and CDOs, dealer banks largely did attempt to do just that. The introduction of the ABX indices, however, caused dealers to abandon matrix valuation and mark these securities at trading prices. As a result, banks were forced to write-downs assets, and some failed altogether, contributing to the current global economic contraction. But where are these assets now? Markets for them are illiquid, so they continue to clog banks’ balance sheets – thereby preventing bank lending due to impaired asset bases. The U.S. government’s Troubled Asset Relief Program (TARP) intends to directly intervene by infusing financial institutions with capital in exchange for “toxic” assets.6 Academics largely agree that government capital infusions should be mandated so as to prevent undue market reaction against firms that would otherwise have voluntarily decided to recapitalize using TARP funds. They also reach unanimity that U.S. taxpayers should be protected at all costs, and that assets should not be purchased at amounts greater than their fundamental values.7 Where experts differ are in the forms of remediation. Because toxic assets are not 3 See Exhibit B for illustration of MBS 4 According to Gorton (14), “the spreads on subprime BBB tranches appeared to be wider than other structured products with the same rating.” 5 Vintage 2006 subprime mortgages dropped by 80% in about 20 months. (See Exhibit C for recent ABX-HE BBB- pricing levels and performance) 6 See Exhibit D for a current summary of TARP funds 7 Proposals intending to mitigate overpaying for assets include avoiding held-to-maturity prices, avoiding paying premium prices for the assets of insolvent banks, allowing private investment managers to bid competitively for rights to manage
  4. 4. only difficult to value but likely to be fundamentally undervalued due to illiquidity, Lucian Bebchuk of Harvard Law School argues that, instead of merely purchasing these assets, they should demand new equity in return, to protect against buying at premium prices. She goes on to argue that asset management mandates should be awarded by competitive bidding, to minimize costs and conflicts. University of Chicago professors Douglas Diamond, et al further the aim of establishing a plan at the lowest public cost. They also concentrate on the current recession and prevention of unintended, long-term effects. The inability of undercapitalized financial institutions to function normally has a contagious effect on the economy; so, one of the Treasury’s goals should be to raise capital through mandated government funding as well as public equity offerings. For banks unable to raise capital easily in public markets, the government may take non-voting equity stakes – co-investment, so-to- speak. Equity stakes offer protection in the event that the government has overpaid for bad assets. Finally, Campbell Harvey of Duke University takes his views from the history of financial crises. Harvey proffers establishment of two separate funds, one to take on the assets of insolvent banks (the Resolution Trust Corporation) and another to remove bad assets from solvent banks (the Bank Capitalization Fund); together, the two funds ultimately intend to restore confidence and lending capabilities. The BCF should receive 2-5% of a bank’s existing stock (mandated, again) while allowing private investors to co-invest in the fund.8 Campbell also ascribes to a time limit on government investments. He also argues for recapitalizing the FDIC quickly and raising most insured limits to prevent further bank runs. Insofar as burdensome mortgages go, Campbell is partial to helping homeowners by resetting principal and allowing prepayments penalty-free. He also pays closer attention to non-financial institutions in distress (e.g. Ford Motor Company) to reduce further spillover. At Morgan Stanley from 2004 to 2008, I had the opportunity to research MBS, CDOs, IO/POs, and ABX. Our senior investors echoed the sentiments that these investments were safe due to subordination and effective hedging; further, they argued, the yield pickup outweighed most risks. I disagreed. The convoluted, engineered, and synthetic nature of these instruments hid risks that were inappropriate for even the most sophisticated investors. After I left the firm in February, losses caused most of MSIM’s fixed income business to be dismantled. These readings reaffirmed my feelings, and I believe that our society at-large will continue to suffer until the last subprime principal payment is made. assets, establishing particular types of auctions to establish trading prices, and obtaining equity stakes in the case that prices paid are too high. 8 This is similar to actions taken by the governments of The Netherlands, Belgium, Luxembourg, and France, as well as BNP Paribas, to divide the assets of Fortis Bank and Fortis Insurance, among others
  5. 5. Exhibit A: U.S. Residential Housing Prices Home Price Indices Performance 1999-2008 240 220 200 OFHEO Index Level 180 (Seasonally Adjusted) Case-Shiller Composite-10 160 Case-Shiller Composite-20 140 120 100 Sources: Standard & Poor’s, Office of Federal Housing Enterprise Oversight
  6. 6. Exhibit B: MBS Structure $I $P Source: Kevin Kendra, Fitch, “Tranche ABX and Basis Risk in Subprime RMBS Structured Portfolios,” February 20, 2007
  7. 7. Exhibit C: Recent Subprime Performance Source:
  8. 8. Exhibit D: Summary of TARP Funds Funds Awarded or Expected Greater than $1 billion Expected Write- Capital Date Company Type Heaqdquarters Investment Funds Awarded downs Raised Oct. 14 Citigroup Bank New York $50,000 Yes $65,700 $74,000 Nov. 14 Philadelphia, Phoenix and Atlanta U.S. cities N.A. $50,000 N.A. N.A. Nov. 10 A.I.G. Insurer New York $40,000 Yes N.A. N.A. Oct. 14 JPMorgan Chase Bank New York $25,000 Yes N.A. N.A. Oct. 14 Wells Fargo Bank San Francisco $25,000 Yes $17,700 $41,800 Oct. 14 Bank of America Bank Charlotte, N.C. $15,000 Yes $27,400 $55,700 Dec. 31 General Motors Automaker Detroit $13,400 Yes, but $4 billion is pending N.A. N.A. Oct. 14 Goldman Sachs Group Bank New York $10,000 Yes $4,900 $20,500 Oct. 14 Merrill Lynch Bank New York $10,000 Yes $55,900 $29,900 Oct. 14 Morgan Stanley Bank New York $10,000 Yes N.A. N.A. Dec. 31 PNC Financial Services Group Bank Pittsburgh $7,579 Yes N.A. N.A. Nov. 03 U.S. Bancorp Bank Minneapolis $6,599 Yes $2,200 $6,600 Dec. 29 GMAC Financial Services Specialty lender New York $5,000 Yes N.A. N.A. Dec. 31 SunTrust Banks Bank Atlanta $4,850 Yes, two allocations N.A. N.A. Jan. 02 Chrysler Automaker Auburn Hills, Mich. $4,000 Yes N.A. N.A. Oct. 27 Capital One Financial Bank McLean, Va. $3,555 Yes N.A. N.A. Oct. 24 Regions Financial Bank Birmingham, Ala. $3,500 Yes N.A. N.A. Dec. 31 Fifth Third Bancorp Bank Cinncinati $3,408 Yes $2,700 $2,600 Nov. 14 Hartford Financial Services Group Insurer Hartford, Conn. $3,400 N.A. N.A. Oct. 27 BB&T Bank Winston-Salem, N.C. $3,134 Yes N.A. N.A. Oct. 14 Bank of New York Mellon Bank New York $3,000 Yes N.A. N.A. Oct. 27 KeyCorp Bank Cleveland $2,500 Yes $1,600 $4,200 Dec. 31 CIT Group Specialty lender New York $2,330 Yes N.A. N.A. Oct. 27 Comerica Bank Dallas $2,250 Yes N.A. N.A. Oct. 14 State Street Bank Boston $2,000 Yes N.A. N.A. Nov. 18 Principal Financial Group Bank Des Moines, Iowa $2,000 N.A. N.A. Nov. 14 Marshall & Ilsley Bank Milwaukee $1,715 Yes $1,500 $1,700 Oct. 27 Northern Trust Bank Chicago $1,576 Yes N.A. N.A. Oct. 28 Zions Bancorporation Bank Salt Lake City $1,400 Yes N.A. N.A. Oct. 27 Huntington Bancshares Bank Columbus, Ohio $1,398 Yes N.A. N.A. Amounts in millions USD Source: New York Times Dealbook, January 7, 2009