Structured Finance and the 2007-2008 Financial Crisis

Table of Content

Abbreviations

List of Figures

Glossary

Introduction and Channeling of the Research

1 Characteristics of Credit Risk Transfer Instruments
1.1 Securitization
1.1.1 Mortgage Backed Securities (MBS)
1.1.2 Asset Backed Commercial Papers (ABCP)
1.1.3 Cash Flow Collateralised Debt Obligations (CDOs)
1.2 Credit Derivatives and Hybrid Products
1.2.1 Single Name CDSs
1.2.2 Synthetic CDOs
1.3 Re-Securitization
1.3.1 ABS CDOs
1.3.2 CDO²

2 The Precursors and Triggers of the Crisis
2.1 Soft Macroeconomic Environment in the United States and the Vulnerability of Banks
2.1.1 The Soft Macroeconomic Environment
2.1.2 The Vulnerability of Banks
2.2 The Augmentation of Subprime Mortgages
2.3 Increased Significance of the “Originate to Distribute” Model
2.4 Surging Default Rates in the Subprime Mortgage Sector

3 THE CHANNELLING OF STRUCTURED FINANCE & THE FINANCIAL CRISIS
3.1 Step I: Reprising of Risk and Credit Market Spillovers (Feb – July 2007)
3.2 Step II: The Liquidity Squeeze (Aug 2007)
3.3 Step III: The Rapid Deleveraging Process (Sep 2007- Dec 2007)
3.4 Step IV: Dysfunctional Credit Markets and Further Deleveraging (Jan - May 2008)

4 The Vital Players
4.1 The Role of Supervision by Regulatory Institutions
4.1.1 Greenspan and his failed motives
4.1.2 The Dispersion of Financial Regulation among Multiple Institutions
4.1.3 The Gloomy Banking System
4.2 The Role of Banks
4.2.1 Unforeseen Consequences of Basel II
4.2.2 The Short Term Horizons of Manager’s Incentive Schemes
4.2.3 Failures Associated with Structured Finance
4.3 The Role of the Rating Agencies
4.3.1 Conflict of Interest between Rating Agencies and Issuers
4.3.2 Absence in Cross-Checking the Origin of the Loans
4.3.3 The Dependency on AAA Credit Ratings
4.3.4 Misleading Risk Interpretations

5 Pro-Cyclicality & The Exacerbation Of The Crunch
5.1 Issues of Capital Adequacy Requirements and Accounting Disclosure
5.1.1 The Basel II Accord and the Curtailment in Lending Activity
5.1.1.1 The Concept of Basel II
5.1.1.2 The Drawbacks Associated with Basel II
5.1.1.3 Pro-cyclicality and Basel II
5.1.2 Fair value accounting and plummeting asset values
5.1.2.1 The Concept of Fair Value Accounting
5.1.2.2 Loopholes, Advances in Accounting Standards and their Consequences
5.1.2.3 Pro-cyclicality and Fair Value Accounting
5.1.2.4 Discussion
5.1.3 Summary
5.2 Case Study: Northern Rock
5.2.1 The Role of Securitization
5.2.2 The Downfall
5.2.3 Pro-cyclicality and Leverage
5.2.4 Summary

6 A post-crisis outlook and policy implications
6.1 Pro-active Monetary Policy
6.2 Fair Value Accounting: Current Value Measurement Method
6.3 An Alternative Approach to the Market Based Basel II Models
6.3.1 Less Reliance on Risk Sensitive Market Based Models
6.3.2 The Imposition of a Liquidity Regulation

Conclusion

Appendix

Bibliography

Methodology:

Words underlined in Italics are defined in the glossary

Illustrative practical examples are represented in blue boxes

Example Boxes:

Example 1: Consolidation of structured investment vehicles

Example 2: Credit ratings and the cash flow waterfall

Example 3: Effects of Minimum capital requirements on credit risk transfer instruments

Example 4: Manipulative techniques associated with fair value accounting

Example 5: Effects of mark to market fair value accounting coupled with Basel II

Abbreviations

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List of Figures

Figure 1: Overview of credit risk transfer instruments (Own illustration based on Jobst, 2003 and Rudolph et.al 2007, p.14)

Figure 2: Structured credit dispersion (IMF)

Figure 3: European and US structured credit issuance (IMF)

Figure 4: Global securitization by collateral (IMF)

Figure 5: Global securitization by currency (ECB & BIS)

Figure 6: Creation of a true sale residential mortgage backed securities (Sarai & van Rixtel, 2008, p.18)

Figure 7: Creation of ABCP by conduits/structured investment vehicles (Sarai & van Rixtel, 2008, p.21)

Figure 8: Composition of the US ABCP market by collateral type: March 2007 (JP Morgan)

Figure 9: US ABCP outstanding amounts (Federal Reserve)

Figure 10: CDO issuance by type (SIFMA)

Figure 11: Single name CDS cash settlement (Sarai & van Rixtel, 2008, p.21)

Figure 12: Single name CDS physical settlement (Sarai & van Rixtel, 2008, p.21)

Figure 13: Single name CDS spreads of US investment banks (DataStream)

Figure 14: Single name CDS spreads of European banks (DataStream)

Figure 15: CDS notional outstanding amounts in $ trillion (ISDA)

Figure 16: Synthetic collateral debt obligation based on an RMBS (Sarai & van Rixtel, 2008, p.37)

Figure 17: Creation of a collateralized debt obligation (CDO) based on “mezzanine” tranches of residential mortgage-backed securities (RMBS) (“Cash flow”, “true” sale CDO)

Figure 18: The relationship between structured CDOs and the subprime crisis (Bank for international settlements)

Figure 19: CDO outstanding volume in July 2007 (IMF)

Figure 20: Risk profile of subprime mortgage loans (UBS)

Figure 21: The channels of structured finance and the financial turmoil (Sarai & van Rixtel, 2008, p.41)

Figure 22: Mortgage debt outstanding in $billions (Financial shock, Mark Zandi p.44)

Figure 23: S&P/Case-Shiller Home Price Index (Standard & Poor’s)

Figure 24: Global stability map 2007-2008 (IMF stability reports 2007-2008)

Figure 25: Rising number of downgrades of mortgage related products (IMF stability reports)

Figure 26: Index spreads from CDS contracts on subprime mortgage bonds (JP morgan chase; Markit; BIS)

Figure 27: Mark to market losses of credit risk transfer instruments (IMF stability reports)

Figure 28: Spreads of mezzanine ABS CDO tranches over LIBOR (BIS)

Figure 29: US commercial papers outstanding in 2007 (Federal Reserve)

Figure 30: Asset backed commercial paper spreads (Federal Reserve Bank of New York; Bloomberg; BIS calculations)

Figure 31: Expected bank losses as of March 2008 (IMF stability reports)

Figure 32: Net income Ambac and MBIA (ECB)

Figure 33: Mark to market losses April 2008 (IMF stability reports)

Figure 34: Difference between 3 month LIBOR and Treasury bill yields (Bloomberg)

Figure 35: Mortgage lending regulators (Mark Zandi, p.146)

Figure 36: The shadow banking system vs. the traditional banking system (Mark Zandi, p. 120)

Figure 37: The capital structure of a mortgage security (Mark Zandi, p.115)

Figure 38: The absence of cross checking the origination of the loans (Own illustration)

Figure 39: ABX price index spreads: Jan 2007- Jan 2009 (Brunnermeier 2008)

Figure 40: The cash flow waterfall (IMF stability report)

Figure 41: Subprime residential MBS downgrades: 2007-2008 (IMF stability reports)

Figure 42: Corporate bond downgrades: 2001 (IMF stability reports)

Figure 43: Comparison of spreads of corporate bonds and MBSs (IMF stability reports)

Figure 44: The relationship of business cycles to overall economic growth (SEMP 2009)

Figure 45: Timeline for implementation of Basel II framework (IMF April 2008, stability report)

Figure 46: Accounting for securities held as financial assets (IMF April 2008, stability report, p.65)

Figure 47: Leading US based financial institutions (IMF April 2008, stability report)

Figure 48: Total assets to leverage of US investment banks 1963-2006 (Shin & Adrian, 2009, p.9)

Figure 49: Write downs of selected financial institutions (IMF April 2008)

Figure 50: Mark to market write downs of structured finance instruments, Apr 2008

Figure 51: Mark to market write downs of structured finance instruments, Oct 2008 (IMF April 2008)

Figure 52: Leverage in a downturn (Shin & Adrian, 2009, p.12)

Figure 53: The structured finance environment exacerbated by pro-cyclicality (own illustration)

Figure 54: A composition of Northern Rock’s liabilities (Northern Rock)

Figure 55: Northern Rock’s retail funding as a proportion of total liabilities (Northern Rock)

Figure 56: Northern Rock’s securitization dispersion (Prospectus Northern rock, 2005)

Figure 57: Composition of liabilities after the run (Northern Rock)

Figure 58: Northern Rock’s leverage (Northern Rock)

Figure 59: Northern Rock vs. Their creditors (Northern Rock case study)

Figure 60: Internal rating based approach (International Monetary Fund, April 2008c)

Figure 61: Granite master issuer series 2005-2 (Prospectus Northern Rock, 2005)

Figure 62: Leverage and total asset growth, asset weighted 1992-2008 (SEC)

Figure 63: Comparison of haircuts (Bloomberg)

Figure 64: Illustration of haircuts (Bloomberg)

Figure 65: Rating Changes in RMBS and Home Equity ABS, by Year (Ashcraft 2008.p 61 based on Moody’s stability report October 27, 2007)

Figure 66: Third quarter bank losses in 2007 (Citigroup)

Glossary

- ABS: Security that represents an interest in non-mortgage financial assets (consumer loans, credit card debt, etc.).

- ABCP: A short-term investment vehicle with a maturity that is typically between 90 and 180 days. The security itself is typically issued by a bank or other financial institution. The notes are backed by physical assets such as trade receivables, and are generally used for short-term financing needs.

- ABS CDO: ABS CDO is a CDO whose portfolio is comprised of ABS (asset backed securities). A CDO is subject to credit risk, because some of the assets in the portfolio might not generate the expected cash flows (when the underlying credits go into default).

- ABX.HE: The Markit ABX.HE index is a synthetic tradable index referencing a basket of 20 subprime mortgage-backed securities.

- Arranger: In a CDO structure, the arranger is the entity (an investment bank or an asset management firm) responsible for placing tranches with investors in return for a fee. In the case of “arbitrage CDO” it may also be the originator of the transaction, or even the entity which actively manages the underlying portfolio.

- Alt A: A classification of mortgages where the risk profile falls between prime and subprime. The borrowers behind these mortgages will typically have clean credit histories, but the mortgage itself will generally have some issues that increase its risk profile. These issues include higher loan-to-value and debt-to-income ratios or inadequate documentation of the borrower's income.

- ARM: A type of mortgage in which the interest rate paid on the outstanding balance varies according to a specific benchmark. The initial interest rate is normally fixed for a period of time after which it is reset periodically, often every month. The interest rate paid by the borrower will be based on a benchmark plus an additional spread, called an ARM margin

- 2/28 hybrid ARM: A type of adjustable-rate mortgage that has a two-year fixed interest rate period after which the interest rate on the mortgage begins to float based on an index plus a margin. The index plus the margin in known as the fully indexed interest rate. Often, a 2/28 ARM is designed as a short-term financing vehicle that provides borrowers with time to repair their credit before they refinance into a mortgage with more favourable terms.

- 3/27 hybrid ARM: A type of adjustable-rate mortgage (ARM) frequently offered to subprime borrowers. These mortgages are designed as short-term financing vehicles that give borrowers time to repair their credit until they are able to refinance into a mortgage with more favourable terms.

- Amortised cost: Amortised cost is the amount at which a financial asset or financial liability is measured at initial recognition, less principal repayments and plus or minus any unamortized original premium or discount.

- Basel I: A set of international banking regulations put forth by the Basel Committee on Bank Supervision, which set out the minimum capital requirements of financial institutions with the goal of minimizing credit risk. Banks that operate internationally are required to maintain a minimum amount (8%) of capital based on a percent of risk-weighted assets.

- Basel II: Capital reserve requirements: A set of banking regulations put forth by the Basel Committee on Bank Supervision, which regulates finance and banking internationally. Basel II attempts to integrate Basel capital standards with national regulations, by setting the minimum capital requirements of financial institutions with the goal of ensuring institution liquidity.

- Case Shiller home price index: A group of indexes that tracks changes in home prices throughout the Untied States. The indexes are based on a constant level of data on properties that have undergone at least two arm's length transactions. Case-Shiller produces indexes representing certain metropolitan statistical areas (MSA) as well as a national index.

- CBO: Type of CDO where the underlying portfolio comprises bonds.

- CDS: A financial contract between two parties in which a protection buyer pays a premium to a protection seller in exchange for protection against the occurrence of a credit event on the reference entity.

- CDO squared: Type of CDO where the underlying portfolio is itself made up of CDO tranches.

- CLO: Type of CDO where the underlying portfolio comprises bank loans.

- CMO: A type of mortgage-backed security that creates separate pools of pass-through rates for different classes of bondholders with varying maturities, called tranches. The repayments from the pool of pass-through securities are used to retire the bonds in the order specified by the bonds' prospectus.

- Commercial papers: An unsecured, short-term debt instrument issued by a corporation, typically for the financing of accounts receivable, inventories and meeting short-term liabilities. Maturities on commercial paper rarely range any longer than 270 days. The debt is usually issued at a discount, reflecting prevailing market interest rates.

- CSO: Type of CDO where the underlying portfolio comprises credit derivatives.

- CLN: A security with an embedded credit default swaps allowing the issuer to transfer a specific credit risk to credit investors.

- CDO: A security backed by a pool of bank loans and/or negotiable financial instruments (bonds, other debt securities, etc.), and/or credit derivatives.

- CMBS: A debt obligation that represents claims to the cash flows from pools of mortgage loans on commercial property.

- Conduit: An organization, usually a government agency, that issues municipal securities to raise capital for revenue-generating projects where the funds generated are used by a third party (known as the "conduit borrower") to make payments to investors. The conduit financing is typically backed by either the conduit borrower's credit or funds pledged toward the project by outside investors. If a project fails and the security goes into default, it falls to the conduit borrower's financial obligation, not the conduit issuer.

- Credit enhancement: A method whereby a company attempts to improve its debt or credit worthiness.

- Collateralization: The act where a borrower pledges an asset as recourse to the lender in the event that the borrower defaults on the initial loan. Collateralization of assets gives lenders a sufficient level of reassurance against default risk, which allows loans to be issued to individuals/companies with less than optimal credit history/debt rating.

- De leveraging: A company's attempt to decrease its financial leverage. The best way for a company to de lever is to immediately pay off any existing debt on its balance sheet. If it is unable to do this, the company will be in significant risk of defaulting.

- Derivative Product Company: A special-purpose entity created to be counter-party to financial derivate transactions. A derivative product company will often originate the derivative product to be sold; as well, they may guarantee an existing derivative product or be an intermediary between two other parties in a derivatives transaction

- Discounted cash flows: A valuation method used to estimate the attractiveness of an investment opportunity. Discounted cash flow (DCF) analysis uses future free cash flow projections and discounts them (most often using the weighted average cost of capital) to arrive at a present value, which is used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one

- Equity tranche: In a securitization structure, this tranche absorbs the first losses arising from defaults on the underlying portfolio.

- Hair cuts: The difference between prices at which a market maker can buy and sell a security. The percentage by which an asset's market value is reduced for the purpose of calculating capital requirement, margin and collateral levels.

- Jumbo ARMs: An initial rate on an adjustable-rate mortgage (ARM). This rate will typically be below the going market rate, and is used by lenders to entice borrowers to choose ARMs over traditional mortgages. The teaser rate will be in effect for only a few months, at which point the rate will gradually climb until it reaches the full indexed rate, which will be a static margin rate plus the floating rate index to which the mortgage is tied (usually the LIBOR index).

- Loan to value ratio: A lending risk assessment ratio that financial institutions and others lenders examine before approving a mortgage. Typically, assessments with high LTV ratios are generally seen as higher risk and, therefore, if the mortgage is accepted, the loan will generally cost the borrower more to borrow or he or she will need to purchase mortgage insurance.

- Mark to market fair value accounting: Mark-to-market or fair value accounting refers to the accounting standards of assigning a value to a position held in a financial instrument based on the current fair market price for the instrument or similar instruments.

- Mezzanine tranche: In a securitization structure, this tranche absorbs the losses arising from a default on the underlying portfolio if they exceed the value of the equity tranche.

- Mono-line: An insurer that provides financial guaranty insurance for bond issuance or securitization transactions.

- Originator: The entity setting up a securitization vehicle. Depending on the type of securitization, the originator may be the arranger or the seller.

- Over collateralisation: Situation where the asset pledged for a debt far exceeds the debt principal.

- Prime borrower: A classification of borrowers, rates or holdings in the lending market that are considered to be of high quality. This classification is placed on those borrowers that are deemed to be the most credit-worthy and the prime rate is the rate that a lender will lend to its high quality borrowers.

- Principal-agent relationship: The arrangement that exists when one person or entity (called the agent) acts on behalf of another (called the principal). For example, shareholders of a company (principals) elect management (agents) to act on their behalf, and investors (principals) choose fund managers (agents) to manage their assets. This arrangement works well when the agent is an expert at making the necessary decisions, but doesn't work well when the interests of the principal and agent differ substantially. In general, a contract is used to specify the terms of a principal-agent relationship.

- Pro-cyclicality: A condition of positive correlation between the value of a good, a service or an economic indicator and the overall state of the economy. In other words, the value of the good, service or indicator tends to move in the same direction as the economy, growing when the economy grows and declining when the economy declines.

- Reserve account: In a securitization structure, a reserve account is used to provide credit enhancement. Excess cash flows from the transaction are progressively deposited in this account.

- Repurchase Agreements: A form of short-term borrowing for dealers in government securities. The dealer sells the government securities to investors, usually on an overnight basis, and buys them back the following day.

- Return on equity: The amount of net income returned as a percentage of shareholders equity. Return on equity measures a corporation's profitability by revealing how much profit a company generates with the money shareholders have invested.

- Re-securitization: Re-securitization: The repackaging of securitised or structured products through a CDO into securities once again, such that the securities created at the second stage represent a further securitization of securities initially created as a result of securitization.

- RMBS: A debt obligation that represents claims to the cash flows from pools of mortgage loans on residential property.

- Rolling: The annualized average return for a period ending with the listed year. Rolling returns are useful for examining the behaviour of returns for holding periods similar to those actually experienced by investors.

- Synthetic CDO: A form of collateralized debt obligation (CDO) that invests in credit default swaps (CDSs) or other non-cash assets to gain exposure to a portfolio of fixed income assets. Synthetic CDOs are typically divided into credit tranches based on the level of credit risk assumed. Initial investments into the CDO are made by the lower tranches, while the senior tranches may not have to make an initial investment.

- Senior tranche: In a securitization structure, this tranche absorbs the losses arising from a default on the underlying portfolio if they exceed the amounts of the equity and mezzanine tranches.

- Super senior tranche: In a partially-funded synthetic CDO, this unfunded tranche benefits from the subordination of the senior tranche. Therefore it represents the piece of the deal that offers the best protection against losses.

- Surety wrap: When a guarantor or a sum of money is held as a guarantee for a loan in good faith.

- SPV: In a securitization structure, an SPV is a standalone ad-hoc vehicle with a finite life, which holds the underlying asset portfolio and issues securities representing this portfolio.

- Subprime: A type of loan that is offered at a rate above prime to individuals who do not qualify for prime rate loans. Quite often, subprime borrowers are often turned away from traditional lenders because of their low credit ratings or other factors that suggest that they have a reasonable chance of defaulting on the debt repayment.

- Tranching: A piece, portion or slice of a deal or structured financing. This portion is one of several related securities that are offered at the same time but have different risks, rewards and/or maturities. "Tranche" is the French word for "slice". A piece, portion or slice of a deal or structured financing. This portion is one of several related securities that are offered at the same time but have different risks, rewards and/or maturities. "Tranche" is the French word for "slice".

- Teaser rate: An initial rate on an adjustable-rate mortgage (ARM). This rate will typically be below the going market rate, and is used by lenders to entice borrowers to choose ARMs over traditional mortgages. The teaser rate will be in effect for only a few months, at which point the rate will gradually climb until it reaches the full indexed rate, which will be a static margin rate plus the floating rate index to which the mortgage is tied (usually the LIBOR index).

- Underwriting: The word "underwriter" is said to have come from the practice of having each risk-taker write his or her name under the total amount of risk that he or she was willing to accept at a specified premium. In a way, this is still true today, as new issues are usually brought to market by an underwriting syndicate in which each firm takes the responsibility (and risk) of selling its specific allotment.

- Waterfall: A type of payment scheme in which higher-tiered creditors receive interest and principal payments, while the lower-tiered creditors receive only interest payments. When the higher tiered creditors have received all interest and principal payments in full, the next tier of creditors begins to receive interest and principal payment.^[1]

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Introduction and Channeling of the Research

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The fundamental motive of this thesis is to locate the main catalysts that caused the 2007/2008 financial crisis, and the rationale of their unique interaction. The three primary avenues used to layout the analysis are the Structured Finance Instruments involved, the parties concerned and the channels that exacerbated the rapidity of the spread that ultimately increased the severity of the crunch.

Chapter One lays an overview of the Structured Finance Instruments prevalent in the financial spectrum, of which the main instruments that, contributed to the triggering and propagation of the financial turmoil are demonstrated and explained.

Chapter Two exemplifies the pre-cursors of the crisis which began in the sub-prime sector of the United States. The vital triggers that caused the bust of the subprime bubble are further illustrated as well.

Chapter Three examines the varying involvement of the contributing instruments to the rapid propagation and displays the connecting link between the Structured Finance Instruments and the very source of the turmoil.

Chapter Four illustrates in depth the involvement of the three vital players (the Rating Agencies, Banks and the Regulatory/Supervisory Institutions) and their effect on the propagation of the crisis.

Chapter Five analyses the two main regulatory catalysts that contributed to the crunch through Pro-cyclicality and will also examine the role and consequences of mark-to-market Fair Value Accounting and Minimum Capital Adequacy Requirements (Basel II Accord).

Chapter Six will present a post crisis status quo with recommendations and remedies for relevant counter-cyclical mechanisms.

1 Characteristics of Credit Risk Transfer Instruments

The markets for credit transfer instruments have encountered surging growth in the past decade and the exponential growth of structured credit products globally has been immense. Until July 2007 the growth of structured credit products in Europe and the US reached $2.6 trillion in 2007, relative in comparison to $ 500 billion in 2000. Moreover the issuance of collateralised debt obligations (CDO) grew from $ 150 billion in 2000 to $1.2 trillion in 2007.^[2] Hence, the credit derivates market has doubled each year since inception.^[3]

Credit default swap (CDS) issues have partaken as the lion’s share of issuances with record breaking volumes of $62 trillion in 2008.^[4] Consequent to the robust issuance of these structured instruments, market participants are given the opportunity to optimise and fine tune their risk return profiles. The investors are compensated with a larger selection of products to stabilise their portfolios and alternatively the originator utilises the instruments to manage their risk positions as a means to free up capital.^[5] However despite the numerous advantages of these products, ever increasing complexities of these structured instruments together with their resistance towards market changes contributed as a driving force to the 2007-2008 liquidity crisis.^[6] The birth of these highly advanced credit risk instruments have enabled entities to exploit new arbitrage opportunities by transferring risky assets from their balance sheets to encompass more flexibly towards managing their risks.^[7] Subsequently the immense density and detailed characteristics of these structural instruments, makes it a challenging task to categorise them.

Structured Finance Instruments can be categorised into four categories: Securitization products, credit derivatives, hybrid products and re-securitization. The securitization process begins with the packaging of debt instruments and individual loans, further enclosed in to securities followed by the enhancement of their credit status or rating which is consequently sold to third party investors.^[8] The second sub-category credit derivatives, exemplifies a contract between two counterparties where a derivative instrument is utilised to transfer the risk. Moreover it is important to note that in a credit derivative the credit risk is separated from the underlying asset. Hybrid instruments possess characteristics of securitization products and credit derivatives. This is the creation of the product that securitises assets where the transfer of the risk occurs by a credit derivative. Finally resulting from the lucrative market for securitization, re-securitization of already existing securities was created. Re-securitization comprises of repackaging an already securitised product through a collateralised debt obligation into further securities (refer to Figure 1).^[9]

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Figure 1: Overview of credit risk transfer instruments (Own illustration based on Jobst, 2003 and Rudolph et.al 2007, p.14)

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Figure 2: Structured credit dispersion (IMF)

In this thesis the author predominantly focuses on the instruments that contributed to the triggering of the 2007-2008 financial crisis (refer to Figure 1 and 2).

Securitization products: Mortgage backed securities (MBS), short term asset backed commercial papers (ABCP) and cash flow collateralized debt obligations (CDO)

Credit derivatives: Credit default swaps (CDS)

Hybrid products: Synthetic collateralized debt obligations (CDO)

Re-securitized products: ABS CDOs and CDO²

1.1 Securitization

“Securitization ” has been seen as one of the most innovative discoveries emerging in financial markets since the 1930’s. The substitution of traditional loan financing by the securitization process has lead to the rapid advancement of technological changes in financial markets. In the 1980’s the tendency of securitization has been ranked as one of the rapid developments that were evident within the past years, together with internationalization, globalization and deregulation.^[10] There were four main reasons for the evolving of securitization processes in the late 1970’s and early 1980’s. The financial situation of the industrial countries and repercussions on American and European banks after the two oil crisis’s in 1973 and 1979/1980. Furthermore the debt crisis prevalent in the third world, the deregulation of state restrictions in the banking sector and the surge in information and communication technology were further contributing booster factors towards the evolvement of securitization in the 1980’s. The definition of securitization in this era underpins the robust growth of the sector “substitution of more efficient capital markets for less efficient, higher cost, financial intermediaries for the funding of debt instruments.”^[11]

Through the evolving of securitization loan originators, funders, securities conduits, credit enhancers, investment bankers and domestic and global investors are displacing the traditional portfolio lenders, local thrifts and banks.^[12] Over one half of all the home loans existing today are securitized, moreover one fifth of all auto loans and one fourth of credit card receivables have been securitized. The process of securitization has only been expanding during the recent years. Different arrangement possibilities of securitization are prevalent. However the basic structure of securitization is mutual, the illiquid assets in the balance sheets of the originator are polled up and passed on to a bankrupt remote entity or a special purpose vehicle (SPV). This payment by the SPV is refinanced by the issuance of asset backed securities. The payments to the investors will be fulfilled through the sale of the pooled assets, this method enables illiquid assets inception in to capital markets and the separation of the risk from the books of the originator.^[13]

The financial turmoil of 2007-2008 was exacerbated by the complex structure of risk transfer instruments; however the origination of the crisis was the subprime mortgage industry. Thus products that were collateralised by mortgages or subprime mortgages were characterised as toxic instruments that fuelled the occurrence of the financial turmoil. The structured credit issuance is depicted in Figure 3 with mortgage backed securities (MBS) dominating issuance followed by collateral debt obligations (CDO) and asset backed securities (ABS).

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Figure 3: European and US structured credit issuance
(IMF)

The importance of securitization by collateral can be visualized in Figure 4. The representation of securitization by collateral exemplifies the increasing predominance of mortgages as an underlying asset, through residential mortgage backed securities (RMBS) and commercial mortgage backed securities (CMBS).

The awaken of the financial crisis begun in the third quarter of 2007 and continued to spread in to 2008, the issuance of structured finance products lost sharp predominance after the third quarter of 2007.The valuation and disclosure shortcomings associated with these products was a contributing factor for the fuelling of the crisis and resulted in the loss in confidence by investors towards structured finance instruments. The diversification of securitization by currency is depicted in Figure 5. The US by far dominated the global issuances; however the global issuances in Europe have experienced a rising streak since 2005. The author in the upcoming section focuses on the main structured finance instruments that contributed to the 2007-2008 financial crisis.^[14]

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Figure 4: Global securitization by collateral (IMF)

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Figure 5: Global securitization by currency (ECB & BIS)

1.1.1 Mortgage Backed Securities (MBS)

Illiquid assets in the balance sheets of the originator are polled up and transferred to a bankrupt remote entity or a special purpose vehicle (SPV). This payment by the SPV is refinanced by the issuance of asset backed securities. The payments to the investors will be fulfilled through the sale of the pooled assets. This method enables illiquid assets inception in to capital markets and to separate the risk from the books of the originator. As the collateral of these assets are mortgages they are defined as mortgage backed securities. These mortgages can be divided into commercial mortgage backed securities (CMBS) or residential mortgage backed securities (RMBS). An illustration of an MBS is visible below in Figure 6 below.

The example below corresponds to a RMBS true sale transaction. The bank or originator lends money to home owners to finance their homes; these loans from a number of borrowers are pooled together and sold to a SPV. The SPV alternatively issued MBS (the underlying are mortgages) to investors to finance the purchase of the pooled assets. The tranching of these assets through the rating agencies is a vital step in the sale of the MBS to the investor. In accordance to the profile of the bank that originates the loans, the quality of the SPV that creates the loans and the tranches of the RMBS are determined by the rating agencies.^[15] Furthermore the creditworthiness of the borrower exemplifies the type of mortgage that the borrower owns^[16] (prime or subprime). Finally, the SPV can reduce financing costs and elevate the rating of the assets issued (RMBS) by incurring in credit enhancement techniques such as over collateralization and third party guarantees by a mono-line.^[17]

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Figure 6 : Creation of a true sale residential mortgage backed securities (Sarai & van Rixtel, 2008, p.18)

1.1.2 Asset Backed Commercial Papers (ABCP)

ABCP is a short term tool used to finance long term senior tranche investments, also known as a “rolling” as they constantly need to be rolled over for existence.^[18] Asset Backed Commercial Papers are collateralised debt instruments issued by SPVs with a maturity consisting of a few days up to two years. Through the marginal fraction of capital an extraordinarily high leverage effect could be realized, given that sufficient liquidity and a steady functioning in the markets is prevalent.^[19]

An illustration of the functioning of an ABCP is interpreted in Figure 7. The originator or the collateral providers sell assets to the SPV for which a rating is required. Next, the conduit financed its purchase of the collateralised assets by the issuance of ABCP. These ABCP are consequently purchased by investors. Credit enhancement is sought to make the ABCP more striking for investors. Losses that could be incurred from the underlying are protected through credit enhancement, a mechanism through over-collateralization (the amount of ABS issued is less than the amount of collateral) or third party guarantees issued by a mono-line. Given that the security issued fails to pay the principal or delays with interest payments, the mono-line guarantees this position by issuing surety wraps or protecting the investor’s position through a CDS derivative contract. This contract acts as a lever to the credit quality of the instrument and secures the investor from losses caused by the underlying.^[20] The final step involved in the ABCP illustration is the participation of a bank or a syndicate of a bank who provides liquidity support on behalf of the SPV. In other words when the conduit finds it difficult to locate investors to roll over the issuing process the syndicate of a bank intervenes with liquidity support. Resulting from the short maturities inherent with ABCP, this guarantee is crucial.^[21]

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Figure 7 : Creation of ABCP by conduits/structured investment vehicles (Sarai & van Rixtel, 2008, p.21)

ABCP markets experienced rapid spill-over effects from the financial turmoil in August 2007; Investors were doubtful as the exposure to mortgage related commercial paper markets was worth $300 billion and the SPV based issuances consisted of one third of this amount (refer: Figure 8).^[22] The assets sold by collateral providers or originators to the SPVs contained one quarter of mortgage related assets. As the subprime tensions mounted in August 2007, the off balance sheet conduits were badly struck, subsequent to the drying up of liquidity in money markets and the disability to rollover assets (refer: Figure 9).

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Figure 8 : Composition of the US ABCP market by collateral type: March 2007 (JP Morgan)

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Figure 9: US ABCP outstanding amounts (Federal Reserve)

1.1.3 Cash Flow Collateralised Debt Obligations (CDOs)

CDOs are securities that are founded on packaging types of high risk assets into new securities. The high risk assets include exposures such as mortgages, asset backed securities and other risky loans. CDOs are subordinated similarly to asset backed securities; the liabilities are separated into tranches consisting of different credit quality. However, it is important to note that ABSs are based on large pools of homogeneous assets, whereas as CDOs are based on a few pools, with rather diverse assets. Thus the assessment of risk among CDOs is relatively complex.

The classification of a CDO, takes numerous forms when the underlying debt obligations are owned by the SPV; the deal is classified as a true sale or a cash flow CDO. As illustrated in Figure 10 cash flow CDOs dominate the global issuance volumes.^[23] If the underlying portfolio consists of loans, the exposure is identified as a collateralised loan obligation (CLO) and alternatively a collateralised bond obligation, given the underlying assets are bonds.^[24]

The motives of the CDO transactions differ. Two types of motives are evident, balance sheet CDOs and the arbitrage CDOs. The arbitrage CDO enables the originator to benefit from the difference in the spreads between the yields of the portfolio and the issuance of the tranches. Alternatively, balance sheet CDOs enable the originator to transfer credit risks from their balance sheets to an SPV or an off balance sheet entity.^[25]

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Figure 10: CDO issuance by type (SIFMA)

1.2 Credit Derivatives and Hybrid Products

The phenomenon of lending against financial assets has been a traditional form of investment. Nevertheless, the concept of trading derivatives based on their credit quality has been a growing modern trend in financial markets. Amidst the teething problems (during inception) this specific market has been facing, the transformation to a multibillion dollar market within a short time frame has been perceived as a phenomenal transfer. The following section gives a detailed analysis of credit derivatives (single name CDS) and hybrid products (synthetic CDO).

Hybrid instruments such as synthetic CDOs (which enclose an embedded option) played a very apparent role in the proliferation of the crisis. However, single name CDSs and index CDSs contributed in an indirect manner as a monitoring tool, in assessing the expansion and the profundity of the turmoil.^[26]

1.2.1 Single Name CDSs

A credit derivative is a private contract where a market participant purchases or sells a risk protection over the counter (OTC) to hedge against the credit risk associated with the reference obligation or entity. Credit default swaps (CDS), total return swaps and credit spread options can be classified as credit derivative instruments. CDSs (single name) will be the main focus of the following section.^[27]

A single name Credit Default Swap (CDS) is an arrangement between two counterparts.^[28] The seller of the protection does not make an upfront payment and thus is characterised as an unfunded transaction. The protection payment is made at the termination of the contract when a credit event occurs. If a credit occurrence doesn’t take place, the protection payment is not paid at all. The protection buyer makes regular payments (quarterly) to the protection seller in return for a promise of a protection payment, given the third party also known as the reference unit, defaults paying back the debt. In a default occurrence the protection buyer makes an arrears payment of the final premium to the protection seller, in return the protection seller pays the nominal value of the asset minus the value of its residual market value (refer: Figure 11). Conversely, in a physical settlement the payment structure varies from the cash settlement structure. In a case of default, the protection seller pays the nominal amount of the bond. The protection buyer subsequently physically delivers the reference obligation to the protection seller (refer: Figure 12).

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Figure 11: Single name CDS cash settlement (Sarai & van Rixtel, 2008, p.21)

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Figure 12: Single name CDS physical settlement (Sarai & van Rixtel, 2008, p.21)

The CDS markets became very popular since the credit risks rapidly surged after the turn of the millennium. Banks believed that through CDSs the credit risk could be dispersed globally. CDSs possess similar characteristics to insurance policies; you pay into a scheme to hedge against the risk of default. However, neither of the two counterparties is committed to show collateral and thus CDSs have become speculative instruments.^[29] Furthermore, the flexibility embedded in CDOs and credit linked note (CLN) has resulted in the evolving of structured products such as synthetic collateral debt obligations and other hybrid products.

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Figure 13: Single name CDS spreads of US investment banks (DataStream)

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Figure 14: Single name CDS spreads of European banks (DataStream)

The market functions of CDSs reveal that the outstanding amount of credit derivatives have been surging since the inception of CDSs, reaching its peak during the second quarter of 2007 with $62 trillion notional outstanding amounts, as illustrated in Figure 15. The spread of CDS has been the crucial determinant that assisted the assessment of risk profiles and reliability of financial institutions. Facts have proven that significant information for banks to assess counterparty risk, credit risk and liquidity risk can be pre- determined with the data on the CDS spreads. Thus, CDS spreads and indices facilitate as a monitoring tool during the financial crisis. Furthermore, the default probability of banks can be assessed using advanced econometric tools, with relevant data provided from CDS spreads. Figure 13 and Figure 14 above illustrate data from leading American and European investment banks. In both graphs it can be affirmed that the pinnacle of the crisis occurred during March and April in 2008. Furthermore, surging spreads specifically illustrate the financial institutions that were most affected by the crisis: Lehman Brothers, Merrill Lynch and UBS.^[30]

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Figure 15: CDS notional outstanding amounts in $ trillion (ISDA)

1.2.2 Synthetic CDOs

The synthetic CDO is similar to the cash flow CDO structure; however the SPV does not purchase the portfolio of underlying debt instruments, rather sells credit default swaps (CDS) over the underlying debt instruments of a cash flow CDO. The credit risk exposure that the SPV acquires relative to the underlying debt is exact to the cash flow CDO; however, the SPV does not own the asset. The credit risk is transferred to the investors.

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Figure 16: Synthetic collateral debt obligation based on an RMBS (Sarai & van Rixtel, 2008, p.37)

The originator of the securitization deal has intentions to transfer the credit risk inherent within the transaction rather than the physical assets. Refer to the example in Figure 16, the assets the originator intends to sell are mezzanine tranche RMBS. The protection is purchased through the SPV in the form of CDSs. The originator buys the CDS protection and the SPV receives a premium for the transfer of the credit risk. The SPV issues CDO tranches and sells the CDOs to investors. From the proceeds the SPV receives through the investors, the SPV further purchases low risk senior debt. Given an occurrence of a credit event, the low risk senior debt is sold to pay off the originator, the owing protection amount. The remains from the sale of senior debt is then paid off to the investors of the CDO tranches in order of their seniority relative to the cash that is left over after paying the credit protection back to the originator.^[31]

1.3 Re-Securitization

Structured CDOs also referred to as “double layered securitization” or “re-securitization” categorised through ABS CDOs and CDO² exposures were very popular traits among financial markets during the subprime crisis.^[32] The upcoming section illustrates the functioning of these re-securitised assets and further illustrates the reasoning behind their roaring success.

1.3.1 ABS CDOs

ABS CDOs involve the securitization of structured products, derived from already existing securitization structures. Mortgage loans, consumer and credit card loans may be considered as the structured products used for these exposures.^[33] The securitization process is based on an underlying that was securitised before (refer to: Figure 17 & Figure 20).^[34]

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Figure 17: Creation of a collateralized debt obligation (CDO) based on “mezzanine” tranches of residential mortgage-backed securities (RMBS) (“Cash flow”, “true” sale CDO)

(Bank for international settlements)

The vulnerability of structured products during the subprime crisis is illustrated in Figure 18 50% of CDOs grounded on high grade ABSs were collateralised by RMBSs.^[35] Moreover, 77% of the CDOs were based on lower mezzanine ABSs interpreting the rapid vulnerability inherent within these products. The overall outstanding volume of CDOs in 2007 comprised of over 60% re-securitised exposures (ABS CDOs and CDO²) illustrated in Figure 19.^[36] As the subprime turmoil struck CDOs based on tranches of MBSs that encompassed subprime exposure were adversely affected. ABS CDOs have been evident as the most affected asset classes during the financial crisis, recording $290 billion worth of write downs, from the $ 400 billion outstanding issuing, reported in October 2008.^[37]

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Figure 18: The relationship between structured CDOs and the subprime crisis (Bank for international settlements)

[...]

^[1] Definitions have been derived from the Investopedia dictionary

^[2] (IMF, 2008b, p.56)

^[3] (Nowel, 2008, p.8)

^[4] (ISDA, 2008)

^[5] (Basel Committee Banking Supervision, 2008)

^[6] (Weber, 2008)

^[7] (Kiff & Michaud, 2003)

^[8] (Fabozzi, 1998)

^[9] (Kothari, Vinod, 2009)

^[10] (Gehrig. B, 1987, p.79)

^[11] (Michael, 2000, p.1)

^[12] (Michael, 2000, p.1)

^[13] (Bär, 1997, p.86)

^[14] (Sarai & van Rixtel, 2008, p.23)

^[15] (Elul, 2005)

^[16] (Ashcraft & Schuermann, 2008)

^[17] (Sarai & van Rixtel, 2008, p.23)

^[18] (Fitch, 2001), (Moodys, 2003)

^[19] (Sarai & van Rixtel, 2008, p.20)

^[20] (Sarai & van Rixtel, 2008, p.21)

^[21] (Moodys, 2008)

^[22] (BIS, 2007a)

^[23] (Cousseran & Rahmouni, 2005, p.45)

^[24] (Jobst, 2003, p.7)

^[25] (Cousseran & Rahmouni, 2005, p.46)

^[26] (ECB, 2008)

^[27] (Sarai & van Rixtel, 2008)

^[28] (Choudhry, 2004, p.14)

^[29] (Choudhry, 2004, p.15)

^[30] (Sarai & van Rixtel, 2008, p.33)

^[31] (Sarai & van Rixtel, 2008, p.37)

^[32] (BIS, 2008b, p.5)

^[33] (Cousseran & Rahmouni, 2005, p.51)

^[34] (BIS, 2008b)

^[35] (Zandi, 2008 ,p.119)

^[36] (Hamerle & Plank, 2008)

^[37] (IMF, 2008a)