Download The Traditional Securitization Process Bank

What Have We Learned from the
Sub Prime Crisis?
Professor Anthony Saunders
John M. Schiff Professor of Finance
New York University
Stern School of Business
May 2008
How did we get here?
• Traditional Banking
– Banks as Delegated Monitors
• Disintermediation
– Securitization
• Traditional SPV-based (special purpose vehicle)
• SIV-based (special investment vehicle)
– Syndication
• Back to the Future
– Off-Balance Sheet Proprietary Investing
– What happens when the delegated monitor
delegates?
2
Getting here: Traditional Banks as
Delegated Monitors
The Traditional Bank – Delegated Monitoring
Bank
Assets Liabilities
Cash Assets
Deposits
Loans
Purchased Funds
Capital
3
Getting Here: Traditional
Securitization
• Securitization allowed banks to remove
risk from their balance sheets
• Securitization allowed banks to avoid
onerous capital requirements
• Securitization turned banks into
underwriters – originate the loans and
then sell them off.
4
The Traditional Securitization Process
Bank
Assets
Cash Assets
Liabilities
Deposits
Loans
Purchased Funds
Loans
Capital
Cash
SPV
Assets
Loans
Liabilities
Asset-Backed Securities
Cash
Investors
5
Getting Here: Asset-Backed Securities (ABS)
and Decline in Quality of Underlying Assets
• Mortgage-Backed Securities (MBS)
– Residential MBS
• Pass-throughs and Collateralized Mortgage Obligations
(CMOs)
• Subprime and No/Low Documentation
– Def. Subprime (2001 Interagency Expanded Guidance):
 ≥Two 30-day delinquencies in last 12 mos. or ≥one 60day delinquency in last 24 mo.; OR
 Judgment, charge-off. foreclosure, repossession in last 24
mos.; OR
 Bankruptcy in last 5 yrs; OR
 FICO score ≤660; OR
 Debt service/income ratio ≥50%
• Second Lien Mortgages (High Loan/Value Ratios)
• Collateralized Debt Obligations (CDOs)
– Cash CDOs and Synthetic CDOs
• Collateralized Loan Obligations (CLOs)
• Covenant Lite and PIK (payment in kind)
6
Source: Bank of England, Financial Stability Report, October 2007, Issue 22, page 6
7
US and European CDO Issuance 2004-2007
60.00
Total Issues of US CDOs
Total Issues of European CDOs
50.00
40.00
30.00
20.00
10.00
8/28/2007
5/28/2007
2/28/2007
11/28/2006
8/28/2006
5/28/2006
2/28/2006
11/28/2005
8/28/2005
5/28/2005
2/28/2005
.
11/28/2004
8/28/2004
5/28/2004
2/28/2004
0.00
Source: Loan Pricing Corporation website
8
Getting Here: Loan Syndication
• Banks as underwriters
– Firm Commitment (Underwritten) deals: The lead bank commits
to making the loan in its entirety and then assembles
participants to reduce its own loan exposure. Thus, the
borrower is guaranteed the full face value of the loan.
– Best Efforts deals: The size of the loan is determined by the
commitments of banks that agree to participate in the
syndication. The borrower is not guaranteed the full face value
of the loan.
– Club deals: For small deals (usually $200 million or less), the
loan is shared among banks, each of which has had a prior
lending relationship with the borrower.
• Leveraged Loan Syndications
– Below investment grade
– Often, they will have debt to cash flow levels in excess of 4:1
(i.e., their outstanding indebtedness (i.e., face value of debt) is
more than four times the borrowing firm’s annual revenues)
– Decline in Quality of Loan Syndications.
9
Syndicated Lending
Borrower
Bank
(Syndicate Lender)
Syndicate
Member
Syndicate
Member
Syndicate
Member
10
S y ndi c a t e d Loa n Vol ume 2 0 0 0 - 2 0 0 7
1800. 00
1600. 00
1400. 00
1200. 00
Lever aged
1000. 00
I nvest ment Gr ade
Ot her
800. 00
T ot al
600. 00
400. 00
200. 00
0. 00
2000
2001
2002
2003
2004
2005
2006
1-3Q07
Source: Loan Pricing Corporation website.
11
Getting Here: SIVs
• Banks as underwriters
– Switching from spreads to fees
– Reduce risk, but reduce return
– Response: A new form of intermediation –
back to the future of SIVs.
– Formula for disaster:
• SIV = Traditional Bank – Regulatory Oversight
• SIVs are exposed to traditional banking risks:
interest rate risk, liquidity risk, credit risk
12
A New Securitization Process
Bank
Assets
Cash Assets
Liabilities
Deposits
Loans
Purchased Funds
Capital
Loans
Cash
SIV
Assets
Loans
Liabilities
Commercial Paper
ABCP
Cash
Investors
13
Getting Here: Proprietary Investing
• Banks establish hedge funds, private
equity funds, venture funds through equity
investing and/or lending.
• Unregulated activities conducted off the
bank’s balance sheet.
14
Anatomy of the Storm and Credit
Risk Models
• Can we have higher return without higher
risk?
– Why did Credit Risk Measurement Models fail?
– Which risks were underestimated?
15
Anatomy of the Storm: The Phases
of the Crisis – Bank of England
16
Phase 1: Anatomy of the Storm: Assumption
of Perpetually Rising US House Prices
• Subprime and “teaser” rate mortgages depend on rising
housing prices to:
– Refinance upon hitting expiration of introductory teaser
rate. But, there is a strong correlation between PD and
level of rates (see, Stiglitz and Weiss)
– Sale of property in the event of borrower’s inability to
make payments. If housing prices increase, Loss Given
Default = 0
– Both PD and LGD exhibit “procyclicality”
– Thus underestimate PD, LGD and ρ (PD, interest rates).
17
Phase II of the Storm: Rising
Spreads on RMBS
• Underestimate ρ (RMBS vs. RMBS
EUR
Source: Bank of England, Financial Stability Report, October 2007, Issue 22, page 7.
18
Phase II: Higher spreads, lower
prices, fewer MBS originations
• Underestimate ρ (AAA, BBB-)
19
Phase III of the Storm: The Crisis
Spreads to Other ABS Markets
• CDO spreads increase
• CDO issuance declines
• Leveraged Loan prices fall
20
CDO Spreads Increase
• Underestimate ρ across debt markets, i.e., ρ (RMBS, CDOs)
Source: Loan Pricing Corporation website.
21
Leveraged Loan Prices Fall
• Underestimate ρ (RMBS, HLT)
Source: Leveraged Loan Index is the CSFB Leveraged Loan Index Plus Average Price, expressed as a percentage of par, Bloomberg Ticker = DLJLPX
22
Phase IV: Risk Flows Back to Banks
– Reintermediation
• SIVs are unable to issue Asset-Backed Commercial Paper
• SIVs access their backup lines of liquidity and take down
•
•
•
•
credit lines
Banks are unable to securitize or syndicate these loans
due to the decreased volume of new deals
Even if they could sell off these unwanted loans, the
prices would be low as spreads increase.
SO: Banks did not really remove the risks from their
balance sheets.
Underestimate correlation between on and off-balance
sheet risk , i.e., ρ (Risk on, Risk off)
23
Phase V: Liquidity Hoarding and
Flight to Quality Creates Mispricings
3 Month LIBOR, 3 Month US T-Bill Rates and Federal Funds Rates
January 2007-October 2007
7.00000
6.00000
5.00000
4.00000
3 Mo. LIBOR
3 mo. T-Bills
Effective Federal Funds Rate
3.00000
2.00000
1.00000
10/2/2007
9/2/2007
8/2/2007
7/2/2007
6/2/2007
5/2/2007
4/2/2007
3/2/2007
2/2/2007
1/2/2007
0.00000
• Underestimate ρ (credit risk, liquidity risk)
Source: St. Louis Federal Reserve Bank database, FRED website.
24
How do we steer out of the storm?
• Better Risk Modeling
– Price of risk was set too low in the mortgage market.
– Quantity of risk was underestimated – the pitfalls of hidden
leverage.
– Improve credit rating models PD and LGD.
– Analyze correlation across markets, risks and countries
• Align Incentives
– What does it tell you when informed lenders treat their loans like
hot potatoes?
• Avoid Regulatory Mispricings
– Basel II implications
25
If capital is required:
• Standardized model risk weights:
• Credit Conversion Factor for Off-Balance Sheet Items:
• 100% unless “eligible liquidity facility” – limited
draw-down privileges unrelated to default – then
50% CCF for maturity > 1 year and 20% CCF for
maturity ≤ 1 year
26
Steering Out: Potential Pitfalls of
the Basel II Securitization
Requirements
• Places heavy reliance on external credit
ratings.
– Standardized model uses credit ratings
– In the hierarchy of IRB approaches, RBA is
preferred – tied to credit ratings
• What happens when the credit ratings are
wrong?
27