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Interbanking Conference in Almaty, Kazakhstan Subprime Loans: How to improve Transparency September 24 , 2008 Toshihiko Sasaki Japan Securities Dealers Association 1 1.Matters in Question Structure of Subprime Mortgage Loans fees H ousing loan lenders housing loan finance com panies,com m ercialbanks, ( etc.) lending H ousing loan brokers (interm ediaries) H ousing loan borrow ers ・sales ・credit evaluation ・required docum entation G SEs transfer of housing loans (conform ing loans) Investors (investing in m ortgage-backed securities w ith high securities credit rating) (Fannie M ae, Freddie M ac) Short-term funding through A B C P rating C redit R ating A gencies rating rating transfer of housing loans (non-confirm ing loans<subprim e loans,etc.>) RMBS,CDO (w ith high credit rating) Investm ent B anks (SPC) RMBS,CDO (w ith low credit rating) B anks provide back-up lines for A B C P Investors (investing in securities w ith low credit rating) Short-term funding through repo transactions 2 Matters in Question US Economy and Financial Market before Subprime Crisis ・Continued booming economy ・Prolonged loose monetary policy ・Ample liquidity ・Rise in housing prices ・Reduction in credit and liquidity risk premiums 3 Matters in Question Investors ・ preferred high-risk-high-return investing under the aforementioned economic and financial circumstances ←invested in high-yield subprime products (particularly secondary securitized products) aggressively taking interest-rate, liquidity and credit risks ・ meanwhile, lacked awareness and management of risks (credit and liquidity risks) ←lacked firm-wide risk management, sometimes without top management’s involvement ←overlooked risks that should be recognized and managed, e.g. liquidity risk arising from off-balancesheet vehicles ←followed conventional risk management practices and lacked awareness of their limitations ←used risk models that did not properly perceive risks of underlying assets of securitized products ・ made investment relying excessively on credit rating 4 Matters in Question Housing Loan Lenders ・ made loans under substantially relaxed lending criteria ← failed to conduct due examination of loans in the originate-to-distribute process ・ after securitization, provided insufficient disclosure on performance of housing loans which were underlying assets of securitized products Government Authorities ・ kept regulations to protect the privacy of borrowers and may have eventually hindered adequate information disclosure ←Loan-by-loan information has not been disclosed to all market participants 5 Matters in Question Credit Rating Agencies ・ failed to duly investigate rating methods and accuracy of information ・ did not exercise due diligence to credit capability of housing loan borrowers ・ failed to make reviews periodically by independent groups from those originally made ratings ・ had organizational structure apt to cause conflict of interests (acquisition of customers vs. accuracy of ratings) Originators ・ did “rating shopping” where they selected rating agencies to get higher ratings they wanted ・ purchased housing loans without due diligence based on the subsequent sales just after securitization 6 2. US and European Initiatives to Redress the Issues Enhanced risk management ・ CEO and top management should be wholly responsible for risk management. In particular, CRO has a critical role. ・ When taking risks, all kinds of risks including off-balance-sheet vehicles should be managed. ・ Risk management methods should be revised flexibly depending on the amount of risks taken and on changes in external economic environment. ・ Limitations of risk management models and logics like VAR model should be recognized. ・ For securitized products, risk management models that directly measure underlying assets’ risks and sensitivity to market should be employed. ・ Methods for stress test should be improved by expanding its coverage of risks including liquidity risks. 7 US and European Initiatives to Redress the Issues Restoration of Confidence in CRAs ・ CRAs should constantly make internal reviewing of their ratings done by an independent monitoring department. ・ CRAs should build systems for external review of the afore-mentioned internal monitoring. ・ CRAs should distinguish ratings of securitized products from those of corporate bonds. ・ To prevent “rating shopping”, issuers should provide enough disclosure so that third parties can make alternative analysis. 8 US and European Initiatives to Redress the Issues A. Improvement in Transparency ・ “Too much ” information means “too little” .Proper transparency of information matching the needs of each market player is imperative. ←For investors to easily understand schemes of securitized products, well-focused and comprehensive summary of prospectus should be provided. ・ Key countries should take concerted approach for better transparency and disclosure principles for securitized products. ・ A common platform that provides database of securitized products would improve transparency. ・ As well as private sector’s efforts, support from regulatory and accounting fields (i.e. ensuring consistency between both fields) is essential. 9 US and European Initiatives to Redress the Issues B. Improvement in Transparency ・ Investors should expand and enhance disclosure on securitized products that they hold. ・ Investors should provide sufficient disclosure both in quality and in quantity as for valuation process for securitized products. ・ Investors should provide proper disclosure on liquidity risk management and potential obligations for funding guarantee for off-balance-sheet vehicles. 10 3.Recent US Financial Market and Economy Stock Price → Witnessed a small pick up after the Treasury’s announcement of rescue measures for GSEs on Sep. 7 but traced downward path with Lehman’s bankruptcy (US$) 14,500 (Dow Jones Industrial Average) 14,000 13,500 Lehman Brothers Holdings Inc. announced that it intends to file a petition under Chapter 11 of the U.S.Bankruptcy Code ( 15 Sep.) 13,000 12,500 GSEs Rescue Announcement (7 Sep.) 12,000 11,500 11,000 10,500 08/ 07/ 3- 3- 3- 3- 3- 3- 3- 3- 3- 3- 3- 3- 3- 3- 3- 3- 3- 3- 3- 3- 3Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep 11Aug 14Aug 17Aug 20Aug 23Aug 26Aug 29Aug 1Sep 4Sep 7Sep 10Sep 13Sep 16Sep 11 Recent US Financial Market and Economy Corporate Bonds’ Spread → Still continues to widen (bp) (Spread between corporate and government bonds) 360 BBB Rated 320 A Rated 280 AA Rated 240 AAA Rated 200 160 120 80 40 3- 06/Jan 3Mar 3May (source) Morgan Stanley 3Jul 3Sep 33Nov 07/Jan 3Mar 3May 3Jul 3Sep 33Jan Nov 08/ 3Mar 3May 3Jul 3Sep 12 Recent US Financial Market and Economy Real GDP → During 2Q in 2008, recorded 3.3% annual growth compared with the previous period, but its main driving force was external demands. Meanwhile, the trend of domestic demands keeps weaker. Annual rate compared to previous period (%) CY Private consumption Inventory Investment Residential Investment Net export Capital investment Government Expenditure Real GDP 13 Recent US Financial Market and Economy Private Consumption → Already consumed tax reduction effect, private consumption could be much weaker, due to sharp increase in energy prices and jobless rates combined with negative-wealth effects triggered by sharp falls of real estate prices and stock prices. (Breakdown of Private Consumption) (Saving Ratio of Household sector) Real change, annual rate compared to previous period, contributing rate (%) CY CY Durable goods Nondurable goods Services All goods and services /2Q 14 Recent US Financial Market and Economy Employment → Continues to show decrease in number of employees and increase in unemployment rate US: Number of employees and unemployment rate (10 thousand) Number of employees ( right scale) Unemployment rate (left scale) CY 15 Recent US Finance Market and Economy Residential Investment →Facing sharp reduction and keeps falling (Residential Investment) (New Privately-owned Housing Units Started) Real base, annual rate compared to previous period, contributing rate (%) 10 thousand units Housing Units Started (left scale) Average fixed interest rate of 30 year mortgage /2Q CY single family houses collective housing others residential investment CY 16 Recent US Financial Market and Economy Future Prospects -key items A. When would the private consumption hit the bottom? B. When would the sharp construction of liquidity in the financial markets get loose? C. When would the stock prices hit the bottom? ⇒ Vicious circle between weaker real economy and dry-up of liquidity in the U.S. should be avoided at any cost. At the same time, a balance between “bail-out” and ”moral hazard” should be perused. 17 4.Japan’s Situation Subprime-related Losses in Japanese Financial Institutions →Very limited compared with their business capacity and periodic income. ( S ubprim e-related losses of Japanese deposit-taking institutions) billion U S $ S ubprim e-related realized S ubprim e-related T ier1C apital O perating valuation profits/losses(-) ( end-M arch, P rofits( endprofits/losses(-) (totalfrom 2008) M arch,2008) ( end-June,2008) A pr.2007 to Jun.2008) 475 57 -1 -7 (source) FinancialS ervices A gency →Japanese financial institutions have limited exposure to subprime-related products. →Most securities firms’ subprime-related business is also a small portion. ( Exposures of Japanese deposit-taking institutions to subprim e-related products) billion U S $ P roducts w hose underlying assets w ere originated abroad B ook value 223 ( source)FinancialS ervice A gency 134 S ubprim e-related products 9 18 Japan’s Situation A. Responses in Japan Japanese financial sector hold bonds issued by Fannie Mae and Freddie Mac amounting 142 billion US dollars, second largest figures in Asia next to China. In addition, losses triggered by the bankruptcy of Lehman Brothers should be handled. Assuming all the negative elements are taken into account so far, our efforts have focused on establishing preventive methods to avoid the same problem to occur in the future. Recent Issuance of Securitized Products (\ trillion) Japan (Billion US$) 12 United States 1400 July-Dec. Jan.-June 10 8 Aug.-Dec. Jan.-July 1200 1000 800 6 600 4 ▲31.9% 400 2 200 0 0 2006 2007 2008 (source) Survey by Securitized Product Research Dept. of Deutsche Securities ▲78.2% 2006 2007 2008 (source) Debt Capital Markets Review, Thompson Reuters 19 Japan’s Situation B. Preventive measures in Japan “Risk Management” ・ Japanese authorities are taking steps to strengthen risk management of investors. ・ Market-related bodies at the same time, started working to strengthen risk management on their part. “Avoidance of Moral Hazard” ・ In Japan, the lenders of housing loans, such as banks and others, rarely sell the assets because the conditions are relatively good enough for most banks. As a result, there are relatively few loans extended to later securitization. ・ Overall loan screening is carried out more prudently because of Japan’s experience suffered by NPLs in the last decade. Inspections by authorities have also been strengthened. “Restoration of Confidence in CRAs” ・ Authorities and rating agencies are planning to take actions based on the discussions in international bodies, such as the FSF and IOSCO. ・ Investors are also reinforcing their risk management and revising their excessive dependence on ratings. 20 Japan’s Situation “Accounting Valuation”←Enhancing Transparency ・ Actions will be taken based on the discussions in international bodies such as the FSF and IOSCO “Traceability of Underlying Assets”←Enhancing Transparency ・ Authorities made a revision of the supervision guidelines for Financial Instrument Businesses Operators requiring distributors to establish procedures that ensure traceability of underlying assets of securitized products for investors. The JSDA set up a Working Group on Distributions of Securitized Products to formulate self-regulatory rules. 21 Japan’s Situation Initiative by JSDA 〇 In its interim report announced July 24 of this year, JSDA’s Working Group on Distributions of Securitized Products indicated the intention to formulate self-regulatory rules. ( Towards formulation of self-regulatory rules) A. A Unified Information Disclosure Format will be created to indicate the detailed contents of information provision. → see Appendix 2 B. Distributors will have to properly provide information on the details and risks of the underlying assets in securitized products to investors taking fully into account the instructions described in the supervision guidelines (The use of the Unified Information Disclosure Format will be decided depending on individual transactions.). 〇 Following further detailed analysis in terms of practicality based on the above, JSDA is planning to compete formulation of the self-regulatory rules by February next year. 22 (Appendix 1) US Government and Financial Authorities’ Responses Urgent measures (to avert negative impacts between financial markets and the real economy) A. Policy rate reduction and liquidity supply → From August 2007 to April 2008, FRB cut the Federal Funds (FF) Target Rate and official discount rate several times (FF Target Rate: 5.25%→2.00%, official discount rate:6.25% →2.25%) → In July 2007, FRB supplied huge amounts of funds and, in December, started the Term Auction Facility (TAF) Program which allows to collateralize a wide range of assets including RMBS. → In March 2008, FRB extended lending to Bear Stearns (BS) facing difficulty in its management through JP Morgan Chase, who eventually acquired BS. → In December 2007, five central banks in the US and Europe announced measures to ease pressure toward rising interest rates in short money markets. In March 2008, their second collaborative approach was carried out. → Major Central Banks declared to provide ample liquidity to financial markets triggered by the bankruptcy of Lehman Brothers (18,Sep). B. Announcement of relief measures for GSEs → On September 7, the US Treasury Secretary Paulson announced that, in order to bail out the two ailing GSEs (Fannie Mae and Freddie Mac), the government would put them under its government control in the meantime and inject public money amounting to 2 bil. dollars (approx. 220 bil. yen) . C. Rescue of AIG by US Government (16,Sep) 23 US Government and Financial Authorities’ Responses Protection of Housing Loan Borrowers ・Measures to avoid foreclosure → In August 2007, President Bush announced countermeasures to subprime housing loan problem including review of the Federal Housing Loan Insurance, budgetary support to avoid foreclosure, etc.). → The Bush administration expressed its support to “Hope Now” Plan, the framework initiated by the American Securitization Forum (ASF) to bail out subprime loan borrowers. 24 (Appendix 2) Item s on the C om m on Inform ation Item List( For RMBSs) Ⅰ.Inform ation on S pecialFeatures of P roduct and O utline of Issue I-1 P roduct nam e I-2 P roduct type I-3 M ain applicable law s I-4 Issuance total,ussance am ount of each tranche I-5 A rrangers,underw riters and distributors I-6 Issue date I-7 Issue am ount I-8 Interest rate and planned dividend rate I-9 Interest paym ent date I-10 R epaym ent m ethod I-11 Finallegalrepaym ent date I-12 P lanned repaym ent date or schedule I-13 Forecast repaym ent schedule,etc. I-14 R atings Ⅱ.Inform ation on structure and parties involved II-1 B asic schem e II-2 O riginator II-3 S ervicer II-4 Issuer II-5 O ther m ajor parties involved II-6 S chem e-related risk II-7 C redit and liquidity enhancem ents II-8 Location of risk in structure II-9 S tructure of trigger II-10 W aterfall Ⅲ.Inform ation on U nderlying A ssets III-1 O utline of underlying assets III-2 O utline of origin of underlying assets III-3 Eligibility requirem ents III-4 G rouping of underlying asset pools III-5 C ash flow from underlying assets (planned) III-6 W eighted average coupon (W A C ) III-7 W eighted average m aturity (W A M ) III-8 G roup distribution of debts or debtors for assets Ⅳ.P erform ance of core pool,etc.,and asset pools used as com parative reference IV -1 D elinquency rate IV -2 D efault rate IV -3 A dvance repaym ents IV -4 C ollection or loss rate IV -5 O thers IV -6 G rouping of com parison pools Ⅴ.S urveillance follow ing issue V -1 Issue am ount V -2 Interest rate (dividend rate) V -3 R atings V -4 C urrent credit and liquidity enhancem ent V -5 Trigger indicators V -6 O ccurrence or non-occurrence of events V -7 A llocation of paym ents V -8 B alance of subordinated portion Ⅵ.P aym ents on U nderlying A ssets V I-1 B alance of debt involved w ith underlying assets V I-2 W A C V I-3 W A M V I-4 O ther poolgroupings V I-5 G rouping allotm ent of debt or debtors behind underlying assets V I-6 D elinquency am ount and rate V I-7 A m ount of incurred default and rate V I-8 C um ulative default or am ount of incurred loss and rate V I-9 A dvanced repaym ent rate V I-10 C ollection rate or loss rate V I-11 B uyback rate V I-12 O thers 25