Origins of Industry Commentary
←
→
Page content transcription
If your browser does not render page correctly, please read the page content below
Industry Commentary:
Origins of
the Subprime
Collapse
A poorly conceived affordable housing policy and the growth of an unregulated, opaque market
for complex structured assets are among the potential causes of the subprime mortgage
debacle. Richard Christopher Whalen offers his thoughts on the roots of the subprime crisis,
the inefficiencies of proposed solutions and the best ideas for rebuilding market confidence.
espite the considerable media attention given to the subprime mortgages at the start of 2008, arguably can trace
D collapse of the market for complex structured assets
that contain subprime mortgages, there has been
precious little discussion of why this crisis occurred.
Such a discussion, which is the primary goal of this
article, will hopefully lead members of the risk com-
munity to consider how the market for structured assets should
change and evolve in future.
The private market for complex structured assets, partic-
ularly the $1 trillion or so of face amount that contained
its origins to the market for agency debt, particularly paper
issued by government-sponsored entities (GSEs) such as
Fannie Mae and Freddie Mac. The collapse of the subprime
market is attributable to many factors, but three basic issues
seem to be at the root of the problem. First, an odious pub-
lic policy partnership — spawned in Washington and com-
prising hundreds of companies, associations and govern-
ment agencies — to enhance the availability of "affordable
housing” via the use of “creative financing techniques.”
12 GLOBAL ASSOCIATION OF RISK PROFESSIONALS J A N UA RY / F E B R UA RY 0 8 I S S U E 4 0
G L O B A L A S S O C I AT I O N O F R I S K P R O F E S S I O N A L S
C O V E R S TO R Y
Second, active encouragement by federal regulators of the inherent in the explosive growth in unregulated OTC deriva-
rapid growth of over-the-counter (OTC) derivatives and tives and structured assets markets is another matter.4
securities by all types of financial institutions. And third,
the related embrace by the Securities and Exchange A Shadowy Market
Commission (SEC) and the Financial Accounting The second factor that helped foment the subprime debacle,
Standards Board (FASB) of “fair value accounting.” strangely enough, is not the monetary policy followed by the
The partnership for affordable housing was the creation Fed earlier in this decade, but rather bank regulatory policy.
of the real estate, home building and GSEs lobbies, relying During the past two decades, the proliferation of off-
upon legal mandates such as the Community Reinvestment exchange-traded derivatives and the use of off-balance-sheet
Act (“CRA”) to “encourage” the banking industry to tar- entities (à la Enron) have been actively encouraged by the
get increased home ownership in the US. It began after the Congress, the Federal Reserve Board staff in Washington and
real estate collapse of the late 1980s, when the savings and other global regulators. The combination of OTC derivatives,
loans (S&L) industry was almost entirely de-capitalized risk-based capital requirements authorized by Congress in
and real estate prices in many parts of the US saw double- 19915 and favorable accounting rules blessed by the SEC and
digit declines. the FASB enabled Wall Street to create a de facto assembly
The methods used by the partnership to garner political line for purchasing, packaging and selling unregistered securi-
support were, not surprisingly, similar to those employed ties, such as subprime collateralized debt obligations (CDOs),
by GSEs such as Fannie Mae and Freddie Mac on Capitol to a wide variety of institutional investors.
Hill. Support for “affordable housing” became a key part Observers describe the literally thousands of CDOs and
of local and national politics, aided by copious “dona- other types of structured investment vehicles (SIVs) created
tions” from the GSEs to members of Congress, a fact that during the past decade as the “shadow banking system,” but
lenders and real estate developers used to great advantage. few appreciate that this deliberately opaque pseudo market
Banks, for their part, saw the affordable housing push as came into existence and grew with the direct approval and
a way to placate politicians and also to meet visibly CRA active encouragement of Alan Greenspan, the former chair-
requirements for making credit available to minorities. By man of the Federal Reserve, and other senior bank regulators
the early part of the 21st century, nearly every mortgage in the US and EU; moreover, all of this occurred with the
lender in the US incorporated the twin messages of “afford- encouragement and approval of the academic research com-
able housing” and “creative financing” into marketing, munity. Regulators even issued cautionary guidance to help
credit approval and product development efforts. the dealer firms manage the quite apparent operational risks
At a meeting at the Harvard Club this past September,1 from dealing in complex structured assets, but did nothing to
Josh Rosner, a principal of Graham Fisher & Co., noted that stop the financial services industry from creating this huge
the partnership for affordable housing helped push structur- unregulated securities market.6
al changes in the housing industry, which ultimately led to a The true lesson of the subprime crisis has less to do with
significant increase in home ownership in the US between the the use of subprime mortgages as collateral in the SIVs and
early 1990s (63%) and its peak in 2005 (69%).2 much more with how these inferior assets were packaged and
Said Rosner: “We saw changes in the loan-to-value ratios sold outside the bounds of established regulatory controls.
for loan approval, changes from manual underwriting to Interestingly, the growth in the “markets” for OTC asset
automated underwriting, which made the approval models classes and related phenomena represents a reversal of nearly
used easy to game. We saw reductions in documentation a century of regulatory and prudential practices in the US.
requirements, changes for mortgage insurance require- Following the financial market crises of the 19th and early
ments and a general perversion of the appraisal process via 20th centuries, the US Congress substituted personal market
the move to automated appraisals. By 1995, home prices discipline for regulation.7 The US put in place legal strictures
start to rise and home ownership levels also start to rise.” and market guidelines that required virtually all financial
Rosner and others, such as Drexel University professor instruments to be traded on exchanges, with price discovery
Joseph Mason,3 argue that the original model for the sub- and counterparty credit risk issues exposed to the full light of
prime market was the GSE market and that most of the fea- public scrutiny and, thus, market discipline.
tures of CDOs and complex structured assets that we now However, with the “Big Bang” of decimalization in
look upon as irresponsible or poor risk management started March 2001, the sell-side consensus surrounding the
in the markets for agency paper. The utopian dream of an exchange-traded model, which already was under pressure,
efficient, transparent, private securitization replacing com- completely unraveled.8 While retail investors realized big
mercial banks as a means of raising capital was simply car- savings in terms of the cost of execution after decimaliza-
ried further (by Wall Street) than anyone in the Congress or tion, the Big Bang also ripped the profitability out of insti-
the regulatory community anticipated. Whether or not it was tutional trade execution, forcing the major Wall Street
reasonable for the Fed or other agencies not to see the danger firms to strip the services provided to investors down to the
J A N UA RY / F E B R UA RY 0 8 I S S U E 4 0 GLOBAL ASSOCIATION OF RISK PROFESSIONALS 13G L O B A L A S S O C I AT I O N O F R I S K P R O F E S S I O N A L S
C O V E R S TO R Y
bare bones. More than the restrictions of Regulation FD or more than a decade. “Fair value” accounting is a new era
threats of prosecution by former New York State attorney notion that has developed over the past two decades and is
general Elliot Spitzer, decimalization forced spreads to now being promoted by large segments of the accounting
shrink and gradually compelled many large sell-side firms and economics profession, as well as by leaders of the finan-
to cut back on research and banking coverage for issuers of cial services community.
public securities and to focus new investments on OTC As with the link to the GSE markets, the common intel-
asset classes. lectual lineage of complex structured assets and the shift to
Post-decimalization, trading and sales of stocks and fair value accounting is crucially important. Going back
bonds were no longer profitable for many securities firms; decades, economists argued that securitized assets such as
thus, the only way to enhance or even maintain profitabili- those developed by the GSEs would be more transparent,
ty was — and remains today — to focus on OTC assets. and thus more efficient, than bank assets. It was conse-
In the shadowy world of OTC structured assets, bid- quently expected that as the securitization market grew
offer spreads are much wider than on exchanges because of beyond the market for agency paper, the intermediary role
poor transparency and disclosure. It helps if you think of of the commercial banking industry would decline and
the OTC market for derivative securities as comparable to banks would instead focus more and more effort on acting
the market for precious art, where the assets are all unique as agent and sponsor for these assets.
and pricing is rarely disclosed, except between dealers and The trouble, notes Bert Ely, a Washington-based accoun-
clients. Further complicating matters, because OTC assets tant and banking expert, is that the rapid acceleration of
like CDOs often carried investment-grade ratings pur- financial technology created classes of assets that neither the
chased from ratings firms, these assets heretofore carried Federal Reserve nor the other regulators ever anticipated —
lower risk-based capital requirements than other assets.9 or understand even today. Unlike fairly simple GSE obliga-
Including relatively standardized products such as single- tions or even interest-rate swaps (which are entirely stan-
name credit default swaps (as well as all manner of cus- dardized and thus quite liquid), CDOs and other types of
tomized credit default contracts), the world of credit deriva- OTC derivatives blossomed into hideously complex and
tives looks an awful lot like an unregulated insurance mar- opaque permutations, configurations that a smart trial
ket — and it is. One party pays and the other party pays, lawyer might successfully argue were deliberately deceptive.
but only if a specified event occurs. Many CDOs are entirely In place of the implicit guarantee of the US Treasury,
synthetic, with no collateral, supporting the gaming Wall Street substituted a paid rating from Moody’s or S&P,
metaphor. Because no contract is comparable to another as well as a guarantee from a thinly capitalized bond insur-
and because participants can “write” unlimited amounts of er such as Ambac or MBIA. Whereas the intellectual
default protection without any margin requirements or authors of structured finance anticipated that these new era
reserves, pricing for these custom instruments is entirely rel- assets would be highly liquid — for example, qualifying for
ative and uncompetitive, and the potential to multiply the Level One status under FAS 157 — instead Wall Street cre-
basis risk used to define a given transaction is open-ended. ated an entirely illiquid market of unique assets that qualify
It is no accident, then, that since 2001, the massive growth only for Level Three treatment under the FASB rules.10
in the number of hedge funds and the assets these vehicles As mentioned earlier, the debate over fair value account-
control also spiked, as broker dealers used their own balance ing is not new. In fact, it dates back many years, even
sheets to boost trading volumes and to widen spreads in decades. In April 2006, an article in the CPA Journal neatly
OTC products. To be fair to Greenspan and the regulators, summarized the argument between fair value accounting
the major derivative dealer firms share the largest part of the proponents and opponents:
blame for the subprime crisis. Indeed, as 2008 began, many Perhaps the root of the disagreement over a shift to fair-
prime brokers were forcing hedge fund clients to reduce value measurement is the philosophical debate over rele-
leverage and thereby the amount of assets that the dealers vance versus reliability. Proponents of fair-value account-
need to finance — assets that the dealers, in fact, own. Once ing argue that historical-cost financial statements are not
seen as a source of double-digit returns, hedge funds are now relevant, because they do not provide information about
viewed by dealers as sources of open-ended liability. current values. The fair-value dissenters argue that the
information provided by fair-value financial statements is
The Flaws of Fair Value Accounting unreliable, because it is not based on arm’s-length transac-
A third significant factor in making the collapse of the mar- tions. They contend that if the information is unreliable, it
ket for structured assets containing subprime debt a true should not be used to make financial decisions. This trade-
catastrophe is the move to fair value accounting, a process off should be at the core of any discussion about the use of
that was implemented last year but has been debated for fair value in financial statements.11
14 GLOBAL ASSOCIATION OF RISK PROFESSIONALS J A N UA RY / F E B R UA RY 0 8 I S S U E 4 0G L O B A L A S S O C I AT I O N O F R I S K P R O F E S S I O N A L S
C O V E R S TO R Y
Most recently, fair value accounting was pushed by the have instead created a framework (Basel II) that is arguably
very same Wall Street firms that wanted to support and nur- ineffective and conflicts with traditional regulator bench-
ture the OTC market for structured assets. After all, what marks, such as leverage ratios. Banks learned very quickly
better way to validate and protect the wider spreads and prof- how to game the risk- based capital regime — e.g., the use
itability of OTC asset classes than to give investors greater of SIVs to move assets off balance sheet — and all with the
comfort when it comes to valuation, especially for assets that blessing of regulators and the FASB.
carried investment-grade ratings and third-party guarantees It is no small irony, then, that the positive public policy
from the major bond insurers? The combination of an exter- goal of providing a more flexible way of describing the
nal rating, third-party guarantees by monoline insurers and value of different types of assets (i.e., the shift to fair value
fair value accounting provided the necessary ingredients for accounting) has now become a Draconian regime that is
investors to overlook the obvious liquidity risk defects inher- forcing banks and some investors to write down CDOs and
ent in CDOs and other complex structured assets. other types of derivative assets entirely, even though the
Fair value accounting was also promoted by economists assets have not yet reached levels of default that would justi-
at the Federal Reserve and other regulatory agencies that fy even a modest haircut! Two factors — the near-zero liq-
were proponents of the risk-based capital requirements uidity in structured assets and the severe legal strictures of
that are now embedded in the Basel II capital framework. Sarbanes-Oxley — have forced banks to take total losses on
The “fair value” of assets is now a key part of the capital assets that were once a source of enormous profitability but
adequacy analysis of US banks — a fact that has caused lacked organized and defined markets to ensure liquidity.
many practitioners to complain that Basel II may result in Part of the reason that companies for centuries used
higher capital charges for many assets. “book value” (e.g., historical cost accounting) to describe
The very same visionaries who believe (mistakenly, in the value of assets is that book value accurately reports the
this author’s view) that different types of risk can and cost of the investment. Once an investment is made, as noted
should be parsed into separate buckets, measured accurate- in the CPA Journal excerpt (see pg. 15), the only way truly to
ly and then used to support bank safety and soundness determine, on an arm’s length basis, the value of an asset is to
J A N UA RY / F E B R UA RY 0 8 I S S U E 4 0 GLOBAL ASSOCIATION OF RISK PROFESSIONALS 15G L O B A L A S S O C I AT I O N O F R I S K P R O F E S S I O N A L S
C O V E R S TO R Y
sell it to a third party. Unfortunately, since there currently is to push the proposal until just before Christmas 2007,
no market for CDOs and other structured assets, banks have when Secretary Paulson was forced to admit that the pro-
no choice, under the fair value accounting rules, but to take a posal was moribund.12
near total loss — even though the economic value of the The key motivation behind the MLEC proposal was to
assets in terms of cash flow may be closer to par! attempt to restore investor confidence in complex structured
Ely and other observers believe that banks and other assets; this lack of confidence was the key change in market
investors are overreacting to the subprime debacle and that sentiment that occurred during 2007, and, unlike past market
many investors will not know the true economic cost of the disruptions, it did not wane. The larger players in the struc-
crisis in the market for complex structured assets for more tured finance market were literally left holding billions worth
than a year. But what is clear is that the change to fair value of subprime assets on their books and in the SIVs they spon-
accounting has turned the subprime crisis into a frightening sored. For example, during 2006, Countrywide Financial
debacle that threatens the safety and soundness of some of (NYSE:CFC) originated and sold mortgages equal to several
the largest US commercial banks – perhaps needlessly. times its $200 billion in balance sheet assets — but by mid-
As this article went to press, Citigroup had reported an 2007, this market had collapsed and CFC had lost access to
$18 billion write down from structured assets, and was the capital markets. Subsequently, in January 2008, CFC
desperately seeking to raise new capital as further credit agreed to be sold to Bank of America, at less than 30% of its
and valuation losses loom in 2008. In the absence of fair book value.
value accounting, the tens of billions of dollars in trading Two months after the MLEC proposal was advanced,
book losses reported by Citigroup, Merrill Lynch and other Secretary Paulson put forward a second proposal, which
global investment firms might have been greatly reduced provided direct forbearance to subprime mortgage holders
or avoided entirely. who face rate resets on adjustable-rate loans. In essence,
While the subprime fiasco may cause the insolvency of a the proposal would have frozen the interest rate on these
large commercial bank during 2008, the survivors may be mortgages at the introductory or “teaser” rate for a year or
able to report extraordinary gains on these same written- more, but would only have applied to a small percentage of
down assets once the current investor hysteria passes. As total subprime borrowers. Many of these loans do not float
and when the dealer community and their patrons in with market rates and feature rate reset terms than can take
Washington make adjustments to the structured asset busi- annual percentage rates into double digits.
ness model, much of the paper now viewed today as toxic President George Bush announced the effort amid much
waste may actually be quite valuable. fanfare, joined by members of Congress from both parties.
But as with the MLEC proposal, the idea of providing lim-
Inadequate Solutions ited relief to a few subprime borrowers did not generate a
In the wake of the collapse of the market for complex great deal of positive response. With housing markets
structured subprime assets, Washington responded with around the country reporting drops in home values, new
two “solutions,” neither of which addresses the causes of housing starts and other key indicators, the problems fac-
the problem. The first proposal was put forward by the US ing subprime borrowers are starting to be felt by a much
Treasury last summer when it became apparent that many broader cross-section of the US population and arguably
mortgage lenders and CDO sponsors had been caught with require a broader response from Washington that go
tens of billions of dollars worth of subprime mortgage beyond the gimmicks seen from the Treasury to date.
paper that they could not sell, either directly or via the
issuance of CDOs. Alternative Ideas
Proposed by Treasury secretary and former Goldman The trouble with both of the Bush Administration’s pro-
Sachs chief executive officer Hank Paulson, the Master posals is that they ignore the underlying causes of the sub-
Liquidity Enhancement Conduit (MLEC) was in effect a giant prime crisis and do nothing to improve investor sentiment
mortgage debt fund or conduit. Participants in the MLEC regarding structured assets. Fixing the problem is going to
structure would contribute assets and the vehicle would then take a concerted effort by the major dealer firms and the
issue debt backed by these assets, in much the same way that regulatory community — an effort that so far is missing
private conduits had issued paper prior to the crisis. necessary leadership from Washington and Wall Street.
Banks such as Citigroup, Bank of America and Job one is to rebuild market confidence in structured
JPMorgan Chase initially expressed interest in the propos- assets. The way to achieve this obviously necessary end is
al, but an overall lack of interest from banks — and, more to go back to first principles when it comes to issues like
important, a lukewarm reaction from investors — doomed market transparency, standardization of contracts and
the proposal to failure. The Bush Administration continued accounting treatment. There is no reason why structured
16 GLOBAL ASSOCIATION OF RISK PROFESSIONALS J A N UA RY / F E B R UA RY 0 8 I S S U E 4 0G L O B A L A S S O C I AT I O N O F R I S K P R O F E S S I O N A L S
C O V E R S TO R Y
assets cannot trade as easily as interest-rate swaps or even bid-offer spreads would shrink and the profits would large-
GSE paper, but only if a limit is placed on complexity. ly disappear, like many of the older asset classes in the
The problem with complex structured assets containing investment world. There is an inverse relationship between
subprime loans is not the loans, but rather the opaque liquidity and transparency, on the one hand, and dealer
structure and lack of disclosure of these derivative securi- profits on the other. However, the subprime crisis will cost
ties. At a speech in December 2007, Christian Noyer, gov- many dealers far more than they made in profit over the
ernor of the Bank of France, said, “When banks are past five years.
engaged in financial intermediation, they gather and In any evaluation of the subprime mortgage crisis, the bot-
process the information concerning their borrowers tom line is this: losses of hundreds of billions of dollars
through their customer relations. Bank intermediation is incurred by banks, investors, home owners and others are
therefore a means of overcoming the problems of the asym- largely due to US government intervention in the private mar-
metry of information and its accessibility. However, on a ket for home loans — intervention that dates back decades.
securitized market, where borrowers are directly in contact You can blame the ratings analysts or sell-side traders for the
with lenders, this solution does not exist.”13 subprime mess, but regulation and the active encouragement
If we were to use simple deal structures and give by the Congress and regulators of banks dealing in OTC
investors the information needed to analyze the collateral derivatives, as well as policy efforts like the push for "afford-
in complex structured securities — for example, by requir- able housing,” are among the root causes. When you see a
ing SEC registration and public pricing — much of the cur- member of Congress or a senior bank regulator offering solu-
rent liquidity problem would go away. But of course, were tions to the subprime bust, remind them gently that it was
structured assets subject to the same disclosure and trans- their past actions and inaction that created the circumstances
parency requirements as exchange-traded securities, then for this financial disaster in the first instance. ■
FOOTNOTES:
1. For a complete summary of Rosner’s comments, see “The Subprime Crisis: PRMIA Meeting Notes,” The Institutional Risk Analyst (September 24,
2007).
2.According to the US Census Bureau, there were an estimated 128.2 million housing units in the United States in the third quarter 2007.
Approximately 110.3 million housing units were occupied: 75.2 million by owners and 35.1 million by renters or some 68% owner occupied.
This compares with some 63% owner occupied in the early 1990s measured against a smaller population and housing inventory.
3. See Rosner and Mason, “How Resilient Are Mortgage Backed Securities to Collateralized Debt Obligation Market Disruptions?” The Hudson
Institute, February 15, 2007.
4. See Christopher Whalen, “New House Rules: How the Feds Are Seeking to Make the World Safe for Derivatives,” The International Economy
(Summer 2004): 54.
5.The Federal Deposit Insurance Corporation Improvement Act (FDICIA) required banks to use risk-based capital requirements to measure cap-
ital adequacy in a prelude to the Basel II framework.
6. See “Interagency Statement on Sound Practices Concerning Complex Structured Finance Activities,” Federal Register (May 19, 2004).The state-
ment has since been amended. Notice that the SEC and federal bank regulator guidance is “suggested” only and has no force of law, either for
safety and soundness purposes or to support civil fraud claims.
7. Prior to the 1930s, investors in US banks had double liability for their investments and had to be prepared to invest an additional dollar for each
dollar in shares held.With the reforms of the 1930s, however,Washington took explicit responsibility for bank safety and soundness.
8.The SEC issued an order requiring all US exchanges to implement decimalization on June 8, 2000. See http://www.sec.gov/rules/other/34-
42914.htm.
9. The case of Citigroup’s initial support for its foundering SIVs in mid-2007 is a case in point. Rather than provide direct loans to the SIVs to
finance client redemptions, Citigroup reportedly purchased the “AAA” rated paper itself and thereby held an asset with the lowest possible risk
weighting! This façade, however, was abandoned later in 2007.
10. Level One assets are those for which publicly quoted prices are available. Level Three is for illiquid assets for which there is no public market.
See “Summary of Statement No. 157” (http://www.fasb.org/st/summary/stsum157.shtml).
11. Rebecca Toppe Shortridge,Amanda Schroeder and Erin Wagoner,“Fair-Value Accounting:Analyzing the Changing Environment,” The CPA Journal
(April 2006).
12. See “Banks Abandon Effort to Set Up Big Rescue Fund,” The Wall Street Journal (December 22, 2007):A1.
13. Speech by Mr. Christian Noyer, Governor of the Bank of France, at the Symposium on financial ratings, organized by the Cercle France-
Amériques, Paris, December 12, 2007.
✎ RICHARD CHRISTOPHER WHALEN is co-founder and managing director of Institutional Risk Analytics (www.institutionalriskanalyt-
ics.com). Mr.Whalen edits The Institutional Risk Analyst commentary and represents IRA in various risk management and technical forums. He
has worked as a journalist and investment banker for more than two decades and has advised government agencies and corporations from the
US, EU and Japan on financial and political risks around the world. He is the global risk editor for The International Economy magazine and
speaks frequently on financial and geopolitical topics. He can be reached at cwhalen@institutionalriskanalytics.com.
J A N UA RY / F E B R UA RY 0 8 I S S U E 4 0 GLOBAL ASSOCIATION OF RISK PROFESSIONALS 17You can also read
