/14 Focus Focus /15

The sub-prime crisis has changed the global financial landscape for ever. The new market environment provides opportunities to improve historic practices and business models. Andrew Cavenagh investigates Lessons to be learned

he worsening credit crisis over home ownership had previously been the last six months has given the impossible dream. the lie to two – in hindsight, As all have belatedly realised in T smug – assumptions that hindsight, there was a fundamental flaw prevailed in the international capital with this lending model. The US com- markets up to August. One was a widely- panies that were offering loans of more held belief that the global market for than 100% of home values didn’t always debt was now so deep and liquid that it make the sort of credit checks that could absorb any imaginable shock have historically been a prerequisite for without precipitating a systemic crisis. mortgage lenders. The other tenet that proved false This was because they were safe in was that the exponential growth of the knowledge that they would soon be securitisation worldwide over the passing on the entire credit risk of the previous decade had created a class of loans to bond investors. So volume of stable and liquid bonds that would lending became the key driver to the continue to provide financial and profitability of these mortgage corporate borrowers with a cheap originators, rather than the credit quality and reliable source of funding. It was this of their borrowers. It could be argued growth of securitisation that enabled US that the same was sometimes true for mortgage lenders to extend low-cost the investment banks that marketed and Source:iStockphoto. British Museum Reading Room loans to a large raft of people for whom sold the bond issues that were backed

the markit magazine – Summer 08 Summer 08 – the markit magazine Focus /17 /18 Focus

by these loans to investors around the Decline And Fall – The Past Year For A Synthetic Index Of US Home Equity ABS world – whether directly as sub-prime to those who had never had access to

RMBS (residential mortgage-backed The Markit ABX.HE 07-1 Indices such borrowing before, and he insists securities) or indirectly through CDOs that remains a desirable goal.

(collateralised debt obligations). 100 “I do think this is a learning point that The banks were also earning their is going to improve the overall target money from the volume of their of lowering the cost of global debt,” he turnover. All they had to do was tier 80 says. “But regulating the business hasn’t the bond issues into tranches that kept pace, and I do think that will need could secure staggered ratings – with to catch up.” 60 the highest triple-A rating covering the One change that seems certain to bulk of the issue – and sell them into result from the debacle is that the market. Then they would move on institutions that originate mortgages – or Composite price 40 to the next issue. They also began to any other types of loan – will no longer “slice and dice” the debt to a greater be allowed to sell on the entire risk to and greater extent through increasingly 20 the capital markets. It is hard to imagine complex CDO structures – the so-called that some of the reckless sub-prime CDO-squared and CDO-cubed variants lending that occurred in the US would 0 – which managed to transform much of 5/3/07 5/5/07 5/7/07 5/9/07 5/11/07 5/1/08 5/3/08 Tom Elliott, global strategist, JPMorgan Asset Management have happened if the lenders had been the middle-ranking debt in an initial CDO obliged to keep the “assets” on their into triple-A securities. balance sheets. The US sub-prime lenders and a consequence of the “seriously flawed” valuations of complex instruments, “Next time round, originators will investment banks have since learned a ABX.HE.AAA ABX.HE.AA ABX.HE.A ABX.HE.BBB ABX.HE.BBB- model that banks and other financial disclosures of risk positions and on surely be obliged to retain some hard lesson, as a sharp rise in defaults institutions had adopted to expand crisis management,” he concedes. exposure rather than selling the whole on US sub-prime mortgages from Source: Markit their lending so rapidly over the past Prof Spencer believes it will take thing on,” comments Elliott. 2006 initiated a progressive collapse few years. more than two years to resolve some of of confidence in all securities backed desert the CP markets, the SIVs were England that had expanded aggressively The Review itemised a number of the core causes of the crisis. “The wider Agencies under scrutiny by such assets. While US sub-prime left horribly exposed. through heavy – and increasing – “significant” failings of the “originate and use of securitisation, the role of the The role of the rating agencies is also lenders have filed for bankruptcy in Because the sponsoring banks did reliance on borrowing from the whole- distribute” model that had been behind rating agencies – I’m afraid these under real scrutiny. Standard & Poor’s, droves, the investment banks have not provide 100% liquidity facilities to sale money markets. But within a matter the issue of such a vast volume of are absolutely humungous issues.” Moody’s and Fitch all face lawsuits in the been forced to declare write-downs on cover their debt – unlike most bank of weeks, no non-government financial asset-backed bonds over the period. But despite the magnitude of the US from disgruntled investors who lost sub-prime related investments of more conduit programmes – the structure of institution or corporate could raise “These include inadequate information crisis – which now threatens to inflict money on sub-prime related invest- than $100bn, led by the US giants Citi the vehicles obliged them to sell assets money from anywhere other than central about the true credit risk underlying misery on hundreds of thousands of ments. At the same time, market (with $18bn of losses) and Merrill Lynch to meet maturing CP if they could not banks. The asset-backed bonds that financial instruments; an excessive consumers as tighter lending criteria will regulators are closely examining the rela- ($14.1bn). Both firms’ chief executives roll it over. Most SIVs were also subject were supposed to deepen the liquidity dependence on rating agencies; surely make it impossible for credit- tionship between the agencies and the resigned as a consequence and the to “market-value triggers”, which forced of the capital markets to a degree never opaqueness about the distribution risks impaired borrowers to re-mortgage investment banks that pay their fees. banks received cash injections from them to sell off assets if valuations seen before had done just the opposite. in the financial system; over-reliance on their homes at affordable cost or obtain While the credit quality of any security sovereign wealth funds in the Middle reached the trigger points. “The idea was that these investments continuous liquidity in financial any other form of credit – most believe can deteriorate over a period of time, East to improve their balance sheets. spread the risk, but all they did was markets; and inadequate liquidity risk that securitisation per se has not been the speed with which the ratings of As the damage spread beyond RMBS Vicious circle spread the contagion,” comments Peter management,” it concluded. discredited beyond repair. some US sub-prime and CDO bonds fell and CDOs backed by US sub-prime A vicious circle rapidly developed Spencer, the York University professor Sir John Gieve, deputy governor at the “It has made people sit up and think from the triple-A level to sub-investment loans to all asset-backed securities where the threat of widespread sell-offs who is the chief economist for the Bank, responsible for financial stability, about the huge amount of securitisa- grade – within a matter of a few weeks (ABS), it also exposed a fundamental by SIVs sent all asset-backed bond independent ITEM Club forecasting acknowledges that regulators also tion that we have had over the past few – inevitably raised questions over the weakness in the investment vehicles that valuations plummeting and activated group sponsored by Ernst & Young. need to reassess some of their years,” says Tom Elliott, global strategist agencies’ competence. “They clearly are banks had set up to invest over $400bn the market-value triggers in more and So why did the market depart so procedures – as the Bank itself, along at JP Morgan Asset Management. “In exposed to the charge of not paying full in such bonds. These structured invest- more of the vehicles. This soon radically from the script, and what with the Financial Services Authority the near term we are going to see a attention,” comments Elliott. ment vehicles (SIVs) had financed their precipitated a wider debt crisis as banks further lessons should all involved learn and the government Treasury, face rolling back, but it’s not going to stop While it would be difficult to prove ABS purchases with cheap short-term became fearful of their own and others’ from the experience? widespread criticism over their failure because of this hiccup.” that any rating agency compromised its borrowing in the asset-backed commer- potential exposures to SIVs and The Bank of England summed up to intervene earlier and more decisively Elliott maintains that the ability to sell opinion to safeguard its fees, there is cial paper (ABCP) market – and made a other ABS losses, and stopped lending succinctly what had gone wrong in in the Northern Rock case. “Some debt so widely through securitisation no doubt that over the past four years profit on the arbitrage between the two. money to each other. its latest Financial Stability Review. It important lessons need to be learned is what lowered the cost of borrow- lead managers on issues have put the However, as fears over the sub-prime That spelt the end for Northern Rock, warned that the UK’s financial system by both financial institutions and ing to the point where it was possible agencies under increasing pressure to exposures led money market funds to the bank based in the north-east of remained vulnerable to further shocks as authorities on liquidity risk management, to advance mortgages at feasible cost “get to” required ratings – particularly

Summer 08 – the markit magazine the markit magazine – Summer 08 Focus /19 /20 Focus

worldwide of more than $100bn, for deals involving assets that the lead “ These days there are a lot more inefficient corporate and consumer borrowers will managers were also originating, banks in the payments system, learn once again that when the banking such as sub-prime mortgages and system sneezes it will not be long before commercial property loans. There was some have very ancient IT architectures.” they catch a cold. This year has already often an implicit – sometimes explicit seen big lenders restrict their offer- – threat that too much obstinacy on the ings in the retail market. All the big UK part of any rating agency might lead mortgage lenders have withdrawn the the arranging bank(s) to drop it in favour 125% products that enabled many first- of the other two, and there is plenty time buyers to get a foot on the property of anecdotal evidence that arrangers also relaxed the stress tests they ladder, while Citi credit card subsidiaries played the agencies off against each conducted on their operations. It was have served notice they are terminating other in this way. obviously in management’s interest to the facilities of riskier borrowers. “What we see in the last few years favour less stringent stress testing that Such measures will reduce banks’ was a squeeze on the rating agencies,” allowed banks to take greater risks and risk exposure but inevitably lead to a confirms Chris Greener, structured – supposedly – improve the profitability higher incidence of defaults. Home finance analyst at SG Corporate and of their operations. repossessions in the UK climbed to an Investment Banking in London. As the shortcomings of such policies eight-year high of 27,000 in 2007, and At the same time, the rating agencies’ Chris Greener, structured finance analyst, SG Corporate and Investment Banking, London are apparent to all now, banks seem the figure is bound to rise this year as stress models often underestimated the sure to replace such unreliable testing the untold thousands who have lived correlation risk of multiple defaults formulae with more analytical tools that beyond their means on the back of occurring simultaneously. “In the event, the rating agencies rate deals. For the any illusion that the British government can determine effective liquidity and rising house prices – and constant the correlation was much higher next two years, I don’t think you’ll need would step in and nationalise a collateral strategies, and reflect a bank’s re-mortgaging – will no longer be able than everyone had factored into their any kind of regulation because it will be second high-street lender that got into true lending capabilities more accurately. to do so. (Non-conforming borrowers models,” says Greener. self-regulating.” such difficulty. “It’s really a question of the stress testing accounted for half the repossessions “There are limits to these analytical And what else do the banks need you do,” explains Bradshaw. “It’s very last year.) models,” agrees Anita Bradshaw, to do? Many are occupied by cleaning Vulnerable systems important that you test the things that With UK consumer debt standing at director at IT systems consulting firm up the wreckage of the SIVs, as most But while banks’ current focus on the have the biggest impact on your a record 160% of disposable income, LogicaCMG. “What tends to happen is have been forced to support the vehicles liquidity issue is perhaps understandably Anita Bradshaw, director, LogicaCMG operations – and it’s very important that this inability to refinance mortgage debt that all the models that are out there with their balance sheets in one way on maintaining diverse and economic you know what those impacts are.” seems certain to feed through into a are pretty uniform.” or another – either through buying the sources of funding, Bradshaw at sharp increase in unsecured borrow- Despite the unprecedented interest in CP the vehicles issue themselves or LogicaCMG warns that they should “Some have very ancient IT architectures Revising risk models ing defaults and personal bankruptcies. their operations from the regulators, through providing them with full liquidity also be examining the threat that their for their payments systems.” Banks’ risk models will also need (Mortgage lenders have refused to however, it seems unlikely that the support and turning them into conduits. internal systems might pose. She points While it might seem fanciful to revision. Bradshaw says the sector’s disclose how many of their borrowers agencies activities will become subject Consequently, the creation of new types out, for instance, that several of the large imagine that failure to process end-of- reliance on credit risk models that have relied on refinancing to stay afloat to formal regulation. Given the relative of arm’s length investment mechanisms UK clearing banks seem to be unaware day payments on a given date could require more and more data input has over the past two to three years.) speed with which the different organi- will not be high on their agendas. At of how vulnerable their systems for precipitate the collapse of a high-street long been a shortcoming, because Meanwhile, a survey commissioned sations operate, for instance, it would some juncture the need will return, intra-day payment and settlement could bank, in the current climate of nervous- such models do not give an accurate by Belgium’s KBC Bank in February of hardly be practical for a body like the UK however, and it seems certain that the leave them on this score – particularly in ness it would certainly cause it some correlation between market risk 107 senior corporate executives (nearly Financial Services Authority to authorise vehicles of the future will have two key the current environment. “You do have embarrassment. How would the and credit risk – and tell a bank how half of them financial directors and the rating agencies’ stress models, let characteristics as a consequence of the occasions when someone thinks that a payment counterparties react, and what much capital it requires to support the treasurers) showed that a vast alone sanction individual ratings. last six months’ experience – guaran- missed payment is a sign of weakness,” would be the impact on its short-term actual credit risk. majority expected the availability of As the agencies seek to improve teed liquidity lines to cover all the debt she observes. borrowing ability? “The transition matrices are not bank-supplied credit to diminish this confidence in their operations from its they issue and the absence of market- Bradshaw says banks were probably It is easy to see how such a failure always stable,” she points out. “The year – and that its price would go up. present all-time low, changes to their value triggers. more attuned to the risk posed by late would cause tremors at the top of any banking industry has a history of The executives said that companies stress models and in their approach to Meanwhile, liquidity concerns will payment and settlement 15-20 years leading bank. One UK clearing bank, for not having very good credit models – it’s would also need to rely on the strength rating deals are much more likely to be remain paramount in the sector. The ago, when – as a former Deutsche Bank instance, went to great lengths to keep a particular failing of the sector.” She of their banking relationships more driven by investor pressure in the collapse of Northern Rock was an object employee – she recalls that institutions quiet a significant failure of its IT system expects to see the replacement of heavily in 2008 – as banks became more near term. lesson as to how quickly even a large used to deliberately test each other with recently, which apparently prevented the such analytical risk models with systems cautious and less trustful – and that as a “People are just nervous and financial institution (with over £100bn “games of chicken” towards the end of bank from performing several functions that make more use of simulation. result of this tighter credit climate, higher sceptical of the whole sector,” explains of assets) can easily face ruin if it loses the working day. “These days there for a matter of hours. Meanwhile, as the banks draw interest rates and a general economic Greener. “The reality is that investors are the confidence of its peers and its are a lot more inefficient banks in the In the benign lending environment lessons from the mistakes that have downturn, the number of corporate going to take a much closer look at how depositors. And no-one can be under payments system,” she maintains. that prevailed up to July 2007, banks led them to declare aggregate losses defaults would rise.

Summer 08 – the markit magazine the markit magazine – Summer 08