The Rise and Fall of the Shadow Banking System Zoltan Pozsar his article provides an overview change, and have led to the gradual and investors stretched for yield made for of the constellation of forces emergence of the originate-to-distribute a potent mix of inputs for trouble ahead. T that drove the emergence of the model of banking. Part I—CDO evolution. The 1988 network of highly levered off-balance- The originate-to-distribute model Basel Accord was the main catalyst for sheet vehicles—the shadow banking has deeply changed the way credit is the growth and development of credit system—that is at the heart of the credit intermediated and risk is absorbed in risk transfer instruments. Following the crisis. Part one of this four-part article the financial system, as these functions banking crises of the late 1980s, which presents the evolution of collateralized now occur less on bank balance sheets were triggered by loan defaults by Latin debt obligations and how they changed and more in capital markets. Banks American governments, the accord from tools to manage credit risk to a no longer hold on to the loans they applied a minimum capital requirement source of credit risk in and of themselves. originate as investments, but instead to bank balance sheets and required Part two discusses the types of investors sell them to broker-dealers, who in more capital protection for riskier who ended up holding subprime turn pool the underlying cash flows assets. These rules prompted banks exposure through CDOs, and why the and credit risks and, using dedicated to reconfigure their assets using credit promise of risk dispersion through the securities, distribute them in bespoke risk transfer instruments such as credit originate-to-distribute model failed to live concentrations to a range of investors default swaps or CDOs. This was done up to expectations. Part three defines the with unique risk appetites. To properly either by purchasing insurance against shadow banking system, discusses the function, the originate-to-distribute credit losses using CDSs (reducing causes and repercussions of its collapse, model needs liquid money and securities the gross risk of a loan portfolio) or by and contrasts it with the traditional markets to intermediate credit through removing the riskiest (first loss) portions banking system. An accompanying the daisy chain of asset originators, asset of a loan portfolio using CDOs. chart provides an exhaustive view of the packagers and asset managers. Initially, CDOs were applied to institutions, instruments and vehicles that The originate-to-distribute model corporate loans. A bank would pool make up the shadow banking system and and the securitization of credit and its the corporate loans on its books (the depicts the asset and funding flows in it. transfer to investors through traded assets of a CDO) and carve up the pool’s Finally, part four discusses why it might capital market instruments has been underlying cash flows into tranches with still be too early to call an end to the part of the financial landscape since the varying risk profiles (the liabilities of a credit crisis. 1970s, when the first mortgage-backed CDO). Payouts from the pool were first Banking’s changed nature. The securities were issued. But this model paid to the least risky senior tranches, traditional model of banking—borrow has grown increasingly more complex then the mezzanine tranches, and short, lend long, and hold on to over the past decade, as securitization lastly to the most risky equity tranches. loans as an investment—has been expanded to riskier loans and came Conversely, losses were first allocated to fundamentally reshaped by competition, in increasingly more opaque and less equity tranches, then to the mezzanines, regulation and innovation. Everything liquid forms such as structured finance and only then to senior tranches. from the types of assets banks hold collateralized debt obligations. These Correspondingly, equity tranches offered to how they fund themselves to the developments were driven by loose the highest yields and senior tranches sources of their income have changed monetary policy and depressed yields in the lowest in CDOs’ capital structures. dramatically. Competition from finance recent years and became most apparent Tranching did not reduce the overall companies and broker-dealers in in subprime mortgage lending. Low amount of risk associated with the pool. lending to consumers, corporates and interest rates created an abundance of It merely skewed the distribution of risks sovereigns; changes in rules governing credit for borrowers and a scarcity of such that equity tranches ended up with capital requirements; and innovations yield for investors. With the housing a concentrated dose and senior tranches in securitization and credit risk transfer boom as the backdrop, exotic mortgages ended up with diluted ones. In this have been key facilitators of this to borrowers with spotty credit histories sense, equity tranches are overleveraged Moody’s Economy.com • www.economy.com • [email protected] • Regional Financial Review / July 2008 13 Chart 1: ABS CDOs Drive Demand for Loans As the backed securities backed by credit card Global cash flow/hybrid arbitrage CDO issuance breakdown, % originate-to- receivables and auto loans (see Chart distribute 1). CDOs that invested in these new 140 Investment-grade bonds High-yield bonds model matured, collateral types came to be known as ABS 120 Structured finance (ABS) Leveraged loans arbitrage CDOs (or structured finance) CDOs. Through Emerging market and other debt Source: Lehman Brothers have become the use of riskier classes of debt, ABS 100 an integral part CDOs offered fat spread incomes and of the credit hence filled the vacuum created by the 80 intermediation narrowing of spreads on CDOs that process, with invested in investment-grade corporates. 60 their role Before 2004, the market for ABS 40 changing CDOs was small, and ABS CDOs had a from one of well-diversified pool of assets across the 20 repackaging ABS/MBS universe. Over the 2005-2007 existing loans period, however, ABS CDOs’ underlying 0 and bonds portfolios became increasingly 99 00 01 02 03 04 05 06 to one of concentrated in MBSs referencing facilitating the subprime mortgage pools. The typical creation of new ABS CDO issued during this period instruments, whereas senior tranches loans. Through the slicing, dicing and invested nearly 70% of its portfolio into are underleveraged instruments, and dispersion of credit risk, CDOs enabled subprime MBS according to Moody’s the leverage of the entire CDO, similar the underwriting of some loans—subprime Economy.com estimates.3 to whole loans and bonds, is one by mortgages, for example—that would ABS CDOs have one crucial construction.1 This pooling and tranching never have been underwritten had banks difference from CDOs investing in of loans allowed banks to sell credit been required to hold on to them as corporate bonds. Traditional CDOs invest risk in concentrated forms using equity investments in the form of whole loans. in heterogeneous pools of corporate loans tranches and to hold on to credit risk in On the flip side, CDOs also helped expand and bonds, spanning a range of names diluted form through senior tranches, homeownership to those whose personal and industries, where diversification offers allowing them to set aside a much smaller finances should have precluded them from safety against company and industry amount of capital than for whole loans.2 buying a home in the first place. idiosyncratic events, while systematic risk This initial raison d’etre of CDOs At the very top of the housing and is controlled by having a mix of cyclical changed over time. They were no longer securitization boom, arbitrage CDOs’ role and countercyclical industries in the pool. used solely to fine-tune the risk profile of further morphed into one in which they ABS CDOs’ risk instead is driven by a bank’s loan portfolios to manage capital became a powerful source of demand economy-wide factors such as interest requirements (so-called balance sheet for loans in and of themselves, driving rates, house prices, and the job market. CDOs), but also to pool traded whole the spectacular collapse in underwriting These risks are systematic and cannot loans and corporate bonds, earning a standards that occurred from 2005 to be diversified away. However, such spread between the yield offered on these early 2007. a “diversification” was assumed to be assets and the payment made to various Wrong assumptions. The assets present, as ABS CDOs were pooled from tranches (arbitrage CDOs). that CDOs were investing in have also loans originated in different states with changed over time. The first generation separate local economies and, apart of arbitrage CDOs was backed by from the Great Depression, the U.S. 1 The distribution of risks among tranches is achieved investment-grade corporate loans and never experienced falling house prices through overcollateralization and subordination. Overcollateralization is achieved by structuring CDOs such bonds. The widening of corporate credit or mortgage credit problems in multiple that value of the loan pool the CDO invests in exceeds the spreads in the wake of the tech bubble regions at the same time. total principal amount of rated securities issued by the CDO. The size of overcollateralization is by definition equal and corporate bankruptcies made it Due to the “diversified” nature of to the size of the CDO’s equity tranche. The secondary form easy to structure CDOs, as wide spreads these pools, ABS CDOs were expected of credit enhancement in CDO structures is subordination. Subordination is the sequential application of losses to the provided sufficient spread income to to perform well in most circumstances, securities, starting with the equity tranche and then moving handsomely compensate the CDOs’ but could suffer steep losses during up the mezzanine, senior and super-senior tranches as originators, investors and managers.