/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.