ESSAYS ON ISSUES THE FEDERAL RESERVE BANK APRIL 2008 OF CHICAGO NUMBER 249 Chicag o Fed Letter Hedges in the warehouse: The banks get trimmed by Brian Gordon, senior technical expert, Supervision and Regulation, and Adrian D’Silva, vice president, Financial Markets Group When banks “warehouse” loans, that is, hold them temporarily before selling them through securitizations, how do they protect themselves against credit risk? This article examines the effectiveness of hedging strategies in the context of the recent heavy losses in financial markets. To Wall Street bankers, market conditions The originate-to-distribute business in the spring of 2007 looked close to model perfect. The world savings glut meant The largest and most sophisticated that liquidity was pouring into the U.S. banks in the world, which reported the fi xed income markets; interest rates were majority of the losses, use a common relatively low compared with historical business model known as “originate-to- averages; the U.S. economy was growing distribute” (OTD). These institutions strongly; and increasingly complex asset- originate loans for the specifi c purpose backed securities (ABSs) that banks had of selling them to others, typically developed as a way to trade loans to other through securitizations. This model investors were being sold as fast as they was widely considered to be benefi cial Banks typically use hedging could be created. for the banks because it moves risks off techniques to protect the the banks’ balance sheets and distrib- Then suddenly the fi nancial world utes them through the fi nancial system value of their assets. However, changed. Banks that had been posting among investors who can match their hedging is a diffi cult art where record profi ts started reporting record risk tolerances with the return goals. losses. While there are a lot of well- best practices are still evolving. Subsequent events have revealed that the documented reasons for the abrupt banks actually retained more of the risks change in fortune, we focus on one than had originally been believed; for seemingly obscure, but in retrospect instance, the banks retained “hung deals,” important, part of the picture in this which are loans intended for securitiza- Chicago Fed Letter. One source of losses tion that cannot be securitized under (although certainly not the only source) current market conditions. They also for the banks is that the loans that they may not have fully hedged their risks. were intending to hold temporarily— or “warehouse” before selling them to The need for speed others—fell in value. Banks typically In late 2006 and early 2007, the banks’ use hedging techniques to protect the biggest challenge was not in selling the value of such assets against declines ABSs they had created; rather, their during the warehouse period. How- challenge was in creating enough ABSs ever, hedging is a diffi cult art where to meet the demand of investors. Thus, best practices are still evolving; and banks were more focused on upside risk because of the bull market conditions (not having enough inventory to sell) that prevailed when the banks bought than “spoilage risk” (inventory getting the loans, they may not have fully old and stale). The key to profi tability, hedged their positions. especially as the market became more aggressive, was to minimize the amount in inventory. The longer a loan asset stays during this period banks often found of time the assets were actually owned by in the warehouse awaiting sale, the great- that spreads had tightened during the the bank. Indeed, the warehouse periods er the risk that the loan will lose value warehouse period. This progressive tight- dropped from nine months to as short for some reason. ening increased profi t margins by more as three months for some products. Grow- than had been anticipated. It then en- Spoilage risk in the warehouse can affect ing competition among banks for loans couraged greater risk-taking by banks single loans and groups of loans. For led to increasingly aggressive bidding for because the more assets they booked, example, an individual loan can have an new loans from originators, with pur- the more money they made. increase in default risk. A group of loans chasers sometimes doing little or no due can be adversely affected when the mar- The OTD business model depends on diligence before submitting bids. Another ket moves against them (whether because a liquid ABS market because securitiza- tactic was to vertically integrate by buy- of interest rates or a general increase in tion is the primary distribution channel ing out suppliers of loans to lock away credit risk). Both risks potentially reduce to investors. Thus, the bank is exposed production from the competition. the value of the portfolio of loans. In- to risk if the credit market becomes more Credit market turmoil terest rate risk is fairly well understood conservative or if the ABS market be- and relatively straightforward to hedge, comes less liquid. Both conditions arose At the beginning of 2007, banks were an- leaving credit risk as the major risk of in the second half of 2007. Banks that ticipating record sales volume for securi- warehoused loans to the bank. had originated loans in late 2006 or early tized assets, so they were ramping up the 2007 in an aggressive credit market found amount of assets in their warehouses. Credit risk to single loans and groups of that they suddenly could not sell the They were also taking more risk with loans comes in two forms: spread risk and assets for a profi t, if they could sell them those assets. As the market became default risk. Spread risk is the larger at all. They were forced to liquidate the frothier, their ability to sell assets at and more volatile of the two. Default loans at a steep discount to what the bank tighter and tighter spreads increased. risk is typically lower because most of believed was their “intrinsic” value, or they could hold the assets and hope for By mid-2007, banks that had not hedged or had hedged a market rebound. Still, doing the latter required them to recognize an account- insuffi ciently found their downside unprotected. ing loss because the market was now sim- ply unwilling to pay what it had been This encouraged some to originate ever- the warehoused loans are new and few willing to pay in the recent past. more-marginal assets. In addition, since loans default soon after closing (sub- Hedging the warehouse their focus was on production and sales, prime mortgages that are fi rst payment hedging these warehouse lines against defaults being the notable exception). Hedging helps banks avoid losses by buy- downside risk, which was diffi cult and ing protection against a fall in the value Spread risk is the risk that the market will expensive anyway, did not seem as of the assets. However, banks did not become more conservative in its attitude high a priority. fully hedge their warehouse credit risk. toward credit risk between the time the Hedging warehouse credit risk is diffi - When the subprime mortgage crisis loan is funded and the time the loan is cult and expensive, especially in an en- began to affect the broader fi nancial sold. For example, a loan booked at a vironment where the possibility of large markets in mid-2007, suddenly the strat- spread of 150 basis points (bps) over short-term profi ts created by the bull egies that had been richly profi table Treasuries could be sold into a securiti- market tended to reduce risk managers’ became losers. As the markets tumbled, zation at a lower spread, say, 125 bps, focus on downside risk. so too did the value of the warehoused because the securitization structure typi- loans. Banks that had not hedged or cally provides the investor with benefi ts, Hedging warehouse lines is notoriously had hedged insuffi ciently found their such as risk matching and liquidity, that diffi cult because of basis risk, which low- downside unprotected. offset the tighter spread. The difference ers hedge effectiveness or effi ciency. in spreads produces a 25 bps profi t for Basis risk is the risk that there is a diver- Presecuritization warehouses the bank because bond prices move in- gence between the asset that is being Securitizations are sold as pools of assets. versely to yield (spread is a component hedged (protected from loss) and the Banks accumulate a large amount of of yield). Alternatively, if credit risk in- asset providing the hedge (typically a assets for relatively short periods as they creases and the spread widens to 175 bps, derivative contract). This divergence is prepare a pool of assets for securitization. then the bank loses 25 bps. It is spread the result of a mismatch between the During these periods, the assets are widening (increase) that banks are prin- price movement of the asset being stored in the bank’s “warehouse,” which cipally seeking to hedge. hedged and the derivative contract used is conceptually similar to a physical ware- to hedge it. Hedge effi ciency is measured The OTD market began to grow quickly house used to store physical goods. Like by the correlation between the asset after 2002, and in that time, market toler- vegetables stored in a physical ware- being hedged and the hedge itself. ance for risk steadily increased. In fact, house, loans have “spoilage risk” while When effi ciency is high (strong negative correlation), the contracts move in the products to hedge warehouse positions. customized swaps that may also in- opposite directions with the same speed These include basis risk, accounting crease counterparty credit risk and are and magnitude.