I shall be posting one post a day this week as I take you through this Six Minute Strategist Guide to the 2008 Financial Crisis. Today’s post will look at some of the financial instruments which were at the heart of the Crisis.
A brief explanation of some of the key market instruments is important to explain how the complexity of the market and some of the characteristics of derivatives ultimately greatly magnified the effect of the crisis when it finally took place.
1. Sub Prime Loans
Sub-prime loans are defined as loans made to people who may have difficulty maintaining the repayment schedule. This can be measured in a number of ways, in the US typically either by the borrower failing to meet the criteria set down by the US Government sponsored home mortgage federations Fannie Mae or Freddie Mac or with FICO scores of less than 640. (I am trying to avoid Jargon but have provided Wikipedia references to these in the Appendix).
To avoid difficulties with payments, borrowers often took out Adjustable Rate Mortgages (ARMs) most with a 2-28 repayment profile. Two years at an artificially low interest rate adjusting upwards to 28 years at a floating market rate. 80% of all subprime loans issued were ARMs. These were sustainable as long as house prices kept rising and interest rates remained low. After 2006 when house prices started to fall and interest rates increased, defaults began to rise as refinancing became more expensive and any equity, which had accumulated in the house value, evaporated. Under these circumstances, the borrower was financially better off handing the keys back to the bank – i.e. defaulting on the loan.
As the cycle developed, in order to satisfy the appetite for MBS’s the mortgage originators gradually lowered their lending standards. The result was some interesting acronyms. NINJA loans were made to borrowers with No Income No Job or Assets.
As has been seen in the earlier discussion, the Wall Street investment Banks became adept at packaging up these mortgage loans, thousands at a time into MBSs, ABSs and CDOs and selling them internationally to a broad range of investors. These Bonds became an increasing source of revenues and profits and because each bond was the subject of a detailed (130 page) listing document, any innovation by one bond desk was quickly and easily copied by its competitors.
The best way to think of a Mortgage Bond is as a skyscraper with different floors. The underlying mortgages had a wide range of different characteristics and risk. Those at the top of the skyscraper had the lowest risk, investors got their money back first and that part of the bond consequently had the highest rating. The bonds on the in the basement had the highest theoretical risk of default, investors took the first loss and they were regarded as the equity and they had the lowest rating. Just above this were the lowest rated bonds, which were referred to as “Mezzanine” bonds to make them sound somewhat better than they were. To pay investors for this the high rated bonds had the lower interest rates and the poorest quality paid the highest interest rate to compensate for their quality.
3. Credit Derivatives
In the earlier discussion, we have covered the role of Wall Street Investment Banks in creating CDOs, MBSs and ABSs. The CDO was the first stage of the credit derivative process, offering a bond base on the underlying MBSs or ABSs.
The key thing about such a derivative is the number of contracts is no longer dependent on the supply of bonds. At a stroke the scale of the market moved beyond the physical boundaries of the mortgage market, in the end multiplying the associated risk and scale of the problem. In 2008 the worldwide credit derivative market was valued at $62 trillion
To make the market more interesting (lucrative) the next step was to create CDOs which themselves were made up of tranches of other CDOs. This was typically done using the lowest quality – BBB – tranches which, once processed by the Rating Agencies models, were rated 80% AAA. These were typically referred to as CDOs-squared
4. Credit Default Swaps
The financial engineers then took this a step further creating instruments whose value depended not on the underlying bond but on its risk of default. Strictly speaking, a Credit Default Swap is not a swap at all. It is an insurance policy on a corporate bond. The insurance policy has a semi-annual premium and a fixed term. The person who buys the CDS agrees to pay the premium in return for being protected in the event that the issuer of the bond defaults on its repayment.
Originally this was a form of insurance for the bondholder but it rapidly developed into an investment strategy of its own.
In order for this market to prosper, there needed to be a counterparty that believed that the CDO or underlying Bond would not default and who is happy to accept the risk in return for regular (but up to 2006 small) regular premiums.
AIG and a unit within AIG called AIG Financial Products dominated this market. A team from the defunct Drexel Burnham had created the department after Michael Milken and the Junk Bond market fell apart. They had started selling CDS to holders of Corporate Bonds in return for which they received a premium. They typically charged 12 basis points (0.12%) for AAA risk. From 2004 they started selling CDSs on Subprime AAA rated mortgage bonds. As these were also rated AAA, the premium remained the same although (with hindsight) the quality of the bonds were substantially different to those of a bond issued by an AAA corporate such as General Electric.
The buyers of this “insurance” were charged 2.5% annual premiums by Wall Street Investment banks. After deducting charges to other professionals (lawyers), for each CDS issued against a bond Wall Street made 2% risk free. To make it interesting Wall Street packaged these bonds in $1 billion piles, which made them $20 million risk free – annually and typically for six years. By 2008 this was a TRILLION $ market. Between 1987 and 2004 AIG FP contributed over $5 billion to AIG’s pre-tax income. In September 2008, the Federal Government had to extend an $85 billion line of Credit to AIG to cover its losses from Credit Default Swaps.
It is worth noting that in the run up to the crisis a few hedge funds made fortunes buying Credit Default Swaps – effectively betting on a crash in the subprime market. This story is eloquently told in Michael Lewis’s new book The Big Short.
5. Synthetic CDOs
The term synthetic CDOs refers to a form of CDO where the credit exposures being taken on are taken on using a Credit Default Swap rather than owning the underlying bonds. This was an additional “innovation” which enabled the market to expand, Wall Street fees to grow but without any tangible link to the underlying assets in the market.
6. Structured Investment Vehicles – Shadow Banks
Technically the Shadow Banking system referred to financial institutions in the financial markets, which were not deposit receiving banks and therefore not subject to the same level of regulation or protection accorded to banks. Examples include Bear Stearns and Lehman Brothers both of whom collapsed in 2008. It also includes hedge funds, SIVs, money funds, monolines and investment banks.
The main characteristics of these have been discussed above when considering SIVs in some detail. Critically in a high interdependent market, they had limited equity in relation to their assets – i.e. they used significantly higher levels of leverage that a Bank would have been permitted to use and were subsequently significantly more exposed to the market downturn when it happened. The fact that regulated Banks were using SIVs as a means to circumvent their regulatory capital responsibilities (Citigroup had 7 SIVs in 2007) just extended the problem.
In my next post I will look at risk and the multipliers which caused the scale of the crisis to balloon out of control.
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