The 2008 Financial Crisis – Risk? what Risk? – A Six Minute Strategist Guide Part 4

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 I want to discuss risk and examine why the scale of the Crisis grew exponentially, beyond the scale of the sub prime mortgage market itself.

The Risk Multiplication Process

Let us now consider the risk inherent in these instruments to understand how this contributed over time to the financial crisis.

1. Sub Prime Origination

The various factors behind the housing bubble formation can be seen in the diagram below and were the underlying drivers of the sub prime loan origination market.

Source: Wikipedia

Over time the quality of the loans being made deteriorated.  Part of this was down to speculation on the part of the borrowers; part of this was the competitive pressures on the mortgage origination firms to lend increasingly larger amounts of money to a limited market.  By March 2007 the value of the US sub prime mortgages outstanding was estimated to be $1.3 trillion, in a total mortgage market of approximately $10 trillion.  By August 2008, 9.2% of all US mortgages outstanding were either delinquent or in foreclosure.

2. Wall Street Securitisation

The Wall Street Securitisation process turning mortgage loans into Asset Backed Securities or Mortgage Backed Securities became a major profits engine for both the Wall Street Investment Banks and their employees.  The momentum of this market and the competitive pressures on the Banks and bankers to make profits made this a juggernaut that was very difficult to stop.

Up to this point, the US Subprime Mortgage Market was a straightforward horizontal market where the scale of the market and the risk was limited by the amount of subprime mortgages the Mortgage Originators could sell.  If the market had not developed any further there would still have been a crisis – one as much a result of US Government policy as the greed of the Wall Street banks – but of course it did not.

3. Derivatives

As the supply of bonds started to become a limiting factor on bond issuance, the Investment Banks used derivative instruments to create investment vehicles which were derived from the asset value, risk and performance of ABS and MBSs but which did not require ownership of the underlying assets.  This freed the Bankers from their supply problems and enabled them to continue to grow their markets and profits.

4. Synthetic Derivatives

These instruments enabled investors to take bets on the direction of the market in a highly leveraged strategy.  While derivatives increased the overall market size, synthetics and CDSs enabled the market to increase its leverage.  This enabled investors to take market positions without owning the underlying assets and further removed them from the detailed understanding of exact what assets underlay the instruments in which they were “investing”

5. Credit Default Swaps

These bets on the risk of default allowed investors to short the market i.e. to sell assets they do not own ahead of a fall in the price of the market after which they could buy the assets back at a lower price and make a profit.  While this was done effectively by paying an insurance premium which paid out in the event of default, because the premiums became more expensive as the market deteriorated, the owners of the CDSs were able to sell them on at a profit before the market completely collapsed and lock in their profit.

The failure of AIG FP and other special investment vehicles who specialised only in selling CDS contracts (Monolines) highlighted the investment risk of the person buying the contract i.e. in the event of widespread default, the contract writer would not have sufficient capital to pay-out to the owner of the insurance policy holder.

6. Risk Management

The issuers of the bonds, whether CDOs or other derivative instruments, the Wall Street Investment Banks stood behind the instruments and would be liable to repay the capital in the event of default.  They could have laid off this risk by backing the bond issues with Credit Default Swaps, transferring the risk of default to the seller of the insurance policy.  This would have significantly reduced the profitability of the bond issue, eating into their fees and the investors’ returns.  In most cases, erroneously believing that the risk of default of these AAA rated instruments was minimal, most chose to keep them on their own balance sheets or if not to set up and SIV and transfer the risk off balance sheet, but not in the event removing the risk.

In my next post I will try to highlight what went wrong and what precipitated the crisis.

If you enjoyed this or wish to comment please do so on the Blog.  I would be delighted to discuss this or other Corporate Strategy issues with you – you can contact me at jbdcolley [at]aol[dot]com.  My full contact details can be found on my About page here.

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