What Have We Learned from the Sub Prime Crisis

1
What Have We Learned from theSub Prime Crisis?

• Professor Anthony Saunders
• John M. Schiff Professor of Finance
• New York University
• Stern School of Business
• May 2008

2
How did we get here?

• Traditional Banking
• Banks as Delegated Monitors
• Disintermediation
• Securitization
• Traditional SPV-based (special purpose vehicle)
• SIV-based (special investment vehicle)
• Syndication
• Back to the Future
• Off-Balance Sheet Proprietary Investing
• What happens when the delegated monitor delegates?

3
Getting here Traditional Banks as Delegated
Monitors
The Traditional Bank Delegated Monitoring
Bank
Assets
Liabilities
Cash Assets
Deposits Purchased Funds
Loans
Capital
4
Getting Here Traditional Securitization

• Securitization allowed banks to remove risk from
  their balance sheets
• Securitization allowed banks to avoid onerous
  capital requirements
• Securitization turned banks into underwriters
  originate the loans and then sell them off.

5
The Traditional Securitization Process
Bank
Assets
Liabilities
Cash Assets
Deposits Purchased Funds
Loans
Capital
Loans
Cash
SPV
Assets
Liabilities
Loans
Asset-Backed Securities
Cash
Investors
6
Getting Here Asset-Backed Securities (ABS) and
Decline in Quality of Underlying Assets

• Mortgage-Backed Securities (MBS)
• Residential MBS
• Pass-throughs and Collateralized Mortgage
  Obligations (CMOs)
• Subprime and No/Low Documentation
• Def. Subprime (2001 Interagency Expanded
  Guidance)
• Two 30-day delinquencies in last 12 mos. or
  one 60-day delinquency in last 24 mo. OR
• Judgment, charge-off. foreclosure, repossession
  in last 24 mos. OR
• Bankruptcy in last 5 yrs OR
• FICO score 660 OR
• Debt service/income ratio 50
• Second Lien Mortgages (High Loan/Value Ratios)
• Collateralized Debt Obligations (CDOs)
• Cash CDOs and Synthetic CDOs
• Collateralized Loan Obligations (CLOs)
• Covenant Lite and PIK (payment in kind)

7

Source Bank of England, Financial Stability
Report, October 2007, Issue 22, page 6
8

.
Source Loan Pricing Corporation website
9
Getting Here Loan Syndication

• Banks as underwriters
• Firm Commitment (Underwritten) deals The lead
  bank commits to making the loan in its entirety
  and then assembles participants to reduce its own
  loan exposure. Thus, the borrower is guaranteed
  the full face value of the loan.
• Best Efforts deals The size of the loan is
  determined by the commitments of banks that agree
  to participate in the syndication. The borrower
  is not guaranteed the full face value of the
  loan.
• Club deals For small deals (usually 200 million
  or less), the loan is shared among banks, each of
  which has had a prior lending relationship with
  the borrower.
• Leveraged Loan Syndications
• Below investment grade
• Often, they will have debt to cash flow levels in
  excess of 41 (i.e., their outstanding
  indebtedness (i.e., face value of debt) is more
  than four times the borrowing firms annual
  revenues)
• Decline in Quality of Loan Syndications.

10
Syndicated Lending
Borrower
Bank (Syndicate Lender)
Syndicate Member
Syndicate Member
Syndicate Member
11

Source Loan Pricing Corporation website.
12
Getting Here SIVs

• Banks as underwriters
• Switching from spreads to fees
• Reduce risk, but reduce return
• Response A new form of intermediation back to
  the future of SIVs.
• Formula for disaster
• SIV Traditional Bank Regulatory Oversight
• SIVs are exposed to traditional banking risks
  interest rate risk, liquidity risk, credit risk

13
A New Securitization Process
Bank
Assets
Liabilities
Cash Assets
Deposits Purchased Funds
Loans
Capital
Loans
Cash
SIV
Assets
Liabilities
Loans
Commercial Paper
Cash
ABCP
Investors
14
Getting Here Proprietary Investing

• Banks establish hedge funds, private equity
  funds, venture funds through equity investing
  and/or lending.
• Unregulated activities conducted off the banks
  balance sheet.

15
Anatomy of the Storm and Credit Risk Models

• Can we have higher return without higher risk?
• Why did Credit Risk Measurement Models fail?
• Which risks were underestimated?

16
Anatomy of the Storm The Phases of the Crisis
Bank of England
17
Phase 1 Anatomy of the Storm Assumption of
Perpetually Rising US House Prices

• Subprime and teaser rate mortgages depend on
  rising housing prices to
• Refinance upon hitting expiration of introductory
  teaser rate. But, there is a strong correlation
  between PD and level of rates (see, Stiglitz and
  Weiss)
• Sale of property in the event of borrowers
  inability to make payments. If housing prices
  increase, Loss Given Default 0
• Both PD and LGD exhibit procyclicality
• Thus underestimate PD, LGD and ? (PD, interest
  rates).

18
Phase II of the Storm Rising Spreads on RMBS


Underestimate ? (RMBS vs. RMBS EUR
Source Bank of England, Financial Stability
Report, October 2007, Issue 22, page 7.
19
Phase II Higher spreads, lower prices, fewer MBS
originations
Underestimate ? (AAA, BBB-)
20
Phase III of the Storm The Crisis Spreads to
Other ABS Markets

• CDO spreads increase
• CDO issuance declines
• Leveraged Loan prices fall

21
CDO Spreads Increase

Underestimate ? across debt markets, i.e., ?
(RMBS, CDOs)
Source Loan Pricing Corporation website.
22
Leveraged Loan Prices Fall

Underestimate ? (RMBS, HLT)
Source Leveraged Loan Index is the CSFB
Leveraged Loan Index Plus Average Price,
expressed as a percentage of par, Bloomberg
Ticker DLJLPX
23
Phase IV Risk Flows Back to Banks
Reintermediation

• SIVs are unable to issue Asset-Backed Commercial
  Paper
• SIVs access their backup lines of liquidity and
  take down credit lines
• Banks are unable to securitize or syndicate these
  loans due to the decreased volume of new deals
• Even if they could sell off these unwanted loans,
  the prices would be low as spreads increase.
• SO Banks did not really remove the risks from
  their balance sheets.
• Underestimate correlation between on and
  off-balance sheet risk , i.e., ? (Risk on, Risk
  off)

24
Phase V Liquidity Hoarding and Flight to Quality
Creates Mispricings
Underestimate ? (credit risk, liquidity risk)
Source St. Louis Federal Reserve Bank database,
FRED website.
25
How do we steer out of the storm?

• Better Risk Modeling
• Price of risk was set too low in the mortgage
  market.
• Quantity of risk was underestimated the
  pitfalls of hidden leverage.
• Improve credit rating models PD and LGD.
• Analyze correlation across markets, risks and
  countries
• Align Incentives
• What does it tell you when informed lenders treat
  their loans like hot potatoes?
• Avoid Regulatory Mispricings
• Basel II implications

26
If capital is required

• Standardized model risk weights

27
Steering Out Potential Pitfalls of the Basel II
Securitization Requirements

• Places heavy reliance on external credit ratings.
• Standardized model uses credit ratings
• In the hierarchy of IRB approaches, RBA is
  preferred tied to credit ratings
• What happens when the credit ratings are wrong?