Independent Risk Monitoring Ltd

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Independent Risk Monitoring Ltd
Whats REALLY been going on the credit
markets?How and why could they unravel, and
what does the future hold?
11th October 2007
LUXEMBOURG CHAPTER MEETING
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Whats REALLY been going on the credit markets?

• What were the conditions leading to the credit
  market collapse and the bubble that preceded it?

• Loose monetary policy, leading to
• Excess market liquidity in search of yield,
  leading to
• Increased prices/decreased yields in all
  financial markets, leading to
• Investor demand for higher-yielding securities,
  leading to
• Availability of investors for complex securities
  and riskier securities having comparably higher
  yields, leading to
• Ability to package subprime mortgages into MBS,
  leading to
• Ability for lenders to originate subprime
  mortgages and sell them into the capital markets
  while retaining very little risk themselves.

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Whats REALLY been going on the credit markets?

• What happened to the subprime MBS market?

• Investor lack of understanding of subprime
  mortgage collateral and over-reliance on rating
  agency analysis.
• Rating agency underestimation of risk and
  subsequent incorrect sizing of credit enhancement
  for subprime MBS.
• Mortgage brokers with no downside risk pushed
  mortgage loans to under-qualified borrowers.
• No vested interest on the part of lenders led to
  lax credit underwriting standards.

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Whats REALLY been going on the credit markets?

• What happened to the CDO market?

• Defaults in subprime MBS included in CDOs.
• Correlation flaw for CDOs with subprime MBS
  collateral.
• Subprime MBS are much more highly correlated than
  normal unsecured bonds.
• Extreme leveraging of risk.
• CDOs backed by subordinated tranches of other
  CDOs backed by subordinated tranches of subprime
  MBS.

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Whats REALLY been going on the credit markets?

• Leveraging of Risk -- Example

CDO2
CDO
Subprime MBS
CDO 1
CDO 1
Subprime MBS 1
Subprime MBS 2
CDO 2
CDO 2
Subprime MBS 3
CDO 3
CDO 3
Subprime MBS 3
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Whats REALLY been going on the credit markets?

• Why did the rating agencies get it wrong?

• No history of credit performance for this asset
  type in down markets.
• Outstanding prior credit history for MBS.
• Possible inability to cope with unprecedented
  deal flow.
• Previous models for structured transactions were
  developed at the developmental stages of the MBS
  and ABS markets when deal volume was much smaller.

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Whats REALLY been going on the credit markets?

• Have we seen the worst?

• Mortgage loan defaults could continue to
  increase.
• Payment shock mortgage payments will increase
• At the end of teaser rate periods for recent
  loan originations.
• For adjustable rate loans if interest rates
  increase.
• Declining property values will lead to
  loan-to-value ratios gt 100.
• Possible economic effects of job losses/decreased
  compensation in the financial sector.
• Property prices could continue to decline.
• Increasing supply due to projects still in the
  pipeline.
• Increasing supply due to increase in repossessed
  properties.
• Decreasing demand due to decreased availability
  of funding.
• Risk of a downward spiral
• ?defaults ? property prices ? defaults, etc.

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Whats REALLY been going on the credit markets?

• Was what happened really a surprise?

• Potential problems with credit derivatives were
  identified in late 2006.
• Problems in the subprime mortgage market began to
  surface in early 2007.
• The problem was that market players wanted to
  believe that the above problems were isolated,
  that overall favourable market conditions were
  sustainable, and that the sheer size of the
  credit markets would ensure continued liquidity.

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IRML Contact Details
For information about IRMLs risk monitoring and
reporting services, contact

• Chris Butterwick
• Independent Risk Monitoring Ltd
• 10-11 Charterhouse Street
• London
• EC1M 6EE
• Tel [phone]
• Fax [phone]
• chris.butterwick_at_irml.net
• www.irml.net