The Great Deleveraging

1
The Great Deleveraging

• how the subprime crisis became a run on the bank

2
In the Beginning there was Commercial Paper

• 1869 Marcus Goldman starts the company that
  will become Goldman Sachs and invents Commercial
  Paper.
• From 1869 to 1975 the commercial paper market
  grew slowly and as late at 1975 there was only 48
  billion outstanding.
• It was primarily used by corporations to provide
  working capital.
• Until the 1950s most CP holders were banks.
• In the 1950s and 1960s industrial firms began
  to hold CP as an alternative to bank deposits.
• In the 1970s money market funds were created by
  the 199os had become the dominant player in the
  CP market.
• Because of the 1970 default by the Penn Central
  Transportation Company, the market insisted that
  almost all CP hold a short term rating by the
  rating agencies.
• In order to obtain this rating commercial paper
  issuers had to obtain backup liquidity lines from
  banks.
• Once money market funds, ratings, and liquidity
  lines had been institutionalized, commercial
  paper use grew rapidly
• 1980 122BB, 1985 294BB, 1990 558BB and 2007
  1.3 trillion.
• In 1983 the first Asset Backed Commercial Paper
  (ABCP) conduit was created.
• This allowed firms to finance assets in a
  bankruptcy-remote entity.
• SIVs (structured investment vehicles) are a
  variant on ABCP conduits
• By 1999 there was over 500BB of ABCP outstanding

3
Then, Wall Street Created the Asset Backed
Security

• Before 1970, investors could only trade whole
  loans
• 1970 GNMA guaranteed the first mortgage pass
  through securities
• They were quickly followed by FNMA and FRE
  (Freddie Mac)
• 1983 The first collateralized mortgage
  obligations were issued (CMOs)
• 1985 Sperry Lease Finance Corporation creates
  the first asset backed security (ABS)
• It was backed by computer equipment leases
• Since 1985 the banks and investment banks have
  rushed to securitize any asset they can find with
  a cash flow that is easy to describe
• CMBS, student loans, home equity loans, credit
  card receivables
• Aircraft
• Commodities
• Insurance products, e.g. catastrophe bonds
• By 2003 there was over 6 trillion dollars of
  asset backed paper outstanding
• There have been periodic blow-ups in this market,
  usually involving securitizations of
  securitizations
• CMOs
• CLO/CDO squared
• CDO of ABS

4
Finally, Bank Regulatory Standards were Codified

• Before Basel I banks were required to hold
  capital equal to a fixed percentage of assets
• In the early 1980s the United States began to
  adopt more sophisticated bank capital rules
• In 1989 it adopted the Basel I accord
• Capital requirements are defined based on
  simplified risk-based rules
• Different financial institutions were regulated
  (or not) by different bodies, the rules for
  banks, investment banks, insurance companies,
  mutual funds, hedge funds, etc are all different
  and are not necessarily consistent
• The capital rules tried to segregate risk into
  different types
• Credit Risk
• Interest Rate Risk
• Market Risk
• Insurance Risk
• Liquidity Risk

5
Wall Street Abhors a Vacuum

• By the 1980s the tools were in place for an
  explosion in financial product development
• The commercial paper market made it possible to
  separate financing from asset ownership
• The securitization market, and its child the
  derivatives market, made it possible to
  transform risk at will. By passing cash flows
  through a series of legal entities or
  transferring risk via contract one could change
• The legal form
• The accounting
• The tax treatment
• The regulatory treatment
• An influx of quantitative and legal talent,
  coupled with cheaper computers, made it possible
  to create and model increasingly complex
  transactions
• With the ability to separate financing, legal
  ownership, and risk taking a number of companies
  sprang up to play specialized roles such as
• Origination
• Warehousing
• Structuring and Sales
• Risk Taking
• Financing

6
The Players

• Originators banks, savings and loans, and
  mortgage companies that made the original
  mortgage loans.
• Loan officers at these firms were viewed as
  salesmen and not as risk takers
• Compensation was commission based
• Loans were sold on as quickly as possible
• Warehouse providers loans were kept in
  warehouse facilities while enough volume was
  accumulated for a securitization. There were
  several types of warehouse
• ABCP conduits
• The balance sheets of banks
• The balance sheets of mortgage companies
• Usually financed via a total return swap with the
  bank that would ultimately create and distribute
  the bonds
• Structurers banks and investment banks that
  created securities
• Large financial institutions that created the
  legal vehicles to
• Own the loan pools
• Service the loans
• Segregate the cash flows into the appropriate
  bonds
• Once the bonds were created, the structures sold
  them on to various risk takers and finance
  providers

7
More Players

• Equity Providers banks and hedge funds
• These people took the risk of the lowest (equity)
  tranche of the securitization
• It was viewed as an equity investment and they
  required equity-like returns
• Essentially, the investment is a leveraged
  purchase of the underlying loans with
  non-recourse financing
• Senior Risk Takers banks, insurance companies,
  mutual funds, and monoline insurance companies
• These players are buying highly rated assets for
  cash flow.
• Banks and insurance companies, they provide both
  the financing and the risk transfer
• Monoline insurance companies provides only risk
  transfer and need a third party to finance the
  assets
• Leverage providers banks, insurance companies,
  mutual funds and conduits
• All of these parties provide the cash needed to
  finance the assets.
• They assume that there is little or no risk to
  repayment of cash and that they are only
  providing liquidity
• The rating agencies
• In exchange for a fee, these companies opine on
  the relative credit worthiness of borrowers.
• A borrower may be an institution or it may be a
  special purpose vehicle
• A borrower may not even borrow money. It may
  just be somebody who has to pay money out under
  certain circumstances.
• All of the bonds, as well as the CP conduits and
  monoline insurance companies all required ratings
  to play the game

8
Risk and Reward

• Originators lend money to borrowers
• Because they are selling the assets on very
  quickly, they have little or no incentive to make
  sure that the assets are of good quality.
• As long as they follow the rules set by the
  warehouse provider and the rating agencies they
  know that the assets will quickly move off of
  their books
• Warehouse providers earn carry off the assets
  while providing initial financing
• Again, the primary risk management tool of these
  players is velocity.
• As long as the assets are securitized quickly,
  there is no time for anything to go wrong
• Structurers take only legal and compliance risk
• They create the bonds and sell them
• They earn structuring and underwriting fees
• The primary risks that they take are either
  mis-selling or poor structuring which would
  result in them retaining risk that they thought
  was gone
• Equity providers take the largest slice of the
  risk
• In theory these players have the greatest
  incentive to do a full analysis of the terms
• Senior Risk Providers and Leverage Providers rely
  on agency ratings to protect them
• They generally do not have the capacity to
  analyze collateral in great detail
• They use the rating agency analysis, sell side
  analysis and diversification as their primary
  tools for decision making
• Rating agencies take a fee for an unbiased
  estimate of the credit risk in a transaction

9
The Game

• Originators make loans to unqualified borrowers
• Usually done by making no income verification or
  no appraisal loans
• Warehouse providers are happy to accept no-doc
  loans as they know that these loans are allowable
  collateral for securitizations
• Structurers rely on their knowledge of rating
  agency and regulatory capital rules to create
  securitizations. For example
• An asset rated AAA requires only 1.6 capital on
  a banks balance sheet. While an asset rated
  below BBB requires 8 capital.
• If you can get a rating agency to rate a bond AAA
  with less than 8 subordination then when you
  create the securitization you have freed up
  capital.
• In the simplest case (which is not allowed), a
  bank could hold the equity and the senior piece
  of a securitization and hold less capital than it
  did if it just held the loans.
• The extra income produced by the freed capital
  can be spread around to multiple players
• As long as defaults dont pass the equity layer
  of the structures everybody makes a higher return
  on capital.

10
The Problem

• Over time, money rushed into the sector to earn
  the excess returns.
• As returns dropped investors required more and
  more leverage to make enough money
• In order to get this leverage the ABS CDO was
  created
• This took low rated tranches of ABS
  securitizations, threw them into a trust and
  re-securitzed them.
• This created new equity and new AAA debt
• This whole process relied on two key assumptions
• The loan originators were making loans that were
  just as creditworthy as past loans had been
• The system took away all incentive for this.
• They got paid if the loans were good or bad
• Acceptance of no-doc loans meant that they didnt
  even need to ask the questions.
• The rating agencies were correct about the
  ratings of the bonds and of the various parties
• In order to rate the bonds they needed to get the
  default rates right within the original
  collateral class
• They were wrong, but losses stayed within
  stressed parameters
• In order to rate the CDOs they needed to get the
  correlations right among the various bonds in the
  trust
• They got this horribly wrong and massively
  underestimated the correlation

11
What Went Wrong?

• The rating agencies were providing the tools to
  use less and less capital to support asset
  purchases
• Each time the assets were re-securitized, this
  leverage went up.
• In the end there were two highly leveraged
  classes of player that had massive exposure to
  any rating errors, the CP conduits and the
  monoline insurers
• When defaults occurred in excess of prior
  experience, market players recognized this and
  began to mark down BBB rated ABS securities.
• Because the BBB rated ABS securities were the
  collateral for ABS CDOs this mark-down led to
  losses in the junior tranches of the CDOs.
• The correlations turned out to be much higher
  than those used in the ratings and the losses
  spread to AAA tranches
• As soon as it became apparent that AAA assets
  were going to be downgraded in large numbers, we
  had the makings of a liquidity crisis

12
Out of Liquidity

• When it is likely that enough assets owned by
  monoline insurance companies will default, it
  causes their ratings to come into question and
  they get downgraded
• Once an asset is downgraded below a minimum
  threshold, CP conduits have to liquidate that
  asset.
• CP conduits were hit by a double whammy
• They had to liquidate assets that were
  experiencing losses
• They had to liquidate assets wrapped by monoline
  companies
• Over 500BB dollars worth of assets had to be
  liquidated or taken back onto bank balance sheets
• Because taking an asset back onto a balance sheet
  requires more regulatory capital than financing
  it, the banks had to liquidate other assets to
  make sure that they had enough capital
• Because many assets were being liquidated at
  once, this had to be done at fire-sale prices
• Because banks have to mark newly consolidated
  assets to market they had to take even bigger
  losses into earnings
• The market for these securities ground to a halt
• In order to restore their capital position, banks
  had to stop making loans or sell assets, often at
  a loss
• Because nobody knew who owned which pieces of
  risk, trust broke down leading to general
  unwillingness to lend even when capital was
  available.

13
The Great Deleveraging

• Every time an asset is moved onto a balance sheet
  or marked down it removes capital from the
  system.
• In order to shore up capital, banks have been
  selling assets or taking back credit previously
  provided
• Asset holders who can no longer obtain financing
  must sell those assets
• There may be nothing wrong with the asset holder
• There may be nothing wrong with the asset
• There is simply no liquidity
• Every time one person sells at a fire sale price,
  everyone else has to mark down their position and
  the cycle starts again
• Eventually it stops because you get enough
  irrational pricing or because people go bankrupt
• We have what appears to be irrational pricing now
  but we still have a lack of trust
• This is why the Federal Reserve engineered the
  Bear Stearns takeover and allowed investment
  banks to borrow. They need to restore trust
• Deleveraging has real world consequences
• Our economy is built on credit. If people and
  businesses cant get credit, they dont invest
• An asset bubble can create a realworld slow down.

14
What Can We Do?

• We need to take our medicine quickly.
• The economy cant rebuild until people are done
  taking their losses
• This is the lesson of the Japanese bubble economy
• We may need more government intervention
• Left alone, each market participant, may, while
  acting in their own self interest, act in such a
  way as to exacerbate the problem.