The Alphabet Soup of the SubPrime Crisis

1
The Alphabet Soup of the Sub-Prime Crisis

• Marti Subrahmanyam
• Charles E. Merrill Professor of Finance,
  Economics and International Business
• Stern School of Business
• New York University
• For presentation at the
• Bangalore International Centre
• January 24, 2008

2
Outline

• Introduction
• Institutional structure The players
• Credit-sensitive instruments
• Regulatory environment
• Credit and liquidity
• The role of correlation
• The crisis unfolds
• Policy solutions - Micro
• Policy solutions - Macro
• Q A

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Introduction

• Rumblings about credit situation in late
  2006-June 2007
• Assurances from crediting rating agencies and
  regulators
• Crisis hit the headlines in July 2007 with
  write-downs by major financial institutions e.g.
  Citigroup, UBS, Bear Stearns, Goldman Sachs etc.
• Despite some up-ticks from time to time, the
  crisis continues to this day, with no end in
  sight
• Spread to other markets, including the global
  equity markets
• Fear that this financial crisis will spread to
  the real economy in the US/Europe/Japan and
  trigger a recession

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Introduction (Contd.)

• Focus on
• - What are nuts and bolts of this crisis?
• - Who are the major players?
• - What structures are used?
• - What financial instruments are used in these
  markets?
• - What are the drivers of the valuations and
  how have they changed?

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Institutional structure The players

• Borrowers Mortgage loans
• - Fixed vs. Adjustable rate mortgages
• - Credit quality sub-prime, Alt-A and A-paper
• - Securitization
• Borrowers Corporate, agency and sovereign debt
• - Securitization pooling and tranching
• - Rating of tranches
• - Targeting of tranches to particular
  customers,
  
  e.g.
  hedge funds, bank SPVs (SIVs, other
• conduits) etc.

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Institutional structure The players (Contd.)

• Investors hedge funds, banks, municipalities,
  non-profits etc.
• - Arbitrage between tranches
• - Investors in senior and super-senior tranches
• Rating agencies
• - Models for assessing default risk
• - New relationship ofrating agencies and issuers
• Regulators
• - Impact of Basle II
• - Bank supervision
• Low credit spreads after 2002 search for yield

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Credit-sensitive instruments

• Mortgage loans prepayment and credit risks
• Mortgage-backed securities (MBS)
• Corporate debt instruments
• Collateralized debt obligations (CDOs)
• Tranches super-senior, senior, mezzanine, equity
  (first loss)
• Credit default swaps (CDSs)
• Exotic CDOs e.g. synthetic CDOs, CDO squared

8
Regulatory environment

• Basle II Risk weighting based on credit rating
  the greater the credit risk, the lower the rating
• Overall capital adequacy of 8, limits on Tier 1
  versus Tier 2
• Bank supervision of SIVs and conduits
• Accounting treatment of off-balance sheet
  vehicles
• Emphasis on credit ratings
• Ignoring yield curve risks
• The moral hazard issues

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Credit and liquidity

• Determinants of spreads on bonds
• - Credit
• - Liquidity
• - Market frictions
• - Tax
• Measurement of credit risk
• - Models structural and reduced form
• - CDS prices
• Measurement of liquidity premium and liquidity
  risk
• Interaction between credit and liquidity risk

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The role of correlation

• Multiple assets numbering in the 100s
• Two factors
• - probability of default (hazard rate)
• - recovery rate (loss given default)
• Correlation in defaults across assets
• Number of correlations estimation problems and
  dimensionality
• Attachment points

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The crisis unfolds

• Falling real estate prices
• Losses in hedge funds
• Inability of SIVs/banks to refinance their CP
  borrowings
• Freezing-up of the CP market
• Banks recognition of credit losses liquidity or
  credit?
• Unraveling of SIV structures move to balance
  sheer e.g. HSBC
• Pressures on rating agencies

12
The crisis unfolds (Contd.)

• Broader liquidity/credit crisis LIBOR/Fed Funds
  and LIBOR/TBill spreads explode
• Discount rate/Fed Funds target rate cuts do not
  quell fears
• TAF and concerted action by central banks
• Credit crisis turns into liquidity crisis and
  then into a crisis of confidence

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Policy solutions - Micro

• Better models for credit in regulation and risk
  management
• Regulation of rating agencies to avoid conflicts
  of interest
• Better accounting disclosure of risks
• Encouragement of loss recognition including
  bringing structures on to balance sheet
• Infusion on new capital from long term strategic
  investors
• Joint venture to manage liquidity risk

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Policy solutions - Macro

• Coordinated actions by major central banks
• Reducing the stigma of borrowing at the discount
  rate
• Extending the range of assets qualifying for
  collateral
• Extending the maturity of loans
• Fed funds rate cuts and infusion of liquidity by
  central banks
• TAF facility
• Fiscal stimulus

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Q A