Financial crisis dissected

By David Bukey
The current financial crisis took nearly everyone — including professional risk managers — by surprise. When housing prices began to fall in the first half of 2006, the decline triggered a chain reaction few risk experts anticipated.

Indeed, in a recent lecture on the financial crisis, Dr. Christopher Culp, adjunct professor of finance at the University of Chicago and senior advisor at consulting firm Compass Lexecon, admitted that a large portion of his own assets were tied up in vulnerable markets — a certificate of deposit from IndyMac Bank, which failed in July 2008, and auction-rate securities, a market that froze in early 2008.

“It was like I took my own class and violated every single principle,” Culp jokes.

As the financial crisis ripples across seemingly uncorrelated areas — from housing to banks and various credit markets — everyone is wondering how this chain reaction began, why the crisis wasn’t contained within the housing industry, and when it might end.

In mid-November, Dr. Culp spoke to members of the Professional Risk Managers’ International Association in Chicago and answered some of these questions. In an engaging speech, Culp explained why the housing slump triggered such wide-ranging economic troubles, but he refused to blame specific players.

The subprime mortgage debacle
The crisis began with subprime mortgages — home loans to low-income borrowers with low credit scores. As interest rates fell in 2001 and 2002, mortgage brokers peddled more of these loans to high-risk borrowers, because they could eventually sell them to investors eager to earn a higher interest rate.

Most subprime mortgages are adjustable — they offer low initial interest rates before resetting at a higher interest rate after two or three years. As long as housing prices continued to rise, subprime borrowers could refinance their loans to avoid higher rates and monthly payments.

Clearly, homeowners depended on rising housing prices in order to refinance and keep their loans. But Culp says lenders also depended on refinancings to keep their investments solvent, which magnified problems once housing prices tanked and refinancings dried up.

First, banks sold mortgages to intermediaries who bundled them together, a process known as securitization. This process gives banks cash and takes the loans off the balance sheet as they are turned into residential mortgage-backed securities (RMBS). In the subprime market, these securities were divided into different risk classes, or “tranches.” For instance, the higher levels (i.e., class A) get loan payments first, and if borrowers don’t pay, they get hit last.

Turning mortgages into securities isn’t inherently bad, according to Culp, but 80.5 percent of all subprime loans were securitized in 2006, meaning an alarming number of investors bet on the housing market just before it crumbled. More importantly, the RMBS structure was based on the flawed assumption that borrowers would continue to refinance, providing an additional cash cushion that covers some loss from delinquent borrowers. Securities issued several years ago had time to build up this cushion before housing prices collapsed, but those launched in 2006 and 2007 couldn’t absorb any losses and failed quickly, triggering the current crisis.

“It’s a combination of the securities’ design, their timing, and the actual decline of housing prices that affects collateral and sets this chain reaction in motion,” Culp says.

Figure 1 combines a probability distribution of cumulative losses (orange, left) with the capital structure of a typical mortgage-backed security (class A to residual, right). Notice capital exceeds losses of 100 percent because one section represents these extra payments, labeled “overcollateralization (O/C).”



Without extra cash from refinancings and prepayments, these securities lost money sooner than expected when housing prices sank (Figure 2). 



Magnifying the problem
Securitizing loans was so profitable that Wall Street didn’t stop there. They created collateralized debt obligations (CDOs), or pools of debt that invested only in RMBS, and the dreaded CDO2  — instruments that bought only CDOs and other RMBS.

At each step, investors moved further away from the underlying mortgages, a dilemma Culp compares to looking at a photocopy of a photocopy.
“You still have the same picture, but it gets slightly blurrier each time you step away,” he says.

Clearly, some investors didn’t understand the real risk of these instruments.

As murky as these investments were, however, a $1 mortgage loss still equaled a $1 loss for RMBS, CDOs, and CDO2s. By contrast, traders of credit default swaps (CDS), unregulated contracts offering insurance against default on these securities, magnified exposure to housing prices. In this $62 trillion market, $1 of mortgage losses was multiplied up to 100 times as hedge funds, investment banks, and other institutional players bet on the housing industry.
 
The chain reaction
After peaking in the summer of 2006, home prices fell 23.4 percent by September 2008, as measured by the S&P/Case-Shiller composite home price index (Figure 3). The decline was especially devastating because investor housing exposure had ballooned because of securitization and the CDS market. Credit ratings for these securities tumbled sharply. Starting in September 2007, for example, 14.3 percent of all “A”-rated structured-finance securities dropped to ratings of “CCC” within a year, a historic decline.



“The real shock for me was in the summer of 2007 when we realized this was absolutely not confined to subprime mortgages,” Culp says.

At that point, the commercial paper market, which provides short-term loans to many companies, seized up and interest rates skyrocketed. Also, trouble appeared in other critical markets — the London Interbank Offered Rate (LIBOR), auction-rate securities, and leveraged loans, or borrowings from companies with less than investment-grade credit ratings.

Selling assets and raising money
Financial markets have fallen hard and fast, mainly because firms that use debt are reducing risk by selling all types of assets. After suffering losses, leveraged firms are especially vulnerable to collapse because equity is wiped out as its debt level increases.

“Even small losses cause firms to deleverage, because the probability of insolvency is higher,”  Culp says.

Suppose a firm worth $100 has $20 of equity and $80 debt. If the firm loses $10 its equity drops to $10 but it still owes $80 in debt, so its debt-to-equity ratio doubles from 4:1 to 8:1. To avoid insolvency, a firm could sell the riskiest assets to lower its debt-to-equity ratio. In this example, the company could sell $40 in assets, leaving it with $10 in equity and $40 in debt, which reduces the debt-to-equity ratio back down to 4:1.

Instead of selling assets, firms can also raise new capital by selling more stock or bonds. Injecting new capital will also restore a company’s debt-to-equity ratio to safer levels, which is the goal of Treasury Secretary Hank Paulson’s revised bailout plan. 

The evolving credit crisis
Although the commercial paper market has been disrupted, Culp doesn’t believe it will implode.

“[Commercial paper] is still a very deep, thick market in which companies can finance their working capital,” Culp says.

As the U.S. economy remains mired in recession, the credit crisis has evolved from concerns about liquidity to concerns about corporate defaults. Moreover, commercial-bank and leveraged lending dropped 54 and 31 percent, respectively, in the third quarter of 2008. Despite these worries, Culp says lending held up well until recently, a good sign considering the financial crisis is nearly two years old.

Unlike the financial pundits, Culp knows better than to predict what will happen next.

“If we could perfectly predict every scenario, we wouldn’t make or lose money, and [everyone] in this room would probably be out of work,” he says.


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