Financial crisis is a bubble created by excessive investor inclination towards a particular market. It shadows the valuations and when the bubble bursts, the investors want to exit and therefore rapidly start selling their stake.
Too much of capital led to lower interest rates and this in return forced the investors to look for creative investment platforms where the yield was high. This requirement led to an unprecedented growth in the securitization market as the inclination towards such derivative instruments was high. Investors were willing to take higher risks as compared to the returns they would receive for their investments. Greed for higher returns, excessive leverage and low volatility led to the financial crisis of 2008. This low volatility which was a result of shadowed valuations led the borrowers to borrow over and above what their asset base allowed notwithstanding the criteria of credibility.
1. Low Volatility and High Leverage:
Low volatility means that the risk is low as the value of the security does not fluctuate dramatically but, changes at a steady pace. And thereby there is more capital available at a lower asset base. This leverage fueled the rising housing market in the US. A lot of savings turned into investments as lower risks were reflected at the existing volatility rates. Thus, the lower interest rates remained low for a considerably longer duration due to the inability of the Federal reserve to raise the interest rate amidst such financial conditions.
Fannie Mae’s and Freddie Mac’s public purpose is to facilitate the steady flow of low-cost mortgage funds. Their primary focus is on residential mortgage market and they won’t abandon it or change lines. Their charter states that the mortgages that they purchase and guarantee must be below an amount specified by the Office of Federal Housing Enterprise Oversight (OFHEO). Also, they are barred from entering the business of other housing finance companies e.g. mortgage origination. They must meet annual goals established by the Department of Housing and Urban Development (HUD). These goals center around low and moderate income housing and housing for minorities. They are subject to risk-based and minimum capital requirements and annual examinations by OFHEO. Fannie Mae and Freddie Mac are driven by profits, as their shareholders demand. While fulfilling their public mission, they make their profit in two primary ways: guarantee fee income and retained portfolios.
Fannie Mae and Freddie Mac are regulated by the OFHEO (Office of Federal Housing Enterprise Oversight) and the HUD (Department of Housing and Urban Development (HUD). OFHEO regulates the financial safety and soundness of Fannie Mae and Freddie Mac, including implementing, enforcing and monitoring their capital standards and limiting the size of their retained portfolios. OFHEO also sets the annual confirming loan limits. HUD has responsibility for the housing mission of Fannie Mae and Freddie Mac.
There is no doubt that Fannie Mae and Freddie Mac played a critical role in US housing finance system. However, there was a danger in having so much risk concentrated in only two companies. They managed an immense amount of credit and interest rate risk. Many critics feel that, due to their size and the complexity of managing mortgage risk, they posed too large of a systematic risk to the US economy. Put simply, there was a danger that the two companies have been allowed to take on too much risk at the potential expense of the American tax payer. To put things in perspective, according to Treasury Secretary Steel, at the end of 2006, Fannie Mae and Freddie Mac had about $4.3 trillion of mortgage credit exposure, which was about 40% of total outstanding mortgage debt in the U.S. In the summer of 2007, the market for all mortgages except those guaranteed by Fannie Mae and Freddie Mac came to a complete standstill, emphasizing the importance of the roles played by the two companies. In the fall of 2007, Freddie Mac shocked the market by announcing large credit-related loses, fueling the fire for the argument that the two companies pose a tremendous risk to the entire financial system the impact of which could be seen worldwide.
2. Financial Innovation during the Period in Question:
This housing bubble of the mortgage market became a part of a more attractive system of securitization. The mortgages tendered to the consumers purchasing houses were pooled together and sold off as tradeable assets. Due to low volatility the underlying risk was ignored. After reaching the peak, the market saw a decline and this affected the securities backed by these mortgages. Due to consumer default and excessive mortgage, the mortgage market faced a slump and house prices fell. This raised investor panic.
Although, the conditions preceding the crisis which are characterized by high risk appetite, high leverage and low volatility significantly contributed towards the development of structured finance within the capital markets, it was also one of the main reasons behind the crisis. The global interconnectedness and the wrongful risk assessment of these innovative financial structures led to the disruption in the financial markets.
The assignment of receivables has traditionally represented a means for trading companies and finance houses to raise funds readily and to predict the cash-flow with some degree of certainty and independently from debtors’ defaults. This was conventionally achieved through factoring agreements whereby a factor would purchase receivables for a discounted sum or for a periodic commission, providing thereby necessary funds for the assignor to continue trading without having to rely on receivables to be serviced. In its essence securitization developed as a more sophisticated form of factoring, one of the main developments being that assets are sold to a special purpose vehicle (SPV) that funds the operation by issuing bonds on the capital market, secured on the receivables. This fairly linear process started to be more extensively employed in the US housing market in the 1970s, when two government-sponsored agencies–”Fannie Mae” and “Freddie Mac” began acquiring home mortgages from lending institutions and issuing securities backed by pools of those mortgages. Subsequently investment banks as well embraced this financing model, and set up trading departments to specifically handle these securities. When banks then entered the securitization market for their home loans new frontiers opened up, with wider classes of assets being involved in the transaction and a broader category of originators participating in the market. Although the vehicle is sponsored by the originating company, it qualifies for the purpose of the transaction as an independent company and not as originator’s subsidiary. The SPV is anyway likely to be an almost non-substantive shell entity, whose only function is to raise money through the bond issue; complementary functions, in particular the servicing one, are mostly still carried out by the originator that will maintain existing relationships with borrowers. This risk mainly affects US courts, where assets and liabilities of an entity affiliated to the insolvent one can be merged to create a single common estate for the benefit of creditors. If the sale was to be legally characterized as a security the assets would remain on the originator’s balance sheet, as well as their underlying liabilities, hampering therefore the function of the transaction. Securities issued by the SPV are then rated by credit rating agencies, and at this stage of the transaction bonds receive a higher rating than would otherwise be obtained by the originator directly through a bond issue, chiefly because of the insulation of the former from the originator’s assets and business.
Over the last two decades securitization has blossomed, both among financial institutions that could obviate the maturity mismatch intrinsic to the lending business (especially in the context of mortgages) and also bypass capital adequacy requirements, and among corporations and government agencies wanting to get most of the profits of a certain cash-flow up front. To fully appreciate the advantages of securitization, however, an initial examination needs to look at the regulatory incentives provided by the first enactment of the Basel Accord of 1988. The Accord and the ensuing harmonized capital regulation provided the major incentive for the development of the “originate-and-distribute” model.
The way in which loans and other assets weighted on balance sheets became critical in the way banks started to manage risk accumulation by separating this process from that of credit origination, and by intensifying balance sheet management. This new model allowed banks to lend to a wider pool of borrowers without necessarily having to hold those loans to term on their balance sheets. Loans became the subject of negotiations among banks and other financial institutions, such as investment funds, which were all keen to get involved in the debt finance market where they could originate loans, sell the relating risks to a wide range of investors and thus remain insulated from potential defaults. The legal mechanisms through which this twofold purpose could be achieved–namely the compliance with capital requirements and the risk-shifting off-balance sheet–can be identified with securitization technique. While improving its financial ratio, originators can also improve the return on capital because they have removed assets and liabilities from their balance sheet while still retaining relating profits. From a strategic perspective, securitization provides originators with a corporate finance tool that liberates them from the tight terms of general loan agreements employed by most banks. This is for the simple reason that the bargaining power of investors purchasing bonds is much less constraining than that of a dominant bank that is in a position to negotiate and enforce restrictive covenants.
The off-balance sheet structure can potentially lead to the more problematic issue of the originator’s disincentive to monitor the quality of the receivables it originates, since they become the property–as well as the burden–of some other entity further down the transaction chain. It is worth observing that during the years prior to the crisis this became particularly evident as demand for securitized products increased dramatically, leading originators and CRAs to conduct little due diligence on underlying assets, and overall the exuberance that permeated the economic environment led to a decline in the level of transparency of transactions, as well as in their supervision.
Moving to collateralized securities, such as, for instance, residential mortgage-backed securities, which are subject of a securitization, so representing in essence a securitization of securitization. CDSs can be more closely associated with derivatives and can be defined as a type of protection against default, whereby the seller of a CDS agrees to pay the buyer if a credit event occurs, and the buyer agrees to pay a stream of payments equivalent to the payments that would be made by the borrower. Since the seller of the CDS receives payments that resemble a loan, the CDS can be regarded as a form of synthetic loan, and a mechanism to acquire credit risk of an unrelated party. Arguably, the over-exposure to these products in the broad context of the global crisis is what triggered the downfall of the insurance giant AIG.
3. Role of Credit Rating Agencies (CRAs):
Credit rating agencies rate not only institutions but also credit instruments and securities. It is mainly about the concept of investment grade — a rating given by these agencies keeping in mind a certain threshold. The CRAs hold the view that these ratings are not for the purpose of triggering the decision whether or not to invest in a security but they give relative information about the credit worthiness of an institution. CRAs are exempt from civil liability for their core activity and their financial duty of care as such does not exist.
In US there was a system of nationally recognized CRAs called NRSRO i.e. Nationally Recognized Statistical Rating Organizations. This status gave CRAs an unparalleled reputation and investor confidence. There was a privileged market position for CRAs with this status. Apart from rating institutions and securities CRAs were also caught in a web of ancillary services where the anticipatory expectations of the enterprises affected the quality of information that reached these CRAs which inhibited the ratings. Official recognition has more cons than pros. For instance, the status of NRSRO given to CRAs in US led to over — reliance on their assessments as they were implicitly taken to be backed by government that would indemnify any losses generated from wrong credit ratings. It also inhibits new entries in the field and thereby hampers innovation of assessment methodologies and new technology from coming in.
CRAs were insufficiently equipped in both qualitative and quantitative terms. They had no rules of procedure to follow for assessment of RMBS and CDOs. The activities of the CRAs were non- transparent and their credit ratings were heavily relied upon by the investors specially with regards to investments in securitized instruments and collateral debt obligations. Also, CRAs did not do significant research about the underlying assets in RMBS and CDOs. For instance, certain loans underlying RMBS had no documentation.
Considering the Enron scandal that raised concerns, let us understand what exactly happened. Enron was a company in the energy sector that generally received good ratings from CRAs. However, eventually it ended up filing for insolvency. Prior to this step the company was in talks with Dynegy Inc. regarding a merger. Enron wrote down assets worth US $ 2.2 billion and though there was a further write down of USD 500 million, the CRAs ignored this at the behest of Enron that talks of merger are in process and improvement in the financial condition of Enron was assured. As things unfolded it became clear that Enron could not survive without a merger and a balanced merger agreement seemed a far-fetched idea as Dynegy had backed off. Seeing this the CRAs were adamant at reducing the ratings of Enron from investment grade to a notch above junk. Post filing of insolvency by Enron these ratings went into negative. This shows that credit rating agencies were lax in dealing with the information available to them. They had detailed information about the financial position of the companies but they just restricted its use. Like in the case of Enron off balance sheet inquiries were ignored and only cash flow was assessed.