Friday, November 16, 2007

Subprime Mortagage Crisis - Management Issues

Subprime crisis has brought management issues banks, investment banks and broking companies into the fore. CEOs of Citibank and Merrill Lynch, both top tier companies in commercial banking and investment banking makes evident the importance of management failures. Merrill CEO was criticized for not undertaking proper risk management measures.

11 December 2007

Remarks by Daniel H. Mudd
Fannie Mae President and Chief Executive Officer

Having declined 27 percent so far, housing starts are likely to fall another 14 percent in '08. Home sales are down 14 percent this year, and we expect will fall another 12 percent next year. We expect home prices to fall 3 percent this year⎯they were growing a little bit at the beginning of the year, and are at an exit rate that will produce about a 3 percent fall this year. 4 to 5 percent decrease in home prices next year, with a peak-to-trough decline of 10 to 12 percent on average nationally, through 2009. We expect to see some growth at the end of 2009 at the earliest.

Full transcript

October 2007

The U.S. subprime housing crisis will not peak until 2009

The U.S. subprime housing crisis will not peak until 2009, rating agency Standard and Poor's said on Tuesday, adding it had underestimated the extent of fraud in the industry.

S&P expected the world economy to grow 3.6 percent in 2007 and 3.5 percent in 2008, with emerging market economies driving growth. The U.S. economy would lag at 2 percent in both years, down from 2.9 percent in 2006.

The subprime crisis -- which roiled global markets in late July and August -- was far from over, although its shock value was wearing off, David Wyss, S&P's chief economist, said in Mumbai.

"We underestimated the extent to which fraud was occurring in the industry," he said.

"It looks, based on some surveys that had been done, the extent of frauds increased sharply in 2006."

S&P said the U.S. Federal Reserve had estimated that subprime losses could reach $150 billion, and Wyss said that would feed through to unemployment and remain a brake on growth.

"We think in the United States the housing market is not going to bottom until winter. We think the losses in these sectors won't really hit their peak until 2009," Wyss said.

"We are not halfway through with this crisis yet."

Emerging markets were far less vulnerable to credit market turmoil than during previous crises because of the capital flows attracted by high economic growth coupled with improved corporate governance standards, S&P said.

"The fact that the U.S. slowdown is concentrated in housing, which has relatively low import content, helps," it said.

High commodity prices were also helping many emerging market economies, such as Latin American and African countries that are major exporters.

S&P estimated that, on a purchasing-power parity basis, the United States would contribute only 9 percent of world growth in 2007, compared with China's 33 percent and India's 12 percent.

Subprime crisis - Entities responsible

This mess is a collective creation of the world's central banks, lenders, credit rating agencies and underwriters, speculators and investors.

The economy was at risk of a deep recession after the dotcom bubble burst in early 2000; this situation was compounded by the September 11 terrorist attacks that followed in 2001. In response, central banks around the world tried to stimulate the economy. They created capital liquidity through a reduction in interest rates.

Biggest Culprit: The Lenders

Most of the blame should be pointed at the mortgage originators (lenders) for creating these problems. It was the lenders who ultimately lent funds to people with poor credit and a high risk of default.

When the central banks flooded the markets with capital liquidity, it not only lowered interest rates, it also broadly depressed risk premiums as investors sought riskier opportunities to bolster their investment returns. At the same time, lenders found themselves with ample capital to lend and, like investors, an increased willingness to undertake additional risk to increase their investment returns.

In defense of the lenders, there was an increased demand for mortgages, and housing prices were increasing because interest rates had dropped substantially. At the time, lenders probably saw subprime mortgages as less of a risk than they really were: rates were low, the economy was healthy and people were making their payments.

Subprime mortgage originations grew from $173 billion in 2001 to a record level of $665 billion in 2005, which represented an increase of nearly 300%. There is a clear relationship between the liquidity following September 11, 2001, and subprime loan originations; lenders were clearly willing and able to provide borrowers with the necessary funds to purchase a home.

Investment Banks Worsen the Situation

The increased use of the secondary mortgage market by lenders added to the number of subprime loans lenders could originate. Instead of holding the originated mortgages on their books, lenders were able to simply sell off the mortgages in the secondary market and collect the originating fees. This freed up more capital for even more lending, which increased liquidity even more. The snowball began to build momentum. (For a crash course on the secondary mortgage market, check out Behind The Scenes Of Your Mortgage.)

A lot of the demand for these mortgages came from the creation of assets that pooled mortgages together into a security, such as a collateralized debt obligation (CDO). In this process, investment banks would buy the mortgages from lenders and securitize these mortgages into bonds, which were sold to investors through CDOs.

Rating Agencies: Possible Conflict of Interest
A lot of criticism has been directed at the rating agencies and underwriters of the CDOs and other mortgage-backed securities that included subprime loans in their mortgage pools. Some argue that the rating agencies should have foreseen the high default rates for subprime borrowers, and they should have given these CDOs much lower ratings than the 'AAA' rating given to the higher quality tranches. If the ratings had been more accurate, fewer investors would have bought into these securities, and the losses may not have been as bad. (To learn more on the ratings system, see What Is A Corporate Credit Rating?)

Moreover, some have pointed to the conflict of interest between rating agencies, which receive fees from a security's creator, and their ability to give an unbiased assessment of risk. The argument is that rating agencies were enticed to give better ratings in order to continue receiving service fees, or they run the risk of the underwriter going to a different rating agency (or the security not getting rated at all). However, on the flip side, it's hard to sell a security if it is not rated.

Regardless of the criticism surrounding the relationship between underwriters and rating agencies, the fact of the matter is that they were simply bringing bonds to market based on market demand.

Fuel to the Fire: Investor Behavior
Just as the homeowners are to blame for their purchases gone wrong, much of the blame also must be placed on those who invested in CDOs. Investors were the ones willing to purchase these CDOs at ridiculously low premiums over Treasury bonds. These enticingly low rates are what ultimately led to such huge demand for subprime loans.

Much of the blame here lies with investors because it is up to individuals to perform due diligence on their investments and make appropriate expectations. Investors failed in this by taking the 'AAA' CDO ratings at face value.

Final Culprit: Hedge Funds
Another party that added to the mess was the hedge fund industry. It aggravated the problem not only by pushing rates lower, but also by fueling the market volatility that caused investor losses. The failures of a few investment managers also contributed to the problem. (To learn more. check out Taking A Look Behind Hedge Funds.)

To illustrate, there is a type of hedge fund strategy that can be best described as "credit arbitrage". It involves purchasing subprime bonds on credit and hedging these positions with credit default swaps. This amplified demand for CDOs; by using leverage, a fund could purchase a lot more CDOs and bonds than it could with existing capital alone, pushing subprime interest rates lower and further fueling the problem. Moreover, because leverage was involved, this set the stage for a spike in volatility, which is exactly what happened as soon as investors realized the true, lesser quality of subprime CDOs.

Because hedge funds use a significant amount of leverage, losses were amplified and many hedge funds shut down operations as they ran out of money in the face of margin calls.
October 15, 2007

The Securities and Exchange Commission has launched at least a dozen investigations around the subprime crisis, and filed suit against one fund manager, Sentinel Management Group Inc., which is accused of lying to its clients about its investments. Investors have filed lawsuits against the companies that have collapsed in the wake of the subprime crisis, including the Bear Stearns hedge funds and mortgage lenders. Even credit rating agencies may get swept up in the litigation, according to Columbia University Law School professor John Coffee, an expert in securities regulation and litigation. Outfits like Standard & Poor's and Moody's Investors Service certified many of the bonds at issue as investment grade, even though they had a default rate that was 10 times higher than that of comparable corporate bonds.

No comments: