This is part 2 of Reggie Middleton on the Asset Securitization Crisis – Why using other people’s money has wrecked the banking system and similarities to the S&L crisis of 80s and 90s. I periodically have third parties fact check my investment thesis to make sure I am on the right track. This prevents the "hubris" scenario that is prone to cause me to lose my hard earned money. I have decided to release these "fact checks" as periodic reports. To some they state the obvious, to others they are enlightening. To me, it is necessary to make sure the world is as I percieve it. The recent bear market rally took back a decent amount of the directional, unhedged profit (that's right, I'm a cowboy), but it appears that is over and we will soon resume our descent back into reality. Just in case, let's review some history. I will also release some of my personal bank short research to illustrate how I am implementing these expected stresses to the banking system to my advantage.
The Current US Credit Crisis: What went wrong?
- Intro: The great housing bull run – creation of asset bubble, Declining lending standards, lax underwriting activities increased the bubble – A comparison with the same during the S&L crisis
- You are here => Securitization – dissimilarity between the S&L and the Subprime Mortgage crises, The bursting of housing bubble – declining home prices and rising foreclosure
- To be Published: Credit rating agencies – an overhaul of the rating mechanism
- To be Published: US Federal reserve to the rescue
- To be Published: The counterparty risk analyses – the counterparty failure will open up another Pandora’s box
Now, on to part two of the report...
Asset Securitization and the Crisis of Confidence in Securitized Assets
Securitization is the process of creating and issuing securities, in which the returns of the investors purchasing such securities are dependent upon the cash flows generated by the underlying asset, or in most cases, pool of assets upon which the security was created. These cash flows are payments of principal and interest from the underlying pool of assets.
Broadly, such securities are classified under two heads:
- Mortgage backed securities, or MBS, where the underlying asset is a pool of mortgage loans of a bank or any authorized lending institution. MBS are also called pass through securities as their primary nature dictates that they are meant to pass on the principal and interest payments realized from mortgages to the investors
- Asset backed securities, or ABS, where the underlying assets can be any non mortgage assets which are capable of generating future cash flows
The first MBS were issued in 1970 by the Government National Mortgage Association, well known as Ginnie Mae, followed by similar issuances from Federal National Mortgage Association (Fannie Mae) and Federal Home Loan and Mortgage Corporation (Freddie Mac). These three entities are also called Government Sponsored Enterprises, or GSEs. In the context of asset securitization, they are also called agencies. To date, MBS dominates the entire asset backed securities market across the globe.
The first ABS were issued by Sperry Lease Finance Corporation in 1985, and were based on the expected cash flows from its computer equipment leases. Today, the ABS market encompasses various assets including auto loans, credit card receivables, home equity loans, manufactured housing loans, student loans etc.
Initially, before MBS and the ABS were launched, investors had traded whole loans in the secondary mortgage market, which was relatively illiquid. Due to this illiquid nature, there was a high risk of holding the loans as they were susceptible to interest rate fluctuations. Moreover, trading a whole loan meant tedious paperwork which increased the execution time for such transactions. This reduced the overall attractiveness of the market.
However, with the advent of MBS, the liquidity issue was significantly resolved and the transaction time came down, both of which were beneficial for the investors. For loan originators, this meant the earlier offloading of risk from their balance sheets and reduced exposure to interest rate fluctuations. This led to immense demand for such securities.
A typical securitization process starts with the originator of the loan i.e. the lending institution which disburses the loan(s) to the borrower(s). Then, the originator creates pools of these mortgages (or any assets capable of generating future cash flows).
Next, a Special Purpose Vehicle (SPV or SPE) is created by the originator which acts as a conduit for payment flows. The loans to be securitized are now transferred to the SPV. This process is also called “asset transfer” or “true sale”. This ensures that investors can only turn to this SPV for their due payments, not the originator.
After the asset transfer, the SPV approaches the underwriter, who takes on the risk of buying the issue of the securities and selling them to investors. In most cases, the underwriter also consults on the structure of the MBS/ABS, decides the target investor etc. After this, issuance of the securities is carried out by the underwriter on behalf of the SPV. A broker-dealer may be involved in distributing and marketing these securities or it may be done by the underwriter itself.
Investors then purchase these securities from the underwriter/ broker-dealer entity if involved, which deducts its charges. The residual amount is further forwarded to the issuer and then to the originator. As the originator begins to realize the cash flows on underlying assets, it forwards them to the investor representative entity who then distributes it amongst investors.
There are certain supporting activities that go on during the securitization process. Generally, the originator, to attract investors, resorts to credit enhancements (S1 and S2), which can be internal or external. Internal enhancements include tranching (senior, sub-senior and subordinate) and over collateralization, while external enhancements include letters of credit from a financial institution and credit default swaps (such as those from the monoline insurers. As an example, Ginnie Mae, Fannie Mae and Freddie Mac enhance the credit of securities by guaranteeing the investors complete repayment of principal as well as the interest.
Another important supporting activity is the credit rating process (S3 and S4), which is carried out by independent credit rating agencies. The ratings given by these entities are generally tracked by investors to decide whether the securities under consideration are worth investing.
Benefits of securitization
The main reason for massive growth in securitization industry was that it was beneficial to the originator as well as the investor.
Securitization is advantageous to the originator because it ensures that payments associated with the issued securities are derived only from the incoming cash flows from the pool of assets and not from the originator. This is in contrast to unsecuritized debt, where such kind of ‘isolation’ is not observed. In the case of unsecuritized debt, interest and principal payments are mostly dependent on the ability of the issuing company to generate sufficient cash to make the payments.
Moreover, using credit enhancements on an actually strong, good quality asset pool, it helped the originator access a wider investor base focusing on high grades, which might not be possible otherwise.
Another important positive is freeing up the space in the balance sheet, which not only led to better opportunities for balance sheet expansion but also improved the overall risk profile of the originator by reducing risk capital requirements.
Securitization also provided a supplementary income source in the form of fees, because the originator is also the loan servicer in many cases. The servicer generally forwards the principal and interest payments to the investor representative body, for which it can charge fees. This acted as a support to the revenue growth of the originator.
The investor also stands to gain a lot from investing in the asset backed securities market. Instead of buying a single securitized asset (or even whole loans, as was the case in the pre-securitization era), the pool of assets provides better diversification of risk. Moreover, one can customize the amount of investments, by availing a small percentage of investment across varied type of loans instead of investment in a single loan. This is where the pro-rata arrangement helps investors.
Other important reasons for investors were liquidity and varied investment choice. The ease with which these securities were traded provided a major impetus to many investors to invest in these markets. Moreover, the variety in terms of products offered by the market gave the investor varied choice suiting his risk-return requirements.
Moreover, with credit enhancements provided for most products, investors were assured that they would be paid the principal and interest payments. This was another reason why investors felt assured about investing in asset backed securities.
Growth in securitized assets
Due to a number of advantages for the originator as well as the investor, the MBS as well as ABS market has grown significantly in the recent past. However, more than any other reason, this growth was the primary factor in the lax lending standards, poor discretion and imprudent lending on the part of financial institutions that dominated the last 7 and a half years. This slackening of due diligence in lending led to a reflexive relationship with the asset securitization process, wherein the MBS provided the liquidity while removing responsibility/adding capacity to the balance sheet – which in turn gave the lenders the ability and incentive to churn out loans en masse (regardless of quality) to feed the MBS machine – whose voracious appetite for loan product allowed the removal of responsibility and the additional capacity to the lenders balance sheet...
In the last three to four years, the banks have increasingly resorted to securitization in order to take advantage of the booming MBS and ABS markets. As a result, the total assets securitized by the US financial institutions have more than doubled to US$1,773.8 bn in 4Q 07, from US$870.6 mn in 4Q 03, a CAGR of 19.5% over the four year period.
Total assets securitized and sold by US financial institutions (US$ bn)
MBS market structure - Agency MBS dominate the market
In the MBS market, there are two types of MBS issued. One is the agency MBS or the MBS issued by Ginnie Mae, Fannie Mae and Freddie Mac, while the other is non-agency MBS, also called as private label MBS. As agency MBS have guarantees of payments of principal as well as interest from the respective agencies, they have dominated the market over the years.
Share of total MBS issued – Agency v/s private label
Source: Securities Industries and Financial Markets Association
However, continuous inception of innovative (or complex) products and the increasing number of private label MBS players led to competition in the market. The major growth in market share for private label MBS was observed in the period from 2003 – 2006, wherein the total MBS issued by private labels increased at a CAGR of 30.8%. This led to a depletion in the share of agency MBS over the years. In the context of total MBS issued, the share of private label players in the MBS market has increased to more than three times over a period of 12 years - 10.1% in 1996 to 33.1% in 2007!
The ABS market – let’s securitize!!!
Just like the MBS market, the asset securitization market witnessed impressive growth over the last decade (CAGR of 14.1% in 1998-2007). The composition of the market has undergone a significant change in the last decade, as some markets proved to be more attractive than the others for ABS issuing institutions. To name the major ones, they would be ABS issued on home equity loans and other assorted loan classes.
Like the feedback loop described earlier concerning the MBS market, this rampant growth in the ABS market is also attributable to lax lending standards, imprudent lending and exposure to highly risky assets which were ill-suited for most financial institutions which resorted to it.
Composition of the ABS outstanding in 2007 based on type of collateral
Source: Securities Industries and Financial Markets Association
A major premise of Reggie Middleton’s investment thesis is that the current malaise is not a subprime problem, but a lax underwriting problem spurred by the moral hazard inherent in the current asset securitization model. Recent events have strengthened this thesis into a theory, if not beyond. If one were to run one’s finger around this pie chart, one would literally retrace the headline writedown’s of the securities industry quarter by quarter since the “subprime” crisis first hit the headlines. Initially, the subprime market collapsed, then home equity loans showed massive defaults, the student loan market (led by Sallie Mae) then collapsed, and credit card defaults increased while related markets lost liquidity. Automobile loans are feeling pressure (GMAC), as well as manufactured housing. We suspect equipment leases will follow the commercial office space market in softening. This leaves the 41.4% “Other” market to deal with, which is the largest slice of the pie. As one can see, we are only 50% or so through this ABS correction.
A decade ago, in 1998, ABS issued with credit card receivables as the underlying collateral dominated the market, and constituted 32.4% of total ABS outstanding in 1998. However, with the rise in the housing market and the concurrent rise in home equity loans, there was higher issuance of ABS based on these loans. In times of the rampant growth in real estate market in 2005, there was a significant rise in ABS based on home equity loans. Eating into the share of credit card receivables based ABS – which declined from 32.4% of total outstanding ABS in 1998 to 18.2% in 2005 - ABS based on home equity loans constituted 28.2% of total ABS outstanding in 2005 from a level of 17.0% in 1998. However, due to the recent slowdown in housing market, this has moderated to 23.2% of total ABS outstanding in 2007.
The other type of ABS which has grown significantly is ABS based on other loans, the share of which has increased from 26.3% in 1998 to 41.4% of total ABS outstanding in 2007.
Total MBS outstanding are worth almost thrice as much as total ABS outstanding
Comparing the markets for the types of securities (strictly under asset securitization), MBS have attracted more investments to date and is a much larger market than the ABS market. The rise in the MBS market could be attributed to the increased variety of products offered, solid growth in the real estate market and guarantees of payments of principal as well as interest from the agencies. Moreover, it is a much older market than the ABS market, which began 15 years after the first MBS was introduced.
The current worth MBS outstanding (at the end of 2007) in the US was US$7.21 tn, as compared to the value of the total ABS outstanding in the US market, worth US$2.47 tn. This means that total MBS outstanding in the US market are almost three times the total ABS outstanding.
Nevertheless, the growth numbers state that ABS has grown faster than the MBS over the years. Apart from the reckless lending standards, some of this growth is also because of the variety of the asset classes available under ABS, which in turn led to wider product variety and choice as compared to investment in mortgage securitization. While MBS outstanding have grown at a CAGR of 10.1% in the period from 1999-2007, ABS grew at a CAGR of 13.5% over the same period. The shrinking of a market with such high historical growth portends a commensurate shrinking of bank revenues directly connected to the underwriting and trading of these securities, as well as a decrease in revenues of companies associated with the support of this industry, ex. ratings agencies and insurers.
Total outstanding - MBS market and ABS market
Source: Securities Industries and Financial Markets Association
One way of understanding the importance of MBS in the US markets, is to look at how much it constituted of the total US Capital Markets outstanding at the end of 2007. The total value of mortgage related debt in the US Capital Markets was 13.7% of total outstanding value in 2007, second only to the equity markets! Moreover, mortgage related debt was 24.1% of the total worth of the debt market (US$29.5 tn) in 2007! Thus, a correction on the order of the magnitude that we are witnessing has not other option but to reverberate through the entire US capital market system. We have already seen the effects on the equity markets and significant portions of the debt markets. When adding in the ABS related securities markets, further disruption is inevitable.
Total US Capital Markets outstanding in 2007 (value: US$51.9 tn)
Source: Securities Industries and Financial Markets Association
The risk of prepayment – Mortgage convexity risk
The risk of prepayment is the most common risk associated with mortgage backed securities. With the mortgage prepayment option, MBS investors face the risk of getting the principal amounts earlier than anticipated. If this happens in a high interest rate scenario, it is beneficial for the MBS investor because this higher than expected receipt of cash flow can be invested in a better yielding asset. However, if this happens in a low interest rate regime, the MBS investor has to invest this in an asset which returns less as compared to the MBS.
Generally, as interest rates drop, the value of a bond rises, but this does not hold true in the case of MBS because lower interest rates lead to higher prepayments making the MBS a comparatively less attractive investment. Hence, they are said to have negative convexity.
In the low interest rate regime in the US, a similar phenomenon was observed, as majority homeowners took to refinancing their earlier home loans. This led to increasing acceleration in prepayments in the US, which impacted many MBS investors.
Another problem with MBS was uncertainty of cash flows as well as time period. Most MBS issued in the US were based on fixed-rate mortgage loans with an original maturity of 30 years, but were generally paid off earlier. As a result, MBS became attractive to investors with an investment horizon of 10- 12 years. This led to inventions of products with increased options and benefits, but also increased complexity.
A relatively new twist on the convexity risk is the legislative risk borne from movements among the house and senate to actually legislatively rewrite the contractual obligations inherent in the MBS pools. One of the leading proponents of this movement is the presidential candidate and US State Senator Hillary Clinton.
Innovation in securitization - Structured finance options and mortgage derivatives
Products such as Collateralized Mortgage Obligations (CMO), Collateralized Debt Obligations (CDO), CDO squared and CDO cubed found their way into the market to primarily offer investors a wider time-frame of investment and better cash flow certainty than MBS. CMOs use MBS as well as mortgages as their underlying collateral, with various classes (or tranches) in its offering.
But it did not end here. Some innovators used CDOs as collateral to form CDOs based on them i.e. CDOs of CDOs, hence the term CDO-squared. Generally, CDO squared transactions are leveraged single tranche transactions with their underlying collateral as other CDOs or a mixture of CDOs and ABS. According to creditmag.com, the credit for introducing CDO squared products is usually given to Mr. Christian Zugel, a former bond trader at JPMorgan, who set up the ZAIS Group in July 1997. The ZAIS group launched the first CDO of CDOs in 1999.
This increased the complexity of such exotic products and led to collateral overlap. According to S&P, insufficient new issues and high prices in the CLO market has led to increased degree of overlap, and consequently, repeated investment in the same assets. Hence, one single loan default in a MBS which was a member of an overlap transaction would lead to the downgrade spreading across many CDOs.
Securitization and its role in the asset securitization crisis
To take advantage of the growing real estate market, financial institutions / lenders / originators had already started lending significantly to the real estate sector. With the boom in the sector, it was obvious that secondary mortgage market would benefit too. The originators increasingly securitized their assets to offload the risks and create more space for expansion on their balance sheets. With the booming underlying real estate market, the demand for MBS and ABS picked up. In addition to the already lax lending standards, investment banks added to the misery by poor discretion at the time of underwriting MBS and ABS issues. Moreover, private label MBS did not have the strength to guarantee payments like the agencies, but still managed to grow. With everyone expecting that the real estate market would grow perennially, increased credit enhancements were given even to the riskiest of issuances.
Everything was fine, until interest rates started to go up. Then, the poor credit quality class of homeowners could now not afford the payments in the high interest rate scenario due to which defaults and foreclosures began to increase significantly. This affected the securitization market which was dependent on these payments. As the demand-supply gap shortened with time, the values of the underlying assets also went down. Moreover, exotic products such as CDOs already had overlap positions, which intensified the decline. The reach of the MBS and ABS market had already engulfed varied types of investors into the system. Next came the writedowns.
Inflation adjusted loss – is the asset securitization crisis worse than S&L crisis?
In its audit of the Resolution Trust Corporation’s 1994 and 1995 financial statements, the US General Accounting Office stated that the estimated total direct and indirect cost of resolving the savings and loan crisis was US$160.1 bn. From this figure at the end of at the end of 1995, we can apply the annual inflation cumulatively until 2007. This gives us the value of the losses of the S&L crisis as at the end of 2007, US$219.26 bn.
Now, compare this with the total write downs of US$258.9 as on April 24, 2008. This does not include foreign losses. The UK and Eurozone banks have suffered significant capital and value loss, possibly on par if not greater than US banks after all is told. Even if we adjust the figure of US$219.26 bn at the end of 2007 for the monthly inflations of 0.5% in January 2008, 0.3% in February 2008 and 0.9% in March, the final figure for S&L losses as of March 2008 comes out to be US$223.01 bn from US$219.26 bn at the end of 2007. Clearly, from this perspective the asset securitization crisis is well past the S&L crisis in terms of damages, and what’s bad is we are not done with it yet.
Source: Professor Shiller's Irrational Exuberance
As is made clear by a review of the inflation adjusted home prices of the lates ‘80s and the most recent housing price bubble, the “real” prices of residential real estate this time around are much are more severely inflated, and the spread over both population growth and building costs are much more significant. Other histocial extremes appear just after the US gold rush, in the 1800’s (a peak), the great depression (trough) after 1920, the New Deal of the mid 1900’s (peak), the real estate boom of the 80’s and the S&L crisis. As can be seen, we are not only in the most extreme boom-bust cycle (in nominal and real terms), but are just past the peak of the bubble and have a long way to go to reach mean values, Basically, we are in the very beginnings of this latest and most severe of downturns.
The S&L crisis involved commercial real estate, in large part, as well as residential. We have just experienced a significant boom (moreso than that of the S&L crisis which was primarily CRE) and entering a bust in commercial real estate as well, which we expect to outdo that of the S&L crisis.
Source:National Association of Commercial Real Estate Investors National Council of Real Estate Investment Fiduciaries
There are several ways to view this comparison, though. The S&L crisis resulted in a wholesale bailout by the US government, whose total was used in the comparison above. Many of the entities that failed and those that had to be bailed out were not public entities thus may lack certain disclosure guidelines that would have allowed a direct comparison to the crisis today. Since the large public entities today are receiving heavy injections of equity debt, hybrid debt and liquity the US government, the private sector, and foreign governments, a strict apples to apples comparison would be difficult - but we can draw some fairly convincing conclusions.
Inflation adjusted S&L loss – calculation
Source: U.S. General Accounting Office, U.S. Bureau of Labor Statistics
Real estate prices in the US
Considering the current decline in real estate prices coupled with the reduced housing starts activity in the US, the future still looks bleak for the real estate market. Annual housing starts in the US declined 24.7% y-o-y in 2007 reaching an all time low of 1,355,200 since 1996. The National Association of Realtors expects housing starts to decline continually q-o-q from 1.46 mn in 2Q 07 to 0.97 mn by the end of 4Q 08.
Change in new home price – monthly and yearly
Source: U.S. Census Bureau
Declining housing prices in the US is another indicator of how much the market has suffered. In nine out of the last 15 months, the median price of a new home in the US has declined, the biggest decline being 13.3% y-o-y in March 2008. With this background, the National Association of Realtors expects new home prices in the US to decline q-o-q for the next two quarters from US$2.365 mn in 4Q 07 to 2.249 mn in 4Q 08.
Coupled with the degradation in value of real estate assets, another concern is the additional supply of existing homes as a result of rising foreclosure activity in the US. With rising foreclosure activity, the supply of existing homes is also expected to rise. According to RealtyTrac’s March 2008 US Foreclosure Market Report, total foreclosures in the US increased 57.4% y-o-y in March 2008, totaling 234,685. Moreover, one in every 538 households received a foreclosure filing, which is an indicator of the supply of existing homes that would can accumulate in the housing inventory in the system. This is in addition to existing home sales and the deluge of highly discounted inventory from the home builders who are in dire straits.
The crisis and the dollar
Most of the investments in the MBS/ABS have been traditionally made in dollar, followed by the Euro. Global CDO issuance data provided by the Securities Industries and Financial Markets Association shows that 68.9% of the total CDO issuance in the world was in US dollar denominated terms in 2007.
Global CDO issuance by currency in 2007
Source: Securities Industries and Financial Markets Association
As the number of defaults in the US economy increased, the mortgage market and hence the secondary mortgage market suffered significant losses. As a result, the value of investments in the CDO and CMO market was also hampered. With major investments in the market in dollar-denominated terms, the dollar suffered a drastic decline in its value. From being worth €0.8537 at the end of 2002, the US dollar declined to €0.6848 at the end of 2007, and further weakened to €0.6409 as on April 29, 2008. This has significantly exacerbated unhedged losses and added the expense of cross currency hedging to those enitities who do hedge.
Who bears the final burden?
In the current crisis, a diverse cross section of parties were significantly impacted because due to exposure to the MBS/ABS market as a result of the reach of these securities. While lenders, brokers, underwriters, insurers, external credit enhancing entities and end investors were the major parties affected, the effects of the crisis also spread to the money market and pension market which have traditionally been considered not directly linked to the MBS/ABS market.
As in the S&L crisis, the US taxpayer is due to bear the burden this time around – most of, if not all of the burden. According to FDIC, the US taxpayers bore 81% of the total losses incurred to resolve the S&L crisis. Out of the total loss of US$152.9 bn as estimated by the FDIC, US taxpayer losses amounted to US$123.1 bn as at the end of 1999. While the US Federal Reserve has taken several measures to resolve this problem, the depth of the problem is grave and appears to be getting worse. The agencies, like other financial institutions, have also borne the brunt of the declining market and do not appearto be in a position to repay everything themselves. Additionally, credit has dried up across the globe as one more of the many dire consequences of the crisis. This has reduced the ease and probability of availability of external financing to affected companies. Thus far, the vast majority of recapitalizations have consisted of foreign equity investments, primarily sovereign wealth funds. This author believes that many of these funds will tire of taking significantly, and instant capital losses on their investments and will either pull back on their “savior” investment activities, and/or exact more demanding terms for their capital.
However, the question still remains: Who will really bear the costs of “this” crisis? I will attempt to answer this question in the next installment, which will focus on the Credit Default Swap market - market which I feel very well may be the "next shoe to drop".