The Role of Financial Derivatives In The Origin And Spreading of the Subprime Crisis

1. The Role of Financial Derivatives In The Origin And Spreading of the Subprime Crisis Elisa Parisi-Capone

2. Content • Macroeconomic Environment • Financial Innovation • Risk Management Issues • The Crisis Hits And Spreads • Outlook

3. Main Conclusions Derivatives are not the direct cause of the credit crisis as debt levels have been building since the 1980s. But unregulated derivatives facilitate leverage and thus the potential for contagion to unrelated markets and the real economy. At the center of the latest crisis were lax lending standards together with regulatory capital arbitrage facilitated by financial innovation and securitization. Result: ‘Shadow Banking’ system of the same size as traditional one but with no capital requirements or lender of last resort. Opaque OTC derivatives helped fuel complexity and compound the mispricing of risk. The interaction of market and credit risk is not fully understood yet. The most complex structured products, such as CDOs of asset-backed securities, are not likely to return. The sheer size of the OTC derivatives market binds limited resources and poses the question of opportunity costs. Full cost internalization through central clearing, insurance margining, and price transparency is likely to lead to a cost-benefit reassessment.

4. 1. Macroeconomic Environment

5. Inflation Targeting, ‘Great Moderation’Source: William White (2006); Procyclicality in the financial system: do we need a new macrofinancial stabilisation framework?; BIS After the Great Inflation of the 1970s, central banks put a highpremium on price-stability. BIS argues this paradigm is characterized by the four stylized facts: 1) A general reduction in both level and volatility of inflation; 2) robust and less volatile real economic growth interrupted byfewer recessions (both 1 and 2 referred to as “The Great Moderation"); 3) an increased prominence of credit, asset price and investment "boom and busts" often accompanied by financial crises of various types(i.e. Minsky cycle); 4) increased global trade imbalances. 

6. Consumer and Mortgage Debt Since 1980sSource: M. White ( 2008); Bankrupty: Past Puzzles, Recent Reforms, and the Mortgage Crisis; UCSD and NBER

7. Low Risk PremiaSource: P. McCulley (2006); Moral Hazard Interruptus; PIMCO Three central bank policy pre-commitments removed three major risks from the global markets: Starting in 1995, the PBOC pre-committed to absorbing dollar depreciation risk via a pegged exchange rate regime for the Renminbi; Starting in February 2001, the BoJ pre-committed to absorbing Japanese short-term interest rate risk via its Zero Interest Rate Policy (ZIRP), reinforced by its Quantitative Easing (QE) policy; Starting in August 2003, the Fed pre-committed to holding short rates accommodative for a “considerable period and after that to hiking only at a measured pace” (‘Greenspan Put’).

8. Search For YieldSource: R. Rajan (2006); Monetary Policy and Incentives; IMF As a consequence, four main types of incentivesenhance the pro-cyclicality of the financial system : Risk shifting: shifting portfolios, particularly those held by insurance companies and pension funds, towards higher-yielding, thus riskier, assets or instruments in order to meet pre-contracted rates of return on their liabilities, since the risk-free yield is nowvery low; Tail risk seeking: selling disaster insurance in derivatives markets that produce positive returns most of the time as compensation for a rare but disastrous negative return; Herding: engaging in short-term remunerative bets at the expense of diversification; Illiquidity seeking (“poor man’s alpha”): taking advantage of the ample liquidity supply to engage in financial arbitrage activities with less liquid instruments or markets, such as emerging markets or commodities.  All these strategies are enhanced by the use of derivatives

9. Bond Yield Conundrum And Agency Debt FreezeSource: Richard Duncan (2006); The Bond Yield Conundrum – How It Started. Why It Ended. Starting Q1 2004: GSE accounting irregularities wrt interest rate swaps led to investment portfolio deleveraging net agency debt issuance decreases Riskier private sector RMBS replace implicitly government-guaranteed GSE debt while interest rates are kept low throughout ‘bond yield conundrum’ (see also R.Caballero, A. Krishnamurthy (2009); Global Imbalances and Financial Fragility, MIT/NBER, for discussion)

10. Subprime Loan Explosion Source: Goldman Sachs Global Markets Institute (2009); Avoiding Anorther Meltdown – Part 1 Subprime loans originated in 2005-2007 reached $1.4 trillion; Alt-A loans another $600 billion

11. Lending Standard ErosionSource: Goldman Sachs Global Markets Institute (2009); Avoiding Anorther Meltdown – Part 1 Same dynamics with commercial real estate loans, consumer/auto loans, leveraged loans for LBOs

12. U.S. Home PricesGraph: www.calculatedriskblog.com House prices increase loan to value (LTV) ratio down higher rating House prices fall negative equity, LTV up credit quality/rating down

13. 2. Financial Innovation

14. Growth of OTC Financial DerivativesOwn graph based on: BIS, OTC Derivatives Market Survey H2 2008  End December 2008CDS notional outstanding of $41.8 trillion. CDSGross market value at current prices (or replacement value) is $5.6 trillion. Underlying debt instruments outstanding are $3.2 trillion (IMF).  by January 2009, TriOptima –through its portfolio compression service- reduced the outstanding CDS notional amount to $28 trillion.

15. Key Rules and Legislation - Supply Eric Dinallo, New York Superintendent of Insurance: “The Commodity Futures Modernisation Act of 2000 exempted credit default swaps from the old ‘bucket shop’laws. The act also exempted them from regulation by the Commodities and Futures Trading Commission and the Securities and Exchange Commission. Unregulated, the market grew enormously.” (Financial Times, March 30, 2009) Robert Bliss/George Kaufman on Bankruptcy Act of 2005: Source: R. Bliss, G. Kaufman (2005); Derivatives and Systemic Risk: Netting, Collateral, and Closeout; Chicago Fed. “It is not clear whether netting, collateral, and close-out lead to reduced systemic risk, once the impact of these protections on the size and structure of the derivatives market has been taken into account.” Basel I and II Bank Capital Requirement Frameworks (Source: Goldman Sachs (2009); Avoiding Another Meltdown – Part 1) Both frameworks offer capital relief for: e.g. securitizing a pool of mortgage loans into RMBS; further securitizing a pool of RMBS into CDOs;  ‘originate-to-distribute’ and arbitrage incentives (shadow banking system)  Total capital and collateral requirements in the financial system lower for given economic risk

16. Shadow Banking System – Demand Source: Restoring Confidence in the Securitization Market, SIFMA/ASF, Dec2008 Geithner: “The structure of the financial system changed fundamentally during the boom, with dramatic growth in the share of assets outside the traditional banking system.”By early 2007: 1) Asset-backed commercial paper conduits (ABCP conduit), structured investment vehicles (SIV), auction-rate preferred securities (ARS), tender option bonds (TOB)and variable rate demand notes (VRDN) combined asset size of roughly $2.2 trillion 2) Assets financed overnight in triparty repo grew to $2.5 trillion. 3) Assets held in hedge funds grew to roughly $1.8 trillion. 4) Assets held by the then five major investment banks totaled $4 trillion.  Total ‘shadow banking’ assets amount to $10.5 trillion compared tototal commercial banks’ assets: about $10 trillion  McKinsey/ASF/SIFMA Study: - Securitization financed up to 50% of new lending activity in 2005-2007; - Lack of securitization leaves $2 trillion financing shortfall in 2009-2011

17. Example: Structured Investment Vehicle (SIV)Source: FitchRatings (2007); SIVs — Assessing Potential Exposureof Sponsor Banks Assets on average consist of 50% financial institutions debt, 46% structured finance assets, 2% sovereign debt, and 2% others Liabilities consist of 8% equity notes, 14% short-term asset-backed commercial paper (ABCP), 12% repos, 66% medium-term notes

18. Credit Risk Transfer Building Blocks Corporate: Single-Name Credit Default Swaps (CDS) Multi-Mame CDS (Indices and Index Tranches) Asset-Backed Securities: 3) Collateralized Debt Obligations (CDO), incl. leveraged loans (CLO), consumer loans (ABS) 4) Residential/Commercial Mortgage Backed Securities (RMBS / CMBS) Re-Securitizations: 5) Structured Finance Products (CDO of ABS, CDO of CDO or CDO2, CDO of RMBS or CMO) 6) Hybrids (e.g. CDS and loans etc.) 7) Single-Tranche CDOs

19. CDO TechnologySource: SIFMA Securities Industries and Financial Markets Association 1) Special-Purpose Vehicle (SPV): Ensures bankruptcy remoteness, no regulatory capital requirements, separates (enhances) portfolio rating from loan originator rating. 2) Internal Credit Enhancement/Overcollateralization: Subordination through channeling portolio credit risk into first-loss (equity), mezzanine, senior tranche. Rating agencies bestow AAA rating only if the tranche keeps a certain subordination buffer at all times. 3) External Credit Enhancement/Bond Insurance: Buy financial guarantees from AAA-rated monolines for a fee so that insured tranche carries the same rating as the insurer (underlying must at least be rated investment grade) 4) Strict Payment Waterfall / Cash Flow Prioritization: Interest and principal proceeds from the underlying portfolio are prioritized to senior tranche holders until they are fully paid before the mezzanine investors and so on. If the cash flow is not enough to cover all claims, any losses are first borne by equity investors until they are fully wiped out. The mezzanine tranche is next in line to suffer losses and so on.

20. Credit Default Swaps – Single NameSource: Gibbs Remember: Credit Risk Transfer, Not Elimination  Bilateral OTC contract introduces counterparty risk

21. Collateralized Debt Obligations (CDO) -Portfolio Credit Risk TransferSource:E. Benmelech, J. Dlugosz (2008), The Alchemy of CDO Credit Ratings, Harvard University Fully funded tranches (‘true sale’), i.e. investors pay the full amount of the tranche principal at inception (proceeds) No counterparty risk, investor bears full market and credit risk of his tranche.

22. Synthetic, partially funded CDO Synthetic credit risk transfer via CDS either as refernce portfolio, or as unfunded sale of tranches to investors introduces counterparty risk.

23. Amplification of Subprime ExposureSource: BIS Credit Risk Transfer – Developments from 2005-2007, July 2008  Demand for high-yielding mezzanine tranches beyond available issuance is met with synthetic reproduction via derivatives.

24. Global CDO Issuance By UnderlyingOwn graph, data source: SIFMA Securities Industry and Financial Markets Association

25. Global CDO Issuance By TypeSource: Securities Industry and Financial Markets Association (SIFMA)

26. CDO Implied Leverage and Risk Transfer E.g. Equity Tranche: 30 million notional, highest first-loss risk and highest return, i.e. 12% p.a. tranche’s mark-to-market sensitivity to underlying spread changes = delta => 1200bp/60bp= 20x = equity tranche’s implied leverage in this example Use iTraxx or CDX indices for dynamic delta-hedging with multiple of notional

27. Notional vs Economic Risk TransferSource: IMF Global Financial Stability Report, October 2006

28. Total ‘Effective’ LeverageSource: R. Merritt, E. Fahey; FitchRatings (June 2007), Hedge Funds: The CreditMarket’s New Paradigm

29. CDS Hedge: Standardized CDX Index TranchesSource: Christopher Finger (2009); Testing Hedges under the Standard Trnached Credit Pricing Model; RiskMetrics Group

30. Subprime RMBS Hedge: Markit ABX.HE IndicesGraph source: FitchRatings (2006)

31. Structured Product Hedge: Markit TABX IndexGraph source: FitchRatings (2006) If underlying subprime delinquencies/defaults reach 12-20%, the residual and mezzanine RMBS tranches face a cash flow shortfall all TABXtranches lose, including those rated AAA.

32. 3. Risk Management Issues

33. Main Risk Management Issues ‘Alchemy in the CDO Market’ (Mis)Pricing of Systematic Risk Correlation Risk Concentration Counterparty Risk / Collateral OTC Settlement Infrastructure

34. “Alchemy in the CDO Market”Graph source: E. Benmelech, Jennifer Dlugosz (2008), The Alchemy of CDO Credit Ratings, Harvard University Ratings Arbitrage (indicated by 85% of CDO issuers as motivation, SIFMA): Spread income from riskier red portfolio > cost of blue portfolio  Win-Win: Distribute ‘excess spread’ such that AAA investor receives more than similar-rated bond, and equity investor/issuer the rest

35. CDO Ratings Distribution Graph source: E. Benmelech, Jennifer Dlugosz (2008); The Alchemy of CDO Credit Ratings; Harvard University 60-70% of CDO tranches were AAA-rated compared to less than 1% of corporate bonds (FitchRatings (2007) cited in Coval, Jurek, Stafford (2009)

36. Challenge: CorrelationSource: ECB Financial Stability Review 2006 Degree of diversification benefits within portfolio depends on default correlation among underlying credit instruments  correlation is subject to jumps and non-linearities; very hard to estimate correctly across several assets over time within a joint default probability distribution A low implied correlationincreases diversification and emphasizes the risk of firm-specific events and thus the likelihood of isolated defaults occurring that affect the equity tranche only the value of the first-loss equity tranche falls with low correlation. A high implied correlation of default within the CDO reference portfolio implies a higher risk ofmany names defaulting at the same time (i.e. systematic risk), with the potential to inflicting losses on the senior tranche High correlation reduces the value of the senior tranche relative to equity tranche.

37. Example: CDX Base CorrelationsSource: Christopher Finger (2009); Testing Hedges Under the Standard Tranched Credit Pricing Model, RiskMetrics Group

38. (Mis)Pricing of Systematic Risk Source: J.Coval, J.Jurek, E.Stafford (2009); The Economics of Structured Finance; Harvard/Princeton UniversitySource: BIS: Findings on the interaction of market and credit risk; May 2009 CDO technology subject to two fundamental flaws: The high systematic risk component of AAA-rated tranches after all firm-specific risk is diversified away (i.e. industry standard model), requires far larger risk premium based on instruments with similar payout structure (e.g. digital call options); Structured finance ratings are extremely fragile to small inaccuracies in underlying probability of default and correlation assumptions (e.g. ‘Wrong Way’ risk)  BIS: “Securitization transforms credit risk into market risk but diversification benefits between the two should be regarded with great caution.”

39. Credit Risk Transfer To Whom?Source: Adrian Blundell Wignall (2007), Structured Products: Implications for Financial Markets, OECD Fitch Credit Derivatives Survey: - large dealer banks buy and sell large amounts of derivatives as market-makers largely hedged net exposure; insurers/monolines main net protection sellers [but without mandatory coverage ratio as with other insurance products.]

40. Counterparty Risk ManagementGraph source: Gary Gorton (2009); Slapped in the Face by the Invisible Hand: The Banking Panic of 2007; Yale/NBER ISDA, 2009: “For all OTC derivatives, 65 % of trades are subject to collateral agreements. Further, 66% of OTC derivative credit exposure is now covered by collateral.” Gross CDS replacement value is $5 trillion  Note: Collateral (mostly cash) can by re-hypothecated to another counterparty. Mind also opportunity costs

41. OTC Settlement InfrastructureSource: IMF Global Financial Stability Report, April 2009, Chapter 2; Box 2.4: Basics of OTC Counterparty Risk Mitigation Bilateral close-out netting and central clearinghouse (CCP): Bilateral netting: The systemic counterparty risk is $30 although maximum potential loss for any bank is only $10 potential for trade compression (i.e. eliminate circular/redundant trades) CCP reduces domino effect with margin requirements, capital funds, and loss-sharing. However: watch transition costs!

42. 3. The Crisis Hits And Spreads

43. Example: ABX.HE.06-02 PerformanceSource: I.Fender/ M.Scheicher (2009); The Pricing of Subprime Mortgage Risk in Good Times and Bad: Evidence from the ABX.HE Indices; BIS

44. Run On the Shadow Banking SystemSource: Markus Brunnermeier (2008); Deciphering the 2007-2008 Liquidity and Credit Crunch; Princeton UniversitySource: Gary Gorton (2009); Slapped in the Face by the Invisible Hand: Banking and the Panic of 2007; Yale and NBER  Short-term commercial paper is equivalent to deposits in traditional banking system

45. Interbank Liquidity Dries Up

46. Investment Bank Dominoes FallGraph Source: IMF Global Financial Stability Report, April 2009; Chapter 2

47. Bailout Of AIG and Derivatives Counterparties Mary Williams Walsh, New York Times, March 15, 2009: “Financial companies that received multibillion-dollar payments owed by A.I.G. include Goldman Sachs ($12.9 billion), Merrill Lynch ($6.8 billion), Bank of America ($5.2 billion), Citigroup ($2.3 billion) and Wachovia ($1.5 billion).” “Big foreign banks also received large sums from the rescue, including Société Générale of France and Deutsche Bank of Germany, which each received nearly $12 billion; Barclays of Britain ($8.5 billion); and UBS of Switzerland ($5 billion).”  In total, AIG counterparties received about $100bn out of the $180bn in bail-out funds

48. Foreign Claims On U.S. BanksSource: BIS 2008 Annual Report Flow of Funds data: about 40% of U.S. originated securities are held abroad Source: D. Beltran, L.Pounder, C.Thomas (2008): Foreign Exposure to Asset-Backed Securities of U.S. Origin; Fed Board.

49. Hedge Fund DeleveragingSource: R. Merritt, E. Fahey; (June 2007), Hedge Funds: The CreditMarket’s New Paradigm; FitchRatings

50. Vicious Deleveraging CycleSource: Restoring Confidence in the Securitization Markets; SIFMA/American Securitization Forum (ASF) et al.(2008)