Role of Structured Credit Products in the Recent Financial Crisis

Abstract In 2008, the world faced the most serious financial crisis since the Great Depression of 1930s. The collapse of the housing bubble and the increasing default rates on subprime mortgages in 2006 triggered liquidity constraints and the insolvency of firms which were priorly considered “too big to fail”, set off a domino effect across the US and global financial markets. Although it has been suggested that the causes of the crisis in the big picture are attributable to the fundamental properties of capitalist system, today it is beyond any doubt that the structured financial instruments and the prevalent risks they revealed were at the center of the turmoil. In this paper, we look at the development of financial innovation and the advent of the structured products. The major risks they possess, how they have led to the financial crisis.

Keywords: structured credit products, global financial crisis, CDO, CDS, structured finance

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TABLE OF CONTENTS

Structured products …………………..…………………………………………………..……4

Risks involved with structured products ………………………………………………………7

Role of structured products in the global financial crisis …………………………………….10

Measures taken and post-crisis situation .……………………..……………………………...12

References ……………………………………………………………………………………14

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Structured Products
Structured products have changed the way the banks manage and mitigate the risk in

their portfolios. By the help of structured products, banks sell a pool of loans they originated to a special purpose vehicle. The SPV will pay for the assets by issuing a set of tranches of liabilities with different seniorities. Investors buying part of a tranche assume some of the credit risk of the underlying pool of collateral to the extent that losses on the loans may exceed the par value of more junior tranches (Perraudin, 2004). Earlier, considerable size of the growth in structured credit markets was driven by banks’ attempts to reduce the regulatory capital they must hold under the 1988 Basel Accord rules. The banks securitized a pool of loans but kept most of the SPV’s more junior liabilities and therefore retained almost all of the credit risk. Regulators required banks to dispose the junior tranches from their capital but the total increase with the tranches is often less than the required capital to hold the loan pool on the balance sheet (Perraudin, 2004). As the structured credit market has matured, banks have increasingly used structured products to transfer their risks to other financial institutions. In the past, debt origination generally amounted to a “originate and hold” strategy by the originating bank. With the help of the structured products, banks moved to a “originate to distribute” strategy to pass the risks to other investors. Just as the broad category of balance sheet structured products has changed the banking system, collateralized debt obligations (CDOs) have transformed investment in previously illiquid bond markets. In a CDO transaction, a collateral manager issues liabilities through an SPV and purchases a pool of illiquid bonds that he then manages, following a more or less active investment strategy. This creates valuable liquidity in corporate bond markets, allowing investors to take positions with different levels of risk in diversified pools of illiquid credit sensitive instruments. The complex nature of structured products caused ratings agencies to play a key role in this market. Issuers setting up an SPV generally consult ratings agencies early on about the ratings that the tranches of the SPV’s liabilities will receive if the structure is designed in different ways. The agencies may specify particular levels of over-collateralization or tranche thickness for senior tranches to attract given high credit ratings. After a structure has been established, ratings agencies play a significant role in monitoring the secondary market performance of

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structured products, assisting investors’ decision-making through changes they make in the ratings they gave to structured exposures. Organizations have used securitization and collateralization as a source of long-term finance for many years. In the US sub-prime mortgage market, mortgage lenders used securitization for credit creation and risk transfer. Mortgage lenders pooled the interest income streams of many mortgages and sold them to banks. Pooling mortgages together provided some risk diversification benefits because, even if a few mortgage holders delayed or defaulted on their payments, the majority of the mortgage payments would still be received. The losses from the defaulting mortgages would be shared among all those who had bought the mortgage-backed securities, thus minimizing the impact on any one investor (Fisher and Malde, 2001). Normally, the mortgage income was divided into three levels or tranches. The highest-rated tranche [80% of MBS/CDO tranches according to Ryan (2009)] would attract the lowest interest, the lower rated tranche would attract a higher interest and the final equity tranche would attract the highest interest or return (Fitch Ratings 2007). In the event of default by the mortgage borrowers, the income from the equity tranche would be reduced until it reached zero, followed by the lower rated tranche and finally the higher rated tranche. In this way, the risk attached to the MBS was spread. The highest-rated tranche would be protected from defaults by the lower tranches. Purchasers of the tranches would bear the risks and reap the rewards depending on the tranche purchased. The relatively high returns from the sub-prime mortgages enabled these tranches to offer higher yields at each level compared with similar rated conventional products such as corporate bonds. Therefore, these products became popular because of the perception of low risk and higher returns. Banks and hedge funds combined a number of MBS tranches and other asset-backed securities to create asset-backed CDOs and, like MBSs, these CDOs in turn are divided into different risk-level tranches and the tranches sold as bonds or financial products to banks, hedge funds and other financial institutions (Jacobs, 2009). The funds raised from the sale of the CDOs were used to buy more MBSs and in turn provide funds for the issue of more sub-prime mortgages. Two points can be made from this account. First, the creation of tranches by slicing and dicing income streams created liquid products from underlying illiquid mortgages. Mortgages cannot be sold off easily but the products emerging from them could be. Second, the creation of new products from existing tranches made it extremely difficult or impossible to identify where the source income for the products was coming from. Insurance companies offered insurance against the loss of interest on the structured financial products resulting from default of the original mortgages in the form of credit default swaps 5

(CDS). However, whereas with normal insurance there is one policy to insure an asset, several CDSs were taken out on the same structured financial products. Synthetic CDOs were in turn created from CDSs. The creation of new products from existing products such as CDO²s, CDSs and synthetic CDOs led to significant increases in the quantity of products that were intrinsically linked to each other and that all originated from a narrow base. For example, The Securities Industry and Financial Markets Association (SIFMA) (2009) pointed that the increase in the issue of new CDOs between 2004 and 2006, was almost 231% at 520 billion dollars. Ferguson (2008) notes that in 2006 there were 3 trillion dollars of CDOs in issue and the notional value of all derivatives, including CDSs, stood at 600 trillion dollars. This can be compared against the entire world economic output in 2006, which totaled around $47 trillion dollars. The sub-prime mortgage market was particularly susceptible to decline in the housing market. When US house prices fell, the high borrowing costs and a high proportion of loan to value (resulting in negative equity in the properties) meant that there was a high incidence of default. Furthermore, the benefits of risk diversification, by having a large quantity of different mortgages in an MBS, disappeared, because declining house prices affected all or most properties, in most geographical areas. As the number of defaults in the sub-prime mortgage market increased, the credit rating agencies downgraded the ratings of the products that were based on these. This created a problem for the balance sheets of many financial institutions. Greenlaw et al (2008) stated that a reduction of one dollar in revenue would have a negative impact many times greater, because of the leverage that was created from that single dollar. This forced financial institutions such as hedge funds to sell their liquid investments such as shares, thereby causing stock markets to fall and triggering the financial crisis.

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Risks Involved with Structured Products
The collateralized debt obligations, which is one of the most in use financial

instruments, is created first time towards the end of the 1980s and also at the end of the 1990s, the CDO become the fastest growning sector. This shows that CDO is an attractive financial instrument for insurances companies, pension companies, investment banks, commercial banks and asset managers.

The structured products are designed to simplify highly customized risk-return objectives. The structured products are a technique of managing assets, which do not have enough liquid by itself, are brought together to create a pool and these pool of assets are reconfigured to trading in financial markets. With converting these assets into structured products, they will be gained several risk profile, interest rate and payment dates with new structures.The aim of the re-configuring of financial assets is creating less risky, more liquid and more cost-effective. The risks associated with many structured products, especially those products that present risks of loss of principal due to market movements, are similar to those risks involved with options. The potential for serious risks involved with options trading are well-established, and as a result of those risks customers must be explicitly approved for options trading (Mattoo,1997). If you need to look at a broader perspective on the global crisis, the main reason of the crisis is attitudes of individuals and institutions. In 2001, with the starting trend of decreasing 7

interest rate reached the lowest level especially in 2006 and banks and other financial institutions loosen the criteria for borrowing by ignoring the risks of credit provided to consumers.

There are some risks that apply to the structured products: Credit risk: The credit risk is loss of principal or loss of a financial reward stemming from a borrower's failure to repay a loan or meet a contractual obligation. The credit risk of the CDO is non-payment by counter-party or other partners of the CDO which are arising from its portfolio. There are some problems which create credit risk. Basic correlations with colletarals, effects of increase in unpaid debt obligation and effects of change in the expected recovery values. Interest rate risk: The interest rate risk is a risk that an investment's value will change due to a change in the level of interest rates. The interest rate risk is due to several factors that affect the risk of CDO’s. One of the factors is the complex structure of the CDO’s. The CDO’s basic interest rate risk comes from false matching between assets in the portfolio and fixed or free floating rate of debt obligations. Liquidity risk: The liquidity risk is a lack of marketability of investment that cannot be bought or sold quickly enough to prevent or minimize a loss. The common risk associated with CDO or structured products is a relative lack of liquidity. There are two basic liquidity risks for CDO. The first one is limited secondary market for CDO. Investors should be careful that no firm indication as to how the structured products will trade in the secondary market. The second one is limited liquidity of CDO’s assets. Asset managers often have problems to find another counterparty when the first one defaulted and also the assets cannot be converted to cash for their full face value,although they have short maturities. Foreign exchange rate risk: The foreign exchange rate risk is a risk of an investment's value changing due to changes in currency exchange rates. The portfolio, that include CDO’s assets, can be made with different currencies and when this happens, the foreign currency situation is a complex and difficult to hedge. The foreign exchange risk may arise from exchange rate fluctuations, the long-term direction of the movement in interest rates, payment amount and the amount of scheduling, sales, risk of nonpayment, improvement efforts. Operational risks: The operational risk is the risk of business operations failing due to human error. Distributors should have internal processes and controls in place to consider potential conflicts issues and identify measures designed to mitigate, manage, or disclose material conflicts of interest arising from the sale of structured products. 8

The asset manager plays a key role in each CDO transaction, even after the CDO is issued. An experienced manager is critical in both the construction and maintenance of the CDOs portfolio. An arbitrage CDOs does not separated from it’s manager’s reputation and expertise. The asset manager of the CDOs decide critical decisions on composition of portfolio, trading, buying and selling. Because of these, the asset manager’s ability of managing portfolio create operational risk for the investors. Systemic risk: The systemic risk inherent to entire market or entire market segment. Also known as un-diversifiable risk or market risk. All of risks described above becomes more effective when the period of economic downturn. In such cases, significant declines in ratings notes and payment difficulties arise. Due to declines in ratings of these assets, the CDO notes can be reduced. If the management of CDOs do not execute limited structure of financial flexibility it can create systemic risk

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Role of Structured Products in the Recent Financial Crisis
The recent financial crisis that happened in 2008 has had significant impacts on the

world economy. The seeds of this crisis were sown in the credit boom that peaked in mid2007, followed by the meltdown of sub-prime mortgages and securitized products. The resulting concerns about the health of financial institutions became a caused a panic in banking sector following the failures of Lehman Brothers and Washington Mutual, and government takeovers of Fannie Mae, Freddie Mac, and AIG (Ivashina , Scharfstein , 2008). The current situation is actually the result of the bursting of the U.S. housing bubble that happened because of the dramatic increases in the price of real properties. The low interest rates and huge level of liquidity made it easy for people to get loans. It is important to mention that in addition to all of these factors, accelerating credit lending, banks changing role due to complex structured products in the financial markets and the lax credit standards had huge contributions to the expansion of subprime mortgage lending.

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Until the recent financial crisis, the structured products had been perceived as safe instruments by credit rating agencies and other participants of financial markets. The usage of these products increased because of the perception of low risk and higher returns. Investors who wished to hold low-risk assets with high credit ratings could purchase CDOs with a high priority in the payment sequence. Many investment grade CDOs offered debt returns that far exceeded yields on other investment grade alternatives. In 2006, the BBB-rated portions of CDOs yielded 7 to 9 percentage points above LIBOR or about a 13% annual return (Ogilvie, 2008). However, it is estimated that more than 80% of subprime mortgages were used as collateral for securities in the housing bubble. When US house prices started to fall, the high borrowing costs and a high proportion of loan to value meant that there was a high incidence of default. Furthermore, the benefits of risk diversification, by having a large quantity of different mortgages in an MBS, disappeared, because declining house prices affected all or most properties, in most geographical areas. As the usage of structured products increased, their complexity increased and they became difficult to price. The buyers of these products did not have the ability to perceive the risk and value of these products. As the number of defaults in the sub-prime mortgage market increased, the credit rating agencies downgraded the ratings of the products that were based on these. This created a problem for the balance sheets of many financial institutions. In addition, structured products lack of transparency by its nature. The increase in default rates in the sub-prime mortgage markets made difficult to sell or price these products. At the start of financial crisis investors faced difficulties in being aware of whether the collateral for a CDO was composed of sub-prime mortgages from default-prone regions or not. It was estimated that approximately half of the $412 billion of CDOs sold in the U.S. contained subprime debt (Ogilvie, 2008). As a result, the market for some products dried up. Besides, the crash in the structured markets affected other markets. Counterparties worried that financial institutions carrying high level of structured products on their balance sheets lose their prestige and credibility. Thus, Markets that had relied on highly rated structured debt as collateral could no longer do so.

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Measures taken and post-crisis situation

Historically, crises provided opportunities for policymakers to restructure the economy. Some mortgage originators’ questionable lending practices were at the root of the global financial crisis. Because of these practices, subprime mortgage borrowers obtained mortgage loans on terms that made the mortgages nearly impossible to repay. New regulations require originators to retain some of the risk involved in lending to discourage imprudent lending practices. Many provisions intended to prevent predatory lending practices and to hold consumers accountable if they lie in order to get a loan have been taken after crisis. It would prohibit lender payments to brokers in exchange for signing a consumer into a higher interest rate loan. It would also require a mortgage originator to retain a five percent interest in the mortgage to reduce incentives to make risky loans. Finally, it would require a lender to document a benefit to the consumer in any refinancing transaction, preventing immoral lenders from making unfavorable refinancing agreements with borrowers. Before the crisis, securitization allowed mortgage originators to make risky loans without consequences because they could sell the loans to securities issuers as soon as they were originated. These requirements at least partially remove the incentive to originate risky loans that are unlikely to be repaid.

Regulation of Derivatives Markets The market for derivatives has been largely unregulated in the United States and Europe. Unchecked production of derivatives, contributed significantly to the global financial crisis, both the U.S. and European governments have been quick to propose regulation.

U. S. Derivative Reform • • • • It would require most standardized swap trades to first be “cleared” through a clearinghouse. A clearinghouse also monitors the creditworthiness of each clearing participant and requires participants to post collateral. The swap trade would have to be conducted through a central exchange. It would also impose much more conservative capital requirements.

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The impact of the global financial crisis has forced regulators worldwide to address the regulatory gaps and weaknesses that caused the near collapse of the global financial system. As economists have agreed on the major factors that contributed to the global financial crisis, regulators around the world are all turning to some of the same issues to prevent such a crisis in the future. The global financial crisis emphasized the interconnected nature of the global financial system and increased awareness of systemic risk as a real and present threat to the entire system. Regulators must find ways to work together to police the investment practices and risk-taking of large, interconnected firms that operate on a global scale. Already, many actions have been proposed to address these problems and increase global supervision of the financial system and now these actions need to be improved and system need to be observed more carefully and closely.

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References
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(2009): Ensuring Efficient, Safe and Sound Derivatives Markets: Future Policy Actions, Commision of the European Communities, 563/4, Brussels retrieved from http://ec.europa.eu/internal_market/financialmarkets/docs/derivatives/20091020_563_en.pdf.

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