For the past few weeks, financial markets around the world have been rattled by the US subprime mortgage crisis triggered by the sharp fall in US housing prices. The collapse that Bear Stearns suffered might just be the tip of the iceberg. How and why has the effects spread so rapidly?
It’s actually a complex story involving subprime borrowers, Mortgage-Backed Securities (MBS), Collateralized Debt Obligations (CDOs), investment bankers, hedge funds, Credit Default Swap (CDS), Synthetic CDOs, institutional investors and even retail investors. Let’s try to look at the whole picture.
A few million subprime borrowers had borrowed 100% of the value of their house to finance their purchase. These are borrowers with very poor credit ratings (hence the term subprime).
The mortgage lenders packaged those loans into bonds called Mortgage-Backed Securities, which they then sold to investment banks. Hence, they did not have to worry about default risks and could make those loans freely.
Selling MBS is usually not easy as the credit quality is poor or non-investment grade. This means many professional managed funds could not buy them.
However, smart investment bankers took the MBS and combined them with other higher grade bonds and sold off the entire package in “tranches”. These packages are known as Collateralized Debt Obligations (CDOs).
A typical CDO could have 80% investment grade bonds (low risk), 10% mezzanine (middle risk) and 10% equity (high risk MBS).
If the CDOs are structured properly, they could qualify as invesment grade rating and would be far easier to sell.
Once the original lender has sold off their MBS, they will have cash which they can then loan to new subprime borrowers. This helps add fuel to the hot housing market.
The story does not end here. It is who (and how) the CDOs are sold off to that could cause a ripple effect throughout the financial industry.
One way is for the investment bank to set up a hedge fund to buy over the CDOs.
What has happened over the past few years is that housing prices has gone up.
This means that the market value of the CDOs has increased (significantly) as the risk of subprime borrrowers defaulting is now less. The CDO price is easy to manipulate as there is not an open open market for the CDOs. This leads to a boost in returns of the hedge fund, which attracts more investors’ funds.
The hedge fund then goes to another bank to borrow more money using its “high- performing” CDOs as collateral. The exposure has thus spread to the lending bank holding the CDOs as collateral. The hedge fund buys more CDOs and the money is ultimately channelled down to mortgage lenders who will make more subprime loans, thus pushing housing prices higher.
In Bear Stearns case, its two funds were leveraged about 5 times and 15 times respectively. ie $1 of investor funds holding $5 of CDOs.
Things started to unfold when housing prices drop. The collateral gets marked down, the lender bank wants their money back but the hedge fund has all its money tied up in CDOs. Lending banks are increasing getting nervous but cannot find any buyers for their (sinking) collateral.
At this point, we still do not know for sure who are the rest of the people/funds/institutions around the world holding these CDOs and their degree of exposure.
Some of the CDOs have been sold to other funds or institutions. They could even have landed up in the hands of some sophisticated retail investors.
Fund managers could have been reporting asset values which are fictional (from the market value of the CDOs), and these could all unravel. Until they mark down the value of their CDO, all could still appear rosy on the outside.
It might be a good time for you to look at your holdings and see whether they have any exposure to CDOs.
Another way for the investment banks to manage the CDO is to hold on to them but without holding on to the default risk.
For this part of the discussion, you need to know about the Credit Default Swap (CDS). The CDS is essentially an insurance policy that a person takes out to cover himself for loan default.
In this context, the holder of the CDO, the investment banks, pays a premium to another investment institution for underwriting the risks of the home loans defaulting.
The buyer of the CDS (or synthetic CDO) gets an income stream (the insurance premiums) without even putting up any cash. This appears to be much attractive than a normal bond. He is paid for accepting risk and not lending money. Of course, if the loans default, his exposure will be high.
Through the use of CDS, fund managers can underwrite credit default risk to increase their returns without coming up with any capital. As long as there are no claims, all will be good. Once there is, the fund might even lose everything that it has.
It gets even worse.
Investment banks realised that they could sell such CDS even if they were not holding on to the CDOs!
So, they started to sell insurance (CDS) on the lousiest CDOs around. There were many buyers as fund managers were all desperate for yield.
This can be seen in the tightening credit spread between investment grade US bond yields minus the fed funds rate from 3% historically to about 1%. People can buy an investment grade bond which yields plus 3% versus the fed and offload the default risk by paying a 1% premium.
Back in 1998 when Long Term Capital Management failed, they were adopted their own strategy.
When Bear Stearns collapsed, it was doing what many other people in the financial industry were doing. This time round, the impact could be far greater.
As it is now, banks are getting relunctant to lend money to each other as they don’t know what the other bank’s exposure is. France’s biggest bank, BNP Paribas, has just frozen three of its funds due to their exposure to CDOs. Central banks have been forced to intervene to inject liqudity into the system. The credit crunch might be just beginning.
This post is a summary of Paul Tustain’s excellent article Subprime mortgage collapse: why Bear Stearns is just the start. For a more detailed analysis, please refer to his article.