Risk and the Subprime Credit Crisis:
the ultimate cause
the ultimate cause
I've been puzzling over what happened during the past few years to lead up to the credit crunch resulting from the housing boom/bust and the subprime crisis. Everyone I knew had been concerned about subprime lending for a couple of years, and many people were worried that there might be a downturn in housing prices. So why did mortgage lenders keep granting the funny mortgages, and why did financial institutions keep buying them?
Query #2: do you think the market has fully discounted the stock of financial institutions to account for the risk that there might soon be a further crash in the CDO market?
- Lenders kept granting the funny mortgages because they could. They could grant the loans, re-package them, and sell them to other investors. They could grant the loans and get their money up front with little-to-no-risk to themselves. Also, those who actually retained the mortgage paper on their books appear to have kept mortgages which had a lower default rate than the ones they sold to other financial institutions as part of the securitized, collateralized debt instruments [CDOs] (surprise!).
- So why did financial institutions keep buying these debt instruments if the risk of default was both systematic and comparatively large? My suspicion is that they convinced themselves these things were really quite low risk because they were insured.
- But (double surprise!) it turns out the insuring companies appear to have done a pretty poor job of risk assessment. The risks of default for each mortgage were not independent of the risks of default for similar mortgages (duh!) and so the overall risk of the CDOs was much higher than the insurers had estimated it to be. As a result, with the downturn in the housing market, the insurers are teetering on the brink of insolvency. And once an insurer is downgraded, then the insured loan packages full of default risk will also be downgraded, and since many institutional investors are obliged to hold only AAA-rated securities in their bond portfolios, they would be required to dump all their CDOs on the market, causing some serious havoc.
Ambac Financial said Wednesday that it plans to raise at least $1.5 billion selling new common stock and equity units as the troubled bond insurer tries to keep its crucial AAA rating.Query #1. Why did insurers/rating agencies not see this coming? Is it because the rating agencies have a conflict of interest in dealing with the bond insurers?
Ambac shares dropped 13% to $9.27 after the announcement.
The new capital may be enough to secure the company's AAA ratings, Standard & Poor's and Moody's Investors Service, the largest rating agencies, said. Smaller rival Fitch Ratings said that if the insurer successfully raises the new capital, it still won't be enough to secure an AAA rating. The agency is planning to affirm its current AA rating after the offerings are completed.
Query #2: do you think the market has fully discounted the stock of financial institutions to account for the risk that there might soon be a further crash in the CDO market?
Category: Economics, Housing Posted on
Thursday, March 6, 2008 at 12:21am
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This answer has the virtue that it's plausible pretty much regardless of the question. :-)
Another factor in this is that banks have been working to show growth. The US banking system is much more fragmented that that of Canada. Therefore, investors have more choice in which financial institution to to invest. It is therefore critical for these financial institutions to maintain their growth profiles. The only way for many of these companies to acheive this is to make loans to high risk mortgagees, generally with a 2 year "teaser" rate, and hope that the housing market stays hot and allows the mortgagee to equity strip and continuously refinance.
There is also some thought that the BAPCPA (Bankruptcy Abuse Prevention and Creditor Protection Act) of 2005 had some influence on the timing of the credit crunch. Having used the 2 year anniversary of the BAPCPA as the basis for a hypothetical long/short fund last year (40% return in 2 weeks), this would appear to be borne out, at least empirically.
In answer to query #2, I would tend to be of the opinion that Canadian financial stocks are over-discounted for subprime exposure (with a possible exception of BMO). US financial stocks may feel further pain until the summer holidays erase brokers memories of last summers, so I would expect to see a bottoming out in July-August this year for the US financials, even though I think Canada is pretty much done. In fact, I would argue that many Canadian FI's have taken advantage of the present situation to take a "big bath" and garner a better growth profile going forward. As far as I am aware, many of the write downs (particularly for CIBC) have to do with insurer risk. The insurers seem to be doing quite well at getting bailed out.