PART 4: System-Wide Effects of Credit Rating Downgrades
IV. Financial Instruments at the Heart of the Subprime
“Wall Street reaped huge profits from creating filet mignon AAAs out of BB manure.”642
Financial innovation has given rise to much concern in modern financial markets. Attention is being paid to the financial instruments that played a role in generating the financial turmoil. Overall, financial innovation sup-ported the originate-and-distribute model of intermediation and helped fi-nancial institutions build up more leverage in the fifi-nancial system. Novel financial instruments have supported banks’ off balance sheet activities as well as regulatory arbitrage with respect to bank capital requirements.
The subprime mortgage crisis has given rise to concerns about the securiti-zation of lower-quality mortgage loans. Asset securitisecuriti-zation has been a fact of modern financial markets since it started in the mid 1980s.643 The securi-tization process implies that loans are originated, structured, and then sold to investors.
The securitization process involves a financial institution that buys mort-gage loans from the original lender. Any kind of loans can be securitized.
The underlying loans at the core of the subprime mortgage crisis include subprime loans644 and Alt-A loans.645 In fact, the loans that have typically
641 CLERC, A Primer on the Subprime Crisis, at 1, 3.
642 BARNETT-HART, The Story of the CDO Market Meltdown: An Empirical Analysis, at 14 (quoting MIKE BLUM, former CMBS surveillance expert, Goldman Sachs).
643 CROUHY,JARROW &TURNBULL, The Subprime Credit Crisis of 07, at 8.
644 LUCAS,GOODMAN &FABOZZI,Collateralized Debt Obligations, Structures & Analysis, at 113 (explaining that subprime borrowers fail to satisfy the underwriting standards of mortgage lenders; their borrower characteristics include a compromised credit history and a payment-to-income ratio that is too high. Subprime mortgages and home equity loans (HEL) are used interchangeably to designate these loans); CROUHY,JARROW &TURNBULL, The Subprime Credit Crisis of 07, at 4, 5 (stating that subprime borrowers typically pay 200 to 300 basis points above prevailing prime mortgage rates).
underperformed in recent years are subprime or Alt-A adjustable-rate mort-gages. One type of loan especially illustrates the deterioration of lending standards in the years preceding the subprime mortgage crisis: the interest only negative-amortizing adjustable-rate subprime mortgage.646 This type of loan highlights how lenders were actually willing to extend credit with-out caring abwith-out the borrowers’ ability to pay off the principal. Subprime lenders did not monitor borrowers and uncreditworthy borrowers would end up in increasing debt.
The financial institution then pools the purchased subprime mortgages into securities. Financial institutions designed securities labeled MBS, which are a special case of ABS. These securities can be transferred to buyers. Finan-cial institutions are the initial buyers and they created CDO structures – an application of the securitization technology – in order to make the targeted assets marketable to a broader range of investors. A CDO is generally con-structed by creating an entity that buys assets and issues bonds backed by the assets’ cash flows.647 The issuing entity is set up by the deal arranger – typically a bank – and acquires a pool of assets, namely MBS. The pur-chase of assets is financed by issuing bonds to investors.648 Technically, the CDO arranger partitions the purchased assets into tranches of bonds in or-der to make them marketable. Each tranche has a different claim on the pooled assets.649 In principle the tranches are called “junior”, “mezzanine”
and “senior”.650 Should the portfolio of assets experience any losses due to the failure of individual assets, these losses are first allocated to the “jun-ior” tranche, then to the “mezzanine” tranche and eventually to the “sen“jun-ior”
tranche.651
645 LUCAS,GOODMAN &FABOZZI,Collateralized Debt Obligations, Structures & Analysis, at 112-113 (explaining that – like prime A loans – Alt-A loans are meant to include creditworthy borrowers; but the Alt-A program offers flexibility in terms of necessary documentation and borrowers are willing to pay a premium for the privilege); CROUHY,JARROW &TURNBULL, The Subprime Credit Crisis of 07, at 4, 5 (stating that borrowers who have better credit scores than subprime borrowers – but fail to provide sufficient documentation – are eligible for Alt-A loans).
646 LEWIS,The Big Short, Inside the Doomsday Machine, at 28-29; see also BURRY, I Saw the Crisis Coming. Why Didn’t the Fed (referring to pay-option adjustable-rate mortgages to characterize the types of loans in which the borrower does not need to pay off the principal).
647 BARNETT-HART, The Story of the CDO Market Meltdown: An Empirical Analysis, at 5. The issuing entity is referred to as a Special Purpose Entity (SPE), Structured Investment Vehicle (SIV), Special Purpose Vehicle (SPV) or trust.
648 ALEXANDER ET AL., Financial Supervision and Crisis Management in the EU, at 12.
649 Id.
650 Id.
651 Id. at 13.
Credit enhancement is the amount of loss that can be absorbed before the targeted tranche sustains any loss.652 In a CDO structure, credit enhance-ment comes from subordination, overcollateralization, excess spread or CDS. Subordination represents the maximum level of loss that could occur immediately without being allocated to the tranche in question.653 Over-collateralization requires the CDO arranger to commit more assets to the securitization pool than there are liabilities.654 Alternatively, the CDO ar-ranger could rely on external credit enhancement through reliance on CDS typically sold by insurance companies such as American International Group, Inc. (A.I.G.).655
CRAs played a significant role as regards the composition of CDO struc-tures. They closely participated in the design of the novel financial instru-ments.656 They were in a position to perform such a function because inves-tors relied on their credit ratings for many novel products.657 Issuers were willing to make sure that their debt instruments would attain the required credit rating. CRAs, in turn, gained a new status in the financial markets.
They were practically fixing the structuring criteria as regards CDOs. Issu-ers could exploit the importance of credit ratings while convincing CRAs to adjust their rating models.
Technically, CRAs were assessing how much credit enhancement was needed in order to issue a given credit rating. The rating process could be split into two steps: first the estimation of a loss distribution and second the simulation of the cash flows.658 Then, with a loss distribution in hand, CRAs were able to measure the amount of credit enhancement necessary for a tranche to attain a given credit rating.659
Relating to the CDO structures, the “senior” tranche often got a triple-A rating, the “mezzanine” tranche could range from double-A to single-B rat-ing.660 The “junior” tranche – not being investment grade – was normally not rated and was also called an equity tranche since it was generally not sold to investors. Depending on the underlying assets, the probability of
652 ASHCRAFT &SCHUERMANN, Understanding the Securitization of Subprime Mortgage Credit, at 40.
653 Id.
654 LUCAS,GOODMAN &FABOZZI,Collateralized Debt Obligations, Structures & Analysis.
655 QUINN, The Failure of Private Ordering and the Financial Crisis of 2008, at 579.
656 CROUHY,JARROW &TURNBULL, The Subprime Credit Crisis of 07, at 9.
657 Id. at 8-9.
658 ASHCRAFT &SCHUERMANN, Understanding the Securitization of Subprime Mortgage Credit, at 40.
659 Id.
660 ALEXANDER ET AL., Financial Supervision and Crisis Management in the EU, at 13.
receiving payment was so low that the equity tranche would have been as-sociated with junk status.
Tranching could effectively raise the credit rating of some parts of the un-derlying assets. Being rapidly able to get around rating models, CDO ar-rangers could calculate how to build CDO structures that would generate a sum of tranches greater than the whole portfolio. This process amounted to the financial wizardry of CDO arrangers. They could earn a lot of money out of the packaging process.
“CDO squared” structures would allow CDO arrangers to exploit such prof-itable opportunities even further. A “CDO squared” consisted of re-packaging the hard-to-sell “mezzanine” CDO tranches to create more tri-ple-A bonds for institutional investors.661 CDO arrangers were able to make money merely by re-packaging triple-B CDOs. Due to the high credit rat-ings they were also able to sell off credit risk to investors where it would normally not have been possible. Notably, in the process CDO equity – which could normally not be sold to investors – was partly included into the squared structure.
This business became so lucrative that financial institutions sought more
“mezzanine” tranches to re-package. At one point supply of “mezzanine”
tranches was insufficient.662 Finding enough “mezzanine” tranches became cumbersome. Accordingly, CDO arrangers found a more convenient way to fuel the CDO machine. In 1997 they started to get involved in building syn-thetic CDOs.663 As opposed to cash CDOs, these debt instruments do not need to be sold to an issuing entity such as a Special Purpose Vehicle (SPV).664 Thanks to the use of credit derivatives, CDO arrangers did not need to purchase the portfolio of assets on which the CDO would be struc-tured. Instead, the transfer or credit risk was synthetic.665 The synthetic CDO gained credit exposure to the subprime mortgage market by selling credit protection via CDS.666 Thus, banks took advantage of credit deriva-tives in the sense that CDS could replicate the payoff profile of cash bonds without requiring the upfront funding of buying a cash bond.667
661 BARNETT-HART, The Story of the CDO Market Meltdown: An Empirical Analysis, at 12.
662 Id. at 14; LEWIS,The Big Short, Inside the Doomsday Machine.
663 ALEXANDER ET AL., Financial Supervision and Crisis Management in the EU, at 58.
664 Id.
665 Id.
666 LUCAS,GOODMAN &FABOZZI, Collateralized Debt Obligations and Credit Risk Transfer, at 9;
PARTNOY, Overdependence on Credit Ratings was a Primary Cause of the Crisis, at 6.
667 BARNETT-HART, The Story of the CDO Market Meltdown: An Empirical Analysis, at 13.
From the perspective of the Wall Street banks that arranged the CDO struc-tures, the use of CDS made it easy for them to construct enormous CDO transactions and to generate quick and high profits from building the syn-thetic CDO structures. To create a cash CDO composed of triple-B-rated subprime mortgage bonds in order to re-package it took time and effort.668 To create a synthetic CDO was quick and boundless. As a result, the sub-prime mortgage market experienced an explosion of synthetic ABS CDOs from 2006 through 2007. By the end of 2007, the CDS market was a 60 trillion US dollars market.669 The use of credit derivatives helped the CDO machine to grow at an extraordinary pace. Synthetic CDOs acceler-ated the securitization process and allowed market participants to amplify their risk exposure to the subprime mortgage market. Wall Street banks used CDS to feed the CDO machine.
From the perspective of the market, CDS needed buyers and sellers. On the sell-side, sellers were typically insurance companies such as A.I.G. or mon-oline insurers.670 There were also investors with a risk appetite for highly rated instruments having a higher yield than other highly rated assets; these investors were typically pension funds. There were also financial institu-tions that perceived profitable opportunities without needing regulatory capital upfront while significantly increasing their exposure to the subprime mortgage market.
On the buy-side, Wall Street banks first experienced more difficulty in find-ing counterparties. Eventually, a handful of investors entered the CDS mar-ket to bet against the subprime mortgage marmar-ket. In fact, shorting the sub-prime mortgage market directly was not practically feasible because borrowing securitized tranches would be difficult.671 An indirect option was to short companies that were exposed to the subprime mortgage market.
Another option was more straightforward, easier to implement and a lot cheaper: buying CDS.672 CDS were inexpensive because market sentiment was homogeneously favorable to the subprime mortgage market. At that point, only outsiders were willing to take this side of the bet. Wall Street banks were happy to find a few hedge funds willing to buy CDS. A market
668 LEWIS,The Big Short, Inside the Doomsday Machine, at 74.
669 QUINN, The Failure of Private Ordering and the Financial Crisis of 2008, at 586.
670 CROUHY,JARROW &TURNBULL, The Subprime Credit Crisis of 07, at 16 (describing monoline insurers as counterparties of financial institutions selling to them surety wraps in the form of credit derivatives).
671 BURRY, A Primer on Scion Capital’s Subprime Mortgage Short, at 3.
672 Id.
for side bets was able to develop alongside the subprime mortgage mar-ket.673
At a later stage, some market participants acknowledged the risk related to their high exposure to the subprime mortgage market. Especially in 2007, Wall Street banks preferred to buy CDS to decrease their risk exposure.
Buying CDS could work as an insurance against the default of subprime borrowers.
In the Abacus case, Goldman Sachs was even accused by the SEC of struc-turing synthetic CDOs with the assistance of the hedge fund Paulson & Co., which bet against the subprime mortgage market.674 Goldman Sachs' wrongdoing allegedly consisted of failing to disclose that Paulson & Co.
was not investing in the deal, but betting against it.675 Goldman Sachs acted as a CDO arranger and allowed Paulson & Co. to select the mortgage-related assets against which to bet. Accordingly, Paulson & Co. could buy CDS of the assets that – in its opinion – would underperform. Goldman Sachs used these CDS to build the synthetic CDOs that it sold to investors such as IKB Deutsche Industriebank and ACA Capital Management. In July 2010, the SEC and Goldman Sachs settled the Abacus case.676 By forcing Goldman Sachs to admit to some wrongdoing, the SEC signaled a more confrontational approach that would expose Wall Street to more investor lawsuits in the future.677 Moreover, Goldman Sachs partly recognized being short on the mortgage-related securities when the subprime mortgage mar-ket collapsed. Goldman Sachs may have engaged in proprietary trading in order to bet against the subprime mortgage market, i.e., by trading on its own account as well. In any case, litigation following the financial crisis will bring clarity to Goldman Sachs' dubious activities in the run-up to the subprime mortgage debacle.
Apart from the use of CDS in order to bet against the subprime market, hy-brid CDOs were also created as a mixture of debt securities and synthetic assets. The debt securities consisted of the subprime mortgage assets. The synthetic assets were typically CDS. If these CDS were bought by the vehi-cle, they provided credit enhancement to the CDO structure. In this way they were able to partly hedge hybrid CDO investors against the credit risk exposure to the subprime mortgage assets. For this reason the buy-side was either composed of investors betting against the subprime mortgage market
673 PARTNOY, Overdependence on Credit Ratings was a Primary Cause of the Crisis, at 6.
674 PULLIAM &PEREZ, Criminal Probe Looks Into Goldman Trading.
675 PARTNOY, Wall Street Beware: The Lawyers are Coming.
676 WESTBROOK &GALLU, SEC’s Demand That Goldman Admit “Mistake” Could Spur Lawsuits.
677 Id.
or investors willing to decrease their exposure to the subprime mortgage market.