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June 19, 2008

Autopsy of a Liquidity and Credit Crisis L'Institut canadien des actuaires Canadian Institute of Actuaries Assemblée annuelle 2008 2008 Annual Meeting Québec. June 19, 2008. The Mechanic of a Global Crisis.

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June 19, 2008

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  1. Autopsy of a Liquidity and Credit CrisisL'Institut canadien des actuairesCanadian Institute of ActuariesAssemblée annuelle 20082008 Annual MeetingQuébec June 19, 2008

  2. The Mechanic of a Global Crisis • Over-priced asset class (low risk premium) following a long period of economic prosperity • Financial crisis almost always occur when some assets are overly expensive (1929, 1987, 1998, 2000-2002, 2007-2008). • Correlation risk has a significant impact on amount of losses • Leverage increases correlation risk; • The source of correlation risk is not always obvious. • Securitization increases risk of contagion • It improves diversification of investors, but securitized products are more opaque and similar products have their own systemic risk.

  3. The Trigger of the Current Liquidity Crisis(a significant credit issue) Number of households 7,2 millions % ARM with high adjustments 90% % ARM with 5% adjustments 70% % approved without sufficient documentation on income 45% % approved without fiduciary account for taxes 75% All mortgages Dollar amount of ARM set for reset in 2006 400 billions Dollar amount of ARM set for reset in 2007 1,000 billions Dollar amount of ARM set for reset in 2008 450 billions Number of foreclosures (Jan-May 2008) 825,000 YoY decline in home prices (May) Nearly 15%

  4. Expected Losses (Loans and Securities)(Banks – Insurance cies – Hedge funds – GSE- pension funds) Source IMF • According to the BIS, methodology used to valuate MTM losses on AAA subprime related securities may have inflated estimated MTM losses by 60%.

  5. How it Started • New legislations passed in early 80s: • Depositary Institutions Deregulation and Monetary Control Act of 1982: Abolished caps that limited the rates that banks could charge on primary mortgage. • Alternative Mortgage Transactions Parity Act of 1982: Allowed other mortgages than fixed rate mortgages: - ARM - Balloon-payment mortgage - IO mortgage - Option-ARM

  6. Factors that Led to Growth of the Market • Excess of liquidity, low interest rates, low inflation, high employment. • Securitization – Higher spreads: • 75% of subprime mortgage origination has been securitized; • 80% were funded by AAA MBS. Mortgage pool

  7. Factors that Led to Growth of the Market • Rating agencies – High % of AAA assets required (80%): • Assumptions: 50% to 65% default required with 65% recoveries; • 70% losses are now considered possible which means a default rate break even point of 28%; • Anything A and below likely to have no residual value. • Regulators • Lower capital requirements on securitized assets than on similar corporates. • Instrument • Significant exposure through money market instruments. • Investors • Excess leverage; • From too trusting to negligence (RMBS vs. contagion resulting from RMBS).

  8. Contagion – the Spread of the 30-100 Tranche • The 30-100 tranche exposes investor to a default risk in the event 30% of losses are recorded over a period of "X" years. • AAA rating for an investment grade portfolio such as the CDX requires a subordination of about 10% for 10 years, 7% for 7 years and 5% for 5 years (approximately). • Other tranches are available such as: 0-3, 3-7, 7-10, 10-15, 15-30, 15-100, etc.

  9. Factors that Led to Demise? • Securitization – from monitoring to originating role: • When the economic interest of the originator is no longer in line with that of investors: • Financial institutions with two sets of investment standards; • Some hedge funds had warned in 2006 that all BBB tranches and below would be wiped out.

  10. Factors that Led to Demise? • Securitization – declining standards

  11. Innovations ? When a AAA is not a AAA

  12. Factors that Led to Demise? • Rating agencies • Half of Moody's net income attributed to securitization in 2006. Percentages of mortgage bonds rated are: • Moodys 96,7% • S&P 97,6% • Fitch 51,3% • Ratings are paid by issuers; • Agencies help issuer achieve desired rating; • Computer error allowed some CDPOs to receive AAA ratings in early 2007 when ratings 4 notches below should have been awarded; • Moddy's separated its credit ratings operations from marketing and analytics; • All agencies are reviewing operations and methodologies; • Agences failed to recognize significant changes in the quality of mortgages being originated.

  13. Declining Standards Reflected in Pricing Source IMF

  14. Contagion: Structure of SIVs (US) and ABCPs (Canada) * Siv lite (another 12 billions) had high concentration to RMBS • Main issue in US is credit. • Main issue in Canada was no so much quality of credit, but MTM risk (related to mismach of assets and liabilities and leverage) and weak or possibly valid, but not enforced liquidity agreements. • 7 year duration x 10 leverage x 100 bps increase on credit spreads = MTM loss of 70% even if credit risk remains close to 0% probability. • Skeena restructuring (structure / accounting treatment are important).

  15. Correlation Risk: When a Single Assumption Affects a Large Number of Securities • 2007 • US based securitization = 92% of 1,448 downgrade actions by Moody's; • 2006 / 2007 securitization = 87% of all downgrades; • 2007 through Feb. 2008 - 56% of BBB- to BBB+ RMBS downgraded to CCC+ or below. • 2008 • 2000 tranches under reviews; • More downgrades expected. • Example – portfolio of 100 equally weighted securities / volatility of losses around expected mean

  16. Recommandations • Review implicit consequences of investment policies: • In Canada, only 3 corporate issuers offer a money market instrument with a R1H rating. All others are securitized products. • Paying too much is still the biggest source risk: • VAR is not very helpful for this purpose; • VAR is lowest when the 1% long run scenario is most likely; • It amplifies crisis much like program trading in 1987. • Identify main sources of correlation risks: • Portfolio 1 - An investor holds 10 AAA CDOs with a AAA attachement point of 6% and a detachment point 1% above the attachement point (7%). • Porfolio 2 - An investor holds 10 AAA CDOs with a AAA attachment point of 6% and a detachment point of 100%.

  17. Lessons from this Crisis • Avoid investment with mismatched maturities: • Mistmatch design to generate bigger margin from structurers: • Ex.: LSS at 5 bps leverage 10 times with only 5 bps paid to the investor. • What are the consequences if a liquidity crisis affects the maturity of specific instruments at maturity: • Does it trigger a default or will the underlying assets be allowed to run to term? Can your firm support this risk? • Is this risk really off your balance sheet (reputation issues)?

  18. Two Rating Agencies? • US agencies would not rate CAN ABCPs because liquidity agreements were not necessarily global style. • US approach was lower quality assets with global style liquidity. • CAN approach was higher quality assets with weaker liquidity agreement. • Rating agencies are weak at identifying systemic risk. • Agencies rate probability of losses or expected losses – not a useful approach to evaluate systemic risk. • Rating agencies not well suited to identify correlation risks. That is responsability of investors. • Two ratings may not help as in US. Issue is asset pricing bubble.

  19. Appendix

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