What Have We Learned from the Sub Prime Crisis?

1. What Have We Learned from theSub Prime Crisis? Professor Anthony Saunders John M. Schiff Professor of Finance New York University Stern School of Business May 2008

2. How did we get here? • Traditional Banking • Banks as Delegated Monitors • Disintermediation • Securitization • Traditional SPV-based (special purpose vehicle) • SIV-based (special investment vehicle) • Syndication • Back to the Future • Off-Balance Sheet Proprietary Investing • What happens when the delegated monitor delegates?

3. Getting here: Traditional Banks as Delegated Monitors The Traditional Bank – Delegated Monitoring Bank Assets Liabilities Cash Assets Deposits Purchased Funds Loans Capital

4. Getting Here: Traditional Securitization • Securitization allowed banks to remove risk from their balance sheets • Securitization allowed banks to avoid onerous capital requirements • Securitization turned banks into underwriters – originate the loans and then sell them off.

5. The Traditional Securitization Process Bank Assets Liabilities Cash Assets Deposits Purchased Funds Loans Capital Loans Cash SPV Assets Liabilities Loans Asset-Backed Securities Cash Investors

6. Getting Here: Asset-Backed Securities (ABS) and Decline inQuality of Underlying Assets • Mortgage-Backed Securities (MBS) • Residential MBS • Pass-throughs and Collateralized Mortgage Obligations (CMOs) • Subprime and No/Low Documentation • Def. Subprime (2001 Interagency Expanded Guidance): • ≥Two 30-day delinquencies in last 12 mos. or ≥one 60-day delinquency in last 24 mo.; OR • Judgment, charge-off. foreclosure, repossession in last 24 mos.; OR • Bankruptcy in last 5 yrs; OR • FICO score ≤660; OR • Debt service/income ratio ≥50% • Second Lien Mortgages (High Loan/Value Ratios) • Collateralized Debt Obligations (CDOs) • Cash CDOs and Synthetic CDOs • Collateralized Loan Obligations (CLOs) • Covenant Lite and PIK (payment in kind)

7. Source: Bank of England, Financial Stability Report, October 2007, Issue 22, page 6

8. . Source: Loan Pricing Corporation website

9. Getting Here: Loan Syndication • Banks as underwriters • Firm Commitment (Underwritten) deals: The lead bank commits to making the loan in its entirety and then assembles participants to reduce its own loan exposure. Thus, the borrower is guaranteed the full face value of the loan. • Best Efforts deals: The size of the loan is determined by the commitments of banks that agree to participate in the syndication. The borrower is not guaranteed the full face value of the loan. • Club deals: For small deals (usually $200 million or less), the loan is shared among banks, each of which has had a prior lending relationship with the borrower. • Leveraged Loan Syndications • Below investment grade • Often, they will have debt to cash flow levels in excess of 4:1 (i.e., their outstanding indebtedness (i.e., face value of debt) is more than four times the borrowing firm’s annual revenues) • Decline in Quality of Loan Syndications.

10. Syndicated Lending Borrower Bank (Syndicate Lender) Syndicate Member Syndicate Member Syndicate Member

11. Source: Loan Pricing Corporation website.

12. Getting Here: SIVs • Banks as underwriters • Switching from spreads to fees • Reduce risk, but reduce return • Response: A new form of intermediation – back to the future of SIVs. • Formula for disaster: • SIV = Traditional Bank – Regulatory Oversight • SIVs are exposed to traditional banking risks: interest rate risk, liquidity risk, credit risk

13. A New Securitization Process Bank Assets Liabilities Cash Assets Deposits Purchased Funds Loans Capital Loans Cash SIV Assets Liabilities Loans Commercial Paper ABCP Cash Investors

14. Getting Here: Proprietary Investing • Banks establish hedge funds, private equity funds, venture funds through equity investing and/or lending. • Unregulated activities conducted off the bank’s balance sheet.

15. Anatomy of the Storm and Credit Risk Models • Can we have higher return without higher risk? • Why did Credit Risk Measurement Models fail? • Which risks were underestimated?

16. Anatomy of the Storm: The Phases of the Crisis – Bank of England

17. Phase 1: Anatomy of the Storm: Assumption of Perpetually Rising US House Prices • Subprime and “teaser” rate mortgages depend on rising housing prices to: • Refinance upon hitting expiration of introductory teaser rate. But, there is a strong correlation between PD and level of rates (see, Stiglitz and Weiss) • Sale of property in the event of borrower’s inability to make payments. If housing prices increase, Loss Given Default = 0 • Both PD and LGD exhibit “procyclicality” • Thus underestimate PD, LGD and ρ (PD, interest rates).

18. Phase II of the Storm: Rising Spreads on RMBS • Underestimate ρ (RMBS vs. RMBS EUR Source: Bank of England, Financial Stability Report, October 2007, Issue 22, page 7.

19. Phase II: Higher spreads, lower prices, fewer MBS originations • Underestimate ρ (AAA, BBB-)

20. Phase III of the Storm: The Crisis Spreads to Other ABS Markets • CDO spreads increase • CDO issuance declines • Leveraged Loan prices fall

21. CDO Spreads Increase • Underestimate ρ across debt markets, i.e., ρ (RMBS, CDOs) Source: Loan Pricing Corporation website.

22. Leveraged Loan Prices Fall • Underestimate ρ (RMBS, HLT) Source: Leveraged Loan Index is the CSFB Leveraged Loan Index Plus Average Price, expressed as a percentage of par, Bloomberg Ticker = DLJLPX

23. Phase IV: Risk Flows Back to Banks – Reintermediation • SIVs are unable to issue Asset-Backed Commercial Paper • SIVs access their backup lines of liquidity and take down credit lines • Banks are unable to securitize or syndicate these loans due to the decreased volume of new deals • Even if they could sell off these unwanted loans, the prices would be low as spreads increase. • SO: Banks did not really remove the risks from their balance sheets. • Underestimate correlation between on and off-balance sheet risk , i.e., ρ (Risk on, Risk off)

24. Phase V: Liquidity Hoarding and Flight to Quality Creates Mispricings • Underestimate ρ (credit risk, liquidity risk) Source: St. Louis Federal Reserve Bank database, FRED website.

25. How do we steer out of the storm? • Better Risk Modeling • Price of risk was set too low in the mortgage market. • Quantity of risk was underestimated – the pitfalls of hidden leverage. • Improve credit rating models PD and LGD. • Analyze correlation across markets, risks and countries • Align Incentives • What does it tell you when informed lenders treat their loans like hot potatoes? • Avoid Regulatory Mispricings • Basel II implications

26. If capital is required: • Standardized model risk weights: • Credit Conversion Factor for Off-Balance Sheet Items: • 100% unless “eligible liquidity facility” – limited draw-down privileges unrelated to default – then 50% CCF for maturity > 1 year and 20% CCF for maturity ≤ 1 year

27. Steering Out: Potential Pitfalls of the Basel II Securitization Requirements • Places heavy reliance on external credit ratings. • Standardized model uses credit ratings • In the hierarchy of IRB approaches, RBA is preferred – tied to credit ratings • What happens when the credit ratings are wrong?