In early 2005, the US housing market was booming. As conveyed by the June 2005 Time magazine’s cover title “Home $weet Home,” the housing market was minting money for everyone. Amid this, every individual in the US was living the American dream to own a house. Housing prices were consistently rising and appreciation was the highest over the past 30 years. This, coupled with historically low interest rates, prompted most people to buy “investment properties”. In the US mortgage market, by borrower quality, a mortgage is prime, sub-prime, or Alt-A. Prime borrowers are those who have good credit scores, a strong debt-to-income ratio, provide required documentation, tax history, residence records and so on. The mortgage is a first-lien mortgage. A sub-prime mortgage is to a borrower who does not qualify as per prime norms, or it is a second-lien mortgage. An Alt-A is to a borrower who is not necessarily poor quality, but does not qualify for prime lending due to documentation problems. Understandably, spreads are quite high in sub-prime lending; yet defaults were low largely due to home prices. Buoyed by this, US banks pressed the accelerator on sub-prime mortgage loans. The outstanding volume is estimated $1.8 trillion. Many of the mortgages originated in 2005 and 2006 had features to make the mortgage enticing — interest-only mortgage, negative amortisation mortgage and teaser-rate adjusted-rate mortgages.
Securitisation game:A large part of money for this came from the securitisation market — that implies pooling together mortgage loans and issuing securities that are repaid from out of the cashflows of the mortgage loans. The proportion of sub-prime mortgage securitisation reached peak levels in 2005 and 2006. Roughly 60-70 per cent of the sub-prime mortgages were securitised.
Leveraged vehicles:Securitisation transactions need first-loss support, that is, junior pieces which would suck losses in the mortgage pool upto a level that can make senior pieces safer. Who would buy these junior pieces? Here came collateralised debt obligations (CDOs). A CDO is similar to a securitisation transaction, except that its asset pool is not retail assets but mostly bonds and corporate securities. CDOs buying into other securitisation transactions are known as structured finance CDOs. Data indicates that structured finance CDOs grew very fast from 2004 — today, they form about 70 per cent of all CDO issuance. If CDOs supply equity to home equity securitisations, what provides equity to the CDO market? After all, the CDO also has subordinated tranches, rated like BBB or BB, which are meant to absorb the losses upto specific levels. The rate of return on these tranches could be upwards of 300 bps. Hedge funds saw an opportunity here. Note that the hedge fund also might leverage itself, and that is quite common. Now add up all the pieces of the leverage — a home equity mortgage is itself a leveraged product, as it might be backed by a second lien on the house. These are pooled into a home equity securitisation, which is a leveraged product. The equity of these is bought by CDOs, which are leveraged vehicles. The equity in CDOs is supplied by hedge funds, which are also leveraged. A $1 of equity in typical hedge fund might ultimately create assets of $1,000, implying a total leverage of a thousand times. The combined impact of economic leverage in the market today may put LTCM, the infamous hedge fund that went bust in 1998 mainly due to a hundred times leverage, to shame. Hedge funds and other yield-hungry investors found yet another way of betting on the sub-prime mortgage market — the credit derivatives market. Credit derivatives are derivatives that trade the risk of default of an entity or a security. Linked to a bunch of home equity securitisations, there is a credit derivatives index called ABX.HE. Trades in ABX.HE increased in 2006 and 2007.
The rout begins:Circa 2007, the US housing market was declining. While increasing interest rates halted new origination volumes, foreclosure rates on existing mortgages of 2005 and 2006 vintage went up as they were to enter the floating phase, when rates of interest would be hiked. Delinquency levels have gone up to the highest levels, historically. And then the perfect storm began. Since different vehicles in the leverage game were all inter-connected, there is a chain effect building all over. Mortgage lenders are suffering losses; some have filed for bankruptcy, some have gone out of business, some have liquidated portfolios at huge losses, and so on. These include New Century (filed for bankruptcy), HSBC (provided huge losses), People’s Choice Home Loan (filed for bankruptcy), Countrywide Financial (suffered huge losses, credit spreads have almost doubled), Wells Fargo (quit sub-prime business) and Fremont (sold subprime portfolio at huge discount). Hedge funds suffered losses in either home equity securitisations, or trades in the ABX.HE; many have stopped redemptions and some have filed for bankruptcy. New issuances in the CDO market that supplied liquidity to the securitisation market dropped from $42 billion in June 2007 to $3.7 billion in July 2007. Rating agencies ruthlessly downgraded securitisation transactions and CDOs. Leveraged finance supply has crashed, putting off lots of acquisition financing plans. Credit spreads have gone up for most financial entities substantially. This might eventually lead to rising cost of capital for financial intermediaries. Funding costs for asset-backed commercial paper conduits, another vehicle that supplies liquidity to Wall Street, have gone up. The $1.15 trillion ABCP conduits have cost going upto 5.75-5.95 per cent compared to corporate commercial paper at 5.25-5.3 per cent.
Credit derivatives indices plummet:As may be expected, sub-prime credit derivatives indices took a beating (see chart of ABX.HE which is linked with 20 home equity securitisation transactions).
Global implications:The biggest worry is the contagion impact. There are two big reasons for worry: first, the level of leverage, and second, the nature of the vehicles that have created leverage in the market. As already indicated, the levels of leverage in the financial markets are extremely high. Leverage is a magnifier — it magnifies profits, and magnifies losses. Secondly, most of the leveraged vehicles we discussed have automatic deleverage triggers. When their assets suffer losses or decline in market value, they are required by their constitutional documents to reduce their asset size. In other words, they have to make fire sales, which further exacerbates the problems. The hedge fund industry exceeds $1 trillion in assets — some analysts predict that in next five years, that would be reduced to half. The hedge fund industry supplies the equity that holds the huge inverted pyramid of structured finance that Wall Street is. So, the worry that the problems that emanated in the sub-prime market might spread into a crisis of global scale is not entirely unfounded.
