Turmoil in the Financial Markets

Jakob Windfeld Lund, Financial Markets

INTRODUCTION

Considerable turmoil arose in international financial markets during the summer of 2007. This unrest was triggered by increasing losses on subprime US mortgages.^[1] The proliferation of new financial instruments has spread the credit risk among many different investor types, and there is growing nervousness in the financial markets concerning which financial institutions could be exposed to possible losses. Money market participants have endeavoured to secure liquidity for their own purposes and shown restraint in lending to counterparties, particularly at longer maturities.

This has resulted in strong price fluctuations in the financial markets. Prices of securities directly associated with the subprime market have plummeted. Other securities have been affected too, especially stocks and debt instruments issued by financial institutions that are thought likely to suffer losses or liquidity pressures in connection with the subprime market. Considerable price fluctuations were also observed in derivatives markets, and the costs of hedging market and credit risks have generally risen. Nervousness in the markets has increased demand for very safe financial assets, at times driving the yield on US Treasury Bills far below other short-term money market interest rates, cf. Chart 1.

The market developments can be interpreted broadly as a flight to safety and a sharp increase in risk premia. This turnaround follows several years' hunt for yield, where investors moved towards more risky investments, and financial risk premia narrowed. International reports on financial stability have for some time highlighted the risk of a sharp increase in unsustainably low risk premia.^[2]

THE MARKET FOR SUBPRIME MORTGAGES

Until 2003, prime mortgages, cf. Box 1, accounted for the largest share of the value of new mortgages in the USA. Subprime mortgages have gained considerable ground since then, making up 21 per cent of total new lending in 2006 and around 15 per cent of outstanding housing loans at year-end. The growth in subprime mortgages can, on the one hand, be attributed to aggressive lending. On the other hand, rising housing prices have pushed the financing requirements of many households to levels that exceed the loan amount and debt service limits for prime loans.

Adjustable-rate mortgages (ARMs), often with deferred amortisation, have accounted for a major part of mortgage loan growth in the USA, particularly in the subprime segment. Borrowers have been attracted by the low nominal debt service payments. Furthermore, subprime lenders have managed to reduce the initial debt service payments further by means of so-called teaser loans, offering an attractive, low teaser interest rate in the first 2-3 years. The teaser interest rate is often lower than the money-market interest rate, but is subsequently raised to the normal variable rate for subprime mortgages. The teaser interest rate sometimes masks negative amortisation, i.e. adding the interest discount during the teaser period to the loan principal. The borrower may be able to service the loan during the teaser period, but when the debt service payments increase sharply as the interest rate is raised, there is a considerable risk of the borrower becoming unable to pay.

Teaser loans have only existed for a few years, and most of the interest-rate adjustments from teaser rates to normal variable subprime rates have not yet occurred, but are expected over the next year or so.

Mortgage delinquencies, i.e. loans more than 30 days overdue, have, since mid-2005, grown from 10.3 per cent to 14.8 per cent of all subprime mortgages and from 10.0 per cent to 17.0 per cent of adjustable-rate subprime mortgages, cf. Chart 2. The share of subprime mortgages in foreclosure reached 5.5 per cent in June compared to 3.6 per cent a year earlier. In August, US President George W. Bush promised to implement a number of measures to help vulnerable households to keep their homes and protect consumers against misselling of mortgages.^[3]

STRUCTURED CREDIT PRODUCTS

Subprime mortgages have been used by financial institutions to tailor structured credit products.

Structured credit products are asset-backed securities (ABS), based on a pool of assets, e.g. subprime mortgages, which serves as collateral for various classes of ABS bonds. The individual classes have different levels of seniority in relation to the assets serving as collateral, and therefore different risk profiles. The rating agencies have given the safest class of ABS bonds their highest credit rating, AAA, cf. Chart 3.

In order to protect the high rating of the safest bond class, less safe bond classes with lower ratings are established, known as junior or mezzanine tranches. These tranches absorb the first potential losses on the loans serving as collateral. The least safe class, which absorbs the initial losses, is known as the equity tranche. Only very large losses affect the safest AAA-rated class.

In order to support the very high rating of the safest class, additional collateral can be included, so that the value of the collateral exceeds the value of the issued bonds. Furthermore, it can be ensured that the interest income from the loan portfolio exceeds the interest payments to investors on the total bond issue. Finally, credit insurance can be taken out against the risk of losses exceeding the buffers in the subordinated bond classes.

The credit ratings of the subordinated bond classes, i.e. junior and mezzanine tranches, are lower than those of the senior debt, but decent ratings between AA and BBB- are still possible. These credit bonds can be used in an asset pool as collateral for a new structured credit product called CDO (collateralised debt obligation)^[4]. This process takes advantage of the fact that the losses on the various assets in the portfolio have not been closely correlated historically, which means that losses are not expected to occur simultaneously. In addition, the same methodology as in the first round is used to create a new, very safe class of senior-debt bonds and support a high rating.

Structured credit products, as described above, are based on quantitative credit-risk models including a detailed analysis of substantial historical data on loss events. Historical data that shows low loss levels and little correlation between loss events, implies limited uncertainty about the loss ratio on a diversified portfolio. The interest margin has more than compensated for the risks of loss that could be calculated using quantitative credit-risk models based on historical data. One of the problems with this method has been precisely this reliance on historical data. In view of the strong growth in subprime loans, the historical loss data will generally be misleading in the event of higher losses than predicted in the model.

The rating agencies have played a significant role in the development of the market for structured credit products. Following the recent turmoil in the financial markets, the rating agencies have been widely criticised, especially for their involvement in tailoring credit products that only just make it into the desired rating class. Such a tailored risk profile can make a structured credit product less safe than a corporate or government bond with the same rating, thereby increasing its vulnerability to downgrades. Another point of criticism against the rating agencies is that they only late into the turmoil downgraded some securities from a very high to a very low rating. It has also been pointed out that the rating agencies have a strong financial interest in the development of the market for structured products – a major source of income – which can give rise to conflicts of interest.

INVESTMENT VEHICLES

Recent years have seen the emergence of a new type of leveraged investment vehicle investing in structured credit bonds financed by the issuance of Commercial Paper (CP). These investment vehicles are called Structured Investment Vehicles (SIV) and Asset-Backed Commercial Paper (ABCP) conduits.

CP is a type of short-term debt securities traded in the money market. They are normally issued by banks and large business enterprises with high ratings, but now also to a great extent by SIVs or ABCP conduits under established CP programmes. These programmes are normally rated beforehand by one or more rating agencies on the basis of the investment portfolio and risk management policy of the issuing bank, enterprise or ABCP conduit. For a CP programme to obtain a high rating, it is often necessary to have a backup line from one or more banks and maybe also credit insurance.

The new SIVs and ABCP conduits have had a leveraged position, financing their investments in long-term securities with credit risk by means of short-term variable-rate borrowing with the securities as collateral. Even though the market risk from different interest-rate sensitivities of assets and liabilities is typically hedged, the investment vehicle depends on access to short-term financing, which makes it exposed to liquidity risk.

THE CHANGED FINANCIAL LANDSCAPE

Structured credit and other innovative products have contributed to changing the financial landscape, especially in the USA^[5]. In recent decades, growth in the total assets of the US financial sector has exceeded US GDP growth. Other financial intermediaries, particularly investment banks, mutual funds and securitisation vehicles, have taken over many of the tasks and risks traditionally associated with banks' deposit and lending activities. The banks are participating in this process, but the risks have been passed on and no longer appear directly on the banks' balance sheets. Through innovative structured credit methods, the credit risk from e.g. the market for subprime mortgages has been blended together, sliced, diced and spread in a seemingly intractable and opaque pattern, cf. Chart 4. However, one characteristic feature of this chain is that the business model for both investment vehicles and banks is increasingly dependent on continuing access to market financing.

MARKET DEVELOPMENTS IN THE SUMMER OF 2007

The US housing market has been under pressure in recent years, with increasing delinquencies among subprime borrowers. Against this background, the price of bonds based on subprime loans has dropped strongly, cf. Chart 5, and in July there were more and more reports of losses in SIVs and ABCP conduits. The development in losses diverged from the historical data underlying the structured bonds. Bond classes that were uncorrelated in the historical data, and therefore regarded as low-risk, have turned out to be positively correlated in turbulent periods. This has reinforced price declines and has considerably undermined the collateral basis for CP issuance by many of the leveraged investment vehicles.

During August, the investment vehicles began to encounter problems with issuance of CP to finance their investments in securities, the price of which had in the meantime plummeted. ABCP yields rose from 5.3 per cent to more than 6 per cent, and the outstanding volume of ABCP has shrunk by more than 20 per cent since early August as some ABCP could not be refinanced, cf. Chart 6.

Pronounced drops in stock prices and the prices of other risky securities indicate that some market participants had to conduct fire sales. In addition, there was considerable demand for safe securities, e.g. very short-term government securities.

The investment vehicles' difficulties also revealed that although structured products had removed the direct credit risk from the banks' balance sheets, there was still a considerable indirect connection via backup lines. A number of investment vehicles had backup lines from banks to support their CP issues, and they began to draw on these commitments. In addition, some investment vehicles were owned by banks. In July and August, exposures with investment vehicles landed two German banks, IKB and Sachsen LB, in such serious difficulties that IKB had to be bailed out by its principal shareholder and Sachsen LB was acquired by Landesbank Baden-Württemberg.

Satisfying the liquidity needs of different customers is a core element of banking^[6]. Banks' ability to fulfil their roles as providers of liquidity depends on confidence in the banks among market participants, which facilitates access to the necessary market financing, as well as access to central-bank liquidity.

European banks have been particularly active in supplying liquidity to the credit markets and to private equity funds for leveraged buyouts. At end-2006, the off-balance-sheet backup lines, guarantees, etc. reported by a sample of large EU banks accounted for 30 per cent of their total assets. Half of the total value of ABCP backup lines came from EU banks, whereas US and Japanese banks together accounted for only one third.

Recently, individual banks have concentrated on securing liquidity for servicing their own customers, amidst the strong demand for liquidity due to poorly functioning CP markets and uncertainty concerning bank involvement in investment vehicles. Consequently, banks have shown reluctance in lending excess liquidity in the interbank market. In the USA and the euro area, the very short-term overnight interest rates rose steeply, but in extraordinary open-market operations, central banks intervened to supply collateralised liquidity, thereby pushing the very short-term interest rates back towards the official interest rates. Such collateralised central-bank lending means that the short-term interbank market is partly replaced by transactions with central banks. These loans are mostly very short-term loans that can be renewed as required.

CONCLUSION

The emergence of structured products and the resultant dispersion of banks' credit risk is a positive financial innovation, which has expanded the risk capacity of the financial system. The risk on US subprime loans has been spread all over the world, stimulated by a strong appetite for yield. However, the development in 2007, especially in recent months, has revealed greater uncertainty than anticipated as regards the quantitative assumptions underlying the decisions to create, and invest in, the complex structured products. The rating agencies have helped transform complex products into securities with very high ratings, based on assumptions about correlations and credit risk that have turned out to be untenable. At the same time, it became clear that an unknown part of the risk had not been removed completely from the banks' balance sheets. Many banks worldwide had owned investment vehicles or committed themselves to granting credit to these firms to back up their issuance of securities to finance investments.

At the beginning of September, some uncertainty still prevailed in the financial markets. The very short-term money markets have functioned relatively smoothly after the central-bank intervention, but the money market for the longer maturities and the CP market for maturities of
1-12 months have been characterised by many banks' reluctance to relend longer-term liquidity. In the light of the poorly functioning markets and consequent liquidity risk, the individual banks tend to reserve longer-term liquidity for their own commercial transactions and potential drawings on backup lines, rather than lending to other banks. The tendency to reserve longer-term liquidity makes it difficult for many banks to conduct normal transactions with their customers. This applies to e.g. long-term forward foreign-exchange contracts, for which banks normally hedge the foreign-exchange risk by means of offsetting contracts in the market.

The recent development in the market illustrates that general shifts in risk appetite and risk premia quickly can change the business conditions, especially for banks that continually depend on access to financing in the money market.

LITERATURE

Bank for International Settlements (2007), 77th Annual Report.

Bank of England (2007), Financial Stability Report, April.

Bhatia, Ashok Vir (2007), New Landscape, New Challenges: Structural Change and Regulation in the US Financial Sector, International Monetary Fund, Working Paper no. 195.

ECB (2007), Financial Stability Report, June.

Frankel, Allen, Jakob Gyntelberg, Kristian Kjeldsen og Matthias Persson (2004), The Danish Mortgage Market, BIS Quarterly Review, March.

International Monetary Fund (2007), Global Financial Stability Report: Market Developments and Issues, April.

Kiff, John and Paul Mills (2007), Money for Nothing and Checks for Free: Recent Developments in U.S. Subprime Mortgage Markets, International Monetary Fund, Working Paper no. 188.

Kjeldsen, Kristian (2004), Mortgage Credit in the USA and Denmark, Danmarks Nationalbank, Monetary Review, 2nd Quarter.

White House (2007), Fact Sheet: New Steps to Help Homeowners Avoid Foreclosure, http://www.whitehouse.gov/, 31 August.