4 - The Credit Crisis of

2007

1
Risk Management and Financial Institutions 3e, Copyright John C. Hull 2012

The credit crisis and its consequences

The worst financial crisis since the 1930s started in 2007 in the
United States.

The crisis spread rapidly to other countries, and from financial

markets to the real economy

Some financial institutions failed and much more had to be bailed

out by national governments

Risk management practices of financial institutions have been

subjected to a great deal of criticism

The crisis has led to a major overhaul of banking regulation

2
Risk Management and Financial Institutions 3e, Copyright John C. Hull 2012

U.S. Real Estate Prices, 1987 to 2011:

S&P/Case-Shiller Composite-10 Index

3
Risk Management and Financial Institutions 3e, Copyright John C. Hull 2012

What happened

Starting in 2000, mortgage originators in the US relaxed their lending standards

and created large numbers of subprime first mortgages. This made house purchases
possible for many families that had previously been considered to be not sufficient
creditworthy to qualify for a mortgage.

This, combined with very low interest rates, increased the demand for real estate
and prices rose.

Rising house prices meant that the lending was well covered by the underlying
collateral. If the borrower defaulted, the foreclosure would lead to little or no loss.

To continue to attract first time buyers and keep prices increasing they relaxed
lending standards further

4
Risk Management and Financial Institutions 3e, Copyright John C. Hull 2012

What happened

Bad practices: Features of the market: 100% mortgages, ARMs, teaser rates,
NINJAs, liar loans, non-recourse borrowing

ARM Adjustable rate mortgages: they had a low rate of interest for two or three years and be
followed by a much higher rate.

NINJAs No income, No jobs, No assets. Sometimes, the applicant income reports were not even
checked.

Borrowing was only guaranteed by the underlying asset. The borrower had no legal responsibility
for the repayment of the loan. This encouraged free riding by borrowers as they had an implicit
PUT option on their investment. As long as they understood they had a negative equity, some of
them chose to default.

Political interference: The US government had since the 1990s been trying to
expand home ownership, and had been applying pressure to mortgage lenders to
increase loans to low and moderate income households.
5
Risk Management and Financial Institutions 3e, Copyright John C. Hull 2012

What happened...

Although some mortgage defaulters were unable (but willing) to meet

mortgage payments, many were speculators who bought multiple homes as
rental properties and chose to exercise their put options. They even bought
them a similar house at much lower prices.

This abuse by borrowers meant that while in normal crisis a lender can expect
to recover around 75% of the amount owing in a foreclosure, in 2008 and
2009 recovery rates were as low as 25%.

In 2007 the bubble burst. Some borrowers could not afford their payments
when the teaser rates ended. Others had negative equity and recognized that
it was optimal for them to exercise their put options.

6
Risk Management and Financial Institutions 3e, Copyright John C. Hull 2012

What happened...

Mortgages were packaged in financial products and sold to investors

(securitization). This had been an important and useful tool for transferring risk
in financial markets for many years.

However this time the quality of the underlying mortgages was often very low,
with key information lacking.

Banks found it profitable to invest in the AAA rated tranches because the
promised return was significantly higher than the cost of funds and capital
requirements were low (due to high ratings).

U.S. real estate prices fell and products, created from the mortgages, that were
previously thought to be safe began to be viewed as risky

There was a flight to quality and credit spreads increased to very high levels
7
Risk Management and Financial Institutions 3e, Copyright John C. Hull 2012

Asset Backed Securitization (Simplified)

ABS
Senior Tranche
Principal: $75 million
Return = 6%

Asset 1
Asset 2
Asset 3

SPV

Mezzanine Tranche
Principal:$20 million
Return = 10%

An asset-backed security
(ABS) is a security created
from the cash flows of
financial assets such as loans,
bonds, credit card receivables,
mortgages, auto loans,
A waterfall defines the precise
rules for allocating cash flows to
tranches

Asset n
Principal:
$100 million

Equity Tranche
Principal: $5 million
Return =30%

Tranches are subordinated to

each other

8
Risk Management and Financial Institutions 3e, Copyright John C. Hull 2012

The Waterfall
Asset
Cash
Flows

Senior
Tranche

Mezzanine Tranche

Equity Tranche
9
Risk Management and Financial Institutions 3e, Copyright John C. Hull 2012

ABS CDOs or Mezz CDOs (Simplified)

ABSs
Subprime Mortgages

Different thicknesses
(25% vs. 10%) but
SAME AAA rating: is
this reasonable ?

Senior Tranches (75%)

AAA

ABS CDO
Senior Tranche (75%)
AAA

Mezzanine Tranches (20%)

BBB

Mezzanine Tranche
(20%) BBB
Equity Tranches (5%)
Not Rated and usually retained
or sold to a hedge fund

Equity Tranche (5%)

How much of the original portfolio of subprime mortgages is AAA? For

the originator, making the senior tranche as big as possible without
losing its AAA credit rating maximizes the profitability of the structure

10
Risk Management and Financial Institutions 3e, Copyright John C. Hull 2012

Losses to AAA Tranche of ABS CDO

Losses on
Subprime
portfolios

Losses on
Mezzanine
Tranche of
ABS

Losses on
Equity
Tranche of
ABS CDO

Losses on
Mezzanine
Tranche of
ABS CDO

Losses on
Senior
Tranche of
ABS CDO

10%

25%

100%

100%

0%

15%

50%

100%

100%

33.3%

20%

75%

100%

100%

66.7%

25%

100%

100%

100%

100%

11
Risk Management and Financial Institutions 3e, Copyright John C. Hull 2012

A More Realistic Structure (incredible

but true !)
High Grade ABS
CDO
Senior
AAA

Subprime
Mortgages

Junior AAA

5%

AA

3%

2%

BBB

ABS
AAA

81%

AA

11%

88%

NR

1%
1%

4%

Mezz ABS CDO

BBB

3%

Senior AAA

62%

Senior AAA

60%

Junior AAA

14%

Junior AAA

27%

AA

8%

AA

4%

BB, NR

1%

A
BBB
NR

CDO of CDO

6%
6%
4%

A
BBB
NR

12
Risk Management and Financial Institutions 3e, Copyright John C. Hull 2012

3%
3%
2%

BBB Tranches

BBB tranches of ABSs were often quite thin (1% wide)

This means that they have a quite different loss distribution from BBB
bonds and should not be treated as equivalent to BBB bonds
They tend to be either safe or completely wiped out (cliff risk). They
are much more BINARY, and its distribution is much less NORMAL
than a same-rated bond.
Correlation among the underlying mortgages was much higher than
expected by rating agencies and investors models (and we know
that, the lower the correlation, the lower the expected risk of the
portfolio)
What does this mean for the tranches of the Mezz ABS CDO?

13
Risk Management and Financial Institutions 3e, Copyright John C. Hull 2012

Role of Incentives and regulatory

arbitrage

Arguably the incentives of valuers (provide as high a valuation as

possible to obtain low LTVs), the creators of ABSs and ABS CDOs
(making structures profitable), and rating agencies (which are paid
by the issuers) helped to create the crisis as there were hiding
agency costs embedded
Compensation plans of traders created short-term horizons for
decision making
Capital required for securities created from a portfolio of mortgages
was considerably less than capital that would be required if
mortgages had been kept on the balance sheet

14
Risk Management and Financial Institutions 3e, Copyright John C. Hull 2012

Importance of Transparency

ABSs and ABS CDOs were complex inter-related products

Once the AAA rated tranches were perceived as risky they became
very difficult to trade because investors realized they did not
understand the risks
ABSs and ABS CDOs tranches were heavily downgraded by rating
agencies in the second half of 2007.
The market became illiquid and credit spreads increased sharply for
every banking issue (short term interbank, senior, subordinated,
covered, ) and not just for ABSs or mortgage related bonds.
Other credit related products with simpler structures (eg, credit
default swaps) continued to trade during the crisis.
15
Risk Management and Financial Institutions 3e, Copyright John C. Hull 2012

Lessons from the Crisis

Beware irrational exuberance, overconfidence, herding instincts.

Black swans DO exist
Do not underestimate default correlations in stressed markets
Recovery rate depends on default rate (do not use RR of normal years).
Compensation structures did not create the right incentives (now bonuses are
usually spread out over several years)
If a deal seems too good to be true (eg, a AAA earning LIBOR plus 100 bp) it
probably is
Do not rely on ratings
Transparency is important in financial markets
Do not buy what you do not understand
Resecuritization was a badly flawed idea. It added no further diversification to the
structure, and hence it was only financial engineering.

16
Risk Management and Financial Institutions 3e, Copyright John C. Hull 2012

Lessons from the Crisis do not

blame the subprime episode !

The subprime crisis was not the cause of our problems, it was just
the first link to be broken because it was the weakest.
Financial markets do play a role in the crisis, but they reflect the
overall degree of debt in the economy and the different connections
among social groups (savers and borrowers).
The western world faces a great demographic challenge that requires
an ever increasing social spending that at least since the 80s is not
being matched neither by productivity gains nor by base increasing
(i.e. more population or worked hours) GDP growth.
This fuelled the temptation to use debt as a way to replace real,
fundamental-justified increase of living standards.
17
Risk Management and Financial Institutions 3e, Copyright John C. Hull 2012

Lessons from the Crisis do not

blame the subprime episode !

This increase in debt has been carried

out by citizens and companies (housing
bubble and corporate indebtedness) but
also by governments themselves. (As an
example, France has not had a budget
surplus since 1974 and its debt-to-GDP
ratio has gone up from 22% in 1975 to
82% in 2010).
Europe today accounts for just over 7% of the worlds population, produces
around 25% of global GDP but has to finance 50% of global social spending.
Debt allowed governments (and citizens) to avoid the usual choices between
reducing public spending versus increasing taxes, because debt was a way
to escape both choices.

18
Risk Management and Financial Institutions 3e, Copyright John C. Hull 2012

Lessons from the Crisis do not

blame the subprime episode !

This crisis is then a DEBT crisis, originated in the public and private sector
of most western economies, and accumulated in banks balance sheets.
The housing bubble and the subprime mortgage disaster are specific
episodes, but they are only part of a wider and structural overindebtedness problem which helped (in good years) to hide the fact that
living standards were already stagnating in the west and that only debt
could keep on increasing such levels of welfare.
The social contract is at risk. Debt is a burden for future generations,
(which do not even vote our deficit budgets). Pensions and health services
are at the center of a problem with demographic and social roots that
threatens the very core of our political system and intergenerational implicit
agreements.

19
Risk Management and Financial Institutions 3e, Copyright John C. Hull 2012

Practice questions and problems

20
Risk Management and Financial Institutions 3e, Copyright John C. Hull 2012

Homework
Work in pairs to prepare up to 5 slides with a global overview of the
mortgage market in your home country:
-Which is the market share of home ownership vs. home rentals ?
-Which are the main features of mortgages? (fixed/floating, average
maturity, average cost, average household indebtedness)
-How has the housing market reacted to the global financial crisis:
increase/decrease in prices since 2007, non performing loans for banks,
-Were mortgage lending standards relaxed in the boom times? How?
-Which changes do you foresee in the way banks would assess in the
future credit risk arising from house mortgages?

21
Risk Management and Financial Institutions 3e, Copyright John C. Hull 2012