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As long as the real estate market was doing well (home prices rising, borrowers paying their loans) the banks and investment banks that securitized the subprime mortgages did quite well. But when prices of homes stopped rising problems started to arise.
Not all mortgage bonds are alike, so there are many varieties of stories about how the problems occurred and how they spread through the system. For the purposes of this essay we will analyze the story of a mortgage bond that was more or less legitimate, meaning that most of the parties to the transactions that produced the bond were relatively honest. There were numerous cases of improper behavior in the bubble period: buyers who misrepresented their financial position, mortgage brokers who did not fully explain the nature of the mortgage and so forth. While I know of few careful measurements of the degree of these problems, there are many anecdotes that indicate that these problems were quite serious. But these phony mortgages do not change the way that the problem unfolds, they merely change the ultimate cost of the problem, so I will set them aside for now.
To start, we can examine a specific bond, the Wells Fargo Home Equity Asset-Backed Certificates, Series 2005-1 (see here for information, registration may be required).
This security represents (see Appendix A, page A-1 and following pages) 7,512 subprime mortgages for a total of $1.2 Billion, from all 50 states and the District of Columbia, with interest rates ranging from 4% to 12%, 15 to 30 years time to maturity, in single family homes and condominiums, loan to value ratios from 50% to 100%, principal from $50,000 to $900,000, both original loans and refinancing, primary home and secondary home and with and without prepayment penalty. To properly analyze this security one would have to understand the real estate market in all the states for virtually every kind of loan imaginable; it is said that estimating the value of securities like this takes a specialist (of whom there are very few) a full week.
There were several types of credit enhancement, including overcollateralization and excess interest. The mortgage pool was divided up into a number of slices or tranches, with around $1.05 Billion in three A tranches, and a number of subordinate tranches from M1 to M14.
The A tranches were rated AAA by all three credit agencies (see page S5) and the other tranches received lower ratings (an article describing the Fitch credit ratings on June 29, 2005 can be seen here). More recently, Fitch maintained the AAA ratings on the A tranches as well as the ratings on tranches down to M5; but the news was not so good for tranches M6 and below (see here).
The news for holders of this particular bond was not that bad, at least for holders of the more senior tranches (the A tranches were recently trading at around 90% of face value). But many other similar bonds (as well as the more junior tranches of this bond) had problems, and these problems have spread throughout the banking and investment banking world.
To better understand these problems you may want to spend a few hours reading this summary [pdf] from UBS to explain how they lost $18.7 Billion during 2007, despite the best efforts of management and the existence of a risk control system. I have selected UBS partially as a result of their own public self-analysis, not because it is somehow worse than other banks (although the Chairman himself recently noted [pdf] that “that there are banks which were more cautious and did some things better than UBS.”
If you do not have a few hours, here is a brief summary with a little commentary.
Short version: UBS jumped into the subprime business at the worst possible time, lost a lot of money and now has a new chairman and CEO.
Slightly longer version: in June 2005, UBS set up a new group to invest in hedge funds, DRCM (Dillon Read Capital Management, see an article in the FT here). UBS had been losing both employees and clients to hedge funds and wanted to have a hedge fund of their own. At first, this fund invested UBS’s own money, but it was opened to outside investors in November 2006.
The reason for this was that UBS had been lagging behind their competitors; an external consultant recommended that UBS develop, among other areas, its MBS Subprime business. Their new division, DRCM, quickly started losing money on several aspects of this business, notably risky subprime debt whose value fell more than they had hedged; unfortunately, at that point “[t]he assets could not be sold given the illiquidity in the market and UBS was exposed to further deterioration.” (page 12).
UBS also lost money on (1) their CDO warehouse; UBS would buy mortgages and hold them until they could be packaged and resold; (2) their Super Senior Positions, the AAA tranches of some of the CDOs they sold to clients. The AAA tranches seemed to yield more than other AAA securities with little additional risk; unfortunately, not all these assets were adequately hedged, so when the value of these assets fell UBS suffered large losses compared to the other activities listed here; (3) trading; UBS bet on short-term price moves in mortgage securities and also lost (relatively little) here.
Six months after it opened to outside investors (May, 3 2007), UBS announced the closure of DRCM (see another FT article here). As I write (almost a year later) UBS is still calculating the losses for 2007 and trying to figure out how to move forward.
The problems at UBS are probably typical of those at other large financial institutions. Money was being made in the subprime market and banks tried to get a larger share. When the housing market slowed down, and the profits turned to losses, the first instinct of a number of some banks was to exit the business as soon as possible. The exit of a number of participants in the market exacerbated the problem. As was noted above, valuing a specific subprime bond is not like valuing a share of stock or a government bond. If you want to know what a share of Microsoft is worth (or a specific Treasury Bond) you can see how Microsoft or the Bond is trading today. If you have a security that is similar (but not identical) to another, more heavily traded security, you can estimate the price of your security from the more frequently traded securities. But the subprime bonds were not always similar to other traded securities. As we saw above for the Well Fargo bond, each bond is a claim against a specific portfolio of mortgages.
So the problem for the banks was that the market for these securities was drying up (banks exiting the industry, dumping their portfolios, those remaining unwilling to increase their positions) at a time when the models may have indicated that the bonds were more valuable than other market participants were willing to pay for them. Pressure from investors and regulators caused banks to “mark to market” instead of “mark to model” meaning that the bank would find out what other banks would pay for a bond and carry it on their books at that value, recognizing the loss on their financial reports.
By recognizing these losses some highly leveraged firms came under great pressure. Banks are required by international rules (the Basel II Agreement) to keep a certain level of capital relative to assets; if they experience large losses on subprime debt then they may be forced to sell off other assets; but a number of banks found new investors to add capital (e.g., Citibank and Abu Dhabi) to ensure that they would have sufficient capital.
Some banks with SIV programs (and a mortgage warehouse) had a further complication. By contracting with mortgage originators, they were obligated to buy mortgages for the purposes of reselling them through a SIV. But the demand for the SIV dropped and the costs of financing the SIV in the asset backed commercial paper market increased (see here for ABS commercial paper rates). So SIVs became a burden on banks, being forced to buy mortgages that they could not sell and were expensive to finance.
There were further problems for the end customers who bought some of these securities. Some held this debt in money market mutual funds, that normally fix the value of the fund at $1 per share and provide a return in in the form of interest. When the price of these securities fell, firms were faced with the possibility of “breaking the buck” or allowing the value of the money market fund to drop below $1, which is viewed as breaking an implied contract with people who invest in the fund, and some parent companies had to add extra funds to their money market divisions to preserve the value of the fund.