Finanzkrise - Analysis and Reasons for the Subprime Crisis

Table of Contents

List of abbreviations

List of symbols

List of depictions

1 Introduction

2 Mortgage Backed Securities as a form of Asset Securitization
2.1 Structure and involved parties
2.1.1 Classification of mortgage backed securities
2.1.2 Property loan securitization
2.2 Versions of loan securitization
2.2.1 True Sale vs. synthetic forms
2.2.2 “Pass-Through” vs. “Pay-Through”
2.3 Appraisal of loan securitization of the view of credit institutions
2.3.1 Advantages for the bank.
2.3.2 Disadvantages for the bank
2.4 Risks of securitization

3 Ratings of MBS
3.1 Rating process
3.2 Demand-Pool-asset backing for reaching a certain rating class
3.2.1 Internal credit enhancements
3.2.2 External credit enhancements
3.2.3 Critical appraisal of collateralization measures

4 Analysis and reasons for the subprime crisis
4.1 Definition of “Subprime”
4.2 Securitization- and US-property market
4.2.1 Origin and increase of the securitization market
4.2.2 Development at US-property market
4.3 Trend of interest rates in the US
4.4 Property loans in the US.
4.4.1 Types of credits
4.4.2 Bank lending policy
4.5 Information asymmetries inside the securitization structures
4.6 Outbreak of the crisis by interaction of individual causes

5 Conclusion

List of sources

List of abbreviations

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List of symbols

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List of depictions

Depiction 1: Classification of MBS as a section of ABS

Depiction 2: structure and payment flows of credit securitizations

Depiction 3: The waterfall principle (subordination)

Depiction 4: amount of Subprime-credits of the total securitization market in the US

Depiction 5: Characters of the securitized Subprime-credits

Depiction 6: S&P/Case-Shiller® Home Price Index from 25 July 2000 - July 2008

Depiction 7: Real estate owners in the US (in percent)

Depiction 8: Number of Subprime-credits

Depiction 9: US-prime rate compared to an interest rate for a 30-year fixed rate mortgage (FRM) from January 200 to April 2008

Depiction 10: Interest rate spread between Subprime- and Prime-borrowers compared to the spread between “AAA” and “BBB” rated corporate bonds

Depiction 11: Amount of types of credits for financing of the first Subprime borrower 2001-2006

Depiction 12: LTV ratio of a Subprime-segment between 2001 and 2006

Depiction 13: Delay in payments and compulsory auctions of the first 24 months for property loans in 2001 to 2006 (in percent)

1 Introduction:

In the beginning of 2008 the word „Subprime“ was elected by brokers, analysts and traders at the stock market Frankfurt for the “Unwort 2007”. Whereat “Subprime” just means that something is just below (sub) of top quality (prime). The choice was constituted by the fact that the translation belittles this word and deceptively describes the true quality of Subprime real estate loans.¹

The following bachelor thesis analyzes and intends to look into the reasons for the Subprime Crisis, which burst out in the beginning of 2007 and at the time of this writing - November 2008 - continues to seriously affect the global economy.²

This thesis is structured in various chapters. First and before beginning the analysis of the crisis, chapter 2 will introduce mortgage backed securities (MBS), the financial instruments that were used to securitize the subprime loans. Thereafter chapter³ describes the rating of these MBS, based on which chapter⁴ analyses the reasons of the Subprime crisis and explains that not merely one single factor caused the crisis, but rather an interaction of different factors and a progression of several years created this crisis which already had and will have far reaching consequences for all parts of the world and the economy.

2 Mortgage Backed Securities as a form of Asset Securitization

2.1 Structure and involved parties

2.1.1 Classification of mortgage backed securities

The whole process of securitization includes the securitization of Securities, whereat the arising payment claims are backed by uncertificated assets.3 The first issue of receivables securitization was conducted in the USA in February 1970. The Government National Mortgage Association (Ginnie Mae) securitized mortgage loan claims in the form of Mortgage Backed Securities (MBS).4 Asset Backed Securities (ABSs) were first emitted in 1985.⁵ A classification and differentiation according to depiction 1 is useful, although ABS-transactions were conducted only after MBS-Flotation’s. For one thing, mortgages are assets like other receivables, for another thing there are no jutting differences between the structure and securitization of MBS and ABS. Consequently a classification of both groups under the generic name ABS is congruously.⁶

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Depiction 1: Classification of MBS as a section of ABS⁷

Collateralized dept obligations could illustrate a third part of depiction 1 as a specific form of ABS. They arise out of a portfolio of high diversified assets which inconclusively originate of a designated demand group.⁸

2.1.2 Property loan securitization

The basic idea of property loan and receivable securitizations is to securitize illiquid and therefore not tradable assets, to make them liquid.⁹ Admittedly these assets must fulfill several requirements for example to be homogenous and have a high resale value. Furthermore they should have uniform and comprehensible credit contracts with an assessable residual term as well as geographically and demographically diversified borrowers. A large receivables pool and clearly identifiable payment flows of interest and principal is necessary to securitize this assets. Lastly, the ability to allocate the respective property items in a clear way must be satisfied also.¹⁰ As already identified in depiction 1, mortgage loans in particular suit very well for securitization, as these comply with all the mentioned requirements.

At the beginning of the securitization process the originator, the bank, establishes a special purpose vehicle (SPV) which holds the property loans in its balance sheet. The only function of the SPV is the acquisition of property loans from the bank and the refinancing by stock floatation thereafter.¹¹

Conditioned by the organizational expenses as well as the tax law, SPV’s are normally established as offshore banking centers like the Cayman Islands or the Channel Islands. There a SPV foundation is possible with a seed capital of less than 1000 €.¹² Usually the originator assigns an arranger (an investment bank), which advices the bank while the whole process of securitization and also makes the structuring of the securitization.¹³ To refinance the bought assets, a bank consortium emits the stocks in different tranches, which can have different ratings and pay varying interest rates to their holders. The assets of the SPV and the loan securities comprise the entire liability mass that is available to the investors as the underlying collateral baking the securities bought. In case of property loans the pledged loan securities are usually lien on property.¹⁴ A service agent is delegated to control the property loans and ensure the interest and principal payments paid by the borrower passed on to the bank.

An additional party involved in the securitization process is the custodian. The custodian controls the transactions, forwards the interest and principal payments to the investors and has, for the safety of the investors, an access right to the assets of the special purpose vehicle.¹⁵ The process, involved parties as well as payment flows are shown in depiction 2:

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Depiction 2: structure and payment flows of credit securitizations¹⁶

2.2 Versions of loan securitization

2.2.1 True vs. synthetic sale

The described securitization process in the previous passage is a typical True Sale Transaction where receivables of the originator are sold away from the holder’s balance sheet to the SPV.¹⁷ As a result, in case of the originator’s bankruptcy, his creditors don’t have access to the receivables sold as securities. This aspect was difficult to implement in Germany, because property loans are collateralized by mortgages whose bailments are only possible with a change in land register. For this purpose, the agreements of all barrowers are necessary. On July 8, 2005 the “Kreditwesengesetz” was changed and a refinancing register created, to contain transactions for refinancing to enable the true sale transactions (§§ 22a - 22o KWG).¹⁸

The refinancing register is maintained in the bank and administrated by the respective department of the BaFIN. The purpose of this register is to permit the SPV on a relective basis to redeem emitted loans in case of a bank’s bankruptcy a selection right for their registered items of property to.¹⁹ A critical remark is that as long as there is no bankruptcy, both, the bank and the borrower can dispose of the mortgage. This can offer an enticement to not fulfill the concerted contracts.²⁰

Compared to the true sale version, there is only one difference in the synthetic securitization: The receivables are not sold to the SPV, but rather the credit risk is transferred by way of derivates from the bank to the SPV, whereas the loans stay in the bank’s balance sheet.²¹ An example of such a derivative is the credit default swap (CDS). The special purpose vehicle which normally just buys a small part of the risk, promises in return to carry out adjustment payments to the originator in case of, for example delayed payments.²²

The SPV can perform a refinancing of the risk taken by issuing creditlinked-notes (CLN) where the interest is paid independently of the performance of the property loan and the repayment of the loan is reduced in case of special credit events. Furthermore the SPV can secure itself again, by selling own CDS to other investors.²³

But the synthetic version also exists without an establishment of a SPV. In such a case the originator gives the CLN itself as a security for the credit risk. The so raised capital is then transferred to a collateral account. The interest payments of the loan are refinanced by interest earned on such capital. If the loan becomes payable, the collateral will be sold and the loan less the amounts of capital paid back.²⁴

2.2.2 “Pass-Through” vs. “Pay-Through”

A further classification of asset securitization can be made on the basis of forwarding the payment flows.²⁵ In the Pass-through variation the payments generated by the receivables assets of the SPV are passed directly through to the bonds owner, because they have a coparcener demand of these receivables. and therefore its cash flow. If the borrowers pay their interest and principal payments quarterly, the loan creditors of the SPV consequently get their money quarterly.

The pass through structure is completely unproblematic, as long as the borrowers make their payments full and in time. A premature repayment of the mortgage by the owner has also effects for the bonds investors and the returns earned. Thereof accrue the prepayment risks. Consequently the term or duration of loan and rate of return are variable.

In the US a lot of pass-through-bonds are emitted by state agencies, which guarantee punctual interest and principal payments as well as the avoidance of risk by excluding prepayments.²⁶ The same risk can be reduced by the bank which offers the special purpose vehicle a retirement option for prematurely defaulted credits. Certainly the retirement price must include interest and principal payments, in order for the SPV to not be aggrieved.²⁷

The similarity between pay-through and pass-through structures is that the interest and re-payments are based on the interest and principal payments of the securitized credit. Admittedly the payment flow from pay-through securitizations will not be forwarded directly to the bonds owner, but rather be managed by the special purpose vehicle (SPV) or the delegated custodian.²⁸

If Borrowers repay their credits earlier, these revenues to the SPV will be invested in money market papers or additional receivable assets. Therefore there’s no risk for the bonds owner in pay-through securitization, because the SPV is bearing the interest- and reinvestment risk.²⁹

2.3 Appraisal of loan securitization of the view of credit institutions

2.3.1 Advantages for the bank

The main advantage of loan securitization, especially of property loans, because of their largeness, is the increase of financing possibilities and access to additional capital for banks. Usually account receivables from financing equity and dept capital are on the liability side of the banks balance sheet, whereas for ABS the bank is just making a change in their assets. In the form of a True Sales it generates the same liquidity as comparable equity and dept capital financings. Advantageous for the bank is credit securitization also, if the acquisition of own additional equity and dept capital is limited, based on restrictions. Therefore they have to deposit issued credits with equity capital in accordance to fulfill regulatory standards. If these are exhausted, a true sale can create new capital to allow the issuing of further credits or to pay back dept capital. Further credit portfolio diversification helps to eliminate clump risks, for example the securitization of loan types which are not the core competence of the bank. Further securitization allows smaller institutions that don’t have a straight possibility to enter the capital market to gain such access. Only if they work together on one securitization, they can get into the market. In this context the contact to new, especially international investors is very important.³⁰ For banks under the legal form of an AG, the return of equity is very essential to satisfy their shareholders. Primarily here credit securitization offers the best advantage, because as mentioned, after securitization the bank can originate new loans which produce additional profit.³¹ Overall, the financial and economical advantages can also have positive effects on the bank’s further operations. Therefore the bank becomes more flexible and independent concerning the choice of individual market participants and can control conscious the key risk figures to improve their long-ranging image.³² Another option besides the securitization of loans and receivables could be the leverage, whereat the taking of new capital often contains higher costs. The originator usually has a rating where the finance costs of the market can be derived from. In a True Sale, the receivables are fully transferred to a SPV and the receivables pool is evaluated separately from the bank, therefore the rating of the emitted loan can come off better than the rating of the originator. As a result thereof the interest payable on the securities is lower than those to be paid in by the bank.³³

Additionally the rating of the securitization structure can come off better, based on special hedging processes, than the rating of the originator and can also bring the same cost advantage. This process is explained in chapter 3.2.

2.3.2 Disadvantages for the bank

The advantages set in the previous section confront also some disadvantages. As described in chapter 2.1.2, a securitization transaction is very costly because it has to consider a lot of legal and booking aspects. Therefore a planning period can take somewhere between a few months up to years compared to the classic loan issue. This represents a disadvantage for the securitization transaction.

Also certain incertitude exists, because explicit securitization norms are not disseminated everywhere.³⁴ The enormous effort also necessitates a high fixed cost charging.³⁵ Concerning this, loan securitization causes constant cost charging, for example 0.02 to 0.05% p.a. on the issue volume for the custodian and 0.75% p.a. for the service agent.³⁶ These variable costs in combination with the fixed costs require an exact analysis to identify possible cost advantages or disadvantages. Credit securitization can also affect the costumer relations negatively. Normally the costumer borrower does not notice that his credit was sold, because the bank often accepts the business of the service agent, handling all payment flows. Problems just can emerge when a costumer gets into financial difficulties and wants to change his repayment plan or interest terms. In this case a bank is restricted in its flexibility. A further disadvantage is a strict dunning, because investors are just interested in punctual interest and principal payments. Because the cross selling dealings and customer relation in the future would suffer, the bank tries to avoid any kind of such problems. Unfavorable is also that costumer consultants often don’t know which credits were sold and which not.³⁷

A further negative impact of credit securitization can be a decline of the banks remaining credit portfolio. In order to hold the interest rate of the SPV’s emitted bond as low as possible, the bank has the appeal to securitize just the credits of high quality and to hold the bad credits in the balance sheet. This process is called “Cherry Picking” and involves possible consequences regarding to the proportion of the equity capital needed. The opposite of “Cherry Picking” is “Lemon Selling” where just bad credits are securitized and then the following would have disadvantages for further transactions and the image of the bank. But both forms play a minor part in practice, because credits are usually randomly chosen to avoid Cherry Picking as well as Lemon Selling. This can entail an easing of granting of credits if a bank is under bold competitive pressure in a fast growing market, assuming the bank can securitize anytime. This business policy for example if home prices should fall, can cause high monetary (for example profit setbacks) as well as to not monetary (for example damage of image) consequences for the bank, as further the subsequent “Analysis of the Subprime-Crisis 2007” will show.³⁸

2.4 Risks of securitization

There are different risks based on the complexity of securitization structures. These can be differentiated in asset, collateral and securitization risks.³⁹ These risks will be demonstrated in below taking a MBS-structure as the demonstrating example. The contingency risk for securitized property loans falls in the first category. That implies that in a case of a payment default by the borrower the planned handling of the emitted securities would be endangered. Loans, the borrower of which faces financial distress and decides or is forced to postpone due payments, contain the so called delinquency-risk. Such risk can effect the liquidity situation of the SPV or, in case of a pass-through structure, the liquidity of the investor.

The opposite to this type of risk is, as already mentioned in section 2.2.2, the prepayment-risk, which effects the rate of return and/or leads to reinvestment risk. In case of a pass-through securitization these risks hit the investors directly. In case of a pay-through securitization on the other hand these risk hit the SPV.4⁰

In addition to these risks, market price risks exist where mortgage loans with a fixed rate of interest are purchased rather than those with a variable rate of interest. A potential change in the interest rate levels creates the interest rate risk. Similarly, a currency risk exists, which can further increase the interest rates risk if credits and the emitted securities are related to different currencies.⁴¹

Lastly, securitization-risks refer to the danger of a bankruptcy of one of the parties engaged in the transaction, which may result in a deficit of his due payments or services. If the economic situation of a borrower turns bad, the risk of a rating downgrade of the MBS rises. If any one of the parties involved in the transaction doesn’t fulfill his due tasks on time, such can have dangerous affects on the entire stability of the securitization.⁴²

Finally risks which associated with the legislator should be mentioned.⁴³ Even in case of a materializing crisis situation, there is the risk that the regulatory bodies may intervene in the general framework and enacts new imponderable laws.

[...]

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¹ Cf. authorless (2008a), p. 57.

² Cf. Kiff/Mills (2007), p. 3.

³ Cf. Göpfert (2007), p. 32

⁴ Cf. Greenbaum/Thakor (1995), p. 387; Deutsche Bundesbank (1997), p. 58

⁵ Cf. Peters (1995), p. 750.

⁶ Cf. Bär (2000), p. 46f.

⁷ Cf. Bär (2000), p. 47.

⁸ Cf. Büschgen (2006), p. 188; whereat also CDO property loans were securitized, the term MBS is used for all further explanations.

⁹ Cf. Hartmann-Wendels/Pfingsten/Weber (2007), p. 302; Hermann (2002), p. 183.

¹⁰ Cf. Lerbinger (1987), p. 310f.; Peters (1995), p. 750.

¹¹ Cf. Ohl (1994), p. 21-32.

¹² Cf. Bauersfeld (2007), p. 181.

¹³ Cf. Bär (2000), p. 38.

¹⁴ Cf. Goepfert (2007), p. 32-34.

¹⁵ Cf. Bär (2000), p. 27-31.

¹⁶ Following: Büschgen/Börner (2003), p. 285; Goepfert (2007), p. 34.

¹⁷ Cf. Bauersfeld (2007), p. 90.

¹⁸ Cf. Dittrich/Uhl (2005), p. 994f; Fleckner (2005), p. 2733.

¹⁹ Cf. Fleckner (2005), p. 2734-2736.

²⁰ Cf. Fleckner/Frese (2007), p. 925.

²¹ Cf. Bund (2000), p. 240f.

²² Cf. Bauersfeld (2007), p. 90f.

²³ Cf. Barbour/Hostalier/Thym (2004), p. 79-81.

²⁴ Cf. Vgl. Bauersfeld (2007), p. 92f.

²⁵ Cf. Röchling (2002), p. 14.

²⁶ Cf. Bär (2000), p. 129-138.

²⁷ Cf. Kürn (1997), p. 97.

²⁸ Cf. Paul (1994), p. 141.

²⁹ Cf. Bär (2000), p. 138f.

³⁰ Cf. Bär (2000), p. 289-314.

³¹ Cf. Weimar (2007), p. 896.

³² Cf. Bär (2000), p. 313f.; Ohl (1994), p. 260-263.

³³ Cf. Schwarcz (1997), p. 1290.

³⁴ Cf. Bär (2000), p. 334-338.

³⁵ Cf. Hommel/Schmittat (2005), p. 982.

³⁶ Cf. Ohl (1993), p. 268f.

³⁷ Cf. Bär (2000), p. 334-355.

³⁸ Cf. Bär (2000), p. 348-357.

³⁹ Cf. Bär (2000), p. 197.

⁴⁰ Cf. Bauersfeld (2007), p. 94f.; Bund (2000), p. 37.

⁴¹ Cf. Röchling, A. (2002), p. 38.

⁴² Cf. Bär (2000), p. 196-200.

⁴³ Cf. Bär (2000), p. 196.