Asset Backed Securities. Their Role within the Financial Crisis

Content

Abstract

Content

Index of figures

Index of abbreviation

1 Introduction
1.1 Objective
1.2 Structure of the term paper

2 Asset-Backed Securities
2.1 Overview ABS
2.2 Securitisation process
2.3 Complex Financial Products

3 The Financial Crisis 2007/2008
3.1 Trigger of the financial crisis
3.2 Collapse in the ABS market

4 Conclusion

Index of Sources

Abstract

The subprime crisis in 2007 proved to be the dominant factor in the financial world and triggered a global financial crisis of unimagined proportions. This paper examines the role of asset-backed securities in the financial crisis of 2007/2008, focusing on the triggers and the process that ultimately led to the bursting of the US real estate bubble. The essay also provides an overview of how the downturn in the US real estate market was triggered and how the United States and the global economy slid into recession.

Index of figures

Figure 1: Overview Asset Backed Securities.

Index of abbreviation

ABS Asset Backed Securities

CBO Collateralized Bond Obligations

CDO Collateralized Debt Obligations

CLO Collateralized Loan Obligations

CMBS Commercial Mortgage Backed Securities

MBA Master Business Administration

MBS Mortgage Backed Securities

RMBS Residential Mortgage Backed Securities

SPV Special Purpose Vehicle

1 Introduction

In the mid-90s, a young team from JP Morgan's investment bank developed a new type of financial product to better manage credit risks. At that time, these new financial products were not yet called asset-backed securities, but bistro deals. In the years that followed, these products were so successful and popular that at that time it was impossible to imagine the consequences for the global economy ten years later.¹

As a result, at the end of 2007, one of the biggest financial crises and in 2009 to one of the most serious crises since the “Great Depression”.² The investment banker of Lazard Frères, Felix Rohatyn, expressed this event as follows:

„[..]financial hydrogen bombs built on PCs of 26-year-old MBA graduates. “

1.1 Objective

This paper focuses on the role of asset-backed securities(ABS) in the financial crisis of 2007/2008. The causes and effects as well as the development of the financial crisis are described. The main focus of this essay is on the role of asset-backed securities. The aim is to examine the role of asset backed securities in the financial crisis of 2007/2008.

1.2 Structure of the term paper

The first chapter begins with an overview of structured financial products in order to better understand the overall context. The following section focuses on the securitization process of ABS. This is followed by an explanation of the complexity through tranching and the influence of the valuation of loans by rating agencies. The third chapter deals with the triggers of the financial crisis and shows what effects this had on asset-backed securities. It concludes with a critical examination of asset-backed securities.

2 Asset-Backed Securities

As mentioned at the beginning of this paper, asset backed securities played a central role in the emergence of the 2007 financial crisis. For this reason, the following section discusses asset-backed securities and securitisation and the securitisation process in more detail.

2.1 Overview ABS

Asset-backed security (ABS) is a financial product whose purpose is to securitize, or asset securitize non-tradable financial assets, i.e. receivables, into tradable securities.³ The following figure shows the classification of different variants of ABS.

Figure 1: Overview Asset Backed Securities⁴

Abbildung in dieser Leseprobe nicht enthalten

ABS in the narrower sense, essentially covers all types of receivables, such as credit card receivables. Collateralized debt obligations (CDO) are receivables that are generally based on corporate receivables. A distinction can be made between Col-lateralized Loan Obligations (CLO), which are based on loan receivables, and Collateralized Bond Obligations (CBO), whose underlying consists of corporate bonds, for example.⁵

Another form of ABS is the CMBS which are based on commercial real estate loans. Mortgage backed securities (MBS), on the other hand, can be divided into residential mortgage backed securities (RMBS) and commercial mortgage backed securities (CMBS). RMBS in particular play an important role in the financial crisis due to the underlying residential real estate loans.⁶

2.2 Securitisation process

The basic idea of securitisation is to minimise risk through diversification. Due to the distribution among several market participants, the default probabilities for the individual are lower. However, the prerequisite for this is that the risk remains constant, otherwise it increases for each individual market participant. In general, a distinction is made between two types of securitisation: true sales and synthetic securitisations. In a true sales securitisation, a bank (originator) puts together a portfolio from several hundred or thousand different loans. To ensure that the assets on the balance sheet are not affected by the bank, the bank establishes a special purpose vehicle (SPV). This ensures that the SPV is not considered a subsidiary of the bank.⁷ Since the special purpose entity does not have any own funds, it finances the purchase of the receivables by issuing securities on the capital market. These securities are referred to as asset-backed securities.⁸ Unlike true sale securitisation, in synthetic securitisation the originator retains ownership of the receivables, which means that they remain on the bank's balance sheet.⁹

2.3 Complex Financial Products

The global demand for ABS could not be satisfied by tranching, i.e. dividing the portfolio into different credit rating classes, and lending US mortgages to lower-income population groups. As the demand for mortgages outweighed the supply, new securities could only be created by further securitisation.¹⁰ This approach made it difficult for investors to distinguish which loans made up their securities. It is almost impossible for investors to correctly assess the risks they face because they do not know exactly what the underlying assets are. The greatest danger for investors was thus the default risk of the underlying loans of their securities.¹¹

3 The Financial Crisis 2007/2008

3.1 Trigger of the financial crisis

When the dotcom bubble burst in 2000 and the stock markets lost their appeal for investors, investments in real estate became increasingly attractive as an alternative. Due to the increased demand, real estate prices in the USA rose by 105% from January 2000 to September 2006.¹² Due to the steady rise in real estate prices and the high yields of ABS and also increased the demand for mortgage-backed securities.¹³ Another trigger for financial circles can be seen in the steady reduction of the key interest rate by the US Federal Reserve from 2001 onwards in order to avoid a recession. In the following years, lending standards were further relaxed, and banks issued increasingly risky real estate loans to customers without proof of income or credit history checks, so-called NINJA loans (no in-come, no job, no assets).^{14 15}

3.2 Collapse in the ABS market

The trend of the NINJA loans was promoted for many years and led to a wave of loan defaults¹⁶, when the US Federal Reserve started to raise the key interest rate again in 2004.¹⁷ In addition, the key interest rate hikes led to an ever-decreasing demand for housing loans and in 2006 there was an oversupply of real estate.¹⁸ In addition, many borrowers from the subprime segment were no longer able to repay their loans. This was mainly due to the variable interest rate structure, which either had already existed since the beginning of the borrowing or came into effect in 2006 after initially fixed interest rates. Around 3% more interest had to be paid immediately. As a result of numerous loan defaults, the rating agencies saw themselves compelled to downgrade all tranches from 2007 onwards. Even the supposedly safe tranches.¹⁹ In addition, the declining demand for loans in 2006 also caused US real estate prices to fall. Due to the payment defaults, the banks attempted to foreclose on the properties. Over time, however, it became increasingly difficult to recover the original loan value due to falling property prices. In addition, numerous foreclosure auctions caused property prices to fall even further.²⁰ Subsequently, banks had to make massive write-downs on the securities of these loans and they stopped lending money to each other.²¹ The downgrading of the ABS by the rating agencies, which took place too late and in some cases too quickly, led to a mistrust not only of the really risky securitisations, but of all types of securitisations.²² As a result, the market for these products collapsed because no market prices could be determined for these securities. The subprime crisis reached its supposed peak when the investment bank Lehman Brothers went bankrupt in September 2008.²³

4 Conclusion

The basic idea behind the ABS was to improve the management of credit risks through risk diversification. By bundling credit receivables in portfolios and dividing them into tranches of different risk classes, an attempt was made to make the financial market stable. However, in the course of time, the really secure credits became less and less, so that as a result more and more risky credits with a high probability of default were granted to low-income groups. Through the multiple traching of ABS, increasingly risky mortgage loans were offered to the capital market. However, due to the existing information asymmetry between the banks and the capital market, no investor was able to correctly assess the associated risks. Due to the expected high returns from ABS, the demand for the same financial product also grew.

However, when the US Federal Reserve began to raise the key interest rate again in 2004 and at the same time real estate prices fell, the low-income group was no longer able to service the loan rates due to the sharp rise in interest rates. The result was a rapidly growing number of bad debts in this sector. The bad debt losses led to enormous write-downs by banks and investors, as well as to a loss of confidence in the ABS and the entire capital market.

The result was one of the greatest recessions and global economic crises of our time. The financial crisis of 2007/2008 shows how an originally responsible idea and a real catastrophe could develop into a real disaster.

[...]

¹ Compare Krassin A., Tran T.M.Y., Lieven T., Asset Backed Securities (ABS), 2009 p. 69

² Compare Hartmann-Wendels T., Pfingsten A., Bankbetriebslehre 2019, p.70

³ Compare. Gruber, J., Gruber, W., Praktiker Handbuch Asset-Backed-Securities, 2005, p. 63.

⁴ Compare Krassin A., Tran T.M.Y., Lieven T.,Asset Backed Securities (ABS), 2009 p. 71, own representation

⁵ Compare. Gruber, J., Gruber, W., Praktiker Handbuch Asset-Backed-Securities, 2005, p. 66-67.

⁶ Compare Krassin A., Tran T.M.Y., Lieven T.,Asset Backed Securities (ABS), 2009 p. 70

⁷ Compare Bartmann, P., Buhl H., Hertel, M., Ursachen und Auswirkungen der Subprimekrise, 2009, p. 4

⁸ Compare Krassin A., Tran T.M.Y., Lieven T.,Asset Backed Securities (ABS), 2009 p. 72

⁹ Compare Brenken, A., Papenfuß H., Unternehmensfinanzierung mit ABS, 2007, p. 25

¹⁰ Compare Krassin A., Tran T.M.Y., Lieven T.,Asset Backed Securities (ABS), 2009 p. 78

¹¹ Compare Krassin A., Tran T.M.Y., Lieven T.,Asset Backed Securities (ABS), 2009 p. 85

¹² Compare Krassin A., Tran T.M.Y., Lieven T.,Asset Backed Securities (ABS), 2009, p. 86

¹³ Compare Krassin A., Tran T.M.Y., Lieven T.,Asset Backed Securities (ABS), 2009, p. 88

¹⁴ Compare. Jäger, M., Voigtländer, M., Hintergründe und Lehren aus der Subprime-Krise,2008, p. 6

¹⁵ Compare Hartmann-Wendels T., Pfingsten A., Bankbetriebslehre, 2019, p.72

¹⁶ Compare Hartmann-Wendels T., Pfingsten A., Bankbetriebslehre, 2019, p.72

¹⁷ Compare. Jäger, M., Voigtländer, M., Hintergründe und Lehren aus der Subprime-Krise, 2008, p. 7

¹⁸ Compare Bartmann, P., Buhl H., Hertel, M., Ursachen und Auswirkungen der Subprimekrise, 2009, p. 15

¹⁹ Compare Krassin A., Tran T.M.Y., Lieven T.,Asset Backed Securities (ABS), 2009, p. 88f

²⁰ Compare Krassin A., Tran T.M.Y., Lieven T.,Asset Backed Securities (ABS), 2009, p. 88

²¹ Compare Hartmann-Wendels T., Pfingsten A., Bankbetriebslehre, 2019, p. 71

²² Compare Krassin A., Tran T.M.Y., Lieven T.,Asset Backed Securities (ABS), 2009, p. 92

²³ Compare Hartmann-Wendels T., Pfingsten A., Bankbetriebslehre, 2019, p. 71