The financial crisis part one

You have read the news and heard about sub prime and how those sub prime loans are being package with better rating loans and thus they end up polluting the pool. I would not be touching that.

We would start our story with a ABS. The same concepts can apply to MBS, CDOs etc. An ABS is divided into tranches, with the most senior usually called super senior and the most junior which is usually the equity tranch. Super senior usually gets a credit rating of AAA. Usually the bank would sell the ABS pool to an entity called SPV, who would issue the tranches to investor. This allow banks to remove the loans from their balance sheet and thus lower their regulatory capital requirements. A usual ABS structure consist of 80 to 85% senior tranches funding, and 15 to 20% other tranches with AA and below rating. Typically the SPV or bank would have no problem selling those AAA to A tranches, but would have some trouble selling BBB and below tranches. The case is very complicated but for simplicity sake we can assume that banks would take on the risky tranches if there is an abritage profit to be made, usually resulting from spreads between the pool CFs and CFs to be paid to investor. The bank or SPV would sell the risky tranches if abritiage profit is non existance.

But what if they cannot sell the tranches. Some bright Chaps from some banks decided that since we cannot sell the BBB tranches why dont we bumble them up into a pool. So now they have a pool of BBB tranches in which they sell to SPV again and SPV issue tranches and if you are wondering, the super senior get AAA rating. Now pause and think for a while, how can a BBB pool achieve a AAA rating tranches?

The answer lies in a few factors

1. Diversification means lower risk of default
2. the BBB tranches is backed by a low risk pool (the pool that is initially originated by the bank)
3. the SPV is bankupcy remote (this apply to the initial issue as well)
4. Credit insurance and CDS are usually use to enhance ratings
5. Swaps can be use to match CFs between pools and that require by the investor
6. others techical aspect too much for layman to absorb

So what can possibly go wrong with such a magical structure. The answer is failure of downside risk management. Let us bear in mind that every thing work well when the world is fine but when the world is sick things get out of hand. Every Book would tell you that correlation increases during down markets. While everyone knew that it is very difficult to incooperate that into your system. When correlation increases diversification decreases and so the chances of more than one loan in the pool defaulting increases. Not only this we have beta and credit expansion risk, in which beta and credit increase during down time magiflying the market and credit risk of your investments. Although market risk is not directly relevant here, beta expansion risk is still an important concept to know. Do also know that when default is on the rise we are likely to see recovery rate on the drop, which means loss given default is going to explode.

The ability for banks to sell their loans and then aquire new loans and to pool BBB tranches and then reissue are what we call the power of leverage. Leverage my friend is a two edge sword it can increase return, it can increase losses. A typical VAR calculation assume normality and did not account for downside risk, also VAR cannot tell you how much loss you can get if you exceed the max loss level that is predicted. Leverage would mean this max loss can be way more than you expect it to be. There are modification to VAR that allow for downside risk and leveage but those are too techical to be discuss here, bear with me I still have to reserve some brain juice for my FRM and CAIA studies. Also do not that loans and credit analysts tend to relax in order to get loans and they have no fear since the loans would be sold to innocent investor who then assume the credit risk. Please note that most of these structure finance are trade on OTC markets and with that come lots of other risk like counterparty, settlement risk etc.

So is there solution to the problem, yes there is and in fact the solution are so easy every bird on the streets can think of, but things are easy to say but difficult to implement

• Increase transparency.
• make models to test down side risk
• increase use of stress testing especially in down markets
• incooperate leveage in risk management
• make banks assume some of the credit risk of the loans they sell
• make models that can valuated tranches and traches of tranches not just pool or individual assets.
• decrease reliance of short term compensation
• increase investor financial education
• increase code of ethics for every one working in the bank
• Senior management ought to get involve and be more educated
• Risk management should be given more power and role
• Encourage OTC participant to use collectual, some are doing that now
• Encourage OTC participant to use mark to market feature typical of a clearinghouse or exchange. This may be difficult since OTC contracts are too dynamic and complication in valuation and other techical aspect may make MTM difficult
• More liqiudity risk and management tools are needed. Do keep in mind that when every one buy the price is going to go up and then no one is selling, if every one sell price is going to go down and no one is buying, these extreme cases, which seem extreme but does happen are what authors called liqudity black holes.

Next up part two