By U. R. Bhat, Managing Director Dalton Capital (Advisors) India P. Ltd.
Article
The last thirteen months have been witness to the unfolding
of an unprecedented crisis in the international credit and equity markets
resulting in the ultimate demise of the large independent multinational
Investment Bank as a business. It all started with the onset of a correction in
the US real estate prices in mid 2007 leading to the sub-prime crisis which in
turn brought about the near seizure of the mortgage backed securities market
ending with the ‘guided’ absorption of Bear Sterns and Merrill Lynch, the
well-respected Wall Street Investment Banks, by two large commercial Banks — JP
Morgan and Bank of America, respectively. The US financial services business
model has truly been shaken at its roots with the bankruptcy of the iconic
Investment Bank, Lehman Brothers, the US Government bail-out of the mortgage
majors Fannie Mae and Freddie Mac, as also the largest insurance company,
American International Group and the conversion of the illustrious Investment
Banks Goldman Sachs and Morgan Stanley to commercial banks. To unfreeze the
international interbank money markets that had become virtually non-functional
on account of the fear of the imminent collapse of counterparty Banks, the US
Government has come up with the largest ever bail-out, the US $ 700 billion
Troubled Asset Relief Program (TARP) under which the troubled assets of the
banking system would be bought over by the US Treasury to enable banks to clean
up their books and hopefully resume business as usual. The size of the troubled
assets in the US banking system could be at least five times the planned bailout
and hence it is possible that more bail-outs and recapitalisations will become
necessary before the markets come back to normalcy. While the crisis has
substantially dented the fortunes of the US $ 14-trillion US economy, the
bail-out package and its possible successors may just about manage to pull
through the US economy from a further catastrophe. On the other side of the
Atlantic however, the size of the banking crisis is disproportionately large,
relative to the size of the host country economies. Consequently, the banks once
considered too big to fail have now become too big to save for individual
countries. Hence the process of European bank bail-outs would require more than
one country to chip in and a virtual Government takeover of the ownership of the
banking system is currently in progress.
It is worthwhile examining how the problem assumed such
gigantic proportions without some corrective action being initiated sufficiently
early in the cycle. Mortgages offered by banks and housing finance companies are
subject to the capital adequacy norms prescribed by regulators, which requires
them to back the risk in lending with certain minimum capital. The growth in the
mortgage business of a company is hence limited by the quantum of capital
available. Pursuing a more aggressive growth path would entail new capital to be
raised periodically, which limits the attractiveness of the company in the
equity market. To overcome this problem, companies started selling the loans
that they had originated through a process called ‘securitisation’. This
consists of carving out pools of housing loans with different risk and return
characteristics and selling the same through innovative structures to new
investors in the same way a bond is sold in the debt market. Certain new
attributes were added to the pool of housing loans to make the pool more
marketable by offering credit enhancement — by providing that say the first 5%
of default in the pool will be paid for by the seller — or by a third party
offering credit insurance. Such pools — known as collateralised debt obligations
(CDOs) — are rated by credit rating agencies based on the past repayment history
and the value of the underlying house properties that are mortgaged. The
mortgage companies by becoming originators of mortgage loans who sell the assets
at a profit to other investors — typically mutual funds, insurance companies,
hedge funds, etc. — enhance their return on equity without having the need to
constantly raise capital. The CDOs are generally sold at a yield less than the
contracted yield with the individual mortgagees, thus deriving a profit
approximately equal to the difference between the net present values of the cash
flows at the two yields. The system represents the best form of specialisation
with the mortgage companies concentrating on finding credible borrowers to
originate the loan and the ultimate buyers deploying their large resources in a
pool of assets with reasonable yields. Typically the CDOs are divided into
tranches ranging from investment grade — representing borrowers with a good
credit history and loans with high security coverage — to less than investment
grade, also called sub-prime CDOs and sold at varying yields to investors with
different risk appetite. The risk that a mortgage will not be serviced has
certainly not gone out of the system, but is shared between the originator and
the credit insurer to the extent they are liable and the ultimate holder of the
CDO for the balance amount.
The sub-prime woes in the US are a result of the excesses in the system caused by pushing the balance between risk and return beyond prudent levels. Aggressive US Banks were offering attractively priced mortgages to sub-prime borrowers in the hope that the boom in the real estate market will continue and the security cover will be more than adequate when repossession and sale becomes essential on loan default caused either by rising un-employment or firming interest rates. The prospect of being able to quickly sell these loans as COOs at a profit certainly prompted banks to lower lending standards. The continuing bullishness in the real estate market lulled credit enhancers and insurers to take on risks at a price that they would otherwise have not taken and the ultimate investors – frequently high-yield funds promoted by the very banks who originated the mortgages – to hold securitised assets at low yields emboldenedby credit insurance and softening interest rates. Once the real estate prices started correcting and interest rates firmed up, the holders had to mark-to-market the asset-backed securities incurring considerable losses and the credit enhancers/insurers who had taken leveraged bets while underwriting these risks had to suffer huge losses. Aggressive repossession of housing assets and subsequent sale in an already weak housing market caused a further slide in real estate prices, thus jeopardising the asset coverage of CDOs. This chain of events finally left the Wall Street bankers holding billions of dollars of COOs and other asset-based exotica that represent – variously sliced and diced – home loans made out to sub-prime borrowers. With the supply of these securities exceeding natural demand, when they found that there are no real buyers for these securities, they created buyers called structured investment vehicles (SIVs) who would borrow short-term money from the commercial paper market – based on good credit rating from friendly credit raters – and use the money to buy the long-term mortgage assets from these banks. The catch however is that for this game to continue, the commercial paper would need to be rolled over every few months. With the correction in real estate markets getting worse by the day, the sub-prime borrowers started defaulting in servicing their loan obligations and the value of the mortgaged homes could not cover the outstanding loans. With this, the asset-backed commercial paper market dried up, thus denying the SIVs their primary source of funding.
Under these circumstances, the’ SIV could either liquidate the mortgage securities on a forced sale basis or plead with the sponsoring bank to extend their credit lines. The problem with the first option is that the sale at distress prices will force banks to mark-to-market their holdings of similar illiquid securities worth several billion dollars causing huge losses to be booked. Banks therefore preferred the second option, so that they could continue to value their illiquid securities at ‘fantasy’ prices without providing for mark-to-market losses. In a well-functioning capital market, the SIVs would reflect the real-world prices of their underlying assets and on this basis there would be enough funding available from hard-nosed capitalists through the market mechanism. The mark-to-market valuation would necessarily reflect the distressed nature of these assets and the risk appetite of the capital providers. Some help was at hand from the US Financial Accounting Standards Board in this regard with the adoption of FASB 157 from mid-November 2007, which sought to standardise ‘fair value’ accounting. Under this dispensation, assets are classified into three levels, with the first level involving assets with prices quoted in active markets and the second level involving less-traded securities which are valued using the prices of similar assets. At the third level are securities like COOs that are not traded and are valued with the help of financial models based on a series of assumptions, known as the mark-to-model method. The accounting standards require institutions to classify securities such that the mark-to-model method is kept to the minimum and as far as possible, to value level-3 securities based on a gridded or extrapolated level-2 value. Appropriate disclosures of the methods used to estimate the fair value of assets is a requirement. Avoiding the use of market prices or proxies for market prices in preference to mark-to-model methods became increasingly difficult where the accountants sought to strictly implement the provisions of the accounting standard. If truth be told, the implementation of these standards was not uniformly strict.
One of the aspects of the problem that should concern the accounting profession is the fact that the large banks affected by the sub-prime mortgage meltdown had to take on obligations beyond what were considered contingent liabilities and factored into capital adequacy calculations. Bailing out bank-sponsored off-balance sheet vehicles such as conduits, structured investment vehicles and even money market funds beyond the formal legal ob-ligation of the sponsoring bank was at the root of the massive write-downs. This was indeed necessitated by the need to protect the hard-earned reputation of the sponsoring banks, much beyond the scope of enforceable contracts. This development has far-reaching implications for shareholders, the accounting profession, as also bank regu-lators. For shareholders, this was a risk that they never bargained for, but still had to pay for in terms of value erosion. The accounting profession would do well to revisit the level of disclosures and consider putting in place a reporting standard that requires disclosure on such qualitative and unquantifiable risks. Regulators would need to have a rethink on the adequacy of risk capital that may need to factor the financial consequences of banks opting to take on such unenforceable obligations. The dilution of the credit creation function of banks that would be the inevitable consequence of any deleveraging prescription would need to be balanced with the potential benefits of a healthier banking system.
Another lesson that is worth learning from the ongoing credit crisis and is again relevant to the accounting profession is the inappropriateness of leaning too heavily on complex risk and valuation models. The basis of the high credit rating of pools of sub-prime mortgage loans was the assumption that mortgage defaults were essentially independent of each other. This enabled credit raters to use risk models on the basis of the ‘Law of Large Numbers’ that allowed large portions of these pools to be rated AAA on the premise that the probability of a default of more than 20% of principal was very small. The reality however is that defaults in sub-prime mortgages are not independent events when confronted with a steep interest rate rise or a nationwide housing price collapse. Moreover, the dimension of market liquidity is not factored into financial models because there is no agreed method to value liquidity. Regulators need to be concerned that the soon-to-be-enforced Basel II prescriptions rely largely on the use of such discredited complex risk models. The risks to the financial system on the back of reduced capital adequacy norms based on third-party credit rating of risk assets merits a careful evaluation in the light of recent events.
