Credit Crisis Question

I have a question regarding the credit crisis that I am hoping you guys can help me answer.

What was the reason large commercial banks like UBS, Bank of America, and JP Morgan invested so heavily into CDOs and other "toxic assets?"

If the whole purpose of securitization is to get rid off risk by packaging different debt obligations and selling them off to other investors, why did these large banks end up buying other CDOs and exposing themselves to the same kind of risk they were trying to diversify away?

If anything, I would have expected the banks to be the least affected because they should have used these derivatives to get rid off risk and not put it back on their balance sheet?

For example, if Bank of America knew that the CDOs that it was selling to other investors was partly crap (with a bloated AAA rating), why was it so willing to buy other banks' CDOs (which were most likely also partly crap) to put on its own balance sheet?

 
Best Response

I'm sure people can explain this better/more accurately, but simplified:

Securitization is a mechanism to eliminate credit risk off of banks' balance sheets. So a bank issues a loan, securitizes it, and sells the ownership interest in that loan to investors, allowing them to originate a loan and reap the fees, securitizing it to cash-out their money, and re-deploy that capital into another loan.

A CDO is mechanism to isolate and stratify risk, so an investor can choose which degree of exposure they would like.

So a few things contributed to investment banks getting their asses kicked by CDOs.

1- there is a lag between originating mortgages, structuring them into MBS, structuring them into CDOs, and actually selling them. So along that line, there is some float risk involved until between the day the bank takes ownership of a loan and the day it sells a CDO to an investor.

2- CDO's weren't perceived as "toxic" until after they started taking balance sheets out. The whole purpose was to isolate risk, and possibly beef up the equity tranche to improve credit quality. Obviously, the assumptions made in determining the default probability were not accurate, and as a result the equity tranches were grossly inadequate. So even prop desks trading for the bank's own book were investing in CDO's with the belief that they weren't highly explosive, until they started blowing people's fingers off.

 
quirinus:
If you haven't seen this yet, it has a pretty good, albeit simplified, explanation of the whole crisis.

http://www.crisisofcredit.com

Too bad it fails to mention that the securitization of mortgages is not only great for investment bankers, but for potential home owners as well, since it makes credit dependent on national lenders instead of local ones.

 

part of it was probably because there were many people working at banks that did believe in CDOs.

another thing that contributed slightly to the banks getting into trouble is SIVs. Unlike SPVs, SIVs can come back onto a bank's balance sheet. Actually in October 2007, Citigroup announced that that they would be bringing their SIVs back onto their own balance sheets. probably one of the reasons why they started doing so badly.

I too would like to know more reasons for this though.

 

I have read how these SIVs and the whole "shadow banking" system is largely to blame because it allowed banks to "hide" some of their debt and investments in order to achieve higher debt ratios.

However, I am not quite sure how these SIVs "came back" onto the banks' balance sheets... were they a sort of contingent liability or something?

I appreciate your insight

 
darkmatter:
I have read how these SIVs and the whole "shadow banking" system is largely to blame because it allowed banks to "hide" some of their debt and investments in order to achieve higher debt ratios.

However, I am not quite sure how these SIVs "came back" onto the banks' balance sheets... were they a sort of contingent liability or something?

I appreciate your insight

Banks held NIMS as assets. When the residuals got crushed, it affected their equity directly. Also, someone else mentioned the lag between origination and securitization/syndication, which screwed firms with large books.

 

Yeah, it was SIVs. Keep in mind the SIV is something the bank setup. Some banks took the products off of their balance sheet by selling the MBS to the SIV and got cash back on their balance sheets (to continue securitizing). The SIV then sold tranches of these MBS to investors and got cash. But the whole time, the SIV was something set up by the banks and even though people looking at the balance sheet of the bank won’t see the risk, the bank is still every bit as vulnerable. When these “funds” started failing, the banks had to put the MBS or what have you back on its balance sheet. So it only seemed as if the banks took the risk off, when in reality they were exposed the whole time. Putting shit in the SIV is called “disintermediation.”

As for the AAA rating for MBS, some of them it can be very misleading. Sometimes, a group of say all BBB were bunched together and chopped up into multiple tranches. Of the BBBs, the 1st of the 3 tranches would then be rated AAA because it’s the safest of the BBB pool.

Securitizing made credit easy to access for borrowers. Easy money inflated demand, which drove up and kept up RE prices. Then the balloon pops, and RE prices free fall, then all of a sudden, the mortgage in MBS isn’t worth anything, assets on the bank balance sheets drop in value, and banks that are highly leveraged fall into the red. Smaller regional banks made much worse loans than the larger banks you see in the news. A big bank might have 10% loans as assets, a smaller regional bank can easily have 30 – 40%. Which is why so many smaller banks are failing.

As for a sense of how much RE value drops, some property types will have their values drop by 50% or more, even the safer property types can lose up to 20%.

i just read this its grammatically pathetic, was in hurry

 

Dark Matter - First, let's do a bit of fact checking. The commercial banks really didn't invest that heavily in CDOs, compare the numbers to European Banks, Insurance Companies and Broker/Dealers (ML, LEH, Bear). What was a problem for the commercial banks was leveraged lending and mortgage assets (how many commercial banks didn't offer mortgages?). Leaders in the CDO business typically retained some of the risk, whether it was the unrated tranche, or the super-senior tranche.

SIVs were typically managed by banks alternative investment units to create additional yield. They played a very simple arbitrage: buy long-term assets, issue short-term debt, make the spread and lever it up.

First and foremost, SIVs were a type of SPV. They were "off-balance sheet" because they were considered a separate entity by the accounting rules and bank regulators. The Bank was simply an investment manager, a third party owned the "equity" piece and the bank was simply paid a "performance fee". Once the banks decided to "support" their SIVs (through additional liquidity facilites or guarantees) they would need to consolidate the SPV back onto their balance sheet.

A very common misconception was that SIVs contained only mortgages. Across the SIV industry ($300+bn at its peak), the largest asset class was unsecured bank debt. However, as the credit crisis began and spreads on bank debt widened, losses were realized in the portfolio. The SIVs were thinly capitalized and in general didn't have enough capital to absorb the losses of the mark-to-market value of these assets. To exacerbate the situation, the liability profile was so short that the SIVs would be forced to sell assets at fire-sale prices in order to pay off upcoming debt maturities.

But why would the Bank sponsor want to help out their SIV? Can't they simply declare the SIV bankrupt and pass the losses onto the debtholders? The SIVs were marketed by representatives from the bank, and investors did not view Beta Finance Corp. as a separate entity, they viewed it as a Citibank deal. The investors (think of all your major asset management firms) went to the SIVs and told them, if you want to continue funding yourself in the US market, you need to fix this problem for us.

In the end, there were very few SIV defaults, from non-bank managers or from banks with less reliance on US funding (like Standard Chartered).

 

eric, SIVs are a type of SPV. They are BOTH off balance sheet, but the difference is that SIVs have the possibility of coming back onto the bank's balance sheet while a SPV is a completely separate entity. The reason is that SIVs specifically use short term debt like CPs to fund long term asset, so banks promise that they would provide liquidity facilities to reduce investor's exposure to market disruptions.

Also, SIVs did not invest all in CDO's and ABS's, but once the credit of those assets came under question, the SIVs' credit rating becomes questioned, and they're not able to issue new CPs when their old CP is maturing, so their funding dried up. When banks took them back on their balance sheet, they took their assets, so they ended up with the CDOs and ABSs

 

Blackdog,

You're completely wrong on the balance sheet section of SIVs vs. SPVs. You're in college and your other posts are asking people to critique your resume and general questions on what ibanking is like. Double check your facts before you correct certified users, you never know what type of background they might have.

Let's take a look at Bank of America's 2008 Annual Report where they discuss the possibility of bringing back their other SPVs (called QSPEs here) back onto their balance sheet. It is the accountants that decide really if it belongs on or off, not whether it is a SIV or not.

"On September 15, 2008, the FASB released exposure drafts which would amend SFAS 140 and FIN 46R. As written, the proposed amendments would, among other things, eliminate the concept of a qualifying special purpose entity (QSPE) and change the standards for consolidation of VIEs. The changes would be effective for both existing and newly created entities as of January 1, 2010. If adopted as written, the amendments would likely result in the consolidation of certain QSPEs and VIEs that are not currently recorded on the Consolidated Balance Sheet of the Corporation (e.g., credit card securitization trusts)."

They also provide a definition of an SIV:
Structured Investment Vehicle (SIV) – An entity that issues short duration debt and uses the proceeds from the issuance to purchase longerterm fixed income securities.

Blackdog, your second sentence doesn't even make sense. The SIVs had liquidity facilities (or breakable deposits) to satisfy the liquidity requirement of the rating agencies. These facilities are very expensive, so the SIVs typically had less than full support, typically around 10% of debt vs. 100% for a traditional CP conduit.

The SIVs weren't the primary source of CDOs and ABS onto U.S. bank balance sheets. First off, SIVs were structured by European Banks. There was one large US bank that pioneered the structure through its London office, and some of the team left to start another firm that created more SIVs.

CDOs also ended up onto bank balance sheet through put agreements. Citibank was a big player in this market, and agreed to buy super-senior CDOs in the event they could not be sold. This is well documented in their annual report.

Broker-Dealers with substantial ABS businesses(Merrill, Lehman, Bear) had a lot of exposure through retained portions of existing deals or warehousing existing deals.

 

eric,

apparently you are much more knowledgeable about the subject and I won't dispute you on this. That's just what I learned in risk management class--that the difference between an SIV and SPV is the SIV can come back on BS but SPV cannot. I'm just repeating back what I was taught. It's good that I challenged you too, because now I learned more.

 

So when all these banks announce losses associated with "toxic assets," are these toxic assets stemming from their SIVs or from assets the banks chose to keep on their respective balance sheets as loans/investments?

 

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