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Risky business

The world economy and its major financial institutions have been tested by the instability rooted in sub-prime housing loans.

By Davide Sola and Paul Stonham . 01 June 2008

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It’s a crisis, but Davide Sola and Paul Stonham believe that things can turn for the better if securitization is better managed.


In October 2007, the Bank of England declared that the turmoil in financial markets that had begun earlier in August “has proved to be the most severe challenge to the UK financial system for decades. UK and large international institutions, which are at the heart of the global financial system, have been significantly affected”. As 2007 ended, the financial crisis, which had begun in the US, deepened and spread throughout the global financial community.


How did the crisis happen? Were existing regulatory controls and short-term responses by official bodies and market participants as effective as they should have been? Or, are there additional practical remedies and future safeguards that should be undertaken by official organizations and market participants to ward off similar crises in the future? These, and similar, questions have driven us to make our own declaration: an evolutionary and generally beneficial innovation in financial investment, securitization, the repackaging of debts into tradable securities, has not been well regulated or managed. The problem is less about defects inherent in the nature of the securities themselves; instead, the problem is more that – at least in some parts of the investment community – securitization has not been well understood.


Creating a crisis By August 2007, the decade-long housing boom in the US had reversed, with rapidly falling house prices and mounting defaults and arrears in mortgages, especially sub-prime loans. These are risky mortgages with a high loan-to-value ratio, further divided into three tranches of increasing default risk. The fall in value of mortgages spread quickly to investing institutions holding securities partly backed by mortgages.


The commonest form of these three tranches, or portions of collected debts, is collateralized debt obligations (CDOs), which repackage streams of income from sub-prime housing loans and are then sold on to other investing institutions. Prices of CDOs plummeted in late 2007, and this repricing spread to all other categories of asset-backed paper. Banks were no longer able to finance and refinance CDOs held on their own account or in structured investment vehicles (SIVs), which are off-balancesheet managed funds or companies set up and owned by the banks to originate short-term CDOs at high yield – then lent onwards (at levered levels) on a longer-term basis. Translating this into less financial terminology: banks or other financial institutions made risky housing loans and then had to find other institutions that would back their risk-taking.


The trouble was (and is) that SIVs, investment banks, hedge funds and private equity companies had borrowed in wholesale money markets, issuing paper and using leverage, in order to invest in CDOs. These markets began to freeze up as uncertainty about the original housing-to-loan valuations grew, and all the lenders in the chain began to fear for their own liquidity. Interbank interest rates thus rose – given the precarious nature of the lending chain – and banks began to experience liquidity problems. In November 2007, write-downs of asset values disclosed by the eight largest investment banks (Citigroup, Merrill Lynch, UBS, Credit Suisse, Deutsche Bank, Bear Stearns, JP Morgan and Morgan Stanley) totalled $28 billion. Losses from sub-prime mortgage-backed securities for these banks were expected to eventually reach above $200 billion, according to some estimates.


Share prices in all these institutions fell steeply and profit forecasts were cut. Since Wall Street banks and financial institutions are highly leveraged on investments such as sub-prime loans, by a factor of around 10 per cent, all of this bad news implied that their total lending could be scaled back 10 times. The largest part of the US-originated securities had been sold to overseas investors, and the credit squeeze spread to Europe and Asia. The UK experienced a major bank run with Northern Rock, and two German banks, IKB and Sachsen LB, had to be rescued. In the case of the troubled Northern Rock, the UK government toyed with rescue plans involving a private sector sale – primarily to a Virgin-led consortium, and a Northern Rock management buyout. Eventually on 18th February 2008, it announced it was taking the bank into (temporary) public ownership. A storm of controversy arose. A similar, although smaller, credit freeze was experienced in Russia and Japan. The commercial paper market for short-dated loans virtually dried up, and this acutely impacted the borrowing abilities of banks and SIVs to finance and refinance loans intended for investment in sub-prime mortgage tranches of CDOs. If Dickens were writing a novel about all this, he might have called it “bleak housing”.


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