Structured finance is often mentioned as the main cause of the latest financial crisis. But rather, as this author argues, it was the result of poor risk management, agency problems in the securitization market and poor rating and pricing standards, among a myriad of other causes. The author prescribes strong steps to prevent a re-occurrence.
Structured finance includes all advanced financial arrangements that serve to efficiently refinance and hedge any economic activity beyond the scope of conventional forms of traditional financial instruments (debt, bonds, and equity). Examples of structured-finance products include Collateral Debt Obligations (CDOs), Asset-Backed Commercial Paper (ABCP) and Credit Default Swaps (CDSs). The emergence of structured finance has changed the role of banks and the functioning of financial markets. In Canada, structured finance is now a very important activity that has completely modified the links between borrowers, lenders, and investors.
Structured finance is often mentioned as the main cause of the latest financial crisis. However, as this article will demonstrate, structured finance and its complex products per se did not trigger the financial crisis. In fact, it was the risk management policies and practices employed by institutions engaged in structured finance that were problematic, and to a large extent, brought on and propagated the latest crisis around the world.
Some large banks went bankrupt, while several governments and central banks had to rescue many other financial institutions. While these bailouts were intended to protect the financial markets in the short run, they will not solve the underlying problems. In this article, we emphasize the important role that sound risk management can play in restoring investor confidence in the capital markets.
Structured finance is a multifaceted concept. For many years, it was associated with derivative products and viewed as a fairly insignificant factor in economic and financial markets. Yet structured finance has become an important – albeit, hidden — factor in the economy since the 1990s, and an increasingly pertinent topic of discussion since the onset of the most recent crisis.
The influence of structured finance on the trading of financial products has produced several notable effects on the organization of retail credit and financial markets, effects which are now starting to be understood and explained. For example, structured finance has improved the liquidity of transactions and the management of credit risk. These effects have varied over the recent years and have complex consequences.
Structured finance has greatly affected financial products. It has spawned the creation of increasingly complex products of all kinds, in particular those linked to the securitization of credit risk, such as CDOs. These financial products introduce sophisticated mathematical instruments and complex security and contract design that demand the collaboration of players in various disciplines. They also require high-powered computational capacities and the competent management of large databases. Because of their liquidity, these products call into question the historical methods of regulating financial markets and the traditional management of monetary policy.
The creation of structured finance was mainly motivated by the transfer of credit risk, through the use of credit derivatives (e.g. CDSs) and banks’ securitization of loans, to investors. For example, the selling of bank loans to trusts serves to transfer banks’ credit risk via structured products to various groups of investors such as pension funds, industrial and service corporations, hedge funds or even other banks. The market for CDOs has grown very rapidly since 2000. Banks are the most active players in this market, although insurance companies, pension funds and hedge funds are gaining ground. With the growth of hedge funds and their demand for higher-yielding securities, sellers improved their ability to transfer their credit risk, particularly the more risky tranches (or equity tranches) of the structured products.
Securitization of credit risk by banks was also motivated by regulatory arbitrage under Basel I, because banks were prompted to sell their lower-risk assets. With the new accord for credit risk (Basel II), the motivation for regulatory arbitrage became less important, though regulated capital rules for AAA products have distorted the allocation of capital for banks.
Bad risk management
After 2001, there was a major, rapid transformation of financial markets, as U.S. banks and other retail institutions extended their loans to risky borrowers (subprime loans) and transferred these risks to the overall financial market using credit risk transfer instruments via securitization. CDOs of these mortgages were the most popular structured instruments for credit risk transfer. The AAA ratings that were initially assigned to many of these structures by the rating agencies were clearly inappropriate, as many of these products defaulted when the underlying subprime loans started to default in 2005. Subsequently, many of these structured products were downgraded by the rating agencies. By then, however, most of the damage had been done.
During this period, securitization transformed low-grade assets into investment-grade assets by using complex financial instruments such as ABCP and CDOs, whose effective default risk was much higher than that of traditional AAA bonds. The crisis was accelerated because banks were under pressure from the financial market to increase the supply of high-risk mortgages in order to generate assets with high yields in a period of low interest rates. This repackaging was very lucrative, and it encouraged these CDO equity holders to issue a second generation of CDOs with lower yield. This in turn increased the demand for first-generation and mortgage-backed securities (MBSs). When the subprime loans started to default, these financial products spread the damage to the international markets. This financial crisis has damaged the real economy (unemployment) and the monetary economy (low credit conditions for consumers and business firms even if central banks’ prime rates are very low). It has eroded confidence in financial institutions and rating institutions, which had induced consumers and investors to take large risks.
Risk management and structured finance
There are four major risk-management issues related to the structured finance market.
Incentive contracting under asymmetric information: Banks and mortgage brokers had few incentives to be vigilant and monitor borrowers’ risk because a large fraction of the loans were securitized without the appropriate or optimal contracting clauses that fall under potential moral hazard. The same incentive problem was present for insurers and other market participants that diversified their risk portfolio and managed their capital via securitization. The potential loss was transferred to the market, which explains the lack of incentive to be vigilant. Adverse selection was also present; some BBB-rated products sold by banks to trusts (minimal rating for packaging CDOs) were in fact mostly BB.
Evaluation of structured products by rating agencies: As part of the securitization process, special investment vehicles (SIV) purchase long-term assets such as loans and insurance contracts, and finance them with asset-backed securities such as ABCP and CDOs. Having a high rating from rating agencies is essential for making money. When the credit crisis started in 2007, asset-backed commercial papers were downgraded, and the SIVs could no longer roll over their commercial papers. This led them to seek funding from their sponsors (investment banks). This in turn triggered the decline of many investment banks and sparked a liquidity shortage for many markets, such as the ABCP market in Canada, which was contaminated by these U.S. products (in fact, few trust funds involved in the Montreal Accord were contaminated, representing about 6 percent of the exposure.) At a more sophisticated level, CDOs make profits by repackaging a pool of loans and selling them in the form of bond tranches. The profits associated with the structuring activity are higher when the products obtain a high evaluation by the market via a high credit rating. The problem, however, was that it became increasingly difficult for rating agencies to model these complex assets without good data. It was also very difficult for market participants to monitor and replicate the rating of these products because no data were available.
Pricing of complex financial products: Another cause of the current crisis was that the prices of these sophisticated instruments were often too low and did not reflect their true risk exposure. There was also a systemic risk component that was not taken into account in pricing these products. Systemic risk becomes manifest when events in one market affect other markets. When difficulties arose in asset-backed commercial paper, for example, many money market managers transferred their orders to the Treasury bill market, inducing an increase in prices and a decrease in yields. These effects were amplified because of the lack of transparency. In the case of ABCP in Canada, many investors were not sure whether the collateral for these products contained U.S. subprime loans or not. This forced many investors such as pension funds and hedge funds to sell good assets, which further reduced the prices of these assets.
Regulation of structured finance: It is important to emphasize that currently, risk regulation applies only to banks and investment banks. Pension funds and hedge funds are not regulated. Basel II regulation is partly to blame because it reduced the required regulated capital significantly for AAA grade assets. Banks were then attracted to the new AAA assets, while sellers were motivated to obtain the AAA rating for these structured products, putting undue pressure on rating agencies. The AAA credit rating of these products also affected the purchasing behaviour of pension funds, insurance companies, mutual funds and hedge funds, particularly because regular bonds with the same rating paid lower interest rates when the central banks reduced their target interest rates.
Lessons for risk management
Why did investors purchase these products and why were they offered? Prior to 2007, there were very few defaults for structured securities and thus no apparent reason for concern. However, given the extremely low interest-rate environment, investors were increasingly drawn to higher yields offered by AAA structured products, causing yield spreads to narrow. Although these products still offered slightly higher yields than more traditional short-term securities, they no longer compensated investors properly for the risk they were bearing. Prices did not reflect the embedded systemic risk exposure of these products.
As documented above, the market grew exponentially and banks made large profits by charging high fees for originating and structuring these products. It is well documented that rating agencies made mistakes. There were also incentive problems because the issuer pays for the ratings, and some suspect that these same rating agencies were part of the underwriting process. Regulators and central banks did not anticipate that these practices would become problematic.
Many investors lost money during the financial crisis because they did not apply the basic principles of risk management. Risk appetite was not well stated in many firms; enterprise risk management was not well defined or used and relevant risk-management policies were not supported by top decision makers. In fact, risk management in many organizations appears to have been cyclical, peaking only after the crisis reached full-blown proportions.
Underestimating the default and liquidity risks of the new structured financial products were signs of bad risk management. Several products were introduced in the years leading up to the crisis, and many investors adopted them without sufficiently understanding their risk, mainly because they did not have the proper tools to evaluate them. They consequently evaluated these complex financial products on the same basis that they evaluated standard ones. There was no tail analysis, no back testing and no stress testing related to the risk of these complex products. The risk-management function was ignored by many top decision makers, who delegated their credit risk analysis to rating agencies with incentive problems. Many lessons have yet to be documented.
If the structured finance system is going to work, originators of structured products must be more responsible. They must keep a large fraction of the pool they sell, possibly the complete junior tranche, and even fractions of more senior tranches. This would give them a greater incentive to apply better risk management practices to their credit decisions and obtain better portfolios to sell.
Also, there needs to be more transparency in the tranching of the structured products. As with any security, researchers and participants in the market must be able to replicate the composition of these products. Public data sets must be available for studying these products. The increasing complexity of structured finance creates challenges in terms of efficient management and the dissemination of information. More transparency is needed in the credit market, particularly when loans are securitized. There is also a need for more transparency regarding both the packaging of assets by trusts and the assets held by financial institutions, such as pension funds and hedge funds.
The rating of these products must also be more transparent. Any good researcher or investor is able to verify the rating of any standard bond in the market because data are available and rating methods can be replicated. The same standard must apply to the rating of structured products and their pricing.
Institutional changes in many countries, including Canada, are necessary to foster independence and reduce their vulnerability to international markets, particularly the United States. Institutions must understand the available technology. The design of data collection, processing technologies, and inexpensive communications between financial institutions would provide effective tools to replicate and verify rating agencies’ analyses and trust packaging from various sources. These capabilities must be available to any investor or group of investors. The ABCP market in Canada would not have collapsed in a transparent market with only 6 percent contamination.
For investors, senior management and boards must rely more on sound risk-management policies when making investment decisions. They must obtain detailed information on the enterprise-wide risk and weigh this risk accordingly. The board must be composed of individuals that understand the management of these risks, and the risk management committee must be very active in performing their risk oversight responsibility. The risk appetite of senior managers must be defined, known and monitored by the board.
The CRO (Chief Risk Officer or equivalent) must be granted more authority rather than simply act as a passive officer that monitors, measures and analyses risk. He or she must report to the CEO and meet periodically with the board. Some even suggest that the CRO should have veto power over some transactions. The CRO office must be independent of all business units.
All important transactions must be rigorously analyzed with appropriate data and models for rating, pricing and testing the products (CVaR instead of VaR). This implies a greater investment in risk management education for many investors, along with greater transparency and appropriate disclosure to all constituencies.
These recommendations may seem difficult to apply for investors in the money market, who must manage many assets with a 30-day maturity term. However, risk management is even more important for these investors. New forms of risk analysis must be developed in collaboration with transparent, independent agencies that do not have incentive problems. In the end, more due diligence with respect to risk is absolutely necessary.