Just the other day, ?asset securitisation? and ?credit derivatives? meant cutting edge financial innovation, risk distribution, market stability and the promotion of economic well-being all around. Then came the crisis. While the true scale of the ongoing meltdown is still unfolding, a leading Wall Street player has bitten the dust and markets are reeling worldwide. What went wrong? Who is to blame? How did the magic wand of credit derivatives mutate overnight into such a ?weapon of mass destitution??
The trouble began with last year?s pricking of the US housing bubble. For years now, US housing prices have escalated, letting house-owners get second mortgages on their homes and spurring a credit-driven consumption boom. Mortgage brokers threw caution to the wind and wrote mortgages with no downpayments and low initial ?teaser? rates to lure those with questionable credit records and doubtful employment (?subprime? loans), all under the assumption of perennially rising real estate prices. Eventually, home prices turned southwards, with their values often dropping way below their outstanding mortgage values. Predictably, some subprime borrowers defaulted.
So, what have credit derivatives got to do with all this? Not as much with the housing bubble itself, though they encouraged reckless mortgage issuance, as with spreading the malaise to the rest of the financial system. Two very popular credit derivatives are collateralised debt obligations (CDOs) and credit default swaps (CDS). CDOs allow banks to pass mortgages over to investment banks who pool them and create securities against them (mortgage-backed securities, MBS) which are traded over the counter (OTC) among institutional players. These come in different risk categories or ?tranches?, depending upon the quality of mortgages backing them. While investment-grade bonds are sold to institutions, the riskiest ones are often sold to hedge funds and special investment vehicles (SIVs), frequently floated by the investment bank engineering the CDOs. The net effect is a transfer of credit risk from banks which originate the mortgages to global institutions that operate across different segments of the financial world.
The impetus for securitisation came from the savings-and-loan crisis of the late 1980s, when several mortgage issuers collapsed, leading to a credit crunch and recession. However, due diligence has been a casualty of widespread securitisation. If a bank does not have to live with the consequences of the loans it makes, why worry about quality? It?s ?moral hazard? at its best. Second, the quality of mortgage-backed securities is difficult to assess even for sophisticated institutional investors. With increasing opacity in a market inhabited by private equity players and hedge funds and marked with OTC trading, pricing these assets properly and figuring out the counter-party risk is almost impossible. This is where credit rating agencies are supposed to come in. With hindsight, though, they dropped the ball, failing to factor in the inevitable bursting of America?s housing bubble.
Perhaps the scariest part is that there is no telling yet how deep the malaise is. Estimates of subprime mortgage losses are in the $50-200 billion range, while the figure doing the rounds for total mortgage defaults is upwards of $400 billion. Add to it the losses in the CDS market and the estimate exceeds $1 trillion. Simply put, CDSs are insurance against bond default where the seller (insurer) promises to buy the bond at a specified price from the protection buyer (insured) in case of default. Since these are ?third party? deals, the values insured can far exceed the actual value of outstanding bonds (serving as pure bets on defaults), thus scaling up the problem. The price of such insurance is expressed in the ?CDS spread? which reflects the market?s assessment of the probability of default on the bond. These default swap derivatives can be pooled and then further securitised in tranches, thus creating ?synthetic CDOs?.
During the last decade, the CDS market emerged practically out of nowhere to record notional values to the tune of $50 trillion (!). As the real estate market turned, bond insurers are getting wiped out and resulting counterparty effects are reaching every corner of the global financial landscape.
It is tempting to blame the financial engineer responsible for the current mess, but that would be unfair. The fault lies squarely with poor institutions, lack of transparency and an appalling near-sightedness of the entire financial system.
Where is India in all this mess? Our major banks have some direct exposure to credit derivatives by their foreign branches. The collective exposure of ICICI Bank, SBI, Bank of India and Bank of Baroda to credit derivatives is estimated at nearly $2 billion. It is hard to say what the total write-off would be before the current crisis blows over, but the $264 million write-off by ICICI Bank probably ranks second largest in Indian banking history.
Far more serious, however, are the fears of a protracted US recession. As the Indian stockmarket has shown in recent months, the ?de-coupling??real or financial?thesis is quite weak.
The author teaches finance at the Indian School of Business, Hyderabad