The 2007 Credit Crisis: A summary - Part 1

Whether you're having a class project related to this topic or new to economics/finance and trying to understand how this crisis came about, this post will provide a solid and easy to understand explanation for it. This post is organized based on the content of Chapter 8: "Securitization and the Credit Crisis of 2007" in the book Fundamentals of Futures and Options Markets by John C. Hull. In part 1 of this topic, we'll cover the major factors and the onset of the crisis (real estate buble). In part 2, we'll explore the causes and costs (credit crisis) of it.

To better understand how the crisis started, we can start by asking and answering questions concerning the two factors that set the stage for it: Securitization and the US Housing Market.

a. What is securitization?

Traditionally, banks fund their loans primarily with deposits. However, in 1960s US banks found that they could not keep pace with the rising demand of mortgage with this type of funding any more. This led to the development of mortgage-backed securities (MBS) market, where cash flows generated from the mortgage portfolios were packaged and sold to investors as securities. MBS is a type of Asset-backed Securities (ABS) and the process of creating them are called securitization. The Government National Mortgage Association (Ginnie Mae), created in 1968, guaranteed interest and principal payments on qualifying mortgages and created the securities that were sold to investors. Theoretically, Ginnie Mae's guarantee protected MBS investors against defaults by borrowers.

b. How is an Asset-Backed Security created?

The Asset-backed securities, used during the period of 2000-2007, were typically created as shown in the picture below.

How an ABS is created

A portfolio of income-producing assets (such as loans) are bundled together and sold to a special purpose vehicle (SPV) by the originating banks. Cash flows from these assets - payments by mortgage borrowers - are then allocated into different tranches: Senior tranche, Mezzanine tranche and Equity tranche. 

The portfolio has a principal of $100 million, which is divided into the tranches as in the picture above. For example: the Senior tranche has a share of $80 million from the portfolio's principal and promises a return of LIBOR + 60 basis points or bp (1bp = 0.01%). 

c. How does it work? 

Think about the way cash flows are allocated to tranches as a waterfall (see picture below). Investors in the senior tranche would first receive their promised return. After the Senior investors have received their return in full, cash flows will then be allocated to the other two tranches, starting with Mezzanine. In the same manner, Equity investors will receive the residual amount (if any) after Mezzanine investors have received their return. Since the payments of principal and interest are not guaranteed, to compensate for the risk, the equity tranche has the highest expected return while the senior tranche has lowest expected return. As a result, Senior tranche and Mezzanine tranche are rated AAA and BBB respectively by rating agencies (S&P, Moody's, and Fitch) while Equity tranche is typically unrated.

Allocation of cash flows in an ABS

d. What happens when the mortgage borrowers fail to pay their loans?

If there are losses on the underlying assets, the first 5% of the principal ($5 mil) is borne by the equity tranche. Losses over 5%, Equity tranches loses all its principal and the amount exceeding 5% will be borne by the Mezzanine tranche. Accordingly, when the losses go over 20%, Equity and Mezzanine tranches lose all their principals, the loss amount exceeding 20% is borne by the Senior tranche.

e. How do they make riskier tranches attractive to investors?

Most investors are willing to buy the Senior tranches (AAA-rated) while the Equity tranches are retained by the originators or sold to hedge funds. To make the less desirable Mezzanine tranches appealing to investors, Asset-Backed Security Collateralized Debt Obligations (ABS CDO or Mezz ABS CDO) are created, very much similarly to the way an ABS is created. In addition to tranching out the whole portfolio, banks split the Mezzanine tranche of an ABS into smaller Mezzanine tranches as shown in the picture below.

A simplified ABS CDO

As you can see, the Senior tranche of an ABS CDO makes up 65% of the principal of the ABS Mezzanine tranche - which accounts for 15% of the whole portfolio). Mezzanine and Equity tranches of the ABS CDO accounts for 25% and 10% of the ABS Mezzanine respectively.By design, the Senior tranche of ABS CDO is rated AAA. This makes the total percentage of AAA-rated instruments created from the portfolio 89.75% (i.e. 80% + 65% x 15%)

f. What are the risk of the new tranches created in the ABS CDO?

The Senior tranche of the ABS Mezzanine is riskier than the Senior tranche of the ABS although they are both rated AAA. An investor in the Senior tranche of an ABS may still get his principal and interest when the loss on the underlying portfolio is 20% or less; However, for an investor in the Senior tranche of an ABS CDO, he needs the loss to be at most 10.25% (i.e. 100% - 89.75%). A loss of 20% would wipe out the whole Mezzanine tranche and of course all of his investment in it. In the same way, we can figure out the risk of the rest of the tranches of an ABS CDO. The following table will summarize the losses to an AAA-rated tranches of ABS CDO in different scenarios:

Losses on Underlying Assets	Losses to Mezzanine tranche of ABS	Losses to Equity tranche of ABS CDO	Losses to Mezzanine tranche of ABS CDO	Losses to Senior tranche of ABS CDO
10%	33.3%	100.0%	93.3%	0.0%
13%	53.3%	100.0%	100.0%	28.2%
17%	80.0%	100.0%	100.0%	69.2%
20%	100.0%	100.0%	100.0%	100.0%

Now that we've had a clear picture of the development of sophisticated financial instruments and the increasing risk associated with them, let's have a look at the second factor - the U.S. Housing Market.

g. What's wrong with the US Housing Market?

The US House prices from the year 2000 onwards had been rising much faster than they had in the previous decades as you can see from the P&P/Case-Shiller composite-10 index of U.S real estate. The composite-10 index measures the change in value of residential real estate in 10 metropolitan areas of the U.S.

S&P/Case-Shiller 10-City Composite Home Price Index

What happened to the US housing market in the period of 2000 to 2006 was the increase in subprime mortgage lending, which was significantly riskier than average. As a consequence, houses got a lot more expensive.

h. Why were subprime mortgages highly risky? And why were there so many of them? 

To mortgage brokers and mortgage lenders, more lending meant more profits. And to be able to lend more, more people needed to be qualified for mortgages. As a results, families that had previously been considered not creditworthy enough for mortgages then had access to mortgage loans. Those were called subprime mortgages. This relaxation of lending standards created increase in demand, which in turn, led to the increasing prices of real estates. This again resulted in more aggressive lending activities. And this cycle went on and on.
The problem was that when prices rose, it was more difficult for first-time buyers to acquire houses. In order to attract new entrants into the market, brokers had to find ways to relax the lending standards even more. Their solutions: the amount lent as a percentage of house prices increased. Adjustable-rate mortgages (ARMS) were developed where mortgage borrowers would first enjoy very low interest rate - a "teaser" rate (about 6%) that lasted for two or three years and for the subsequent years paid at a rate that was much higher (LIBOR + 6%). The risk of subprime mortgages was very high because the possibility that subprime mortgage borrowers default on their loans was much higher than that of prime mortgage borrowers. However, this risk was not high enough for brokers and lenders to ignore the huge profits coming from subprime mortgages.

i. How do subprime mortgages relate to securitization?

Subprime mortgages were securitized (into MBS) in the ways shown in questions (b) and (e). Investors in MBS usually did not know or care about vital information such as creditworthiness of the borrowers. The only pieces of information that they received were the loan-to-value ratio and the borrowers' FICO score.

• Loan-to-value ratio is the ratio of the size of the loan to the assessed value of the house.
• FICO is a credit score developed by the Fair Isaac Corporation and is widely used in mortgage lending.

Surprisingly, both the ratio and the score were of doubtful quality as they could easily be modified to give a better financial standing of the borrower. 

j. Why was the government not regulating the behavior of mortgage lenders? 

The government actually played quite a big part in the crisis. The U.S. government had since the 1990s been trying to expand home ownership and had been applying pressure to mortgage lenders to increase loans to low and moderate-income people.  

k. How was the onset of the crisis? 

The relaxation of lending standard created a bubble in house prices.  As prices kept increasing from 2000 to 2006, by 2007 many mortgage holders found that they could no longer afford their mortgage when the "teaser" rates period ended. This led to foreclosures of a large number of households in the market. Additionally, the nonrecourse feature of the US household market (i.e. in case of default, lender are able to take possession of the house but other assets of the borrowers are off-limits) effectively created  free American-style put options for the borrowers. This means that the borrowers can at any time sell the house to lender for the principal outstanding on the mortgage. Consequently, many houses were then put back on the market, making house prices plunge.

l. what of the mortgage defaulters?

Not all mortgage defaulters were in the same positions. Some had to give up their only homes when they defaulted. Others were speculators, which means that they purchased multiple homes as rental properties. When the real estate market crashed, they would reasonably exercised their put options. However, some got creative. After selling their homes to the lenders, they right away bought other houses that were in for foreclosure (at a real bargain). Here's an example to illustrate their strategy. Two people living in identical houses in the same neighborhood have mortgages of $250,000 each. Both houses are worth $200,000 and in foreclosure can be expected to sell for $170,000. The optimal strategy is, and this was what they did, to sell their houses back to the lenders and buy each other's houses after foreclosure.

m. What happened when the bubble burst?

As foreclosures increased, the loss on mortgages also increased. Houses in foreclosure were often in poor condition and sold for a small fraction of their value prior to the crisis. in 2008 and 2009, average losses were as high as 75% of the original values. 


Lenders, brokers, and investors also suffered greatly from this crisis. In part 2, we'll look into the causes and costs of it.