The 2007 Credit Crisis: A Summary - Part 2

In the previous part of this topic, we covered the two major factors that set off the crisis. We left off the last part at the burst of the real estate market; In this part, we will explore the causes and costs of this crisis.


After the real estate bubble burst, investors in Mortgage-Backed Securities (MBS) incurred big losses. The value of the MBS tranches created from subprime mortgages was monitored by a series of indices known as ABX. By the end of 2007, these indices showed that the tranches originally rated BBB had lost about 80% of their value. By mid-2009, they lost almost all of their value, at 97%.

The value of the ABS CDO tranches created from BBB tranches was monitored by a series of indices known as TABX. These indiced indicated that tranches rated AAA lost approximately 80% of their value by the end of 2007 and became worthless by mid-2009.

Many financial institutions had big positions in them and had to be rescued  with government funds or taken over by other banks. Among them were UBS, Merrill Lynch, Citigroup, AIG, Bear Sterns, etc. Most notorious was probably Lehman Brothers, which was "allowed" to fail. Many of them are not U.S. banks, and all of them have businesses worldwide. Such huge impact in the largest  economy in the world was felt globally and this is how the credit crisis spread around the world.

What were the other consequences?

The Credit Crisis. The losses on MBS led to a severe credit crisis. Before this crisis, banks were well capitalized, loans were relatively easy to obtain, and credit spreads were low. (Credit Spead is the excess of the loan interest rate over risk-free interest rate.) By 2008, banks' capital had been badly eroded by their losses; therefore, they were more reluctant to lend. Credit spreads increased dramatically. Creditworthy individuals and companies (not just in the U.S.) found themselves in a difficult situation as borrowing became costly and hard to come by. 

So what went wrong?

First and foremost, it was the behavior of investors during the period leading up to the crisis. It could be described as "irrational exuberance,"  a phrase coined by former Chairman of the Federal Reserve Board, Alan Greenspan in the 1990s. This phrase could be interpreted as a warning that the market might be somewhat overvalued (as it was first used during the Dot-com bubble.) Mortgage lenders, investors in ABS & ABS CDO, and companies that sold protection on those instruments thought that the good time would last forever. This was a deadly mistake.

In addition to that, mortgage originators used lax lending standards, trying to earn as much profits as possible. Complex structured products (ABS, ABS CDO) were developed to transfer the risks to investors.

Rating agencies also played a crucial part in the crisis. They moved away from their traditional expertise of rating bonds to rating structured products, which was at the time relatively new and for which there was little historical data. Moreover, the procedures used to rate such products were not properly designed as they were created mirroring they way agencies rate bonds (which were of course different from structured products in many aspects.) The sophisticated products along with the lack of information about the underlying assets made investors rely more on rating agencies rather than their own judgements.

Structured products like those shown in part 1 of this topic are highly dependent on the default correlation between the underlying assets. The Default Correlation measures the tendency for different borrowers to default at about the same time. Even in normal times, mortgages exhibit moderate default correlation, which means that lower tranches of ABSs and ABS CDOs are more prone to losing their principals. although AAA-rated tranches could be fairly safe. However, investors, mortgage originators, along with many other market participants did not properly factor in "panic." In stressed market conditions, default correlations increases dramatically, making high default rates possible.

Agency Cost could be another factor that worsened the crisis. The term is used to describe the cost in a situation where the interests of two parties in a business relationship are not perfectly aligned. 

• Between the mortgage originators and the investors, their gains and costs were not aligned. For originators, they needed to make more profits by creating and selling as much of their structure products to investors as possible by making bad lending decisions. The crisis might have been less severe if the originators had been required to to keep, for example 20% of each of the tranche created. By having the stake in all the tranches, originators would be more motivated to make the same lending decisions that the investors would.
• Between financial institutions and their employees, agency costs are created by the employee compensation, which falls into 3 categories: regular salary, end-of-year bonuses, and stock or stock options. Many employees in financial institutions, particularly traders, received their compensations in the form of end-of-year bonuses. This type of compensation focused on short-term performance, which means that the employee would try to make huge profits one year even though his decisions would incur severe loss in the next year. He would be rewarded handsomely in the first year but would not have to pay back his bonus in the second year. This could explain why even when many financial institution employees knew that the real estate bubble would burst soon, they still decided to go on with their ABS CDOs investments. By the end of that year they will get huge bonuses regardless of the losses after that.

Source: Chapter 8: Securitization and the Credit Crisis of 2007, Fundamentals of Futures and Options Markets. John C. Hull.