Subprime credit crunch disclosure

Currently the G7 is talking on how to deal with the subprime mortgage crisis. The problem with this is that they are a bit too fast in reacting. Of course, this is to be expected of politicians that want to deal with things immediately in order to get more votes, but there is already a new regulatory framework put in place that started the first of January 2008.

Let me explain what the problem is and how the underlying mechanisms work. When a bank, or any other financial institution for that matter, gives a mortgage to you, it gives you money to buy a house. This is a large amount of money for you, which you're expected to pay back over the next few decades. The chance on you defaulting on your payments is low, but the risk is there for the bank. So in order to mitigate that risk, the bank wants some credit protection in the form of a collateral. This is most likely you pledging to let the bank sell your house when you cannot afford your mortgage anymore.

For every loan a bank gives out, it needs, next to the credit protection, to keep a certain percentage of that loan stacked away to make sure that the bank won't get into trouble if they cannot get their money back of that loan. Currently this is regulated by the Basel Capital Adequacy Accord, or Basel I. This is an accord between banks that set all kinds of these percentages and it has been made into law by the local governments.

Now, in order to lend out more mortgages, a bank needs more money, but that might be hard to come by. Banks, however are generally very clever when it amounts to dealing with money. So what they do is create a special company for one specific purpose, this is generally known as a Special Purpose Entity, or SPE for short. Then the banks take a part of their mortgage portfolio and sell it to that SPE. However, the SPE has no money, so to be able to pay it they issue bonds which are guaranteed by these mortgages. And of course the interest payments on these bonds are covered by the income they get out of the mortgages (e.i. your interest payments to your bank). Typically, an SPE packages together the mortgages into ten or so different tranches, where the top tranche contains the mortgages that pose the least risk and the bottom tranche contains the mortgages that pose the most risk. The bonds from the top tranche have a low percentage payment and a low risk and the bottom tranche has a high interest payment and a high risk. The bottom tranche bonds are also known as junk-bonds. Together they are called Collateral Debt Obligations, or CDO's for short. When the mortgages are sold to an SPE, they no longer appear in the books of the bank, so banks do not have to keep money for them. And adding to that is that the sell of those mortgages gives money to the bank, so they can lend out even more.

The companies that buy these CDO's, or bonds, are mostly banks and other financial institutions. They invest in these bonds and assess how much risk is involved in it. To assess these risks, external rating agencies, such as Moody's and Standard & Poors are asked to provide a rating for a CDO. Based on the rating, the investing company know what the risk associated with that CDO is, and thus how much money they need to keep available for when their investment is lost.

What now happened is that in the lower tier of the bands, people started defaulting on their mortgage payments. But instead of the SPE forgoing on their interest payments themselves, they asked the originating bank to bail them out. And banks do this to save their face. Because if a bank lost the trust of people, they would withdraw their deposited money from it. And when that happens on a large scale, then, according to the fact that banks need a percentage of money for every loan (see above), the bank does not have enough money left to write off their bad loans and then the bank can go bust.

The rating agencies, it seems, did a poor job of rating the risks with the CDO's. Most of the time the rating was to high, meaning the risk associated with it was rated to low.

So that's what's happening now. Banks are bailing out their SPE's and don't have money left to give credit to companies, or to other banks for that matter. And those CDO's that are not bailed out, are defaulted and the investing companies, which most of the times are other banks, have to write them off completely. So they don't have money either to lend out. This is the credit crunch effect and it boils down to the fact that it has become much harder for a company to get credit from a bank.

Now for the fact why the G7 politicians are premature in their assessment that they need to do something about this.

Roughly ten years ago, the global banks realised that the current Basel I accord is too strict and also leads to the SPE situation sketch above. They, combined in the BIS - Bank of International Settlement - created a new Basel accord. The main driver was that the larger banks felt that they were much better at assessing the risk associated with a loan than the standards proposed by the Basel I accord allowed. Under the Basel I accord, if you lended money to BubbleBurst.com had the same associated risk as lending money to Shell. For both loans you had to set aside 8% of the main sum. Banks felt that for BubbleBurst.com they might need to set aside 12% and for Shell only 4%. And internally this is the amount of capital that they calculated with. These things have been set into the Basel II Capital Adequacy Accord, which came into effect per the first of January 2008. In this, banks are allowed to set aside as much, or little, money as they think fit, provided they disclose their risk assessment models upon which they calculate the amount of money set aside to the regulators. And a big part of this information has to be disclosed to the market as well. The idea behind this disclosure is that investors then can decide if banks are taking too much risk or not, which will be reflected in the stock price. The problem is that this disclosure will happen in the next quarterly statement so the effects are not yet visible. A big part of new areas in the accord is what the accord calls Asset Securitisation. An example of a Securitized Asset is a CDO. Banks, under the new Basel II rules must set aside much more money than under the Basel I accord.

So there you have it. There is currently a new regulatory system for assessing risks within banks, which will deal with the Subprime losses in a much more effective way. It also reduces investor uncertainties by ordering banks to disclose how they assess their risks. My personal fear is that, on top of Basel II, the G7 politicians feel they need to do something and come up with extra risk controls on top of the Basel II Capital Adequacy framework.

Zaaf