Credit Crisis - Academics and Analysis - 4

This blog is next in the series of blogs ‘Credit Crisis – Academics and Analysis - 3’. Please read previous blogs for a better sense of flow.

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Here I will try to analyze Risk Elements with MBS securities and attempt to build a sense of what could have gone wrong.

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Borrowers pay a rate of interest for their mortgage loans. This rate includes Risk Free Rate + Risk Premium to compensate risks associated with those loans.

• We know the bubble was created because home prices kept going upwards to a point of burst. No argument on that!
• Upward movement in prices was due to lower interest rates paid by borrowers and a larger investor base making increased supply of loan-able funds. Again no argument on that!
• Larger Investor base is what we desire and going forward, we would aim to maintain/increase that. So, there is no problem with that part of equation.
• Lower Risk Free Rates, we know were controlled by FED’s Monetary Policy. Analysts have already pointed that out as one of the strong reasons for the bubble. FED kept these rates too low for too long. Again no arguments!

Now, the remaining variable in the equation is Risk Premium added to Risk Free Rate. Let’s analyze this to see, if this premium could have been cheaply charged to borrowers.

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I will organize contents of this analysis as:

• Risks for End Investors
• Risks for MBS Issuers/Guarantors
• Total Risks Analysis as against conventional Home Loans

Risks for End Investors

• Credit Risk: Since there was Guarantor party present (i.e. Ginnie Mae, Fannie Mae, Freddie Mac), Credit Risk to Investors was quantified by creditworthiness and credit ratings of these guarantor parties.
• Interest Rate Risk: Same as with any other fixed income security. Security Prices will go down when Risk Free Interest Rates go up in the market. Its quantification is to be based on whether coupon is fixed or floating.
• Prepayment Risk: Higher when Interest Rates are going down.
• Liquidity Risk: Quite low as there was active secondary market for these securities.
• Unknown Product Risk: Since Investors are not so knowledgeable on these new complex structured securities, they should charge a premium for any associated uncertainties.
• Systematic Risk: With increased de-regulations from govt. combined with complex and relative unknown nature of these securities, did expose Investors to added systematic risk, which should have been accounted for in their premium.

Risk for MBS Guarantors/Issuers

• Credit Risk: Guarantors faced risk of defaults from actual borrowers.
• Impairment Risk: Collateral for safeguarding default was the home purchased by borrower. Any devaluation in the value of collateral should be a risk to account for.

Total Risk Analysis as against Conventional Home Loans

• Total Credit Risk: Since end borrower is still the same without any additional collateral, Total Credit Risk is same for this new Instrument.
• Total Interest Rate Risk: Is the same as with conventional loans. It is just transferred from Loaning Bank to End Investor.
• Total Prepayment Risk: For CMOs, this Risk has been reduced (or the combined premium demanded for this is lower), as the instrument has been able to create better matches of demand for prepayments.
• Total Liquidity Risk: This Risk has been reduced too. Earlier, Bank loans were pretty much illiquid, but these loan securities are much more liquid as they are traded in secondary markets.
• Total Impairment Risk: This risk was increased, because of high Loan to Value ratio. De-regulation allowed this ratio to go high, meaning borrowers could borrow with lowered down payments. Together with inflated home prices (collateral), this risk was increased. As Price to Cost ratio increases, so does the Impairment Risk. Supernormal Profits are difficult to be sustained in long run.
• Total New Product Risk: This was an additional risk component added with complex and innovative CMOs.
• Total Systematic Risk: This too had increased with increased deregulations.

So, we see, in Total Risk Premium to be charged to borrowers, there are downward factors like Prepayment Risk and Liquidity Risk and upward factors like Impairment Risk, New Product Risk and Systematic Risk.

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Questions forthcoming from this analysis are:

• Were all these risks and their premiums duly considered?
• Were Credit Rating agencies able to correctly indentify and quantify these Risks and rate these Securities accordingly?
• Did borrowers got away with paying lower interest rates with heavy costs to end Investors and Capital Markets as a whole?

On the hindsight of the Crisis, we know we can answer first 2 questions in negative and the last one in affirmative.

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To summarize, I cannot claim this analysis to be complete. But the idea is to expose more dimensions and create added inputs to your existing thought process.