1.
Economic Crisis, Financial Crisis or Credit
Crisis?
When the 2007-08 Financial Crisis is
first reported in China, I was a graduate student who is interest in the
business world. The first concern of mine is that it may affect my job hunting.
So, what is 2007-08 Crisis, and the influences on the financial industry?
1.1 Chain Effect
First, the name of this crisis.
Generally, we use ’Economic Crisis’ for those depressed periods of capitalist
countries. But this time, most media call it financial crisis, or credit
crisis. The key reason is that this time, the most affected industry is
concentrated in financial industry, and the incentive of this crisis is the credit
issue in housing market.
Second, the credit risk. Although
US has a great credit system compared to China, it also has credit risks. To be
frank, there are still a lot of people in US do not deliver their commitment in
Loan. To start with, we need to know the housing bubble of US before talking
about this crisis. The US housing market experienced high growth after the stock
market crash in 2000. The subprime loans had increased 292% from 332 million in
2003 to 1.3 trillion in 2007[1]. When the housing price crashed in
2007, many subprime loads went to default and caused a chain results. [8]
Third, how severe is the un-payment
of the loan? After the default of loan, banks began to take back those houses,
and list them in the real estate market. This increased supply of houses
continues to push the price of house to be lower. The recovered money from
default cannot be compensated by selling those houses. To begin with, let’s have
a look at the US-Style Asset Backed Securities(ABS), and ”notorious”
Collateralized Debt Obligations(CDO).
1.2 ABS and CDO
What is Asset Backed Securities? It
is a financial security created through securitization from the cash flow of
financial assets including mortgages, loans, auto loans, etc.[2] To
create the ABS, the owner of these assets sell them to a Special Purpose
Vehicle(SPV). Then the cash flow will be allocated to different tranches which
represents different priorities of cash flow. Normally, there are three
tranches: senior tranche, mezzanine tranche, and equity tranche. In this way,
the owner could get liquid money from the buyer of ABS, and part of default
risk are also transferred to the ABS buyer.
Although the senior tranches is not
hard to find investors, it is hard to sell mezzanine and equity tranches.
Financial organizations then created so called CDO. This products focuses on
the Mezzanine tranches, which has a median risk within ABS. Assume the previous
ABS product has a split of 60/30/10 on tranches. Financial engineers take out
the mezzanine part, and split them again. The original ABS has a 60% senior
tranche, and after this process, the updated senior part will be 78%(60+30*60%)
for the new ABS. [2] After many times of operation, most part of ABS
will be senior. These senior tranche has a credit rating as high as AAA from
big three credit rating agencies. In this way, a lot of investors were
attracted by this asset.
2.
How Lehman Brothers is involved?
We all know Lehman Brothers is an
Investment Bank, so its core business should be in IPO related business, why
this 2007-08 credit crisis let it bankrupt?
The answer is very simple: Lehman
Brothers owns money in this business as the issuer of ABS and CDO. Before the
crisis in 2007, most of big financial organizations in US have exposure to ABS.
Below is the Insurance Volume by big investment banks. [3]
It seems that the Lehman Brother is
not a top ten player in the insurance in the CDO, so why only Lehman Brother
and Bear Stern completely failed? The reason is partly that they both have a
lot more part in Mezzanine tranches which have higher default risk than senior tranches.
But why Morgan Stanley and Merrill Lynch did not fail? They also own a lot of assets
in Mezzanine tranche. Below is the diagram of CDO price change in 2007. It
shows the market risk of value depreciation of CDO holder during that time. [4]
(The solid line represents the AAA index; the dotted line, the AA index;
the dashed-dotted line, the A index; the dashed line, the BBB index; the x, the
BBB- index)
2.1 Actions
in 2007 Crisis
The crisis was ignited by the
housing crash in late 2006 and early 2007, then many investment banks began to
take actions to decrease this market risk. For Lehman Brothers, it also began
to short its individual tranches across mezzanine ABS CDOs. According to the
internal analysis presentation from the risk department of Lehman Brothers, the
risk should have been all hedged. Below is the internal slides talking about
this hedge. [3]
2.2 Operation
Risk
It is weird after I checked the
2007 financial report of Lehman Brothers. It is said that ”At November 30, 2007
and 2006, we owned approximately $581.2 million and $55.1 million of equity
securities in CDOs, respectively”,[5] and ”The underlying investment
grade collateral held by SPEs where we are the first-lien holder was $15.7
billion and $10.8 billion at November 30,2007 and 2006, respectively”.[5]
So there must be someone lying, and Lehman Brothers did not hedge these highly
risky assets completely as shown in the internal slides.[7] This
shows the Integrity and Internal Control is not valued in Lehman Brothers. If
the financial report is right, the CDO’s exposure is increased more than time
times after the housing crash!!! And the hold ABS also increased about 50%. So,
when the crisis worsens, and the value of ABS continue to decrease from 2007 to
2008.
The other operation risk is related
to leverage ratio. According to some research, the the leverage before its
bankruptcy was as high as 30.7. It means only 22.5 billion of its total 691 billion
assets was shareholders’ equity. A negative return of 4%, will consume all of
its shareholder equities. [6] That is the reason that after many
years’ profit reporting, a losing of 5 billion within 6 months forced this bank
into bankruptcy.
When there is a big loss, what will
you do? For a gambler, he/she will choose to bet a bigger one. The increase of
CDO assets for Lehman Brother in 2007 shows this case. They know risk management
according to the internal meeting slides, but unfortunately, risk management does
not generate profit.
3.
What we learn
1)
Human psychology plays a role in financial
markets. Risk managers should look for evidence of irrational exuberance and
never assume that bull markets will continue indefinitely. As in the example,
the crash in 2007 does not mean the up trend in 2008. The increased long position
on CDO make Lehman Brothers lose much more, and finally bankruptcy. [2]
2)
Investment that initially appear to be good
investment may be poor investment after further scrutiny. AAA-rated senior
tranches of ABSs typically offered higher return than AAA-rated bonds. The
difference in return was due to the higher risk that the ABS carried.
3)
Investors need to do their own analysis on
assets. Never rely solely on credit rating companies.
4.
References
[1] Tom DeGrace, ”THE HOUSING
MARKET CRASH OF 2007 AND WHAT CAUSED THE CRASH”, STOCKPICKSSYSTEM INVESTMENT
SERVICES, Dec.18,2011
[2] ”SchweserNotes for the FRM
Exam: Foundations of Risk Management”, Kaplan University, 2015
[3] Internal material in Lehman
Brothers, ”Lehman Brothers ABS CDO Exposure”, Nov.1, 2007
[4] Francis A. Longstaff, ”The
subprime credit crisis and contagion in financial markets”, Journal of
Financial Economics, 25 January 2010
[5] ”LEHMAN BROTHERS: 2007 Annual
Report.”
[6] Robin Feng, Niklas Fredriksson,
”A Case Study of the Lehman Brothers Bankruptcy”, 2010-11-24
[7] John Carney, ”Lehman Brothers
Was Dramatically Over Valuing Its CDOs”, Business Insider, Mar. 17, 2010
[8] ”Lehman
Brothers”, Wikipedia
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