The Chartered Accountant

DECEMBER 2008 1010 THE CHARTERED ACCOUNTANT
GLOBAL PERSPECTIVE
India has an opportunity to learn from America’s mistakes. It should develop
secondary markets carefully and thoughtfully, with appropriate regulation,
infrastructure, and disclosure requirements. In the primary market, lenders
must monitor borrowers’ credit histories and track credit scores. India has
already experienced some of America’s problems.
bought home mortgages from local banks and mortgage
originators, picking mortgages based on computerized
programs that modeled risk levels. Investments
banks took mortgages from various parts of
the United States to mitigate the risk; the theory being
that even if one area became depressed the other regions
would still be good investments. The models
became even more sophisticated over time, mixing
and matching mortgages from certain cities, neighborhoods,
types and lengths of mortgages, types of
homes, and prices of homes. The investment banks
aggregated the mortgages and then repackaged them
into Special Purpose Entities (SPEs)—such as Collateralized
Mortgage Obligations (CMOs) and Collateralized
Debt Obligations (CDOs)—that varied in
risk level. The SPE then sold classes or tranches of its
securities to investors.
The investment banks hired credit rating agencies that
used their own computer models to assess the risk
of the securities in the SPE and then issued ratings.
The safest tranches were rated AAA and had lower
yields than tranches that bore more risk of default by
homeowners. Investment banks made a small profit
by selling the different tranches at a higher price than
they paid for the mortgages, but these profits added
up as the US mortgage market grew into trillions of
dollars. From 2001 to 2006, as subprime mortgages
took a larger percentage of all mortgages originated,
investment banks securitized them as well. In 2005
alone, 81% of subprime mortgages, or $507 billion,
were securitized, the vast majority through subprime
lenders or through investment banks. 13
Over time, the investment banks started enhancing
the safety of the securities they sold by insuring them
or guaranteeing them. Investment banks that floated
the SPEs wrote contracts guaranteeing to their investors
that they would buy back securities issued by
SPEs if the investors could not find a ready buyer
for them. In addition, insurance companies, such as
AIG and other institutions, offered new products that
were designed to protect investors against default risk.
These insurance-like products were called Credit Default
Swaps (CDS). In return for a regularly paid fee,
the insurer would pay the buyer if the SPE (or any
other covered entity and its debt) defaulted or had a
significant credit event, such as a restructuring or severe
downward change to its rating. Payment could
be either physical or cash. In a physical settlement, the
CDS seller paid the buyer the face value of the debt
in exchange for the debt itself. In a cash settlement,
the CDS seller paid the buyer the difference between
the original value of the debt and the current value
after the triggering event. CDS became wildly popular
because buyers could hedge against risk without paying
money upfront. Indices (such as the Dow Jones
CDX) cropped up that expanded the CDS market and
allowed freer and more liquid trading. 14 By some estimates
about $75 trillion dollars of CDS contracts
have been written. CDS were sold to insure against
the risk of several entities, not just SPEs, and were
bought and sold multiple times. In particular, the insurance
giant AIG was, by some accounts, is said to
have written CDS contracts worth $450 billion.
Trillions of dollars in privately traded securities were
generated in the last decade; all based on the value
of US real estate. When the real estate market in the
United States started declining and interest rates rose,
home owners began defaulting on their loans. The
number of foreclosures hit 1.3 million in 2007, a steep
75% increase from the year before, and there have
been even more home foreclosures in 2008. When
banks keep the loans that they make to homeowners,
they often renegotiate terms with them to avoid foreclosure.
However, with mortgages being sold to SPEs
and GSEs, pooled with other mortgages, securitized,
chopped up into tranches, and sold to investors thousands
of miles away, renegotiating with homeowners
is difficult if not impossible.
The Crisis spreads
It took nearly a year of falling home prices and subsequent
mortgage defaults to leak into the larger economy.
Lenders with a significant subprime loan portfolio
were affected first. $56 billion New Century Financial
Corporation, one of the largest subprime lenders in
the United States, was one of the first banks to fail,
13 Report and Recommendations by the Majority Staff of the Joint Economic Committee, “The Subprime Lending Crisis,” October 2007, p. 18.
14 Mike Jakola, “Credit Default Swap Index Options,” Kellogg School of Management, Northwestern University, June 2, 2006, pp. 2-3.