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For the exclusive use of M. Abduldaim, 2021. TB0257 F. John Mathis Frank Tuzzolino Venkat Ramaswamy Global Financial Crises and the Future of Securitization Background Rajani Ramaseshan, an outstanding graduate of an MBA program at a major U.S. university, was a global finance specialist. Before he graduated, Rajani had spent a summer on an internship at Citibank (now called Citi) in their asset-backed securities area learning about the structuring of mortgage-backed securities. Rajani’s career goal was to secure a position structuring securitized products at a major global bank’s capital markets area or at an investment bank.1 Rajani took every graduate course he could on structured finance, with a focus on securitization. He had studied global capital and equity markets, and learned about the new instruments impacting both corporate treasury and global investment management. He had also studied global portfolio management to better understand the changing trends in what investors wanted and why. He landed a position with one of the top structured finance shops on Wall Street after graduation. In 2003, Rajani was recruited by HSBC Americas to work in New York as an associate and, after a two-year rotation program, he joined the global corporate lending division covering major multinational corporations headquartered on the east coast of the United States. In his new position, Rajani was pitching ways for major corporations to benefit from using securitized financial instruments to better market their products globally, gain market share, and grow their corporations competitively. Securitization reduced companies’ cost of funding, gave them immediate cash for their sales, provided some tax benefits, and reduced their receivables. Within two years, Rajani was promoted to vice president, and his career was accelerating rapidly. He honed his skills in marketing securitized products in support of the strong growth in corporate profits driven by the continuing global economic expansion. All seemed well. Then, in late January 2007, the major financial newspapers began reporting on problems in the U.S. housing industry and fears that the four-year growth bubble in housing prices might burst. Mortgage-backed securities were a major segment of the structured finance market, and there was growing concern on Wall Street, at the Federal Reserve, and the U.S. Treasury of a possible shock to this part of the financial market. Rajani had developed a close working relationship with the head of the structured finance area at HSBC, and both were increasingly concerned about the viability of subprime mortgages in the mortgage-backed securities market. As Rajani called his colleagues at Citi and JPMorgan/Chase on several occasions over the next couple of months, he learned that they also had growing anxiety about what was happening in this massive and still rapidly expanding segment of the capital market. By June 2007, financial markets were in a state of turmoil, and the picture was deteriorating rapidly day by day. Rajani’s corporate clients, who had used securitized products so effectively to boost sales and profits, were Securitization involves the pooling of assets and the subsequent sale to investors of claims on the cash flows backed by these asset pools. 1 Copyright © 2010 Thunderbird School of Global Management. All rights reserved. This case was prepared by Drs. F. John Mathis and Frank Tuzzolino, Professors of Global Finance at Thunderbird, and Mr. Venkat Ramaswamy, Managing Director of Srinidhi Capital Management in India, and a practicing expert in structured finance for the purpose of classroom discussion only, and not to indicate either effective or ineffective management. This document is authorized for use only by Mustafa Abduldaim in Contemporary Topics in Finance taught by Ardavan Mobasheri, University of Richmond from Aug 2021 to Dec 2021. For the exclusive use of M. Abduldaim, 2021. calling regularly, and Rajani did not know what to tell them other than that the structured finance market was not functioning well because of the increasing subprime defaults. Neither Rajani nor anyone else knew what would happen next. Until the crisis was resolved, the structured finance market would likely remain closed to even the best corporate transactions. But no one seemed to know how long that would take. Rajani was not sure what his corporate customers would do in the meantime. Furthermore, Rajani worried about the longer-term viability of the structured finance market. What had gone wrong, and could it be corrected? A more fundamental concern to the bank and Rajani’s clients was the use of securitized products in the future. Would government regulations make it so costly that they would no longer be used? See Exhibit 1 for recent activity as reported by IMF.2 Exhibit 1. Dramatic Decline in Structured Product Market CDO = collateralized debt obligation; CDO2 = collateralized debt obligation-squared and CDOs backed by asset-backed securities (ABS) and residential mortgage-backed securities (RMBS). Source: IMF staff estimates based on data from JPMorgan Chase & Co.; Board of Governors of the Federal Reserve System; and Inside Mortgage Finance. Rajani was assigned by his direct report to allocate a couple of days to researching recent financial crises in order to acquire a deeper understanding of the factors that had caused the 2007-2009 crisis and how past crises had been resolved. Thereafter, Raja was requested to prepare an analysis and report on the future viability of securitization. He identified three major recent crises prior to the current one: the Asian foreign debt crisis in mid-1997; the collapse of Long Term Capital Management in 1998-2000; and the technology equity bubble in 2000.3 What is Structured Finance? Structured finance is a process of changing the structure of cash flows and distributing default risk by aggregating debt instruments in a pool. The pool is then divided into portfolio tranches (differing amounts of risk in a deal), and then the tranches are securitized and issued as new securities backed by various forms of credit and liquidity enhancements. Structured finance began to emerge in the 1970s building on an old practice of disSee International Monetary Fund, Global Financial Stability Report: Sovereigns, Funding, and Systemic Liquidity, October 2010. 3 Rajani did a Google search and found summary briefs of the crises in Wikipedia and Investipedia, which have been further condensed in this case to provide a summary perspective on the crises and their causes. Nicholas Dunbar, Inventing Money, Wiley, 2000, is also an excellent reference source for more detailed insights. 2 2 TB0257 This document is authorized for use only by Mustafa Abduldaim in Contemporary Topics in Finance taught by Ardavan Mobasheri, University of Richmond from Aug 2021 to Dec 2021. For the exclusive use of M. Abduldaim, 2021. counting, factoring, and forfeiting of receivables and trade finance. It was modified following the global foreign debt crisis in the mid-1980s when securitization was added as a way to convert debt into equity. Then, in the 1990s, structured finance evolved further by incorporating financial engineering to structure products to fit the risk and cash flow preferences of investors. Complex asset diversification structures emerged, including a variety of credit and liquidity enhancement techniques. In addition, Credit Default Swaps (CDS) were incorporated to customize the end security to suit the cash flow needs and risk appetite of an expanding investor base. In 2007, more than $1 trillion in structured credit was issued and, at its peak, the estimated outstanding amount of the market exceeded $4 trillion in the U.S. and $1 trillion in Europe. During the 2000s, the focus of structuring products shifted to volume and achieving economies of scale in order to lower the overall cost of originating loans. This drove the need to expand the sources of cash flow to include more types of assets beyond mortgages, autos, and credit cards. It also promoted the development of synthetic products. What emerged was a variety of very complex financial instruments employing sophisticated credit risk models to determine how to structure the pooled assets to achieve the desired risk profile and cash flow to the investors. In what is often called the Cash Flow Waterfall mechanism (because of its cascading effect between asset classes), if losses begin to rise, the flow through the tranches threatens the lower rated equity and mezzanine tranches first. For example, normally in a Collateralized Debt Obligation (CDO) structure, if 7%-8% losses occur then securities below a Ba rating are wiped out; 13%-15% losses wipe out all Baa and below-rated securities, and 11%-14% losses on subprime mortgage-backed securities wipe out everything from single A tranches down. The Role of Structured Finance in Financial Crises Four significant global financial crises have occurred since 1997, during which time the widespread use and development of structured products expanded rapidly. What follows is a brief review of the causes, what happened, the role of securitization if any, and what was done to end the crises. Asian Financial Crisis—The Asian financial crisis hit most of Asia in 1997 and raised concerns that it would become a global crisis. The crisis was primarily the result of excessive foreign debt levels and rising foreign debt service payments which spilled into the domestic economy with excess leverage ratios supporting real estate speculation. The turning point was triggered in Thailand with the collapse of the Thai baht as the government depegged its currency from the U.S. dollar. The collapse of the Thai currency was driven by the accumulation of foreign debt with short maturities which could not be serviced. Contagion carried the crisis to Southeast Asia and Japan, resulting in depreciating currencies, devalued equity markets, and falling asset prices. The International Monetary Fund (IMF) intervened with a $40 billion currency stabilization policy for South Korea, Thailand, and Indonesia. It came with conditions, of course. The IMF’s restrictive economic policy required a reduction in government spending in order to reduce deficits, an increase in interest rates, and encouraged governments to allow bank failures. This caused a worsening of the crisis as governments failed to service their foreign debts. After a period of significant financial, economic and political restructuring, and major high-growth sector bankruptcies, the economies gradually recovered after 1999 from the serious growth disruption, but the countries involved offered strong criticism of IMF policies. Their governments began to follow a policy of building international reserves to avoid any future need to have to rely on IMF support. This crisis had nothing to do with structured finance. Long Term Capital Management (LTCM)—LTCM was founded in 1994 by John Meriwether, the former vicechairman and head of bond trading at Salomon Brothers.4 The members of the Board of Directors of LTCM included Myron Scholes and Robert C. Merton, who jointly received the 1997 Nobel Prize in Economics. Meriwether chose to start a hedge fund to avoid the financial regulation imposed on more traditional investment vehicles. LTCM was initially very successful, achieving annualized net returns less management fees of more than 40%. John Meriwether headed Salomon Brothers’ bond trading desk until he was forced to resign in 1991 when his top bond trader, Paul Mozer, admitted to falsifying bids on U.S. Treasury auctions. Though Meriwether was not directly implicated, calls for his ouster rose within the company, and he resigned before he was to be let go. See Nicholas Dunbar, Inventing Money: The Story of Long-Term Capital Management and the Legends Behind It, New York: Wiley, 2000. 4 TB0257 3 This document is authorized for use only by Mustafa Abduldaim in Contemporary Topics in Finance taught by Ardavan Mobasheri, University of Richmond from Aug 2021 to Dec 2021. For the exclusive use of M. Abduldaim, 2021. The fund’s operation was designed to have extremely low overhead; trades were conducted through a partnership with Bear Stearns, and client relations were handled by Merrill Lynch.5 The company used complex mathematical models to take advantage of fixed income arbitrage deals (termed convergence trades), usually with U.S., Japanese, and European government bonds. Government bonds are a “fixed-term debt obligation,” meaning that they will pay a fixed amount at a specified time in the future.6 For instance, differences in the bonds’ present value are minimal, so, according to economic theory, any difference in price will be eliminated by arbitrage. To note, price differences between a 30-year Treasury bond and a 29-and-three-quarter-year-old Treasury bond should be minimal—both will see a fixed payment roughly 30 years in the future. However, small discrepancies arose between the two bond types because of a difference in liquidity.7 By essentially buying the cheaper 29-and-three-quarter-year-old bond and shorting the more expensive, but more liquid, 30-year bond just issued by the U.S. Treasury, it would be possible to make a profit, as the difference in the value of the bonds narrowed when a new bond was issued. As LTCM’s capital base grew, its managers felt pressed to invest that capital, but had run out of good bondarbitrage bets which led LTCM to undertake more aggressive trading strategies. By 1998, LTCM had extremely large positions in areas such as merger arbitrage and S&P 500 options (net short long-term S&P volatility). LTCM had become a major supplier of S&P 500 Vega, which had been in demand by companies seeking to essentially insure equities against future declines.8 Because these differences in value were minute—especially for the convergence trades—the fund needed to take highly leveraged positions to make a significant profit. At the beginning of the year, the firm had equity of $4.72 billion, and had borrowed more than $124.5 billion with assets of around $129 billion, for a debt-to-equity ratio of about 25 to 1. It had off-balance sheet derivative positions with a notional value of approximately $1.25 trillion, most of which were in interest rate derivatives such as interest rate swaps. The fund also invested in other derivatives such as equity options. Factors giving rise to the downfall of the fund were rooted in the 1997 East Asian financial crisis, which had a role in precipitating the subsequent Russian financial crisis later in 1998. In May and June 1998 returns from LTCM had declined to -6.42% and -10.14% respectively, reducing their capital by $461 million. This was further aggravated by the exit of Salomon Brothers from the arbitrage business in July 1998. Such losses were accentuated because of the Russian financial crisis in August and September 1998, when the Russian government defaulted on its government bonds. Panicked investors sold Japanese and European bonds to buy U.S. Treasury bonds. The profits that were supposed to occur as the value of these bonds converged became huge losses as the value of the bonds diverged. By the end of August, the fund had lost $1.85 billion in capital. After LTCM failed to raise more money on its own, it became clear that it was running out of alternatives. In September, Goldman Sachs, AIG, and Berkshire Hathaway offered to buy out the fund’s partners for $250 million, to inject $3.75 billion, and to operate LTCM within Goldman’s own trading division. The low offer was not accepted.9 With no other offers available, the Federal Reserve Bank of New York organized a bailout of $3.6 billion from the major creditors to avoid a wider collapse in the financial markets.10 The contributions from the various institutions were as follows:11 $300 million from each of the following— Bankers Trust, Barclays, Chase, Credit Suisse First Boston, Deutsche Bank, Goldman Sachs, Merrill Lynch, JPMorgan, Morgan Stanley, Salomon Smith Barney, UBS; $125 million from Société Générale; and $100 million from Lehman Brothers and Paribas. Bear Stearns declined to participate. In return, the participating banks got a 90% share in the fund and a promise that a supervisory board would be established. LTCM’s partners received a 10% stake, still worth about $400 million, but this money was completely consumed by their debts. The partners once had $1.9 billion of their own money invested in LTCM, all of which was wiped out.12 Both Bear Stearns and Merrill Lynch would have to be taken over by other banks to prevent their collapse in the subprime loan crisis in 2007-2009. 6 Dunbar, p. 80. 7 Ibid., p. 98. 8 Roger Lowenstein, When Genius Failed: The Rise and Fall of Long-Term Capital Management, Random House, 2000, pp. 124-125. 9 Ibid., pp. 203-204. 10 Frank Partnoy, Infectious Greed: How Deceit and Risk Corrupted the Financial Markets, Macmillan, 2003, p. 261. 11 Wall Street Journal, September, 25, 1998; and, on the same day, bloomberg.com:exclusive news report. 12 Lowenstein, pp. 207-208. 4 TB0257 5 This document is authorized for use only by Mustafa Abduldaim in Contemporary Topics in Finance taught by Ardavan Mobasheri, University of Richmond from Aug 2021 to Dec 2021. For the exclusive use of M. Abduldaim, 2021. The fear was that there would be a chain reaction as the company liquidated its securities to cover its debt, leading to a drop in prices, which would force other companies to liquidate their own debt, creating a cycle. Some industry officials said that the Federal Reserve Bank of New York’s involvement in the rescue, however benign, would encourage large financial institutions to assume more risk, in the belief that the Federal Reserve would intervene on their behalf in the event of trouble. The Federal Reserve Bank of New York actions raised concerns among some market observers that it could create moral hazard.13 In all, LTCM lost about $4.6 billion in less than four months in the market turmoil that preceded Russia’s default on its debt, because of its highly leveraged investments in high-risk instruments and in Russia. LTCM went out of business in early 2000. What did these extremely bright experts miss, or was this an example of misdirected greed? This crisis had nothing to do with structured products. The Technology Equity Price Bubble—The tech, or dot-com, bubble occurred during 1998-2000 and peaked on March 10, 2000, with the NASDAQ hitting an all-time high of 5,132.52. Equity markets in industrialized nations experienced a rapid price rise from growth in the “new” Internet sector and Web technology-related fields in the 1990s. A combination of rapidly increasing stock prices, market confidence that the companies would turn future profits, individual speculation in stocks, and widely available venture capital funding created an environment in which many investors were willing to overlook traditional performance metrics such as price-to-earnings ratio in favor of unsubstantiated confidence in sales of technological advancements. Venture capitalists saw sharp rises in stock valuations of dot-com companies. Low interest rates in 1998-99 made it easier for dot-com borrowers to increase the amount of their start-up capital. Although a number of these new entrepreneurs had realistic plans and management ability, many more of them lacked the required business skills, but were able to sell their ideas to anxious investors with ready cash to invest. A basic dot-com company’s business model relied on operating at a sustained net loss to build potential market share. These companies expected that they could build enough brand awareness to charge profitable rates for their services later. During the loss period, the companies relied on venture capital, and especially...