Subprime Crisis Background Information - Understanding The Risks Types Involved in The Subprime Crisis

Understanding The Risks Types Involved in The Subprime Crisis

The reasons for this crisis are varied and complex. Understanding and managing the ripple effect through the worldwide economy poses a critical challenge for governments, businesses, and investors. The crisis can be attributed to a number of factors, such as the inability of homeowners to make their mortgage payments; poor judgment by the borrower and/or the lender; and mortgage incentives such as "teaser" interest rates that later rise significantly.

Further, declining home prices have made re-financing more difficult. As a result of financialization and innovations in securitization, risks related to the inability of homeowners to meet mortgage payments have been distributed broadly, with a series of consequential impacts. There are five primary categories of risk involved:

1. Credit risk: Traditionally, the risk of default (called credit risk) would be assumed by the bank originating the loan. However, due to innovations in securitization, credit risk is frequently transferred to third-party investors. The rights to mortgage payments have been repackaged into a variety of complex investment vehicles, generally categorized as mortgage-backed securities (MBS) or collateralized debt obligations (CDO). A CDO, essentially, is a repacking of existing debt, and in recent years MBS collateral has made up a large proportion of issuance. In exchange for purchasing MBS or CDO and assuming credit risk, third-party investors receive a claim on the mortgage assets and related cash flows, which become collateral in the event of default. Another method of safeguarding against defaults is the credit default swap, in which one party pays a premium and the other party pays them if a particular financial instrument defaults.
2. Asset price risk: MBS and CDO asset valuation is complex and related "fair value" or "mark to market" accounting is subject to wide interpretation. The valuation is derived from both the collectibility of subprime mortgage payments and the existence of a viable market into which these assets can be sold, which are interrelated. Rising mortgage delinquency rates have reduced demand for such assets. Banks and institutional investors have recognized substantial losses as they revalue their MBS downward. Several companies that borrowed money using MBS or CDO assets as collateral have faced margin calls, as lenders executed their contractual rights to get their money back. There is some debate regarding whether fair value accounting should be suspended or modified temporarily, as large write-downs of difficult-to-value MBS and CDO assets may have exacerbated the crisis.
3. Liquidity risk: Many companies rely on access to short-term funding markets for cash to operate (i.e., liquidity), such as the commercial paper and repurchase markets. Companies and structured investment vehicles (SIV) often obtain short-term loans by issuing commercial paper, pledging mortgage assets or CDO as collateral. Investors provide cash in exchange for the commercial paper, receiving money-market interest rates. However, because of concerns regarding the value of the mortgage asset collateral linked to subprime and Alt-A loans, the ability of many companies to issue such paper has been significantly affected. The amount of commercial paper issued as of 18 October 2007 dropped by 25%, to $888 billion, from the 8 August level. In addition, the interest rate charged by investors to provide loans for commercial paper has increased substantially above historical levels.
4. Counterparty risk: Major investment banks and other financial institutions have taken significant positions in credit derivative transactions, some of which serve as a form of credit default insurance. Due to the effects of the risks above, the financial health of investment banks has declined, potentially increasing the risk to their counterparties and creating further uncertainty in financial markets. The demise and bailout of Bear Stearns was due in-part to its role in these derivatives.
5. Systemic risk: The aggregate effect of these and other risks has recently been called systemic risk. According to Nobel laureate Dr. A. Michael Spence, "systemic risk escalates in the financial system when formerly uncorrelated risks shift and become highly correlated. When that happens, then insurance and diversification models fail. There are two striking aspects of the current crisis and its origins. One is that systemic risk built steadily in the system. The second is that this buildup went either unnoticed or was not acted upon. That means that it was not perceived by the majority of participants until it was too late. Financial innovation, intended to redistribute and reduce risk, appears mainly to have hidden it from view. An important challenge going forward is to better understand these dynamics as the analytical underpinning of an early warning system with respect to financial instability."