Subprime Crisis Background Information - Effect On Corporations and Investors

Effect On Corporations and Investors

Average investors and corporations face a variety of risks due to the inability of mortgage holders to pay. These vary by legal entity. Some general exposures by entity type include:

• Commercial / Depository bank corporations: The earnings reported by major banks are adversely affected by defaults on various asset types, including loans made for mortgages, credit cards, and auto loans. Companies value these assets (receivables) based on estimates of collections. Companies record expenses in the current period to adjust this valuation, increasing their bad debt reserves and reducing earnings. Rapid or unexpected changes in asset valuation can lead to volatility in earnings and stock prices. The ability of lenders to predict future collections is a complex task subject to a multitude of variables. Additionally, a bank's mortgage losses may cause it to reduce lending or seek additional funds from the capital markets, if necessary to maintain compliance with capital reserve regulatory requirements. Many banks also bought mortgage-backed securities and suffered losses on these investments.

• Investment banks, mortgage lenders, and real estate investment trusts: These entities face similar risks to banks, yet do not have the stability provided by customer bank deposits. They have business models with significant reliance on the ability to regularly secure new financing through CDO or commercial paper issuance, borrowing short-term at lower interest rates and lending longer-term at higher interest rates (i.e., profiting from the interest rate "spread.") Such firms generated more profits the more leveraged they became (i.e., the more they borrowed and lent) as housing values increased. For example, investment banks were leveraged around 30 times equity, while commercial banks have regulatory leverage caps around 15 times equity. In other words, for each $1 provided by investors, investment banks would borrow and lend $30. However, due to the decline in home values, the mortgage-backed assets many purchased with borrowed funds declined in value. Further, short-term financing became more expensive or unavailable. Such firms are at increased risk of significant reductions in book value owing to asset sales at unfavorable prices and many have filed bankruptcy or been taken over.

• Insurance companies: Corporations such as AIG provide insurance products called credit default swaps, which are intended to protect against credit defaults, in exchange for a premium or fee. They are required to post a certain amount of collateral (e.g., cash or other liquid assets) to be in a position to provide payments in the event of defaults. The amount of capital is based on the credit rating of the insurer. Due to uncertainty regarding the financial position of the insurance company and potential risk of default events, credit agencies may downgrade the insurer, which requires an immediate increase in the amount of collateral posted. This risk-downgrade-post cycle can be circular and destructive across multiple firms and was a factor in the AIG bailout. Further, many major banks insured their mortgage-backed assets with AIG. Had AIG been allowed to go bankrupt and not pay these banks what it owed them, these institutions could have failed, causing risk to the entire financial system. Since September 2008, the U.S. government has since stepped in with $150 billion in financial support for AIG, much of which flows through AIG to the banks.

• Special purpose entities (SPE): These are legal entities often created as part of the securitization process, to essentially remove certain assets and liabilities from bank balance sheets, theoretically insulating the parent company from credit risk. Like corporations, SPE are required to revalue their mortgage assets based on estimates of collection of mortgage payments. If this valuation falls below a certain level, or if cash flow falls below contractual levels, investors may have immediate rights to the mortgage asset collateral. This can also cause the rapid sale of assets at unfavorable prices. Other SPE called structured investment vehicles (SIV) issue commercial paper and use the proceeds to purchase securitized assets such as CDO. These entities have been affected by mortgage asset devaluation. Several major SIV are associated with large banks. SIV legal structures allowed financial institutions to remove large amounts of debt from their balance sheets, enabling them to use higher levels of leverage and increasing profitability during the boom period. As the value of the SIV assets was reduced, the banks were forced to bring the debt back onto their books, causing an immediate need for capital (to achieve regulatory minimums) thereby aggravating liquidity challenges in the banking system. Some argue this shifting of assets off-balance sheet reduces financial statement transparency; SPE came under scrutiny as part of the Enron debacle, as well. Financing through off-balance sheet structures is thinly regulated. SIV and similar structures are sometimes referred to as the shadow banking system.

• Investors: Stocks or bonds of the entities above are affected by the lower earnings and uncertainty regarding the valuation of mortgage assets and related payment collection. Many investors and corporations purchased MBS or CDO as investments and incurred related losses.