The Global Risk of Subprime

8/3/2019 The Global Risk of Subprime

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The Global Risk

of Subprime Remarks by Christopher Whalen to

The Global Interdependence Center

FRB Philadelphia January 30, 2008

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·

. .

• . , re a ng o, or nvo v ng e en re ear ;worldwide:

• 3. Comprehensive; total:



• The s b rime crisis is bo t the coll se of the

unregulated, $3 trillion over-the-counter marketfor complex structured assets, some of whichhappen to contain subprime residential mortgages.

• The subprime structured asset crisis of 2007represents a sharp reversal in how global investors

structures, such as collateralized debt obligationsor CDOs.



“ ”.

quality of the mortgage loans behind a given bond issueand more about how banks ackage loans and other

assets using complex derivative structures, ratings from

Moody’s and S&P, and private mortgage insurance.• More than a simple financial disruption, the subprime

crisis is a “slow motion” systemic event which holds

economy, the business models of entire industries and

financial institutions, and for consumers.



• Economists lon ar ued that securitized assets

such as those developed by the GSEs to liquefythe market for residential mortgages would be

bank assets.

• As the securitization market rew be ond the USmarket for GSE paper, the intermediary role of the commercial banking industry was expected to

more effort on acting as agent and sponsor forthese perfectly transparent and liquid vehicles.



•

created classes of assets that neither the academiccommunit nor re ulators antici ated. Re ulators

and the US Congress enabled this outcome.

•

OTC interest rate swaps, which are standardized

and thus uite li uid, CDOs and other OTC

derivatives blossomed into dozens of hideously

complex and opaque permutations.



• In l ce of the im licit r ntee of the

Treasury with GSE paper, Wall Street substituteda paid rating from Moody’s or S&P and aguarantee from thinly capitalized municipal bond

insurers or even hedge funds.• esu s an enormous mar e compr se o

unregistered securities which appear to be

has virtually no support from dealers or investors;and for which banks retain de facto liability.



•

was securitized as of Q3 2007, although the “fairvalue” of these securities is now si nificantl less

since markets seized up last year.

• At the end of Q3 2007, there was $7 trillion in

.

asset backed securities in the US supported by

ust 6.7 trillion in total bank de osits SIFMA .



•

by the sharp reduction in credit availability forreal estate and commercial needs resultin from

the systemic effect of the subprime crisis.

• Access to credit for small and medium sized

trillion market for non-GSE securitizations is

forced to shrink involuntaril .



• The colla se in investor confidence in man t es

of structured assets and financial institutions hasled to a generalized retreat in global markets.,

suffered huge financial and operational losses.

• Sarbanes-Oxley and Fair Value accounting areforcing global banks and investors to write-down

,feeding crisis atmosphere. Year-end reporting formany public companies could be problematic.



• Immediate: Sub rime crisis has torn a a in hole

in bank business models, eliminating volume andrepeating income which was crucial for some

all banks.

• Long-term: The clock has been wound back decades in terms of bank ALM. Loan origination

option, meaning that banks will have limitedcapacity to extend credit.



•

assembly line, consumers have lost access tohome e uit . New credit is likel to be scarce as

banks raise internal target default rates.

• -implies a permanent reduction in availability of

credit to the lobal econom as banks are forced

to refinance much of the $3 trillion in non-GSEissuance.



• The le ders of the olitic l nd fin nci l

communities in the industrial nations mustquickly begin to discuss the global legal andregulatory changes required to bring bank capital

requirements and risk taking in areas such as .

• The US market desperately needs leadership on

concerns to repairing the overall market forprivate securitizations.



•

transparent, more uniform and thus moreli uid. SEC re istration and reater disclosureof collateral performance may be required to

restore confidence.• No reason why CDOs cannot be as liquid as

GSE paper, given basic reforms in how these

structures are create y ea ers rms anmonitored by ratings agencies.



• The role of the r tin s encies in cre tin

monitoring securitizations must be reformed,perhaps including direct SEC/NASD oversight forissuer-paid ratings activities.

•

If a ratings professional acts like an investmentan er an s pa y e ssuer, en ey s oube regulated as investment bankers.

“ ” securitization deals and provide updates toinvestors in real time.



• Global re ulators need to throw Basel II into the

regulatory dustbin and purge the “risk based”mentality from regulatory vocabulary. Basel II is

dominates bank risk analytics and lies at the heart

of the subprime crisis.

• US regulatory framework must replace derivative

,approach to bank safety and soundness whichrecognizes both direct and contingent risks.



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371 Van Ness Way, Suite 110

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R. Christopher Whalen

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Tel. 914.827.9272. . .

Fax. 310.943.1570

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The Global Risk of Subprime