Financial Stability Review – September 2007
The Global Financial Environment
Over the past few months there has been an abrupt reversal of the favourable credit conditions that had existed in global markets for some years. Spreads have widened on a broad range of debt securities, volatility in financial markets has increased and funding conditions for financial institutions have tightened considerably. These adjustments come after a number of years in which there were widely held concerns that risk was being underpriced, that many financial assets were being valued on the assumption that benign conditions would continue indefinitely, and that many investments had more ‘embedded’ leverage, and were more risky, than widely appreciated.
Many of the movements in the prices of financial assets over the past month or so can be viewed as part of a global repricing of risk, partly due to increased risk aversion by investors, rather than as a response to a fundamental reassessment of the outlook for the global economy. Investors now require more compensation for accepting a given risk, and also perceive there to be more downside risk in structured credit products, than they did just a short time ago. The premium placed on liquidity has also increased significantly. Notwithstanding this, the core financial institutions in the major economies remain sound.
A distinguishing feature of recent developments has been a sharp increase in uncertainty. In part, this reflects considerable opacity about where, and when, the full scale of credit losses on US sub-prime housing loans will show up. Adding to the uncertainty is the fact that many of the newer structured products are difficult to understand and have never really been tested in an adverse environment. The complexity of these products has also meant that transactional liquidity is often extremely limited, complicating the task of accurately valuing these products and adding to volatility. Financial institutions have also been uncertain regarding their future funding requirements. In this environment, the process of returning to more settled market conditions would be aided considerably by greater transparency by institutions and investment funds regarding the scale of any losses arising from the sub-prime problems and the consequent global repricing of risk.
Problems in the US Sub-prime Mortgage Market
The catalyst for the recent adjustments was the worsening problems in the US sub-prime mortgage market. As discussed in the previous Review, there has been a marked increase in the delinquency rate on sub-prime mortgages, particularly those with adjustable interest rates, since the middle of 2005. According to data from the Mortgage Bankers Association, the 30-day arrears rate on US sub-prime adjustable-rate mortgages was around 17 per cent in June, up from 10 per cent in mid 2005 (Graph 1). While this rate is only slightly above the previous peak in 2002, the sub-prime market is now much larger, accounting for around one fifth of all mortgage originations in 2006 and about 15 per cent of the stock of outstanding loans, compared with around 8 per cent of outstandings in 2002. A further deterioration in the arrears rate is widely expected over coming months, with loans made in 2006 experiencing a significantly worse repayment record than loans made in earlier years (Graph 2). Furthermore, the interest rate on many of these loans will increase as the introductory discounts expire; estimates suggest that loans with a total value of about US$450 billion – equivalent to around 30 per cent of the stock of outstanding sub-prime loans – will have their interest rates reset in 2007/08.
The rise in sub-prime delinquencies reflects a number of factors, including lax underwriting standards – particularly for loans originated in 2005 and 2006 – and falling house prices. In recent years, there was very strong competition in the sub-prime mortgage market, supported by low funding costs and strong demand by investors for residential mortgage-backed securities (RMBS); of the estimated US$2 trillion of RMBS issued in 2006, around a quarter were backed by sub-prime mortgages. One result of this competition was a significant weakening of credit standards, with many lenders being prepared to lend to borrowers with very high risk profiles. As mortgage interest rates rose over recent years from their previous very low levels, and house prices fell or showed limited appreciation, many of these borrowers have had difficulty meeting their debt obligations.
Since the problems in the sub-prime market first appeared, a large number of mortgage originators in the United States have closed. While all originators of sub-prime loans have experienced much tighter funding conditions, some have also been required by contractual obligations to buy back underperforming loans. The total potential losses on sub-prime mortgages remain difficult to determine, although some estimates exceed US$100 billion (compared with total outstanding mortgage debt in the United States of around US$10 trillion).
Reflecting the uncertainties around the credit quality of sub-prime debt, there have been sharp falls in the prices of indices of credit default swaps on sub-prime RMBS. For tranches of sub-prime RMBS rated BBB-, the index has fallen to around 40 per cent of par value since the beginning of the year (Graph 3). For AA-rated tranches, the index fell significantly in July this year, though much of this fall has since been reversed.
Contagion to Other Markets
When the problems in the sub-prime market first emerged earlier this year the spillover to other markets was relatively limited. While the spreads on RMBS widened noticeably and the prices of collateralised debt obligations (CDOs) with exposure to these securities fell significantly, the effects on credit and other financial markets were relatively limited.
Broader contagion then became apparent in mid to late June, around the time that Bear Stearns, a large US investment bank, announced significant losses in two of its hedge funds that had invested in sub-prime related debt. A number of other funds, including some in Australia, also announced losses around the same time, freezing redemptions. Some of these funds were using securities backed by sub-prime mortgages as collateral for further borrowing, which meant that as the value of the securities fell, the funds were required to provide additional collateral or repay the loans. This put further downward pressure on the prices of these securities and heightened concerns about the potential damage that could result from a widespread firesale of these securities. These concerns were compounded as investors in a number of hedge funds requested redemptions, placing further strains on liquidity and security prices. Also, in mid July, the credit rating agencies downgraded a large number of mainly speculative-grade sub-prime RMBS and related CDOs, after assumptions about delinquency levels in their modelling were revised.
Then in early August, BNP Paribas, a large French bank, announced that it was suspending withdrawals from its funds that had invested in US sub-prime related debt, on the grounds that it was increasingly difficult to value the underlying exposures. This announcement, which came on the back of growing concerns about the exposures to sub-prime related debt of some state-owned German banks through their so-called credit arbitrage funds, unsettled investors. In particular, it reinforced concerns over the size of the eventual losses on sub-prime mortgages and which institutions would bear those losses. In turn, this led to a sharp tightening of funding conditions for banks around the globe. It also reinforced investors’ reluctance to purchase mortgage-related securities, particularly given the uncertainty regarding the future performance of the underlying loans and where credit spreads will settle once the current turbulence recedes.
Funding conditions have been most difficult in the asset-backed commercial paper (ABCP) market, which provides securitised short-term funding for vehicles holding a variety of financial assets (see Box A at the end of The Australian Financial System chapter). These vehicles, or ‘conduits’, allow financial institutions and other lenders to finance loans and other assets off their balance sheets, offering advantages in terms of both regulatory capital and funding costs. These vehicles are typically sponsored by major banks which provide back-up lines of credit and, in some cases, credit enhancement. Over recent years, they have found strong demand for their paper and, as a result, the amount of ABCP issued in the United States had almost doubled over the past couple of years, to about US$1.2 trillion, representing about one half of all US commercial paper on issue and about one quarter of the size of the US Treasuries market.
The problems in the sub-prime mortgage market originally saw investors become very reluctant to roll over any commercial paper that was backed by sub-prime mortgages, but this reluctance then spread to a much wider variety of commercial paper, particularly in Europe, where market participants described the market as essentially closed in mid to late August. This experience has reconfirmed that credit markets can have difficulty clearing by adjusting prices in times of increased uncertainty. The uncertainty, and in particular, the difficulty of determining the health of those seeking funds, means that investors may view an institution that is prepared to pay a high interest rate with suspicion. As a result, credit becomes rationed by quantity rather than price.
While conditions have also been very tight in the US ABCP market, borrowers with strong reputations have still been able to place paper, albeit at much shorter maturities and at significantly higher spreads than was the case just a few months earlier. Reflecting these difficult conditions, the value of ABCP outstanding in the United States has fallen by around 20 per cent since the start of August (Graph 4).
With ABCP vehicles having difficulty rolling over paper, many of these vehicles have had to rely on the back-up lines of credit provided by banks. In addition to having to extend funding to conduits, banks have faced uncertainty over the extent to which other lines of credit will be called upon in the months ahead. In response, banks have taken a cautious approach to their liquidity.
Reflecting this, in early August, overnight interest rates in a number of countries moved noticeably above the level targeted by central banks. For example, on 9 August in the United States, the actual Fed funds rate rose about ¾ of a percentage point above the targeted rate (Graph 5). In Europe, the equivalent rate rose about 60 basis points above its target on the same day. Recognising that these developments had the potential to develop into a more damaging ‘credit crunch’ if they persisted, most central banks responded by injecting substantial cash balances into their banking systems in order to ease the strains on liquidity in the inter-bank market. Some also extended the range of collateral they accept, and the US Federal Reserve cut the penalty rate on loans from its discount window from 100 basis points to 50 basis points, and extended the maximum term of such loans to 30 days. More recently, the Federal Reserve lowered the target for the Fed funds rate by 50 basis points, citing the adverse effects on the broader economy that might arise from the disruptions in financial markets.
While the actions of central banks have proved successful in alleviating the upward pressure on overnight interest rates, the pressures have remained in inter-bank markets for slightly longer maturities. Spreads between three-month interest rates in the London inter-bank market and overnight indexed swap rates – which reflect the expected cost over the equivalent period of rolling inter-bank loans one day at a time – rose sharply in August (Graph 6). While these spreads have declined over the past week or so, they remain much higher than in recent years. These higher spreads have significantly increased the cost of funding for many banks around the world. They not only reflect the global repricing of credit risk, but also the increased premium that investors (including banks) require for holding assets other than those with very short terms, given the ongoing uncertainty about future funding demands.
The combination of strong risk aversion and desire for liquid assets that characterised markets in August saw a sharp increase in the demand for short-term government securities, particularly in the United States. Reflecting this, the yield on three-month US Treasury bills fell by about 130 basis points around mid August, to 3.3 per cent, although it has subsequently reversed some of this decline (Graph 5). Longer-term government bond yields in most major markets also fell in August and September, reversing most, if not all, of the increases seen earlier in the year, though they remain above the levels of a few years ago (Graph 7).
The pressures in the banking system were also evident in credit default swap premia on bank debt, which rose sharply in the United States and Europe in early August and have remained elevated in the period since (Graph 8). Similarly, share prices of financial institutions in many countries have fallen relative to the broader equity markets over the past few months, partly reflecting concerns about sub-prime exposures and the impact of higher funding costs (Graph 9). The share prices of investment banks and financial institutions that rely more heavily on wholesale markets for their funding have been particularly affected.
Though the recent widening of credit spreads has been most notable on bank and mortgage-related paper, the increase in risk aversion has also translated into higher credit risk premia on a wide range of other debt securities. In the United States, corporate bond spreads have widened across all credit grades and are now around their highest levels in several years (Graph 10). They are, however, still below the peaks reached in 2002, and the level of corporate bond yields has actually fallen given the lower yields on government securities. Spreads on emerging market sovereign bonds have also widened over the past two months, although to a lesser extent than those on lower-rated corporate bonds in the United States.
A notable aspect of the reduced investor appetite for corporate debt has been the cancellation or postponement of a number of leveraged buyout (LBO) debt issues. In mid July, banks were forced to postpone debt sales for two of the biggest LBOs in the market – US$12 billion of loans for Chrysler and US$10 billion of senior loans for the buyout of Alliance Boots, the UK retailer. In a number of cases, the funding for LBOs has had to remain on the balance sheets of the banks providing the bridging finance. Estimates of the value of loans for LBOs that remain unsold in the United States range from US$230 billion to around US$350 billion. Where LBO deals are proceeding, banks and other debt investors are beginning to impose stricter terms and conditions on the debt packages. Lenders are, for example, less willing to provide ‘covenant-lite’ loans than in the past.
In addition to debt markets, a number of other markets have exhibited increased volatility (Graph 11). Stock markets across the globe fell in August, reversing much of the rise in the first half of the year, though many of them have since recovered significantly (Graph 12). In foreign exchange markets, higher-yielding currencies, including the Australian dollar, depreciated sharply in August as investors unwound carry trades, while the Japanese yen appreciated strongly. Many of the affected currencies have, however, since reversed a large part of these movements.
Notwithstanding the recent strains in bank funding and financial markets, the core financial institutions in major economies remain in good shape. For the most part, banks are well capitalised, have relatively low levels of problem loans, and their returns on equity have been high for a number of years (Graph 13). Nevertheless, in Germany – where bank profitability has tended to be relatively low – a number of smaller banks have had quite large exposures to sub-prime loans via their conduits, and rescue packages have been put together for a couple of troubled institutions. More recently, the Bank of England provided emergency liquidity assistance to a British bank that was experiencing difficulties related to its relatively heavy reliance on wholesale funding markets.
The strong overall performance of financial institutions in recent years reflects the favourable global macroeconomic performance which, in turn, provides some grounds for optimism that the effects of the recent financial market stresses will be contained. The world economy has expanded at an above-average pace over the past four years, with Consensus forecasts as at early September pointing towards continued above-trend growth of a little over 5 per cent in both 2007 and 2008, broadly the same as the forecasts made a month earlier (Graph 14). World growth is also expected to be more broadly based, with growth forecasts for the euro area and China revised up since earlier in the year, offsetting a slightly weaker forecast for the United States.
As noted above, these developments follow a long period during which risk was widely considered to be underpriced, with this underpricing discussed extensively in previous Reviews. As such, the effects of the current repricing are reverberating through a global financial system in which, for a number of years, investors were prepared to purchase assets at high prices, and often with considerable leverage. These recent adjustments have refocused attention on a number of long-standing issues.
The first of these is the importance of liquidity for the smooth operation of financial markets. Over recent years, many commentators have taken comfort from the idea that the stability of the global financial system had been enhanced by the wide dispersion of credit risk as the result of the growth of securitisation and other credit risk transfer markets. Recent events have, however, highlighted the fact that a sudden tightening in liquidity can amplify financial disturbances, even when credit risk is widely dispersed. In effect, the very markets that have allowed this dispersion of credit risk to take place have increased funding or liquidity risk, and made that risk more concentrated. Contrary to some commentators’ expectations, the growth of financial markets has further increased the importance of banks for the smooth functioning of the financial system, since it is banks that provide funding liquidity to markets.
A second issue is the extent to which credit risk transfer markets have allowed the banking system to truly shed credit risk. A number of banks have provided securitisation vehicles with large back-up lines of credit, which means that when paper cannot be sold, the underlying credit risk is taken back on to the balance sheets of banks. In addition, some banks that had developed sub-prime backed securities also provided financing to investment funds to purchase those securities, which the banks then held as collateral. Although repurchase agreements are often overcollateralised, the fall in the value of the securities produced a gap between the value of the collateral and the debt owed by the funds to the banks. Without sufficient collateral, the risk transfer from banks is therefore not complete, and the banks have simply replaced their existing exposures to borrowers with counterparty risk to investment funds. Similarly, some banks have operated investment funds that invested in the credit risk transfer markets and have decided to protect investors in these funds from the full losses – even though there was no legal liability to do so – given concerns that investor losses could damage the bank’s reputation. While in some circumstances there may be a strong business case to act in this way, the extension of such support means that banks remain exposed to credit risks even when those risks are not held on the balance sheet.
A third issue is the difficulties posed by the growth of trading in instruments that are difficult for investors to understand and where price transparency is poor. The risk characteristics and pricing dynamics of many new financial instruments are highly complex and not fully understood by all investors. In the benign environment of recent years, this did not seem to cause particular concerns, with investors relying on the assessments of the credit rating agencies and the advice of reputable institutions marketing these instruments. However, in the current environment, this complexity and lack of pricing transparency has served to greatly increase uncertainty, amplifying the effects of the initial problems in the sub-prime loan market.
A fourth issue is that the ‘originate and distribute’ model may have served to increase risk in the financial system. If the institution originating a loan does not ultimately bear the credit risk associated with the loan, its incentives to assess and monitor the credit worthiness of the end borrower may be weakened. In addition, the ability to sell credit risk to other investors may have allowed lenders to make more loans than might otherwise have been the case. As a result, some commentators have questioned whether some aspects of the securitisation model need revisiting.
Each of these issues is likely to be the subject of considerable discussion both by the regulatory community and market participants in the period ahead.