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Global Financial Crisis

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Bank liquidity risk is the risk of not having sufficient funds to meet payments such as those arising from unexpected changes in customers’ withdrawals or loan draw-downs (Gup, Avram, Beal, Lambert&Kolari, 2007). Liquidity risk can be measured using simple liquidity ratio or dynamic liquidity ratio. “Simple liquidity ratio is calculated by first identifying the bank’s liquid assets and then expressing this as a percentage of its total assets” (Gup et al., 2007, p.356). It only considers asset liquidity, and this measure is only one point in time. However, dynamic approach compares projected liquidity needs with projected available liquidity (from both asset and liability sources) for each time period. “This approach is superior to focusing on one or the other parts of the liquidity problem because it evaluates liquidity relative to bank needs” (Gup et al., 2007, p.356).

APRA is proposing that banks in Australia hold more liquidity in the event of future crisis. The reason for this is “APRA noted that the financial crisis exposed the limitations of existing liquidity reporting rules when markets are under severe stress” (Baltazar, 2009, para.8). APRA (2009) said the financial crisis has highlighted the need for ADIs to have adequate levels of liquidity and robust liquidity risk management systems, and has provided considerable insights into better practice in this area. APRA supports the Basel Committee’s measures and agrees that greater international consistency in prudential regulation, promoted by the Leaders of the G20, will strengthen Australia’s prudential framework.

Securitization is the process of taking an illiquid asset, or group of assets, and through financial engineering, transforming them into a security. It is an important source of liquidity for banks. A typical example of securitization is a mortgage backed security (MBS), which is a type of asset backed security that is secured by a collection of mortgages (“Investopedia,”2010).

The securitization process involves a number of participants. In the first instance is the originator, the firm whose assets are being securitized. The most common process involves an issuer acquiring the assets from the originator. The issuer is usually a company that has been specially set up for the purpose of the securitization and is known as a special purpose vehicle or SPV and is usually domiciled offshore. The creation of an SPV ensures that the underlying asset pool is held separate from the other assets of the originator. This is done so that in the event that the originator is declared bankrupt or insolvent, the assets that have been transferred to the SPV will not be affected(Teasdale,2003).

The process is represented by the flow chart in figure1.1 below, which shows how the securities are sold to investors by the SPV. First, the originator desiring financing identifies an asset that is suitable to use. Loans or receivables are common examples of payment streams that are securitized. Second, a special legal entity or SPV is created and the originator sells the assets to that SPV. Next, to raise funds to purchase these assets the SPV issues asset-backed securities to investors in the capital markets in a private placement or pursuant to a public offering. These securities are structured to provide maximum protection from anticipated losses using credit enhancements like letters of credit, internal credit support or reserve accounts. The securities are also reviewed by credit rating agencies that conduct extensive analyses of bad-debts experiences, cash flow certainties, and rates of default. The agencies then rate the securities and they are ready for sale. Finally, because the underlying assets are streams of future income, a pooling and servicing agreement establishes a servicing agent on behalf of the security holders. The services generally include: mailing monthly statements, collecting payments and remitting them to the investor (Jackson, 2001).

Figure 1.1 Source: Mizuho (2008), ‘Securitization’.

“A collateralized debt obligation (CDO) is a specific type of asset backed security that is created through the securitization of various fixed income products. The basic purpose of this security is to hold assets as collateral and then sell the cash flow from the different tranches to investors. Obviously, the lower the seniority in principal repayment renders a higher yield on investment to compensate for the added risk” (Elisa, 2007, para10). As figure 1.2 shows, CDOs are divided into three different tranches: senior (triple A rated), mezzanine (AA to BB), and equity tranches which are unrated.

Figure 1.2 Source: Barbican consulting (2010), ‘collateralized debt obligations’.

Credit rating agencies, such as Moody’s, Standard & Poor, and Fitch, are paid by financial institutions to provide easy to understand ratings of the risk associated with various debt instruments. Each Agency has its own scale of indicators and own models to determine default risk (Sophie, 2009). Here is the sample scale of ratings: * AAA – extremely safe, very low risk * AA – very strong credit, low risk * A – strong credit * BBB – Good credit * BB – good credit but vulnerable to economic conditions
(Kevin, 2005, p.44).

“The credit rating measures the ability and willingness of a borrower to pay its debt. The more creditworthy a borrower, the higher a CRA will rate it” (Sophie, 2009, P.46).
Subprime borrowers are those who have poor credit histories and are therefore more likely to default. Lenders usually charge higher interest rates to provide more return for the greater risk. CDO allow lenders to bundle loans into a package and resell them. However, as long as the housing market continued to rise, the risk was small (Amadeo, 2009).

Figure1.3 source: Status Ireland (2009), ‘US house price index’.

As can be seen from figure 1.3, from year 2007, there was a gradual decline in the US housing price. As housing prices declined, many homeowners found they could no longer support their lifestyle. Defaults on all kinds of debt started to slowly creep up. Holders of CDO's included not only lenders and hedge funds, but also corporations, pension funds and mutual funds -and the individual investors who owned them(Amadeo, 2009).
As foreclosures are increasing, MBSs and CDOs are crumbling. The CRAs admitted that they failed to adequately assess the credit risks in MBSs and CDOs. This failure occurred for several reasons. First of all, the CRAs held an over-optimistic view of the housing market. Their rating model assumed that housing prices would continue to increase generally. Second, when rating MBSs and CDOs, the CRAs relied heavily on historical statistical data, not on personal information about each borrower. Third, CRAs underestimated the complexity of the MBSs and CDOs (Bahena, 2009).
Moreover, “conflicts of interest led some CRAs to cater to MBS and CDO issuers by inflating ratings” (Bahena, 2009, para.7). In fact, CRAs were supposed to serve investors, however, CRAs have had a close, ongoing working relationship with the largest MBS and CDO issuers, 98% of the ratings produced by the CRAs have been paid for by issuers, the pay incentive led some CRAs to try to inflate ratings of paying issuers in hopes of gaining repeat business from those issuers; and CRAs advised issuers on how to structure MBSs and CDOs to get high ratings. Then CRAs“confirmed” that advice by issuing the “promised” ratings (Bahena, 2009).

The problem is, many investors rely on ratings and do not understand the detailed mechanics of individual CDOs. “ They began to treat ratings as buying recommendations and used credit ratings instead of performing their own due diligence” (Bahena, 2009, para.9). This means the investor may suffer much greater losses than anticipated should there be a credit downturn. “In August 2007 several US hedge funds which had been big investors in CDOs announced substantial losses” (Barbican consulting, 2010, para11). However, if the ratings had been more accurate, fewer investors would have bought into these securities, and the losses may not have been as bad.

“As CRAs downgraded their highest-rated instruments, investors wondered if any investments were safe. This uncertainty caused the credit markets to freeze. Suddenly, few wanted to invest in even the highest-rated instruments for fear they would be downgraded. Many wanted to rid themselves of their current investments. Many market participants no longer trust the ratings that CRAs produce” (Bahena, 2009, para.9). Overall markets lost confidence in their ability to assess credit risk. Consequently, this will lead to financial crisis.

“As a result of the global financial crisis, investors have been reluctant to invest in term wholesale funding without a government guarantee or, more recently, without charging a premium. RMBS and securitization in general have suffered with the market all but shut down” (Fuller, 2010, p.2).
Australia's securitisation market shut down along with those of the US, Europe, Britain and other countries, but not because it shared their fatal flaws. The quality of Australia's RMBS has always been high, backed as most are by AAA-rated mortgages. Australia suffered from what is referred to as brand damage. Because of the collapse of the securitisation market in the US, investors shied away from all asset-backed securities, regardless of their quality (“The Australian”, 2009).

“Issuance of RMBS in Australia dried up as it did around the world, as demand fell away. Investors felt they were already too full of structured products and had no appetite for any more. Spreads in the secondary market widened considerably. Indeed, at times, there was no secondary market, with plenty of sellers but no buyers at any price” (RBA, 2009, para.2).
Offshore structured investment vehicles (SIVs and hedge funds) became distressed sellers. Banks were slow to admit to the extent of their exposure to mortgage-backed securities and related derivatives, which led to a breakdown of trust in the markets. Banks became extremely reluctant to lend to one another, the result was a liquidity crisis (Dalton, 2009).

Figure 1.4 source: RBA (2004, September 21), financial stability review, p.51.

“Since the start of 2000, regional banks, and credit unions and building societies (CUBS) have securitized about one quarter of their gross housing lending, issuing a total of $47 billion of RMBS” (RBA,2004,p.51). As can be seen from Figure 1.4, “ The four major banks have funded a smaller proportion (less than 10 per cent) of their new housing loans through RMBS as they have cheaper ways of funding loans on their balance sheets”(RBA,2004,p.51). For example, it is easier for large banks to use liability liquidity. The reason for this is large Banks have higher credit rating, they can borrow funds cheaper. Smaller ADI have a lower credit rating, therefore they don’t have such quick and easy access to the wholesale funding.

Figure1.5 source: RBA (2009, November 18), ‘Whither securitization’, speeches.

In the case of the smaller regional banks and some building societies and credit unions, securitization was an important means of funding. As is shown in Figure 1.5, despite their smaller size, the regional banks accounted for roughly 40 percent of RMBS issuance whereas the major banks accounted for 20 percent prior to mid 2007(RBA, 2009).

Australian ABS

Figure1.6 source: RBA (2009, November 18), ‘Whither securitization’, speeches.

According to the information given in Figure 1.6, in June 2007, just prior to the global financial crisis, asset-backed securities (ABS) accounted for 30 per cent of the Australian bond market, with around $280 billion of securities on issue. The market had experienced rapid growth of nearly 30 per cent per annum since 2000, considerably faster than most other parts of the bond market (RBA, 2009).

Figure1.7 source: RBA (2007, November 29), ‘open market operations and domestic securities’, Speeches.

Australian RMBS outstanding has grown strongly over the past decade to stand at around $170 billion. As can be seen from Figure 1.7, the share of all housing loans that are securitized has increased to around 20 per cent from less than 5 per cent in the mid 90s. Regional banks securitize a higher share of housing loans (around a third) than the major banks (less than 10 per cent) (RBA, 2007).

Figure1.8 source: RBA (2009, November 18), ‘Whither securitization’, speeches.

“Beginning around the middle of 2007, there was a widespread reappraisal of the risks associated with investing in structured credit products. Securitization started to suffer severe brand damage as primarily US RMBS incurred significant credit problems as delinquency rates began to rise. Initially, the problems were most evident in the sub-prime mortgage market, but as figure 1.8 shows, delinquency rates have risen to historically high levels on prime mortgages too. Combined with the decline in house prices, these delinquency rates have translated into sizeable losses for investors in US RMBS” (RBA, 2009).

As a result of global financial crisis, developments in global financial markets reduced liquidity in the Australian RMBS market and constrained the ability of lenders to access funding from the source. Securitization market froze in mid 2008(Australian Office of Financial Management, 2009). This proved to be bad news for smaller Australian banks, NBFIs and even subsidiaries of international banks. They had lost their major source of funding. Many mortgage brokers and NBFIs have vanished, international banks have sold up and moved on, regional banks have merged such as St George Bank and RAMS acquired by Westpac and smaller banks such as St George and Bank West have been swallowed. The major banks in Australia have also suffered as a result of the GFC. But given their market capitalization, their capacity to raise fresh capital, their capacity to increase their already substantial deposit bases and their ability to exploit an AA rating to attract offshore funding, the Big Four have survived. And because their competition relied so heavily on securitization, the death of securitization has not been so much as a setback; instead, Australian major banks have become stronger since the global financial crisis (Peel, 2009).

Figure 1.9 source: RBA (2010, February 16), ‘The evolving financial situation’, Speeches.

As can be seen from Figure 1.9, securitization markets have begun to show some signs of life from the end of 2009. “There have been sizeable RMBS issues by ME Bank, Bendigo and Adelaide, Westpac and most recently AMP and Bank of Queensland” (RBA, 2010).

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