The Credit Crisis: Correction or Catastrophe?

Financial institutionsmust get a grip on their potential exposures.

by Thomas Garside

The current market situation has been called a perfect storm in which credit losses and tighter liquidity feed on each other, creating a cycle of fire sales, which depress prices, which further increase downward pressure. Add to this a possible geo-political shock or global economic downturn and you have the makings of a systemic crisis. Other analysts still view recent events as a correction that brings a much needed re-pricing of risk in a diversified, well-capitalized industry that is able to weather the storm.

“Diversification through distribution” has been a key driver of financial services growth over the past decade. The flipside of diversification is that more players share the pain should it occur. The question now is the degree to which the repackaging and distribution of risk has increased moral hazard and conflict of interest, and by how much it has over-inflated the credit bubble and delayed its bursting. Has the benefit of diversification been outweighed by the size of the problem that now exist?

Since the start of the crisis last summer, some players have managed not just to survive, but to thrive, which points to some important lessons for management. Specifically, executives will need a much tighter grasp of their credit and liquidity exposures and be prepared to respond quickly to any worsening in the environment.

How Low Will It Go?

Bottom-up estimates of losses from the $1.3 –1.4 trillion outstanding of sub-prime mortgages are in the range of $200-300 billion, although these estimates are contingent on the evolution of U.S. house prices, which are now in a period of rapid and perhaps unprecedented decline, and market prices for sub-prime-linked securities imply higher losses in the realm of up to $400 billion. Couple this uncertainty over magnitude with the uncertainty of who is holding sub-prime risk and the drivers of the liquidity crunch are all too apparent.

To understand the impact of the crisis on the industry, we need to look at two issues:

Balance Sheet Holes

Without trying to call the cycle, banks need to consider how the current U.S. sub-prime crisis will spill over into the broader international economy, and the effect that this would have on their earnings, balance sheet, and solvency, as well as longer-term decisions on future business model, risk appetite, and strategy.

U.S. sub-prime losses are concentrated in mortgages originated since mid-2005 (Exhibit 1). The difference in performance across vintages is striking, and illustrates the degree to which house prices drive default rates.

Signals from the U.S. residential market indicate that this cycle will be severe, and other classes of property are now showing signs of strain. To illustrate the highly geared position that investors can hold against property prices, Exhibits 2 and 3 show the performance of an indicative series of residential mortgage-backed securities (RMBs) under different U.S. house price scenarios.

What’s striking is how quickly the value of junior tranches of such a repackaged collateralized debt obligation (CDO) security can change as increased leverage is embedded into the structure, and how initially reasonable diversification assumptions break down in a stress scenario. This highlights the need for more sophisticated analysis and risk management methods than a single alphanumeric rating can provide. It also suggests that under more pessimistic scenarios, total sub-prime losses could reach or exceed current market-implied losses.

So what is the potential for the sub-prime crisis to widen, with transmission into other markets? In previous crises, such as the Asian banking crisis (1998/9), Russian default (1998) and the dot-com crash (2000), OECD markets recovered quickly without significant spillover into the real economy. Moreover, the current loss forecasts for sub-prime are still small on a relative basis compared to, say, Japan in the 1990s. Sub-prime in the U.S. alone is therefore unlikely to lead to long-lasting stress, although it will clearly cause significant short-term earnings pain. The more worrying scenario is that sub-prime does the softening up, eroding capital surpluses and market confidence, before other asset classes then cause additional damage.

Besides inherently unpredictable macro or political events, the most obvious transmission mechanisms are unsecured personal lending, and retail and commercial real estate. Each is showing signs of stress on both sides of the Atlantic, with recent falls in retail and commercial property values—and associated redemption restrictions on commercial property funds—and rising default rates in some personal loan and credit card portfolios. This is amplified by the weakening of bank capital levels and a tightening of commercial credit, driving a more recessionary environment with higher levels of commercial defaults.

Bounding Scenarios

What then are a range of credible scenarios that should be considered by, for example, a European financial institution in order to provide comfort that losses can be managed? Looking at a set of typical peak-to-trough loss ratios for a set of consumer and corporate asset classes (Exhibit 4), and playing them at varying degrees of severity against the aggregate European banking system, allows us to gauge the degree of potential severity in terms of the impact on earnings and capitalization.

To see how combined events would affect a typical European bank, we consider three scenarios, measured against a base case which already includes a write-down of €1.1 billion. The analysis shows that pre-tax profit could drop from the base case of €5.9 billion to €5.4 billion (with a housing bubble burst); €4.2 billion (with a personal credit downturn); or €2.9 billion (after a spillover to corporate defaults).

This analysis squares with other commentators who forecast significant earnings and balance sheet capacity issues, but do not anticipate anything that seriously compromises the solvency of a well-run institution. Of course, investors are currently in an unforgiving mood, and the leverage effect that accumulating losses have on market capitalization, cost of funds, and management tenure can be dramatic. Management must therefore ensure that the current business portfolio is consistent with investor risk appetite, and that they can identify and mitigate out-of-bounds positions should they emerge.

Liquidity Holes

Even when the credit markets stabilize, a return to the days of easy access to traditional or more exotic funding is unlikely. There are two questions with respect to liquidity:

The first question is why did some institutions run into trouble while seemingly similar firms have avoided funding problems?

To illustrate different funding strategies, we have evaluated institutions based on two criteria: the percentage of wholesale funding used and the availability of liquidity, through the level of short-term debt securities used. The analysis shows that two types of bank failures emerge: those institutions whose business model simply could not withstand the current market conditions (such as American Home Corporation); and larger institutions whose failure stemmed largely from shortcomings in risk management and communication (Northern Rock in the U.K.).

The second key question for executives is how do you mobilize to deal with future events? In this regard, banks need to review four aspects of liquidity management:

* * *

The impact from the sub-prime crisis alone will likely be bad but not catastrophic. However, the possible deterioration in a wider set of asset classes, potentially amplified by a geo-political event or general economic downturn, could make the situation much worse.

Therefore, the leaders of financial institutions must get a firm grip on their potential exposures. There are a range of reasonable scenarios in which market conditions turn out to be a correction from which many players emerge without significant damage. But there is now a material risk of further bad news worsening the outlook considerably, and management should have contingency plans for potential downside scenarios. Some firms will thrive, while others will not survive. Prompt action now will give a firm the best
chance of being on the right side of this divide.