Ten Lessons from the Crisis

The financial crisis of 2007 and 2008 took a terrible toll on banks. Global losses on loans and securities were estimated by the International Monetary Fund to be as high as $4.1 trillion at the bottom of the recession in early 2009. In the United States, many banks failed or had to be rescued with hundreds of billions in emergency capital injections from the federal government. Here in 2011, three years after the crisis, bankers are still dealing with the aftershocks as financial institutions struggle to restore both revenues and customer trust to pre-crisis levels.

Can it happen again? That’s hard to say because any future crisis is unlikely to be caused by the same set of conditions that set off the 2007-2008 crash. But we can still look back at what happened back then and try to extract some lessons to prevent anything similar occurring today.

After a year spent researching the topic, here are the lessons that I think are most relevant to bankers today:

1. Be Prepared for Unexpected Shocks. The chief revelation from the crisis is that enormous systemic risks can arise and remain hidden for years before they are unleashed at a moment’s notice with grave consequences.

Banks need to include in their risk assessment processes full consideration for the reality that the international financial system has significant and apparently increasing susceptibility to asset bubbles, panics and crises. Contingency plans should be developed to respond to a full range of potential catastrophic financial or economic scenarios.

A mountain of bad mortgage debt had accumulated by 2008 that turned out to be far larger and generate far weaker credits than anyone anticipated. According to a forensic study by Edward Pinto, the former chief risk officer at Fannie Mae, the two government sponsored enterprises (GSEs) – Fannie Mae and Freddie Mac – had purchased $1.8 trillion of risky subprime, low documentation and very high loan-to-value mortgages, quantities far in excess of anyone’s calculations. Officially, however, the GSEs denied having any significant quantity of risky loans, right up until the moment they had to be placed into conservatorship.

While the markets were aware of another $1.9 trillion in private label mortgage-backed securities backed by non-prime loans, it was not known that the credit quality of newly originated loans had severely deteriorated in 2006 to the point where many subprime borrowers were unable to make even the first payment.

2. Be Thorough with Stress Tests. Banks and other market participants failed to stress test mortgage assets for a national decline in housing values equivalent to the 26% decline that occurred between 1928 and 1933. Failing to do this, banks were not fully aware how some seemingly benign assets could turn toxic. Further, include stress tests for the layering of risks. There was little or no historic record for the loan performance of large numbers of interest-only mortgages made with no down payments and with little or no documentation. Some bank models viewed these as mostly singular risk loans and failed to incorporate in the modeling the lop-sided potential downside that comes with such layering of risks. Regulators such as Fed Governor Susan Bies warned of these risks in early 2007, too late for most banks.

3. Credit Protection May Evaporate When You Need It Most. There were vast unknown exposures to credit default swaps in the $62 trillion unregulated market for credit derivatives in 2007. Credit default swaps are derivative transactions where one side sells credit protection against losses and the counterparty in the deal buys credit protection and pays premiums for it. Investors, regulators, banks and counterparties were not sure who owned bad mortgage assets, how much they owned, who had purchased credit protection for those bonds via credit default swaps, who sold that protection to another party, or whether the institutions that provided credit protection could meet their obligations. Be prepared for such protection to vanish or be severely limited in a crisis.

4. Be Wary of Outsized Short-Term Profits. Banks should have a heavy dose of skepticism about the initial outsized claims regarding the profitability of a new line of business. When banks and other financial institutions began to gear up the business for collateralized debt obligations (CDOs) by resorting to more and more subprime mortgage debt, beginning in 2003, it appeared to be very profitable. A CDO is the securitization of a range of assets from corporate loans to asset-backed securities, including mortgage-backed securities.

The CDO business based on subprime mortgage bonds grew to $700 billion, according to the Financial Crisis Inquiry Commission. It was, however, built on an improbable premise: that the lower-rated credit tranches of subprime mortgage-backed securities could be repackaged into AAA-rated CDO bonds.

While there were big profits in putting together CDO deals for the deal arrangers and the mortgage trading desks, banks were not always able to measure potential offsetting losses. Over time, banks were holding more and more of the pieces of deals they could not unload to investors. Banks took lower-rated tranches they could not sell, rolled them into new deals and kept most of the pieces, thinking their very high credit ratings protected them from losses. Not so.

JPMorgan Chase & Co., for one, looked at the totality of its CDO business, including the difficulties associated with selling some of the pieces or tranches of the deals, as reported by Gillian Tett in Fool’s Gold. The bank found that the CDO business tied to subprime bonds was not profitable and got out in time to avoid the level of losses others sustained.

5. Monitor Concentrations of Risk. The whole idea behind the securitization of loans was to take illiquid loans, make them into tradable bonds and transfer the credit risk off bank balance sheets and spread it around. The securitization of mortgages, which grew to more than $2 trillion in new issuances in 2005 and 2006, initially succeeded in transferring credit risk.

When it became hard to sell some of the assets from securitizations, they began to accumulate on the balance sheets of banks, concentrating risks rather than spreading them. When it became hard to buy protection against the risks, some banks went without it. Thus, the product of a transaction designed to improve liquidity became very illiquid and uninsurable. The frog that turned into a prince turned back into a frog.

6. Off-Balance Sheet Risks Can Return Home. Another lesson for banks is that moving assets off balance sheet does not mean they will never come back onto the balance sheet. This is partly due to the vulnerabilities inherent in the shadow banking system, which relies heavily on what turned out to be unsteady overnight funding.

Citigroup, for example, moved $25 billion in mortgage assets from its CDO business to structured investment vehicles or SIVs. These SIVs, however, were dependent on financing from asset-backed commercial paper. When the asset-backed commercial paper market collapsed in 2007 because investors wanted no part of it for fear the paper was backed by bad mortgage assets, Citicorp was forced to assume the financing for the SIVs and, thus, put those bad assets back on its balance sheet, where they had to be heavily marked down, requiring the bank to report huge losses.

7. Monitor Regulatory Arbitrage. A change in risk-weighted capital rules lowered capital requirements for mortgage-backed securities from 4% to 1.6%. This made it more attractive to hold mortgage-backed securities. By contrast, banks have to hold 4% capital against mortgage loans. Just because regulators may have inadvertently created a regulatory capital arbitrage opportunity does not mean it ultimately makes good strategic business sense to take advantage of it. Banks should be wary of pilling up assets just because the capital charge on them is low. If there is a system-wide regulatory arbitrage incentive to own the assets, it will tend to support the creation of a bubble and  lead to a decline in credit quality.

8. Computer Models Are No Substitute for Basic Risk Analysis. During the crisis, the most vaunted measure of potential losses on assets was Value at Risk or VaR. Given that it was averaged daily over a period of 10 days, it failed to capture swings in values that fell outside those 10 days, including values of tranches or pieces of mortgage securities that were illiquid. VaR failed to capture the risks that helped bring down the system. Banks should be aware that computer models are tools and are limited by the assumptions that went into their creation. They should not become a substitute for broader analysis of risk.

9. Monitor Liquidity Risk. A chief vulnerability of the financial markets is a common heavy reliance on overnight and short-term funding. Washington policy makers have identified this as a risk and regulators are expected to come up with plans to require banks to beef up their liquidity reserves. Yet, no amount of additional liquidity could have saved Bear Stearns or Lehman Brothers, or even Wachovia and Washington Mutual – once the markets lost confidence in the institutions.

In the complex financial structures in place today, runs on banks often occur not from depositors but from overnight funders, who are the shadow banking equivalent of depositors, according to Yale finance professor Gary Gorton. This funding has to be rolled over daily. Since the funds have been invested in assets, a margin call requires banks to engage in fire sales of assets in times of panic.

When no one knew who had bad assets, it seemed that no one wanted to roll over short-term funding. The fact that so much of the overnight and short-term funding was done through repurchase agreements based on mortgage assets made the entire system vulnerable. A repurchase or repo is the sale of securities together with an agreement for the seller to buy back the securities at a later date. The repurchase price is greater than the original sale price, the difference effectively representing interest being charged for the funds provided – or the repo rate. But, repos could also be vulnerable if they depend on other assets that may suddenly come under a cloud.

Banks need to remain vigilant about the credit quality of assets tied to repos or any type of overnight funding and monitor all vulnerable funding sources for weaknesses.

10. Instill a Culture of Prudential Risk Management. As the housing and mortgage bubbles grew and the CDO machine spun out of control, the role of risk management fell into the background. This can be partly attributed to the fact that risk management was not firmly engrained in the culture of some banks. To the extent that a bank has mastered the art of instilling a culture of risk control throughout its ranks, it is better placed to survive the next financial or economic shock.

Mr. England, a longtime contributor to BAI Banking Strategies based in Arlington, Va., has written a book entitled Black Box Casino: How Wall Street’s Risky Shadow Banking Crashed Global Finance scheduled to be published this fall by Praeger Books. He can be reached at [email protected].