The Subprime Crisis

Introduction

The subprime crisis is a financial crisis that affected the real estate sector and affected the global economy from 2007 onwards. Subprime mortgages are variable-rate mortgages, mainly in the United States. The latter were considered risky but profitable as long as the price of American real estate was rising rapidly. Many American households were seduced by these long-term loans, which allowed them to access housing relatively easily. Rating agencies eventually gave these loans the highest rating ("AAA"), which prompted many banks and investors to securitize these receivables, creating a craze for these apparently highly profitable securities. However, when households, no longer able to cope with variable interest rates, were unable to repay their loans, the whole system collapsed, causing securities to fall .

This crisis has had consequences not only on the US real estate and banking market, but also on the global economy. Indeed, a significant number of British, French and German banks bought securities combining low-risk and risky debts (subprimes), which caused an immediate drop in stock market indices and panic on the markets. Bank customers rushed to recover their assets, fearing they would lose everything, creating a bank run . Some people were surprised to discover the nature of bank investments that they thought were safe and low-risk. European governments in particular have had to implement emergency rescue plans. These plans have consisted of nationalisations of banks such as in the United Kingdom where Prime Minister Gordon Brown and his government nationalise the Northern Roc bank for example. In France and Germany, governments have decided to recapitalize banks by injecting capital, which has resulted in further deepening their debt .

This crisis has weakened the global banking and economic systems by creating widespread distrust of banks and the entire financial system. The bankruptcy of some banks such as Lehman Brothers created a snowball effect that precipitated the economic crisis. Credit has declined sharply and banks have had to look for new investors in order to replenish their cash resources (Whalen, 2008).

Now that we know more about the crisis, we can ask the question: What role did Credit Rating Agencies (CRAs) and Collateralized Debt Obligations (CDO) did play in this crisis?

I.        Collateralized Debt Obligations

The first securitisation transactions were launched in the United States in the early 1970s under the auspices of three specialised agencies with government guarantees (Government Sponsored Agencies): the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac) and the Government National Mortgage Association (Ginnie Mae) (almost a year after the crisis began, Fannie Mae and Freddie Mac found themselves in the middle of a crisis of confidence, to the point where the U.S. Treasury is planning a $25 billion plan to help them). However, it was only since the mid-1990s that these operations really gained momentum .

Securitisation initially concerned mortgage loans (in this case mortgage-backed securities, MBS), but quickly other types of loans were used as supports: car loans, student loans, outstanding bank cards... (we then speak of asset-backed securities, ABS). And as with derivatives in general, financial engineers have not ceased to offer new products, increasingly sophisticated: collateralized mortgage obligations (CMO), collateralized debt obligations (CDO), collateralized synthetic obligations (where the underlying assets are credit derivatives), CDO² (CDO of CDOs) and even CDO3 (CDO of CDOs of CDOs) etc.

A CDO ("Collateralized Debt Obligation") is a credit derivative product that refers to a portfolio of bonds, loans, receivables, asset-backed securities or even other CDOs. Assets and their income are thus securitised within a single product. The main attraction of a CDO is then that it can be sold in tranches to investors, each with a different risk profile ("senior debt" or senior debt, "mezzanine debt,""junior debt" or junior debt). The first defaults in the basket will affect the holders of the most junior tranches, who will be able to claim higher interest rates to be compensated. The holders of the most senior tranches will be relatively more protected, and will therefore have to claim lower interest rates. This difference in risk will also be reflected in the rating of the tranches, with the most senior tranches benefiting from a higher rating. Junior tranches are often referred to as "equity tranches" because they have the highest risk of loss .

The first CDOs appeared on the financial markets in 1987, and were the work of Drexel Burnham Lambert Inc. in 2006, the CDO market was worth nearly $500 billion . CDOs, their securitisation system and ratings have been under fire in recent years, accused of being one of the vehicles that contributed to the spread of the subprime crisis. After, came the synthetic CDO. It transfers the risk and benefits of the profitability gap in the transaction, without selling the assets. It thus preserves the relationship between the bank and its client, since notification of the transfer of asset flows does not take place (Purnanandam, 2010).

The securitization phase thus described is therefore both:

• Complete since the seller no longer retains any of the credibility risk associated with the underlying loan;
• Complex since the structuring is based on statistical models of default probability
• Opaque since the underlying is no longer present in transactions that only concern paper described by a probability of default. Their holders therefore only take as an indication of risk the rating of the paper they hold

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The underlying belief among investors was that the rise in house prices guaranteed the borrower's debt, even subprime. It seemed as if the house was saving for its owner, while the increase in its price came from increasingly easy financing. Easy credit made the price, the price that increased credit... but for obvious reasons, this logic has its limits.

The increase in the volume of mortgage loans in the United States was mainly due to an increase in loans to the most vulnerable economically vulnerable households (subprime category versus premium category) (Whalen, 2008). At the same time, however, loan contracts have become increasingly complex: in particular, the share of variable-rate loans has risen sharply. In some cases, financial institutions have resorted to very aggressive commercial practices, sometimes even to the limit of legality (Gayraud, 2011).

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