Wall Street closes at a record for the first time since end of January
Believe it or not, it’s been 18 years since the Global Financial Crisis (GFC). Despite many detailed investigative reports on the events and even the popularity of The Big Short, a box-office hit and bestselling book, the role of subprime mortgages in the near-fatal collapse of the banking system remains a mystery to many investors. As a result, some people think that recent rumblings in private credit may be a precursor to a new financial crisis.
Given some misunderstanding linking subprime mortgages and private credit, we discuss how leverage and derivatives, layered atop subprime mortgages, were at the heart of the GFC. A better understanding of that event will help better assess whether recent woes in private credit are an omen of another crisis or an overstated concern.
When we started writing this article, we thought we would compare subprime mortgage securities and the GFC with the current situation in private credit funds. However, when writing about the causes of the 2008 subprime disaster, we thought it was an important enough lesson on the dangers of leverage to make a standalone article. Accordingly, Part Two of this article will describe the structural flaws of private credit and, importantly, explain why it, on its own, is highly unlikely to lead to another financial crisis like the GFC.
Subprime
In the early to mid-2000s, leading up to the GFC, the amount of outstanding subprime loans grew rapidly to $1.3 trillion. At its worst, the estimated loss rate on these loans exceeded 40%. An approximate $600 billion loss is certainly significant, but it wasn’t nearly enough to bring the largest banks and brokers, and the entire global financial system, to its knees.
What made the GFC nearly catastrophic was the extraordinary web of leverage, complexity, and interconnected counterparty risks built around subprime loans. As we share below, it is estimated that total GFC-related losses were between $3.5 and $4.0 trillion, more than three times the losses that would have resulted if every single subprime loan had defaulted.
The Leverage Tree
The reason a relatively small subprime market caused such devastation is derivatives and the leverage built on subprime loans. Think of the GFC as a tree, with subprime loans as its roots.
The tree started to grow when banks bought subprime loans and packaged them into mortgage-backed securities (MBS) with multiple tranches that divvied up the cash flows. For instance, subprime MBS investors in the AAA-rated tranches were repaid first, while the lowest tranches absorbed losses first and were repaid last. Yields varied with perceived risk. These structures attracted a wide array of buyers from the most conservative insurance companies to the most aggressive hedge funds.
Heading into 2006 and beyond, the losses on the underlying subprime loans were growing rapidly, and the lower-rated MBS tranches were quickly losing value. Because it was much easier to sell the higher-rated tranches, banks and brokers were typically stuck holding much of the lower-rated MBS. Given market conditions and mounting losses, they needed to sell them. Since there weren’t many willing buyers at the prices they wanted to sell at, they created Credit-Debt Obligations (CDOs). The bank would take a bunch of lower-rated tranches from numerous MBS and repackage them into a new vehicle (CDOs), in which the cash flows were divided among tranches, like in the MBS.
Despite the poor quality of the underlying MBS tranches, the rating agencies assigned AAA ratings to the senior, first-pay tranches, fooling conservative investors into essentially buying junk-rated debt. Adding to the risk, hedge funds and other investors leveraged the CDO tranches five, ten, and sometimes twenty times over.
Even if the story ended here, the risks stemming from the original subprime loans were tremendous. But the story gets even crazier.
Synthetic Exposure
The investor appetite for the extra yield offered by subprime mortgages and CDOs could not be filled by the existing mortgages. Accordingly, Wall Street created synthetic CDOs to feed hungry investors.
The MBS and CDOs we discussed were backed by real cash flows of subprime mortgages. Synthetic CDOs were securities that were backed by nothing. They used reference mortgages to determine the cash flows to and from investors.
The synthetic CDO seller, or issuer, collected premiums from investors who were buying protection to hedge their subprime mortgages or seeking to profit from subprime defaults. In exchange for receiving premiums, the issuers absorbed losses on the bonds referenced in the agreement.
Unlike a regular CDO, a synthetic CDO could reference the same CDO an unlimited number of times. If there were $100 million of a particular CDO in existence, there could be $1 billion, $5 billion, or more of synthetic CDO exposure written against it.
If a homeowner defaulted on a $200,000 loan in Omaha, Nebraska, the issuers of synthetic CDOs could collectively lose $2 million or much more in some cases.
It has been estimated that there was between $33 trillion and $45 trillion in synthetic credit exposure, based on the cash flows of $1.3 trillion in subprime loans. The graph below, courtesy of the IMF, shows the massive growth in CDS contracts leading to the GFC. Note that synthetic CDOs accounted for a large share of the growth.
Trust Followed Defaults
When subprime defaults started to increase, losses weren’t the only problem. Equally important was a lack of trust among the largest financial institutions. Eroding confidence was most evident in the boiler room of the financial system, the overnight Fed Funds and repo markets.
These overnight loan markets ensure banks and brokers have ample daily liquidity to function. The biggest risk to the financial system is the concern that money lent today will not be repaid tomorrow. Once the rumors of losses started to grow, Wall Street questioned what their counterparties might be on the hook for. Trust was lost, and the overnight repo markets seized up.
Lehman Brothers, which had survived the Great Depression, went bankrupt in a weekend. AIG, a large issuer of synthetic insurance, collapsed. Many of the world’s largest banks and brokers were on the brink of failure. The web of leverage and derivatives surrounding subprime mortgages was so tight that pulling on one thread unraveled the entire financial structure.
While it’s fair to say that defaulting subprime borrowers were certainly the match, the bonfire, fueled by greed and irrational expectations, had been building for years.
Summary
With that background on the GFC, we hope to show you in Part Two the differences between subprime mortgages and private credit, and moreover, why we do not fear that private credit losses can cause havoc on the financial system. That said, we do have concerns that losses and credit anxieties could have broader impacts on broader liquidity spilling over into the economy.
