Risk Management: Foundations for a Changing Financial World

CHAPTER 29

TUMBLING TOWER OF BABEL: SUBPRIME SECURITIZATION AND THE CREDIT CRISIS^ac

Bruce I. Jacobs

The credit crisis reflects the collapse of a tower of structured finance products based on subprime mortgage loans. These instruments—RMBSs, CDOs, SIVs, and CDSs—shifted the risk of mortgage lending, especially the default risk, from one party to another, until many lost sight of the real risks of the underlying loans. But when housing-price appreciation reversed, many subprime borrowers, having made only negligible down payments, owed more on their mortgages than their houses were worth. These borrowers exercised the put options in their mortgages, and defaults rose beyond the expectations priced into mortgage rates, RMBS yields, and CDS premiums. The downside risk of housing-market prices was shifted to lenders, and losses, magnified by vast leverage, spread up the tower of structured instruments to CDO investors and CDS sellers. The real risk of subprime mortgage investing became apparent, blowing up financial firms and, in turn, the economy.

Financial products that purport to reduce the risks of investing can end up actually magnifying those risks.¹ In the 1980s, portfolio insurance, which was intended to protect stock portfolios against loss, contributed to the crash of 19 October 1987 (see Jacobs 1998, 1999a). In the 1990s, supposedly low-risk globally diversified arbitrage strategies led to the 1998 meltdown of Long-Term Capital Management and the consequent market turbulence ...