Basel 11:

Testing the Effectiveness of See-Through Leverage as Credit Risk Measure

By

Mobolaji M Etiko (A4013106)

Dissertation in partial fulfilment of the requirements for the award for the

Masters of Science (Finance)

Degree of the University of Wales on October 22, 2010

Dissertation Supervisor: Mr Augustine Entonu

i
Abstract
In this dissertation paper, we empirically investigate a conceptual error in the way credit risk
was viewed and measured since the advent of Basel 1 more than 20 years ago. We made a
connection between 2007-2008 crises with the previous crisis such as the 1929 crash, Russia
and LTCM crises of 1998 as being driven by the same management errors. In order to
investigate the efficiency of See-Through leverage as a credit risk measure in practice, we
reviewed past literatures on credit risk models and how they have been used in practice. We
carried out a regression analysis using the natural log of the STL(X) of 300 different ABS
tranches issued in 2006-2007 against their current credit ratings to verify if AAA assets were
actually investment grade assets. We tested a variety of asset class including collaterized debt
obligations, collaterized loan obligations, car loans, credit cards and prime residential
mortgage backed securities.

Key words: Asset-Backed Securities (ABS), Basel, Credit Ratings, See-Through leverage

ii
DECLARATION
I Mobolaji M. Etiko, declare that the contents of this dissertation represent my own work, and

that the dissertation has not previously been submitted for academic examination towards any

qualification. Furthermore, it represents my own opinions and not necessarily those of the

University.

Signed __________________ Date _________________

iii
Acknowledgement
I wish to thank a number of individuals for their valuable insights and criticisms, namely

Sean Tully; the former Managing Director of Citibank and author of See-Through Leverage

who I repeatedly conveyed via E-mail seemingly endless questions and he generously

consented to answer many of my queries, Louise Hinchen, a staff of Harriman publishing

house who got me in contact with Sean Tully, I will also like to thank my tutors; Cesario

Mateus and Dave Coker, who helped me get a better knowledge of options, hedging and bell

curves. The others are Morinsola Olagunju who read the paper in crude form and gave

invaluable and much-needed suggestions, Bolanle Adesanya, Adesewa Olusanya, Folake

Ajose, Adedoyinsola Bademosi, Olaniyi Odesanya, Owosegun Shonowo, Michael Shittu,

Tomi Amushan, Ehimare Irigbovbe, Osamor David, Frank Ahonkhai, Hafiz Muhammad,

Ramy Jaber, Aminu Jega, Artem Machacha, Tamuno Ebikefe, and most especially my

dissertation supervisor; Augustine Entonu who gave constructive criticisms and made me go

back home to dig deeper. Thanks are also due to Nikhil Binani, Nicolai Audon, Sara

Alzadjali, Mark Chapman, Andre Mata, Stella Famutudo, who all contributed in different

ways to my insights and the overall dissertation.

I also wish to thank my parents and siblings; Bukola, Bolatito, Toyin and Ayoola for their

strong support and encouragement, especially during the nights, weekends and holidays

during which the dissertation was written.

I will also wish to acknowledge the following:

Extract from the Age of Turbulence by Alan Greenspan

Extract from the Big Short and Liars Poker by Michael Lewis

Extract from the (Mis) Behaviour of Markets by Benoit Mandelbrot and Richard L. Hudson

iv
Extract from Stabilizing an Unstable Economy by Hyman P. Minsky

Extract from the Black Swan by Nassim Taleb

Extract from When Genius Failed by Roger Lowenstein

Extract from Restoring Confidence in the Financial System by Sean Tully and Richard

Bassett

v
 TABLE OF CONTENTS

ABSTRACT....................................................................................................................................................II
DECLARATION .................................................................................................................................................III
ACKNOWLEDGEMENT .................................................................................................................................... IV
1 INTRODUCTION..................................................................................................................................1
1.1 LEVERAGE: HERO OR ZERO? ............................................................................................................. 3
1.2 CONSERVATIVES ON RISK ................................................................................................................. 6
1.3 THE CONCEPTUAL GAP ..................................................................................................................... 9
1.4 SECURITIZATION ............................................................................................................................ 10
2 LITERATURE REVIEW .................................................................................................................... 11

2.1 INTRODUCTION .............................................................................................................................. 11

2.2 EVOLUTION OF CREDIT RISK MODELS ............................................................................................. 12
2.3 THE MARKET RISK AMENDMENT OF 1996 ....................................................................................... 16
2.4 THE UNINTENDED CONSEQUENCES OF BASEL 11 ............................................................................. 21
2.5 CREDIT RATING AGENCIES AND SHADOW BANKING SYSTEM ........................................................... 24
2.6 THE NEED FOR CHANGE USING SEE-THROUGH LEVERAGE .............................................................. 30
2.7 STL AS A MEASURE OF TRADITIONAL LEVERAGE FOR SECURITISATION ............................................ 31
3 RESEARCH METHODOLOGY......................................................................................................... 32

3.1 RESEARCH STRATEGY .................................................................................................................... 32

3.1.1 Qualitative and Quantitative Research ....................................................................................... 32
3.1.2 Sampling Technique .................................................................................................................. 33
3.2 RESEARCH QUESTIONS ................................................................................................................... 33
3.3 RESEARCH APPROACH .................................................................................................................... 33
3.4 RESEARCH PHILOSOPHY ................................................................................................................. 33
3.5 HYPOTHESIS................................................................................................................................... 34
4 DATA ANALYSIS ............................................................................................................................... 34
4.1 INTRODUCTION .............................................................................................................................. 34
4.2 REGRESSION ANALYSIS .................................................................................................................. 36
4.3 FINDINGS ....................................................................................................................................... 36
4.3.1 Table 4.3.1................................................................................................................................. 37
4.3.2 Table 4.3.2................................................................................................................................. 38
5 CONCLUSIONS .................................................................................................................................. 39
5.1 RECOMMENDATION ........................................................................................................................ 41
5.2 THE EMERGENCE OF BASEL 111...................................................................................................... 42

BIBLIOGRAPHY ........................................................................................................................................ 45
APPENDIX ................................................................................................................................................... 49

DEFINITION OF TERMS........................................................................................................................... 50
GLOSSARY ................................................................................................................................................. 52

vi
 “The more man learned the more he realized he did not know” Dan
Brown

1 Introduction
The global financial crisis of 2007-2008 had many causes: greedy bankers, lax regulators and

gullible investors. However, the very obvious cause was the limited knowledge of market

dynamics, price movement, risk underestimation, reckless assessment and human over-

optimism in terms of the assumptions attached to the sub-prime mortgages whereby house

prices were expected to continue rising for the foreseeable future, default rates staying within

a forecast rate and the hedging strategies that were in place will keep on working

(Mandelbrot and Hudson, 2008).

The crisis follows a perennial trend with previous world-wide financial crisis. (Bordo M.D,

2008). Some known examples of the crises include tulips in seventeenth-century Holland, the

crash of 19291 and investment trust, Black Monday of 1987 and the dangers of leverage 2, the

Japanese financial crisis between 1985-1989, the 1997 Asian economic crisis of 1997,

Russian summer of 1998, dot-com bubble of late twentieth-century America and LTCM34

crisis in 1998 which at some point had twenty-five Ph.D.‟s including Robert Merton and

1
The 1929 crash was majorly as a result of buying stock on margin (Kenneth J, 1954) as cited by
(Bassett R, 2010). For instance, one could put up just 10% against loans used to buy the stock. This
means that one could purchase $1000 stock with just $100 in capital. This period also had a similar
version of shadow banking1. It was made up of investment trust and holding companies whereby the
investment trust were set up as vehicles to give low income investors access to a diversified portfolio.
After a while, they also issued debts and common equity. These securities are similar to the CDOs and
SIVs of the 21st century
2
The Monday 19, October 1987 crash on the other hand was as a result of the excessive selling which
was required by the portfolio insurance. Prior to this, no one anticipated the ripple effect it will have
when everyone tried to de-lever at once (Bookstaber R, 2007). At this point Alan Greenspan, the then
federal reserve‟s chairman was left with no other choice but to reduce rates immediately due to the
negative impact the crash will have on the economy
3
LTCM is an acronym for Long-term Capital Management
4
This crisis hit the heart of derivatives and financial engineering company that had two Nobel
laureates as its employees, Robert Merton and Myron Scholes. The markets behaved in a way they
had never anticipated based on history and their models. Their excessive leverage led them to
bankruptcy and had a huge impact on the financial system as a whole (Lowenstein R, 2000)
1
Myron Scholes who had won the Nobel prize on its payroll and was described by William

Sharpe as perhaps the best academic finance department in the world. Eventually, several

banks reluctantly agreed to bail-out the fund through a $3.625 billion takeover at the behest

of the Federal Reserve due to the wave of bankruptcies that will occur if LTCM went under

(Padma D, 2000). For over a century, financiers and economist have strived to analyse risk

inherent in the capital markets, to explain it, quantify and eventually profit from it. We

believe that most of the theorists have been going the wrong path. The reason being, if risk

and reward which are proxies for mean and volatility make a ratio, then the standard

arithmetic must be wrong. The denominator risk is however larger than acknowledged and so

the outcome is frightening. We intend to derive a better barometer for assessing risk in

practice.

The years 2007-2008 can be seen as a period where models failed, faith in banks failed, trust

in the rating agencies evaporated and confidence which is perhaps the most crucial

component of market sentiment was eroded (Rosner J, 2008). All that was missing was the

failure of a large bank and the US government proceeded to fuel the greatest shock as it

allowed Lehmann Brothers, the 158 year old investment bank that had survived the civil war,

great depression and both world wars to collapse in 2008. As a result, it filed for chapter

11bankruptcy protection. (Shah A, 2008). The EU also came close to a complete meltdown as

well.

If we take a cursory look at these crises, we can determine a common factor which is

leverage5. One could also attribute the financial system meltdown as a failure to

5
Leverage simply put is capital plus borrowed funds, divided by the amount of capital only. It could
be termed, gearing, investing on margin. However, the most important thing is the return on
investment
2
underestimate risk6. (Nassim T, 2007), he attributed the failure to lack of awareness of

network externalities by identifying a correlation between the financial meltdown and risk

taking to the black swan. A black swan as an outlier lies outside regular expectations, because

we are yet to see anything in the past that confirms its existence, we assume its non-existence.

As a result of this, it carries a great impact due to its least expectation. Although nothing can

be proven to be certain, once we attach probabilities, nothing is simple any more. (Greenspan

A, 2007), showed so much respect for uncertainty saying there are known knowns, known

unknowns and unknown unknowns. In other words, there are things we know that we know,

there are things we know but we do not know and there are things we do not know and we

don‟t know. However, as time passes by, we tend to discover some of the unknown

unknowns.

1.1 Leverage: Hero or Zero?

Leverage can be viewed as a double edged sword as it is used by both banks and borrowers.

An increase in leverage leads to a higher return for both bank and borrower. However, it also

increases the risk of default of both parties. The reason being the more levered one is, there is

a corresponding increase in errors in the predicted loss distribution. Leverage takes a poor

return on assets and converts it into a high return on capital 7 (Soros G, 2008). The 2007-2008

global financial crises are the outcome of high leverage used by the sub-prime mortgage

borrowers and by the financial institutions which facilitated their loans (Hyman P, 2008). The

6
Regulatory capital for all structured products is based on ratings. These ratings are based on
subordination or put simply probability of first dollar loss of the lower tranche of the investment.
However, one would have thought that a more robust framework will not only consider amount of
subordination junior to the investment but also the amount of liabilities senior to the investment.
7
For instance, assuming we have $1000 in capital and borrow an additional $9000. Our leverage is
($1000+$9000)/$1000 which is ten times. In terms of investment returns, let us assume the cost of
capital is 10% and the return on investment is 12%. Our return on asset is 200 basis points whereas
our return on capital is 1000 basis points.
3
fundamental cause can be attributed to conceptual error8 in the sense that Basel Accord910 laid

emphasis on risk weighted11 assets (RWAs) 12, thus, neglecting the measurement of

leverage13.

Financial risks of regulated institutions are subject to strict regulations, hence, it should

specifically avoid systemic crisis. However, the failure to contain the sub-prime crisis

extended to the entire system thereby causing economic contagion and pro-cyclical effects14.

As a result of this, the system is faced with the joint effects of these two factors, contagion

and pro-cyclicality as they are difficult to separate. Domino effect can be ascribed as a well-

known example of contagion effect. For instance, a failure of a large financial institution will

trigger many others who are largely exposed as was the case of LTCM where every major

8
What were conceptual errors became eventually the bench mark of the Basel accord. Although one
could argue that these errors might have being avoided if those responsible for the Basel 1 and Basel
11 had an idea of the new products they were dealing with.
9
Basel II focuses on the risk-taking behaviour of individual financial institutions. This is somewhat
micro-prudential. A macro regulation that will capture the entire system would have prevented the
spill over effect. The reason being banks are interconnected and as such, crisis may occur
simultaneously due to their inter-bank lending or common exposure due to diversification at
individual level.
10
Under the Basel 11, rating agencies were vested with the responsibility of managing risk in order to
avoid the capital arbitrage under Basel 1. Rating agencies however failed to explicitly use leverage as
a rating factor for securitised products. The reason being agencies examined known history of
different asset types, determined loss distribution based on the default and recovery rates. A product is
rated AAA if a tranche exceeded the stress case loss in the predicted loss distribution. Based on their
findings, the tranche would not experience a loss. We are of the notion that capital requirements
should focus more on the impact the actual loss will have on the expected loss.
11
Investment banks and trading desk believe so much that tomorrow‟s risk can be inferred from
yesterday‟s prices and volatilities. One begins to wonder why Basel committee on banking
supervision based its minimum regulatory capital requirements on Robert Merton‟s model that got
LTCM into the derivative crisis of 1998
12
Since risk weighted assets were not based on leverage, regulators and market participants stopped
measuring it. This failure to measure leverage led to a failure to measure sensitivity to unexpected
loss. Going back to our previous example on buying stock on margin, any losses up to 10% means our
capital covers it and we remain solvent. However, what happens if we were wrong in our assumptions
about loss distribution. For every time our actual loss distribution is say 0.01% worse than expected
loss distribution, we will lose ten times (margin) 0.01% or put simply 0.1% based on the first
derivative of losses in asset portfolio.
13
The Basel Committee on banking supervision was concerned about leverage when they issued their
first capital standards (Basel Capital Standards, 1988). They noted that high leverage poses a systemic
danger to banking institutions by making it more vulnerable to rapid transmission of problems of one
institution to the other yet, they missed out leverage.
14
Pro-cyclicality refers to magnification of the amplitude of cycles (Bessis J, 2010)
4
Wall street bank including Goldman Sachs, Chase Manhattan, Salomon Smith Barney,

Merrill Lynch, Morgan Stanley Dean had to rescue one of their own of its over $1 trillion

exposure. This will inevitably mean systemic risk. If Barclays Capital or Goldman Sachs

were to go bust, it is likely they will take many more institutions with them or the entire

system as a whole15. Simply put, this can be seen as the foundation of the too big to fail

principle for the fear of contagion. However, this was not fully implemented as Lehmann

Brothers was allowed to go under unlike Bear Sterns which was acquired by J.P. Morgan

with Federal Reserve credit line and the part nationalization of Freddie Mac and Fannie

Mae16 (Tarr D G, 2010). AIG, the insurance giant who is presently accused of securities fraud

for misleading investors about its exposure to sub-prime mortgages was also bailed out as a

result of liquidity crisis to the tune of $182.3 billion (Banks H, 2010) and the federal

government led tax payers to take nearly 80% in the nationalized insurer due to the

catastrophic consequences attached to the collaterized default swaps 17.

These effects led to fire sales of assets for leveraged 18 financial institutions, by lowering the

value of their collaterized securities. All highly levered institutions faced a lower ratio of debt

to value of assets19. Basically, this means that the value of the debt is over collaterized as a

15
Please see Basel committee risk weights of on-balance-sheet asset on www.bis.org
16
The Federal National Mortgage association nicknamed Fannie Mae and Federal Home Mortgage
Corporation nicknamed Fannie Mae are the two largest mortgage finance lenders in the U.S. they are
government sponsored enterprises. They are privately owned but get financial support from the
government
17
They are insurance contracts on securities.
18
The failure to measure leverage prompted the US government to give a clean bill of health to major
financial institutions that were about to collapse even though at the time, they had investment grade
ratings. As we stated earlier, it is a collective conceptual error. (Warren Buffet, 2009) Noted that loses
in mortgage related securities were as a result of flawed history based models used by salesmen,
investors and rating agencies.
19
The gap between a security value and debt is called a haircut and this is subject to minimum values
below which either debt has to be reduced or additional collateral posted also known as margin calls
(Bessis J, 2010)
5
result of the marking to market 20 movements. A fall in the value of an instrument leads to a

fall in ratio thereby triggering deficiency and making debt unsustainable. The only way out

for leveraged institutions will be to fire sales of assets to reduce debt, thus bringing back asset

value in line with loan to value ratios which will eventually add to market crisis.

As we have mentioned earlier, a financial crisis is systemic in nature if many banks fail

together, or if one bank‟s failure triggers as a contagion causing the failure of many banks. At

the heart of bank regulation is a deep-seated concern that social and economic costs of such

systemic crises are large. It is thus broadly understood that the goal of prudential regulation

should be to ensure the financial stability of the system as a whole. We have seen different

reform proposals such as the ones by the Bank of International Settlements (1999) have been

made with the objective of improving bank regulation, and in the aftermath of the global

financial crisis of 2007-2008, many more proposals have come to the fore. 21

1.2 Conservatives on Risk

Basel 11 came to being as a result of the flaws in the Basel1. Yet, it failed to acknowledge

leverage as the primary source of systemic risk which led to the 2007-2008 credit crises. The

Basel 1 accord was known as Basel capital Accord. It was issued in 1988 in order for

international convergence of capital measurement and capital standards. The accord

established the Risk Weighted Assets (RWAs) 22. In other words, assets deemed less risky

will require less capital compared to the more risky assets. With globalisation, capital

requirements became a regulatory factor of the home country just to create a level playing

field for banks to compete. As a result of this, if a bank could hold less capital against given

20
Marking to market is the accounting act of recording the value of a security, portfolio or account to
reflect its current market value rather than the book value.
21
Please see bank of international settlements website.
22
Under Basel 11, risk weight for an AAA rated ABS tranche is 7% to 20%. In other words, the most
senior of the AAA rated tranche will only require 7% times 8%, about 56bps of capital. Thus, it gives
room for increase in leverage (Basel Capital Standards, 1988)
6
risk in one jurisdiction, it stands a better chance of attracting more capital as it could increase

its return on capital at a given risk. Banks have access to deposits that take the form of a

simple debt contract. Upon borrowing, banks invest in risky and safe assets. In addition, they

choose the industry in which they undertake risky investments. The choice of industry by

different banks determines the correlation of their portfolio returns.

Systemic risk arises as an endogenous consequence when in equilibrium, banks prefer to lend

to similar industries. Since deposit contract is not explicitly contingent on bank

characteristics, the depositor losses resulting from bank failures which are not internalized by

the bank owners. This externality generates a role for regulation. In a situation whereby one

bank fails, there are two conflicting effects on other banks. First, there is a reduction in the

aggregate supply of money in the economy, and hence, in aggregate investment. This leads to

a recessionary spill over causing a negative externality to the surviving banks through an

increase in the market-clearing rate for deposits, which reduces the profitability of banks.

Secondly, surviving banks have a strategic benefit, positive externality from the failure of

other banks due to an increase in scale or an expansion, resulting from the migration of

depositors from the failed banks to the surviving banks, or, due to strategic gains from

acquisition of failed banks‟ assets and business. Over a robust set of parameters, the negative

externality effect exceeds the positive externality effect (Hyman P, 2008), in which case

banks find it optimal to increase the probability of surviving together. However, they end up

failing together, by choosing asset portfolios with greater correlation of returns if the banks

are large or the depositors of the failed bank do not migrate to the surviving banks or say

other banks cannot benefit from acquiring the business facilities of the failed bank due to

anti-trust regulations which prevents such acquisitions.

The Basel accord attempts to mitigate systemic and individual risk-shifting incentives of bank

owners through its design of bank closure policy and capital requirements. A bank bail-out on
7
the other hand eliminates the financial externalities discussed above but also induces moral

hazard depending upon the extent of forbearance exercised. The costs of nationalizing a large

number of banks however may render such a policy suboptimal (Tarr D G, 2010).

The risks undertaken by banks can be decomposed into exposures to general risk factors and

idiosyncratic components23 (Bessis J, 2010). For any given level of individual bank risk,

correlation based regulation would encourage banks to take idiosyncratic risks by charging a

higher capital requirement against exposure to general risk factors. Many financial

institutions already employ a collective approach to capital budgeting and regulators have

also acknowledged the role of intra-bank correlations by proposing a long-term shift towards

portfolio models for credit risk 24 measurement (BIS, 1999).

The proposed reforms of the BIS regulation25 appears however to have focused too much on

the portfolio risk of each bank and ignored the inter-bank correlation effects for

diversification of the economy-wide banking portfolio. Basel 1 increased systemic risk as a

result of the application of risk weight measurements and lending among banks which made

them more interconnected, thus, increased systemic risk Also, due to the fact that there was

no differentiation between the highly rated securities and the non-investment grade assets, it

is only rational for a financial institution to increase risk by focusing on less rated credits so

as to amplify the returns. In a nut shell, with the limitations inherent in the Basel 1, one could

theoretically achieve an infinite leverage and return on capital as the highly rated assets

required no capital26.

23
This is the risk of changes due to unique circumstances of a specific security as against the entire
market. It can however be eliminated through diversification.
24
Credit risk is the risk of losses due to borrowers default or deterioration of credit standing. It is
subject to Basel 11
25
Regulations are designed to prevent the failure of institutions by imposing standards to capital base
that are risk driven. In other words, they quantify potential loss as a result of risk taking which
invariably is the factor for determining capital base of financial institutions.
26
With the introduction of securitization, the Basel accord transformed the required capital for
lending to a fraction of what it ought to have been. Also is the much confidence that was placed in the
8
Basel 11 on the other hand was introduced in June 2004 to sanitise the flaws of the Basel 1.

However, it led to the emergence of shadow banking 27. At this point, highly rated securities

required almost no capital. As a result of this, it led to a major increase in leverage in the

financial system. Ordinarily, the more levered one is, the less room there is for error (Bassett

R, 2010). As a result, banks increased their leverage so as to increase return on capital.

Besides, there was an increase in lending capacity to individuals, corporations. However, the

long term effect is the market burst as a result of the misjudgement of risk. The main

objective of the Basel 11 was to create risk requirement that were more sensitive. With

regards to this, they relinquished their risk regulatory capacity to the credit risk agency 28. The

rating agencies as well did not establish leverage in their model for rating securitised

structures as their capital requirement was seen to have been influenced by the expected loss

of a particular security derived from history of loses of similar securities.

1.3 The Conceptual Gap

A conceptual gap in the measurement of risk has been the main reason for the 2007-2008

crises. That gap is the failure to acknowledge leverage as a main source of systemic risk. For

the purpose of this dissertation paper, we are going to focus mainly on credit risk 29. We will

not go in detail with regards to market risk which is assumed to be taken care of by value at

risk (VAR). However, the VAR model should be obvious as a flawed model. It works like

this, you start off by deciding how safe you want to be and then determine a confidence level

rating agencies whose ratings were largely dependent on subordination. Thus, its predictions on loss
distributions were based on an unreliable history.
27
Shadow banking is the system of non-banking financing entities and tools which grew
astronomically since the 1980s. it consist of structured investment vehicles, commercial paper
conduits, collaterized debt obligations to mention a few.
28
The credit rating agencies examined a known history of defaults for each asset type and determined
a loss distribution. After deriving this, it is then attributed to the tranche liability which made up the
capital structure. In a situation whereby a tranche exceeds the stressed case loss in the distribution, it
is rated AAA as they could not establish any case for the instrument to incur a loss
29
Credit risk affects virtually every financial contract. As a result of this, measurement, pricing and
management of credit risk require utmost attention from financial economists, bank supervisors and
regulators, and from financial market practitioners.
9
say 95% such that your probability of making a loss will stay at or below 5%. This is wrong

because the VAR itself was built on the Gaussian model which underestimates volatility and

therefore underestimates the odds of loss. We need to establish the fact that in a turbulent

market situation which is usually the case, the measurement of volatility itself is volatile.

Some of the world‟s central banks however are proposing a more realistic model called

Extreme Value Theory, which was borrowed from the insurance industry. It assumes market

turbulence. In other words, it establishes the fact that markets are wild with fat tails.

However, we feel it still has a shortcoming yet to be addressed. It does not take the tendency

of bad news to come in flocks as a bank that weathers one crisis may not survive subsequent

crisis.

The dissertation paper will examine a new measure of credit risk measurement, See-Through

Leverage (STL)30 which seems to be theoretically sound, although we will propose its

economic viability as a research for future study. We will retrospectively test asset backed

securities issued in 2006 and 2007 against the current ratings for those securities so as to test

its effectiveness as a risk barometer in practice.

1.4 Securitization
Asset backed securities (ABS)31 is a form of securitization32 developed to finance a

collection of assets which by their very nature are non-tradable and therefore non-liquid. The

30
It is a mathematical measure of excessive leverage. It measures products sensitivity to assumptions
in the underlying assets pools loss distribution (Bassett R, 2010). In other words, when a security‟s
STL is high, it means the underlying asset is highly levered and vice versa. STL strips away the
inadequacies of rating agencies and the weakness of Basel 11 in measuring risk in an asset.
31
This is a group of assets sold into a shell company usually known as special purpose vehicle (SPV).
Ordinarily, the assets are loans which are due to pay fixed interest and principal at maturity. However,
in order to fund the purchase of such assets, notes are issued using the SPV with different categories
or class. The different notes are called tranches as they receive a predefined portion of the SPV‟s cash
flow. A senior tranche has first claim on the cash flow before the subordinate tranche. The equity
tranche are the last and they will only get paid after all other tranches have being paid.
32
Securitization was seen as perhaps the greatest financial innovation of the 20 th century. (Shah A,
2010). It is a situation whereby banks pool their loans into sellable assets and split them into various
tranches with different ratings based on the level of risk/return an investor is willing to take. Banks
10
central element of an asset securitization issue is the fact that repayment depends majorly on

the assets and cash flows pledged as collateral to the issue, and not on the overall financial

strengths of the issuer. Put simply, asset securitization can be seen as the process in which

assets are refinanced in the financial market by issuing securities sold to investors by a

bankruptcy-remote special purpose vehicle (SPV)33. (Fabozzi et al, 2004) Mention that the

capital market in which ABS 34 are issued and traded consists of two other instruments known

as mortgage-backed securities (MBS)35, and collateralized debt obligations (CDO) 36. As a

rule of thumb, securitization issues backed by mortgages are called MBS, and securitization

issues backed by debt obligations are called CDO (see Nomura, 2004, and Fitch Ratings,

2004). Securitization issues backed by consumer-backed products such as car loans,

consumer loans and credit cards are called ABS (see Moody‟s Investors Service, 2002).

The remainder of the dissertation paper is structured as follows. Section 2 discusses the

related literature. Section 3 describes the research methodology, section 4 discusses the

sourcing and analysis of data and section 5 is on conclusion and recommendations.

2 Literature Review
2.1 Introduction
All models by necessity in one way or another distort reality. For instance, an economist will

make assumptions about how markets work, how people make financial decisions, how

business operate. Anyone of these assumptions considered alone is absurd. The reason being

make millions in these sellable loans, offloads the risk attached to holding those loans in its books but
security buyer gets fixed income from all those mortgages.
33
SPV‟s are used for facilitating asset securitisation and ensuring that they are established for
bankruptcy purpose. In other words, separating the entity from the issuer (Blum and Di Angelo 1997,
p.244) as cited by (Capiro et al, 2008)
34
Securitization issues backed by consumer-backed products such as car loans, consumer loans, credit
cards are ABS. please see Moody‟s Investors Service
35
Securitization issues backed by mortgages are called MBS
36
Securitization issues backed by debt obligations are called CDO. Please see Nomura and Fitch
Rating
11
once the assumption of homogeneity is dropped, new and complicated things happen in the

models.

The main essence of a credit risk model is to estimate the probability distribution of future

credit losses on a bank‟s portfolio (Basel Committee, 2003). The first step in constructing a

credit risk model is therefore to define the concept of loss that the model is intended to

capture, as well as the horizon over which the loss is measured.

In terms of the definition of loss, models generally fall into one of two categories such as

models that measure the losses arising solely from defaults which are otherwise known as

default mode models, and models that incorporate gains and losses arising from less extreme

changes in credit quality as well as from defaults are also known as multistate or mark-to-

market models. Clearly, the default mode paradigm is a restricted version of the multistate

approach, and some models are designed to produce loss estimates based on both definitions

of loss. For both approaches, losses have to be measured over some future planning horizon

(Ederington L, 2004). The most common planning horizon used is one year, meaning that the

model will estimate changes in portfolio value either from defaults or from more general

changes in credit quality between the current date and one year in the future.

2.2 Evolution of Credit Risk Models

The evolution of credit risk models can be traced back to the framework developed by

(Merton R, 1974)3738 using the principles of option39 pricing of (Black Fischer and Myron

Scholes, 1973), based on the framework, the default process of a company is driven by the

37
In the 1970‟s, Robert Merton, a graduate of economics at MIT made a Newtonian leap by
modelling prices in a series of infinitesimally tiny objects. He called it „‟continuous time finance‟‟. He
tackled the problem that was partially solved by two east coast researchers; Fischer Black and Myron
Scholes by deriving an the then theoretical ideal formula for the pricing of stock option
38
The model showed poor fit over longer maturities as it overestimates risky debt and underestimates
low risk debt.
39
Options are a form of derivatives. They are contracts that derive their value based on the underlying
asset. A stock option is the right to purchase a stock at a pre-specified price and within a certain time
period in the future.
12
value of the company‟s assets and the risk of a firm‟s default is explicitly linked to the

variability in the firm‟s asset value. The basic assumption on this model is that default only

occurs when the value of a firm‟s assets is lower than its liabilities. As a result, payment to

the debt holders at the maturity of the debt is therefore the smaller of two quantities in terms

of the face value of the debt or the market value of the firm‟s assets. For instance, if a

company‟s debt is entirely represented by a zero-coupon bond, if the value of the firm at

maturity is greater than the face value of the bond, then the bondholder gets back the face

value of the bond. However, if the value of the firm is less than the face value of the bond,

the equity holders will be entitled to nothing and the bondholder gets back the market value

of the firm. The payoff at maturity to the bondholder is therefore equivalent to the face value

of the bond minus a put option40 on the value of the firm, with a strike price equal to the face

value of the bond and a maturity equal to that of the bond.

Following this basic intuition, Merton derived an explicit formula for default risky bonds

which can be used both to estimate the probability of default 41 (PD) of a firm and to estimate

the yield differential between a risky bond and a default-free bond. Under these models,

default and recovery at default are functions of the structural characteristics of the firm in

terms of asset volatility (business risk) and leverage (financial risk). The recovery rates (RR),

although not treated explicitly in these models, is therefore an endogenous variable, as the

creditors‟ payoff is a function of the residual value of the defaulted company‟s assets. More

precisely, under Merton‟s theoretical framework, PD and RR are inversely related. If, for

example, the firm‟s value increases, then its PD tends to decrease while the expected RR at

default increases with all things being equal. On the other hand, if the firm‟s debt increases,

40
A put option is a derivative contract whereby a party has the right to sell an asset at a predetermined
price in the future
41
It quantifies a borrower‟s chance of default. It could be a default in payments as at when due as a
result of bankruptcy or debt restructuring due to inability to face debt obligations. It is defined as
90days under Basel 11
13
its PD increases while the expected RR at default decreases. Finally, if the firm‟s asset

volatility increases, its PD increases while the expected RR at default decreases. (Black et al,

1976) And (Vasicek O, 1984) tried to refine the (Merton R, 1974) structural form model by

removing the unrealistic assumptions. (Black et al, 1976) Introduced a more complex capital

structure with subordinated debt with interest payment; (Vasicek O, 1984) on the other hand

made a distinction between time frame of liabilities in terms of short and long term.

One could give credit to the line of research that followed the Merton approach as it

addressed qualitative issues in pricing credit risks. However, it has failed in practical

application. The reason being it is unable to price an investment grade corporate bond of a

simple capital structure better than a model that assumes no default risk 42. (Hull et al, 1995)

And (Longstaff F, 1995) assumed that default may occur at any time between the issuance

and maturity of the debt, when the value of the firm‟s assets can no longer sustain its

liabilities. Under these models, the RR in the event of default is exogenous and independent

from the firm‟s asset value. It is generally defined as a fixed ratio of the outstanding debt

value and it is therefore independent from the PD. These ideas simplifies the structural model

assumptions by both exogenously specifying the cash flows to risky debt in the event of

bankruptcy and simplifying the bankruptcy process. This occurs when the value of the firm‟s

underlying assets hits some exogenously specified boundary.

Having said this, the (Hull et al, 1995) and (Longstaff F, 1995) still posed some drawbacks in

their requirements for asset value parameters which were unobservable. They failed to

incorporate credit rating changes that occur frequently for default risky corporate debt. It also

assumed that a firm‟s value is continuous as such; one could predict default just before it

happens. (Lando D, 1998) And (Duffie D, 1998) do not attach default clause on the value of

42
Merton model assumes that default can only occur at maturity of the debt when the firm‟s asset can
no longer cover its liabilities.
14
the firm, and parameters related to the firm does not have to be estimated to implement them.

Besides, it sees PD and RR as being dynamic in nature as they are independently modelled

from the structural features of the firm in terms of its asset volatility and leverage. At each

instant there is some probability that a firm defaults on its obligations. Both this probability

and the RR in the event of default may vary stochastically 43 through time, although they are

not formally linked to each other. The stochastic processes determine the price of credit risk.

Although these processes are not formally linked to the firm‟s asset value, there is

presumably some underlying relation, even though these processes are not directly linked to

the firms asset value, there are some indirect relationship as described by (Singleton K,

1999). He assumes that an exogenous random variable drives default and that the probability

of default over any time interval is nonzero. Default occurs when the random variable

undergoes a discrete shift in its level. In other words, they treat defaults as unpredictable

Poisson events44. As such, the time at which the discrete shift will occur cannot be foretold on

the basis of our known knowns (Greenspan A, 2007).

Empirical evidence concerning reduced-form models is rather limited. (Singleton K, 1999)

Concluded that there are lots of difficulties in explaining the observed term structure of credit

spreads across firms of different qualities. One could attribute this to the fact that generating

flat yield spreads are relatively difficult when firms have low credit risk and steeper yield

spreads when firms have higher credit risk. However, (Gregory R, 1999) argues that there are

no sudden surprises. (Luciano E, 2009), built his model to further the studies on the

(Mandelbrot and Hudson, 2008) fractional Brownian motion in multifractal time, he used the

Variance Gamma-Merton one model, he measured single default occurrence and default
43
Stochastic process is a situation whereby value changes at random as time passes by. It is said to be
a continuous process when changes can occur at any time. However, in a situation whereby changes
occur only at certain times, we have a discrete stochastic process.
44
A Poisson event that expresses the probability of a number of events occurring in a fixed period of
time if these events occur with a known average rate and independently of the time since the last
event
15
correlation in turbulent time. Based on the flaw in the (Merton R, 1974) model that firm value

follows a continuous process, he distinguished business and calendar time and concluded that

business time runs faster than calendar time when markets are very active due to high trade

and loads of information whereas it runs at a very slow pace when volatility is low due to few

information.

2.3 The Market Risk Amendment of 1996

Based on the encouragement by regulators through the Market Risk Amendment (MRA) 45 of

1996 to Basel capital accord, banks have devoted many resources to develop their internal

risk models in order to better qualify their financial risk and set aside the required capital.

Based on this, the regulatory capital requirements for banks‟ market risk exposures were

explicitly a function of the banks‟ own credit value-at-risk estimates. A key component in the

implementation of the MRA46 was the development of standards, such as for model

validation that must be satisfied in order for banks‟ models to be used for regulatory capital

purposes. This brought about the emergence of so many credit risk models at the time by a

number of financial institutions such as (J.P. Morgan, 1998)47 and (Credit Suisse Financial

Products, 1997), as we mentioned earlier, credit risk is the degree of value fluctuations in

45
The amendment encouraged hiding of risk through Gaussian lenses. As a result, they ignored the
effect of extreme or fat tails. This is the point with usually low predictability but large impact.
Ordinarily, the amendment was to provide capital cushion for risk which banks are exposed most
especially those from their trading activities. However, it had the opposite impact as it encouraged
banks to use flawed internal models for their capital requirements. Based on the thin tailed principle
of the Gaussian lens (normal distribution or bell curve), events outside the normal distribution are not
only unlikely but have been reasonably predicted.
46
The minimum time period needed for determining volatility as stated by the amendment was one
year. The idea of the regulators was the prevention of bank crisis. These same regulators were aware
of the risk in the amendment but went ahead using a multiplication factor of three.
47
A crucial step in the construction of a credit portfolio model is the description of dependencies
between clients. One of the most widespread credit portfolio risk models in the banking industry
world-wide is the so called asset value model which goes back to an article by Robert Merton of 1974
and was then further developed by Oldrich Vasicek and Stephen Kealhofer of KMV Corporation in
the mid 1990‟s and by Mickey Bhatia, Christopher Finger and Greg Gupton under the name of Credit
Metrics in 1997. The asset value model is mainly a reinterpretation of the classical Black-Scholes-
Merton option pricing model in a credit risk context.
16
debt instruments and derivatives due to changes in the underlying credit quality of borrowers

and counterparties. As a result of this, various proposals by (International Swaps and

Derivatives Association, 1998) and (Institute of Finance Working Group on Capital

Adequacy, 1998) have been on the notion that credit risk models should also be used to

formally determine risk-adjusted, regulatory capital requirements.

However, the development of the corresponding regulatory standards for credit risk models is

much more challenging than for market risk models. Specifically, a major impediment to

model validation is the small number of forecasts available with which to evaluate a model‟s

forecast accuracy. Unlike the value-at-risk (VaR) 48 models for daily market risk calculations

which can generate about 250 forecasts in one year, credit risk models can generally produce

only one forecast per year due to their longer planning horizons. As a result, it would take a

very long time to produce sufficient observations for reasonable tests of forecast accuracy for

these models.

In addition, due to the nature of credit risk data, only a limited amount of historical data on

credit losses is available and certainly not enough to span several macroeconomic or credit

cycles. These data limitations create a serious difficulty for users‟ own validation of credit

risk models and for validation by third-parties, such as external auditors or bank regulators.

Credit risk models differ in their fundamental assumptions, such as their definition of credit

losses. For instance, default models define credit losses as loan defaults, while mark-to-

market or multi-state models define credit losses as ratings migrations of any magnitude.

However, the common purpose of these models is to forecast the probability distribution

function of losses that may arise from a bank‟s credit portfolio. Such loss distributions are

generally not symmetric. Since credit defaults or rating changes are not common events and

48
VaR measures variation of the history of prices for a given market and assumes that the underlying
distribution is Gaussian or thin tailed. They are typically based on closing day positions and generally
do not take into consideration intra-day risk or exceptional market events.
17
since debt instruments have set payments that cap possible returns, the loss distribution is

generally skewed toward zero with a long right-hand tail. Although an institution may not use

the entire loss distribution in for decision-making purposes, credit risk models typically

characterize the full distribution.

A credit risk model‟s loss distribution is based on two components, the multivariate

distribution of the credit losses on all the credits in its portfolio and a weighting vector that

characterizes its holdings of these credits. This ability to measure credit risk clearly has the

potential to greatly improve banks‟ risk management capabilities. With the forecasted credit

loss distribution in hand, the user can decide how best to manage the credit risk in a portfolio,

such as by setting aside the appropriate loan loss reserves or by selling loans to reduce risk.

(Institute of Finance Working Group on Capital Adequacy, 1998) and (International Swaps

and Derivatives Association, 1998) in their reports also suggested that bank regulators permit,

as an extension to risk-based capital standards, the use of credit risk models for determining

the regulatory capital to be held against credit losses.

Currently, under the Basel Capital Accord, regulated banks must hold 8% capital against their

risk-weighted assets49, where the weights are determined according to very broad criteria. For

example, all corporate loans receive a 100% weight, such that banks must hold 8% capital

against such loans. Proponents of credit risk models for regulatory capital purposes argue that

the models could be used to create risk weightings more closely aligned with actual credit

risks and to capture the effects of portfolio diversification. These models could then be used

to set credit risk capital requirements in the same way that VaR models are used to set market

risk capital requirements under the MRA.

A number of important issues must be addressed before credit risk models can be used in

determining risk-based capital requirements. (Tracey and Carey, 1998) suggested that the

49
Please see off-balance-sheet risk in appendix
18
first set of issues should focus on the quality of the inputs to these models, such as accurately

measuring the amount of exposure to any given credit and maintaining the internal

consistency of the chosen credit rating standard. Although such issues are challenging, they

can be addressed by various qualitative monitoring procedures, both internal and external. An

ability to compare a credit risk model‟s forecasts to actually observed outcomes is very

crucial. (Altman et al, 2002), for instance used actual prices for a set of publicly traded bonds

to compare the performance of credit loss forecasts from two types of credit risk models.

Towards the mid-nineties, banks and consulting firms also developed credit risk models

aimed at measuring the potential loss, with a predetermined confidence level, that a portfolio

of credit exposures could suffer within a specified time horizon usually one year. These

value-at-risk (VaR) models include J.P. Morgan‟s CreditMetricsÒ (Gupton, Finger and

Bhatia [1997]), Credit Risk Financial Products‟ CreditRisk+Ò (1997), McKinsey‟s

CreditPortfolioViewÒ (Wilson [1997a, 1997b, 1998]), and KMV‟s CreditPortfolioManagerÒ

(McQuown, [1993] and Crosbie [1999])50 as cited by (Altman et al, 2002).

These models recognises RR as being independent from PD. It treats the RR in the event of

default as a stochastic variable which is usually modelled using a beta distribution

independent from the PD. (Fyre J, 2001) proposed that defaults are driven by a single

systemic factor, economic state rather than so many correlation parameters. It assumes that

the same economic factors that cause a rise in default will as well cause RR to decline 51. In

other words, correlation between RR and PD is derived from their mutual dependence on the

50
At first sight these three models seem to be based on non-comparable structures and assumptions
and in practice often yield quite different results when loss distributions of a banking portfolio are
forecasted. However, due to these uncertainties in parameter inputs and model outcomes and the
thereby induced model risk the Basel Committee on Banking Supervision (Basel Committee, 2003)
proposed a revision of the standards for banks‟ regulatory capital requirements which will allow
“internal” estimates only for the default probabilities of the obligors of a financial institution. The use
of complete internal credit risk models for calculating regulatory capital charges will definitely not be
intended.
51
Basically, it assumes that distribution of recovery is different in high-default time periods from low-
default ones.
19
systemic factor. For instance, let us assume that a borrower defaults on a loan, a bank‟s

recovery may depend on the value of the loan collateral. The value of the collateral, like the

value of other assets, depends on economic conditions. If the economy experiences a

recession, RRs may decrease just as default rates tend to increase. This gives rise to a

negative correlation between default rates and RRs. (Jarrow R, 2001) went a step further by

presenting a new methodology for estimating RR and PD implicit in both debt and equity

prices. RRs and PDs according to (Fyre J, 2001) depend on the state of the macro economy.

However, (Jarrow R, 2001) methodology explicitly incorporates equity prices in the

estimation procedure, allowing the separate identification of RRs and PDs.

In addition, the methodology explicitly incorporates a liquidity premium in the estimation

procedure, which is considered essential in light of the high variability in the yield spreads

between risky debt and U.S. Treasury securities which is perhaps one of the safest forms of

investment as a result of the elimination of default risk. A low PD therefore implies that the

firm‟s asset value has to strongly decline in the future before default can occur. Therefore, a

positive correlation between asset value and collateral value implies that the latter is likely to

be relatively low, too, in the case of default.

For high PDs the firm asset value does not have to decline equally substantially before

default can occur. Hence, the collateral value in default is on average also higher relative to

its original value than in the case of low PD. (Perraudin W, 2002) examine the dependence

between recovery rates and default rates. He found that typical correlations between quarterly

recovery rates and default rates for bonds issued by US-domiciled obligors are –22% for post

1982 data (1983-2000) and –19% for the 1971-2000 periods. Using extreme value theory and

other non-parametric techniques, they also examine the impact of this negative correlation on

credit VaR measures and find that the increase is statistically significant when confidence

levels exceed 99%.

20
In the (Merton R, 1974) framework, there exist an inverse relationship between PD and RR;

however, credit risk models developed during the nineties treat these two variables as

independent. One could conclude that recovery risk is a systemic risk component. As such, it

should attract risk premia and should adequately be considered in credit risk management

applications.

2.4 The Unintended Consequences of Basel 11

The Basel 11 capital accord52 (Basel Committee, 2003), a regulatory body under the Bank of

International Settlements allows banks to base their capital requirements on internal as well

as external rating systems. This led to the emergence of so many sophisticated credit risk

models developed by banks to assess their portfolio risk as we mentioned earlier.

Categorising default probabilities as well as probability of moving from one rating state to

another are fundamental issues in the credit risk models. Internal risk rating 53 was given a

prominent role as the entire pillar was set up around three key pillars, the first rule was for

determining banks minimum capital requirements for credit risk, operational risk and trading

52
The model underlying the Basel II internal ratings based capital calculation as agreed upon by the
Basel committee on banking supervision (Basel Committee, 2003) measures portfolio losses only. In
other words, these are loses that are as a result of macro-economic factors which cannot be
diversified. Both the PD and loss given default (LGD) are very crucial in accessing expected capital
losses and measuring the exposure of portfolios of default-able instruments to credit risk. Ignoring the
interdependence borne in PD and LGD could lead to underestimation of risk borne by portfolio
holder. (Carey M, 2000) and (Hamerle et al, 2003) both support the fact that PD and LGD are
correlated and micro-economic risk are likely to affect both variables. However, the gap in the study
will be in the sense that the models were such that PD is dependent on a state variable assuming that
LGD is either fixed or at least independent of default intensities.
53
The internal rating system helps in assigning each credit to one of a series of risk categories
according to the borrower‟s probability of default. Later on, assessment of the probability of
migrating from that position usually called credit quality state is factored in during the planning
horizon. In a default mode model, this process amounts to assessing the probability of default, while
in a multistate model, it also incorporates assessing transition probabilities between internal rating
categories. The accuracy of both the assignment and the quantification of banks‟ internal risk rating
are critical, as these ratings and transition probabilities have a very significant effect on the estimation
of portfolio credit risk. One also has to estimate he likely exposure of each credit across the range of
credit quality states. For whole loans, exposure is simply the face value of the loan and is usually
constant across risk categories, but for other positions such as lines of credit or derivatives due to
variation in exposure over time and might be correlated with the particular credit quality state. At this
point, we determine is the valuation of the position.
21
book issues, the second rule provides guidelines for the supervisory review process and

contains and the third rule itemise disclosure requirements to promote market discipline.

However, unlike the previous accord, big and internationally active banks make the size of

the required buffer capital contingent on their own appraisal of counterparty risk. It will be up

to the banks to characterize the riskiness of the counterparts and loans in their portfolios by

means of risk categories.

Based on all these, the Basel II Accord54 has been extremely criticized because of its

implications from its first conception55. (Altman et al, 2002), suggested that relying on

traditional agency ratings may produce cyclically lagging rather than leading capital

requirements and that the risk based bucketing proposal lacks a sufficient degree of

granularity. Instead they advised to use a risk weighting system that more closely resembles

the actual loss experience on loans.

This criticism was taken a further step by (Hamerle et al, 2003) and (Rozbach et al, 2004),

wherein their paper employed credit risk models for the ultimate goal of calculating capital

requirements under a variety of alternative systems and makes clear, among other things, how

the proposed internal ratings based (IRB) approach relates to general Value-at-Risk (VaR)

models of credit risk and state-of-the-art risk rating and how the technical specification of the

final IRB design will affect banks‟ policies. To what extent a credit is justified will depend on

at least two factors such as the ability of banks‟ internal risk rating systems to adequately

54
Basel 11 required that banks be expected to survive with a 99% confidence level. In other words,
they can only be wiped out once in a thousand years as such, they will only need to aim for that risk
appetite. Imagine predicting with certainty these odds. The only way to achieve this will be taking no
risk at all.
55
Ordinarily, with the near collapse of LTCM based on the models employed by the likes of Robert
Merton, Myron Scholes and John meriwether to mention a few, one would have thought that the next
time Merton proposed an elegant model to manage risk and foretell odds or a computer with a perfect
memory of the past with an ability to quantify risk of the future, investors will run. However, Basel 11
IRB risk weight was centred on Robert Merton‟s model. The model was based on the belief that
tomorrow‟s risk can be inferred from yesterday‟s prices and volatilities.
22
capture the differences between different loans and different types of assets, and the methods

used to calculate the relevant risk measure.

We have reviewed empirical studies of several authors on the ability of banks‟ internal

ratings systems to handle differences between various asset classes and the implications for

credit risk measurement and the eventual functioning of Basel II. Take for instance, (Carey

M, 2000), concludes that the success of the IRB approach will depend on the extent to which

it will take into account differences in assets and portfolio characteristics, such as granularity,

risk properties and remaining maturities. Whereas, (Gordy M, 2000), shows that ratings based

bucket models of credit can be reconciled with the general class of credit Value-at-Risk

(VaR) models.

In other words, IRB parameters such as the target forecasting horizon, the method to estimate

average probabilities of default (PDs) and banks´ business cycle sensitivity will also affect

the way in which the IRB system can function. (Carey and Hrycay, 2001), study the effect of

internal risk rating systems on estimated portfolio credit risk and find that some of the

commonly used methods to estimate average probabilities of default (PDs) by rating class are

potentially subject to bias, instability, and gaming. (Rozbach et al, 2004), investigate the

consistency of internal ratings at two major Swedish banks. They find that loan size and

portfolio size are very important determinants of the shape of credit loss distributions and that

the banks differ significantly in their perceptions of an identical loan portfolio‟s riskiness.

(Schmit M, 2003), studied retail lease portfolios by means of a Monte Carlo resampling

method and finds that the Basel II framework insufficiently recognizes collateral. He also

modelled future margin income and showed that the capital ratios generated by the Basel

formula best match those generated by their model for low-risk portfolio segments. Their

results suggest some inadequacies in the Basel framework. Capital ratios for high-risk

segments can sometimes be lower than for low-risk segments. With regards to these findings,
23
one could say that Basel‟s assumptions about the interaction between asset correlations and

the probability of default may be inaccurate, especially at the extreme ends of the risk

spectrum if we decide to look at it from the Taleb Nassim black swan point of view.

2.5 Credit Rating Agencies and Shadow Banking System

Credit rating agencies (CRA) 56 play a crucial role in the debt market as the accepted

determiners of risk for investors, regulators and issuers 57. There is a growing concern that

investors, particularly institutional investors, rely on ratings without performing their own

credit analysis. A report by the U.S. Securities and Exchange Commission acknowledged the

growing dependence on ratings by investors not only for public debt offerings but also in

private debt arrangements and by regulators. Under (Basel Committee, 2003) a substantial

portion of prudential regulatory role was relinquished to the agency.

The debt market is very huge as it consist of various asset classes such as government bonds,

municipal bonds, corporate bonds, mortgage backed securities, credit card ABS, commercial

mortgage backed securities to mention a few.

Although the three rating agencies (Moody‟s, Standard & Poor‟s, and Fitch) have different

approaches in assigning credit ratings, they do focus on the same areas of analysis. For

instance, Moody‟s investigates asset risks, structural risks, and third parties to the structure

(Moody's Investor service, 2002). In order to evaluate asset risks, they analyse the credit

56
They are the mortar of global financial infrastructure. They are used by issuers to sell their bonds,
by investors to judge the safety of those bonds and by regulators to protect investors (Bassett R,
2010), they are so important as they are seen as the de-facto regulator of the financial system. As
such, if their formulas crumble, the entire system is in chaos as was the case during the crises of 2007-
2008.
57
Of all the players in the market, investors are the least equipped with tools to analyse the various
range of securities. As such in buying securities, what the focus on is the investment grade of the
security as the credit rating agency judges the safety of the security. On the part of the regulator, they
use the credit agencies as the method of choice for determining safety as they have delegated a critical
prudential role to the agency. The issuers would not think of issuing a security without the seal of
approval of a recognised agency based on the watchdog role that has been placed on them.
24
quality of the collateral. They consider the underlying borrower‟s ability to pay and the

borrower‟s equity in the asset. In evaluating structural risk on the other hand, the rating

agencies examine the extent to which the cash flow from the collateral can satisfy all of the

obligations of the tranches in the securitization transaction. The cash flow payments that must

be made are interest and principal to investors, servicing fees, and any other expenses which

is otherwise known as the waterfall feature. Whereas the third-party providers to a

securitization transaction investigated by the rating agencies are credit guarantors commonly

bond insurers or the trustee.

We will in as much as possible avoid the rather simplistic condemnation of the rating

agencies that has become prevalent in so many papers about the crisis. The reason being, they

prevent a rational analysis of the root cause of the problem. Credit rating agencies 58 have

played a key role in the origins of the current crisis which should prompt calls for their

regulation. Abrupt and unanticipated credit rating downgrades of a number of participants

and securities in the structured credit markets have led to large market losses and a rapid

drying up of liquidity59.

If bond ratings were informative with regards to the efficient market hypothesis 60, a method

for selecting investments devised in the 1950‟s by Harry M. Markowitz as inspired by

58
Previous rating crises has shown that ratings increase systemic risk and may be pro-cyclical as they
fuel investments in good times whereas accelerate market losses in bad times. For instance, CRAs
identified weaknesses in the financial systems of a number of Asian countries before the crisis. The
maintenance of investment-grade ratings for many countries and the subsequent sharp downgrades
during the crisis has been seen by some observers as imparting a pro-cyclical element. As a result,
unanticipated abrupt downgrades of securities are therefore negative shocks to securities markets and
can affect one issuer, a whole sector, or the entire financial system.
59
See rating downgrades by Moody‟s and standard and Poor‟s in the wake of the credit crisis
60
The hypothesis holds that in an ideal market, all relevant information has already been priced into a
security today. As such yesterday‟s change does not influence today‟s change nor will today‟s change
influence tomorrow as each price is independent of itself. The assumption being stock prices are
always right as such no one can divine the market future which in turn must be random.
25
(Bachelier L, 1900, Translation 1964) in his doctorial thesis61, one would expect stock and

bond prices to move in response to rating changes.

Besides, the same model assumes that markets are rational; no one can beat the market as

market price reflects all available information. It appears however that you could sometimes

beat the market as was the case of Peter Lynch who guided Fidelity‟s Magellan fund with an

annual average of 28% to outperform Standard &Poor‟s 500 indexes of 17.5%. He achieved

this feet in eleven out of thirteen years (Marcus A, 1990). Even William Shakespeare had an

idea of portfolio diversification “…I thank my fortune for it, My ventures are not in one

bottom trusted, Not to one place, nor is my whole estate, Upon the fortune of this present

year; Therefore my merchandise makes me not sad (Shakespeare W).

As early as the 1970s Pinches and Singleton (1978) as cited by (Kamath K, 2010), found that

the lag between the stock market incorporating changes and the actual bond rating change is

as much as 15-18 months. They conclude the information content of bond rating changes to

be very small. (Ederington L, 2004), suggested that stock prices and stock analyst forecasts

predict bond rating changes. They observe that bond downgrades typically take place after a

period of negative abnormal stock returns. (Guembel A, 2008), argues that rating agencies

may have an incentive to misrepresent 62 credit quality during a systemic crisis.

They facilitated the crisis as a result of conflict of interest. While CRAs have, in principle,

list price schedules, they may renegotiate fees with regular customers. The SEC found that

senior analytical managers and supervisors participated in fee discussions, ratings decisions

and methodology in the context of fees and market share with the issuers (White L, 2002).

61
Louis Jean-Baptiste Alphonse Bachelier was born in March 11, 1870. He was a French
mathematician at the turn of the 20th century. He is credited with being the first person to model the
stochastic process now called Brownian motion, which was part of his PhD thesis The Theory of
Speculation.His thesis, which discussed the use of Brownian motion to evaluate stock options, is
historically the first paper to use advanced mathematics in the study of finance. Thus, Bachelier is
considered a pioneer in the study of financial mathematics and stochastic processes.
62
They see the rating agencies as powerful gatekeepers who have misused their position of influence.
26
Besides, the rating agency is paid only if the credit rating is issued. In other words, if the

issuer is unhappy with a rating, it may solicit another one. besides, credit rating agencies want

to remain in business for the foreseeable future as such, their reputation is at stake in inflating

short term gains against which is quite lower than long term loses from jaded investors.

Let us assume an investment is characterized by its probability of default from the CRA point

of view. A bad investment defaults with probability p > 0, and a good investment defaults

with probability zero. In other words, they will yield the same return R when there is no

default occurrence and the recovery amount r conditional on default. The investment has

constant returns to scale, so that each unit issued has the same return profile. As such, all

party to the contract believe ex-ante that the investment is good with probability ½. With

regards to this CRA can use its technology to find out whether the investment is good or bad.

A signal Ɵ ϵ {g, b} is the private information of the CRA and has the following informational

content about the true state of the world ɯ

Pr (Ɵ = g ǀ ɯ = g) = Pr (Ɵ = b ǀ ɯ = b) = e

Pr (Ɵ = g ǀ ɯ = b) = Pr (Ɵ = b ǀ ɯ = g) = 1 - e

The term e measures the quality of the signal received which is e = ½ as such, where e > ½,

the signal becomes informative signalling two fees; the issuer must pay in order to retrieve

the signal. Thereafter, the rating fee is paid for it to be issued. Basically, the initial fee is for

hiring the CRA to perform the analysis, or put simply, pre-assessment of the investment. The

ratings fee may be thought of as the fee to have the rating publicly reported, and could also

include revenues from consulting business with the issuer. The rating will be a message or

report of m = G (“Good”) or m = B (“Bad”) that will be observable to investors. At this point,

the issuer can either pay to have it distributed or shop for other available agencies.

27
Rating agencies facilitated the distribution of risk and admitted it would take their most

sophisticated computers more than a week to assess the risk of some asset backed securities

(Stafford P, 2009).

Deven Sharma, president of S&P acknowledged that the historical data they used and the

assumptions they made significantly underestimated the severity of what has actually

occurred. Even though most securitisation is valuable as they can match individual consumer

preference, it created enormous risk.

Credit risk agencies models where based on the Markowitz modern portfolio theory63.

Financial engineers could re package a lower rated security into AAA security. For instance,

in many cases, by transforming a BBB into mostly AAA rated securities through financial

alchemy, by transforming toxic assets to gold. A financial engineer will be able to sell all of

the liabilities of this new structure at a far lower spread than the BBB rated securities (Bassett

R, 2010). In analysing a security, the engineers could use the variance and beta; which is the

degree with which the price of an asset correlates with the market.

It also follows the bell curve assumption as such its validity will depend entirely on whether

prices really fit the bell curve, to build an ideal risk and return for investors as they alter the

mix of volatile and stable security.

Rating agencies relied to a large extent on predicted loss and probability of default to

determine ratings of structured credit securities as the distribution was Gaussian 64 or thin

63
He pointed out in his paper portfolio selection in the journal of finance 1952, that highly diversified
portfolios of assets are superior to concentrated portfolios as returns on diversified portfolios are less
volatile. As such, having a reduced loss variance on portfolios of debt meant that one could take a
portfolio of high BBB rated assets which are uncorrelated, slice up the returns on this into various
tranches and have the senior with very little or no projected losses therefore they are rated AAA.
64
Gaussian distribution is attributed to Carl Friedrich Gauss. It is a theoretical frequency distribution
representing the values of a variable may take on. It is symmetrical and bell shaped and it is also
known as normal distribution.
28
tailed65 (Kamath K, 2010). Reason being in order to calculate the expected loss on a tranche

of a structured security, one need to determine the probability of default and loss given

default of each asset. Thereafter, they assume a correlation between defaults for each asset.

As a result of lower correlation between the assets, the tails of the loss distribution has been

reduced as such the result is centred more on the expected loss. This ability to combine

diversified uncorrelated assets66 into portfolios with predicted loses was the genesis of

shadow banking.

The regulatory capital for asset securitisation products as well as all other structured credit

products is based on credit ratings (Basel Committee, 2003). However, these ratings are

based on the amount of subordination or first dollar loss protection sitting below the

investment being rated (Standard and poor‟s). As a result of this, all investors are focused on

the amount of subordination as the centre of the finance universe rather than focus on the

liabilities senior to the investment (Taleb N.N, 2008). The rating agencies examined the

known history of default and recoveries for each asset type and determined a loss distribution

for a pool. Upon determination of the loss distribution, these loses were attached to tranches

65
Let us assume two scenarios using the normal distribution theory. Imagine the distribution of
heights of students in the Msc. Finance class of 2010 at University of Wales is say 5‟5‟‟. If we go
further to take results of say the entire university assuming total student population is 100,000. We
start to get a good idea of the distribution of heights. Let us also assume that UOW is privileged to
have the tallest man in the world with a height of 8‟11‟‟ according to Guinness book of record. While
this is amazing, eventually the average will be in the range of 5‟5‟‟. Now let us assume we take a
survey of wealth in United Kingdom, if we survey 100,000 people, we might come up an average
wealth of £80,000. Now compare the effect of what when we include the wealth of the richest man in
UK. Let us say it is in the range of £40 billion. This individual is 500,000 more than the average.
Including him in the distribution increases the original average by £400,000. Nowhere in the data
point did we anticipate this input. His wealth is totally unexpected and unpredictable.
66
Let us assume we have two assets which are uncorrelated and both have one-in-ten default
probabilities within a year with a 100% total loss if default arises. If one assets defaults, it is a bit
unlikely that the other will default. Going a bit further, mathematically, if the assets are zero
correlated, the chances of default within one year is increased to one-in-one hundred. On the other
hand, the chance of one of the two assets defaulting is about twice the probability of either single asset
defaulting. As such, by pooling the two assets together, we increase the probability of at least one
default within a year but reduced the probability of a total portfolio loss. However, one key note in
systemic risk is that all risky assets become correlated as such a measure of risk which is sensitive to
errors is highly necessary.
29
to make up the capital structure. Any tranche that its subordination exceeds the stress level is

deemed not to experience any loss as such it is AAA rated. Apparently, rating agencies failed

to explicitly use leverage as a rating factor to rate securitisation structure reason being since

Basel 11 specifies a capital requirement and this is based on the history of expected loses. As

we all saw, expected loss67 was highly vulnerable to the financial sector.

2.6 The Need for Change Using See-Through Leverage

The alternative model we are going to present is based on a mathematical approximation of a

tranche‟s sensitivity to errors in underlying loss assumptions at the point where losses first

touch that tranche. The aim of adopting the previous distinction in credit risk models is that

of providing both a better theoretical framework and a better empirical fit. Leverage as we are

aware multiplies financial strength. It enables one to earn a return on the capital borrowed as

well as your own money. However, power to lose is also multiplied (Lowenstein R, 2002).

For any securitisation structure, the capital structure defines the subordination and seniority

of each tranche of the capital (Bassett R, 2010).

In other words, each tranche may have some subordination junior to it and at the same time

have some tranche senior to it. As such the total amount of senior and junior subordination

represents the entire capital structure, whereas the width of a tranche is represented by the

capital represented by just that tranche. Basically, simple tranche leverage can be seen as the

width of a tranche plus the total debt senior to that tranche, divided by the width of that same

tranche. See-through leverage (STL) basically measures the mathematical approximation of a

67
Expected loss is the mean of the loss distribution and represents the amount that a bank expects to
lose on average on its credit portfolio. As such, capital requirement should be more about how the
actual loss may be significantly worse than the expected loss
30
tranche‟s68 sensitivity to errors in the underlying loss assumptions at the point where loses

first touch that tranche. 69

The STL(X), which measures the lender‟s leverage, can also be enhanced to include the

borrowers leverage through the loan-to-value (LTV) ratios. As such, we create an index

which incorporates risk implied by both borrower and lender (Bessis J, 2010). With the STL,

we can derive an ideal relationship among expected loss of a loan, expected losses of a

tranche and the unexpected losses 70. As such, it is important in measuring sensitivity to errors

in loss distributions.

2.7 STL as a Measure of traditional Leverage for Securitisation

Assuming an investor buys a 3% to 6% tranche of a securitised pool of assets. The STL 71 can

be calculated as thus:

The capital investment is 3% (6% - 3%) and there is 97% of the capital structure above the

attachment as such,

97%
3% = 32.3 times STL

68
Tranches are subject to correlation risk (Bessis J, 2010). The reason being tranches issued by a
securitization is similar to N-to-default derivatives where N is a fraction of the total number of assets
within the portfolio. As such the probability that a single tranche defaults is equal to the probability
that a minimum fraction that all assets default.
69
Let us assume a BBB rated tranche has a subordination of 5% and by itself 1.5% wide, it will
therefore be supporting 93.5% liabilities senior to it. We can conclude that STL is 93.5/1.5 which
means 62.3 times levered. Assuming we go further and look at a mezzanine ABS with a zero capital
allocated to it under (Basel Committee, 2003) if it was hedged. It would require 7% times 8% or
56bps of capital in a regulated bank. In other words, the bank could lever itself up to 100/0.56 or
178.5 times. As such in order to achieve a STL of 178.5 times 62.3 or over 11,120 times.
70
Unexpected loss is a measure of the variability in credit losses, or the credit risk inherent in the
portfolio. Unexpected loss is computed as the losses associated with some high percentile of the loss
distribution (for example, the 99.9th percentile) minus expected loss. A high percentile of the
distribution is chosen so that the resulting risk estimates will cover all but the most extreme events as
such, the credit rating agencies usually do not take this into consideration as the model ignores
leverage even though it has a lower probability, the impact is usually higher.
71
Please note that for the purpose of this paper, we have used STL (0) and STL(X) interchangeably.
The reason being STL (0) represents simple tranche leverage whereas STL (X) represents any number
depending on the number of securitisation layers that we need to see-through.
31
Let us assume the bank based on their analysis concludes that there is no way under any

circumstances that the pool of loans will lose more than 3%, you as an investor could agree to

put a 3% cash payment and agree to buy 3% to 100% of the securitised pool of assets.

Imagine the level of exposure that has been created as you have been allowed to borrow the

remaining cash with no recourse as the only collateral available to the bank is the tranche

investment.

3 Research Methodology
3.1 Research Strategy
We have been privy to what previous researchers have found on the subject matter. However,

we have seen that based on most studies, so much attention was placed on probability of loss

and loss distribution. We on the other hand intend to go a bit further by studying the

sensitivity of a tranche to unexpected errors. For the purpose of this study, the data that will

be used in this study will comprise of ABS securities tranches issued between 2006 and 2007.

We intend to ignore the underlying asset class 72 and all water fall73 feature, in other words,

we will focus only at the credit rating and estimated STL.

3.1.1 Qualitative and Quantitative Research

We intend to employ both the quantitative and qualitative research approach in reaching an

objective conclusion. The reason being, the quantitative which is concerned with

measurements and quantities will help us in answering the how questions whereas the

qualitative will help us in answering the why questions.

72
In a typical ABS, it usually consists of various asset classes such as mortgage, credit card
receivables and auto loans. It is quite a homogenous pool of assets.
73
This simply defines the way cash is distributed in a special purpose vehicle according to the
seniority and subordination of the various tranches.
32
3.1.2 Sampling Technique
Our sampling technique could be seen more like a convenient technique as it is focused

mainly on the timeline of the global financial crisis. As the name implies, it is a non-random

and non-probable approach. The main reason for this is the time constraint attached to the

completion of this study. As such, it could be seen more as an exploratory research which

could serve as an insight for a more robust research.

3.2 Research Questions

The aim of this research is to test how well STL will predict riskiness of an investment

security in practice. In order to evaluate its effectiveness, we intend to apply two tests

1. Does STL explain retrospectively the downgrades that have occurred in ABS assets,

and therefore the massive increase in required capital which banks now seek?

2. Does STL explain the change in value of AAA assets of home equity loans?

3.3 Research Approach

The research will follow a deductive and quantitative approach. We intend to review past

literatures on the subject matter, having done this, we will propose see-through leverage as a

measure of credit risk.

3.4 Research Philosophy

The philosophy of our research is that of positivism as we are of the notion that reality is

objective and independent based on the fact that our phenomena can be measured and

predicted. We will not be influenced by unpredictable behaviour of human beings in order to

arrive at a realistic result. We believe our study can be achieved with actual inference based

on the phenomena under study rather than using a dummy test in arriving at a valid

conclusion.

33
3.5 Hypothesis
Our hypothesis will be through the research questions and our strategy in answering the

questions has being such that the dependent and independent variables are robust enough to

provide an adequate answer.

Where:

H0 = STL does not explain retrospectively the downgrades that have occurred in ABS

assets.

μ1 = STL does explain retrospectively the downgrades that have occurred in ABS

assets.

H0 = STL does not explain the change in value of AAA assets of home equity loans?

μ1 = STL does explain the change in value of AAA assets of home equity loans?

4 Data Analysis

4.1 Introduction
The principal data source used in this study was collected from the data reported by Standard

& Poor‟s and Structured Finance International (SFI) magazine published by Euromoney

Institutional Investor Plc. SFI is recognized by participants in the securitization market as one

of the world‟s leading journals and news sources. We collected information on 9,041 tranches

from 2,296 securitization transactions (total par value of €1.45 trillion) completed between

January 1, 1999 and December 31, 2007. Because we limited the types of ABS investigated

as explained below, we used a final sample (from our total population of 9,041 tranches)

consisting of 300 tranches between 2006 and 2007 (total par value of €166 billion) from 56

securitization transactions.

34
In our study we eliminated any tranches that are puttable or callable and tranches that allow

the quoted margin to change over time. Furthermore, we restricted the tranches in our sample

to those that were issued at par value so that the quoted margin on the issues would reflect a

spread above the interbank offered rate without being distorted by any premium or discount

on the offering price. Hence, the quoted margin is the primary market spread in our study

which reflects credit risk.

Next, we used credit rating data to assign numerical values to each rating for each tranche

with higher numbers reflecting lower credit ratings. In our sample we did not did find

tranches with a rating below Ba3 or BB-, so our rating classification scheme consists of 11

credit-rating dummy variables corresponding to Aaa/AAA, Aa1/AA+, Aa2/AA, Aa3/AA-,

A1/A+, A2/A, ….., Ba3/BB-.

A single rating, however, does not capture adequately all of the risks inherent in ABS

(Goldstein et al, 2008), for instance, states “Credit ratings are incomplete descriptions of

riskiness. Credit ratings may be assessments of creditworthiness, but they are not assessments

of the level of liquidity, market or rating volatility risk…”

This paper aims to shed light on the above issues. To this end, we carried out a regression

analysis using the natural log of the STL (X) of 300 different ABS securities tranches issued

in 2006 and 2007 against their current ratings for those securities. We focus on ABS deals for

two reasons. First, parents can easily identify the end, real or sponsors while the CDO, the

identity of the perpetrators is unknown due to the opacity of the CDO and complexity.

35
4.2 Regression Analysis
The regression analysis employed for the purpose of this paper is the natural logarithm

model. The reason being the dependent variable (DV) is binary as it only has two possible

outcome (Yes/No).

Y= exp (b0+b1*X1)/ {1+exp (b0+b1*X1)}

4.3 Findings
 Does STL explain retrospectively the downgrades that have occurred in ABS assets,

and therefore the massive increase in required capital which banks now seek?

We carried out a regression analysis using the natural log of the STL(X) of 300 different ABS

tranches issued in 2006-2007 against the current credit ratings. We tested a variety of asset

class including collaterized debt obligations, collaterized loan obligations, car loans, credit

cards and prime residential mortgage backed securities. We did not take into consideration

the underlying asset class and waterfall features as we were only concerned with the credit

rating and the correlation with the STL (X).

Based on table 4.3.1 below, we can see the origin of shadow banking in a clear perspective.

Mezzanine debt tranches of mostly consumer debt were transformed into AAA rated

securities through the process of financial engineering. If all assumptions were given a

significant level of reality then we could see those probabilities of default and the correlations

between the defaults were highly levered based on the extreme confidence attached to the

models and ability to forecast correlations and defaults.

From table 4.3.1, we can see that even though the Tranche D security was levered over 2000

times, it still has AAA rating. On the other hand, the Tranche A security also rated AAA is 73

times levered as such, it will require only 56bps in capital under the Basel 11 rules. What we

36
are saying in essence is that the AAA rating should not be looked at in isolation as it is not

sufficient enough to identify the riskiness of a security.

We discovered that the natural logarithm of STL (X) explains 34% variation in the credit

ratings of these securities. The t-statistic for the natural log of STL (X) was 13.32, which is

highly statistically significant. We also deviated a bit using the original credit ratings of these

securities so as to explain the current ratings; we find that they explain 7% variation for this

same group of securities.

In order to estimate borrower leverage and the ratio of loan to value (LTV), we created a

proxy for the same securities. We multiplied the STL (X) by the leverage of the borrowers

which have LTV. When we carried out a regression analysis using the natural logarithm of

the proxy against the credit ratings we found that it explained 48% of the variation with a t-

statistic of 16%. Finally, we considered only the AAA rated securities and found it to be

slightly lower.

4.3.1 Table 4.3.1

Subordination
or Original
Tranche Size (000s) Detachment Detachment Width Rating STL(0) STL (X)
A 141,276,595 14.89% 100% 85.1100% AAA 1 73
B 10,595,744 8.51% 14.89% 6.3800% AAA 14.3 1046
C 4,944,680.00 5.53% 8.51% 2.9800% AAA 31.7 2315
D 4238297 2.98% 5.53% 2.5500% AAA 38 2774
E 1271489 2.21% 2.98% 0.7700% AAA 128 9320
F 423829 1.96% 2.21% 0.2500% A- 384 28032
G 2119148 0.68% 1.96% 1.2800% BBB 77.8 5679
SUB 1130212 0.00% 0.68% 0.6800% NR 147 10722
TOTAL 165,999,994

37
  Does STL explain the change in value of AAA assets of home equity loans?

For the purpose of answering this question, we only considered a single asset class of home

equity loan originally rated AAA. After carrying out a regression analysis of the STL (X)

against the current market price, we could only explain 62% of price variation. Based on the

time constraint involved in this empirical study, we ignored the originator and geography of

the security. We were able to distinguish between a toxic and safe AAA rated security.

Based on table 4.3.2, we can see that even though the borrowers were clearly below the prime

lending category as a result to high leverage and record high poor payment history, the pool

can be re-structured through financial engineering into different tranches with mainly AAA

rated bonds. We can see that a security with an STL of 28.2 was rated AAA. This is highly

levered as such; a single basis point loss on the security with no subordination will cause

28bps loss in the AAA rated investment. Besides, home equity is a far riskier asset than the

regular credit cards and auto loans.

4.3.2 Table 4.3.2

Subordination
Size or Original
Tranche (000s) Detachment Detachment Width Rating STL
A 420403.6 66.37% 100% 33.6300% AAA 1
S 420403.6 32.74% 66.37% 33.6300% AAA 2
C 112107.6 23.77% 32.74% 8.9700% AAA 8.5
D 35033.63 20.96% 23.77% 2.8100% AAA 28.2
E 42040.36 17.60% 20.96% 3.3600% AA+ 24.5
F 42040.36 14.24% 17.60% 3.3600% AA+ 25.5
G 28026.91 12.00% 14.24% 2.2400% AA 39.3
H 21020.18 10.31% 12.00% 1.6900% AA- 53.3
I 21020.18 8.63% 10.31% 1.6800% A+ 54.3
J 19618.83 7.06% 8.63% 1.5700% A 59.2
K 16816.14 5.72% 7.06% 1.3400% A- 70.1
L 14013.45 4.60% 5.72% 1.1200% BBB+ 85.1
M 14013.45 3.48% 4.60% 1.1200% BBB 86.1
N 9809.417 2.69% 3.49% 0.7950% BBB 124
O 9809.417 1.91% 2.69% 0.7800% BBB- 125
P 4204.036 1.57% 1.91% 0.3400% BB+ 292.7
38
 Not
Q 19618.83 0.00% 1.57% 1.5700% Rated 63.7
Total 1250000

With this measure, investors could distinguish between the toxic and safe AAA rated

securities. The fact that parents end, real or sponsors of degraded ABS offers return to market

only after experiencing significant delays in its release schedule provides conclusive evidence

for market discipline. However, this finding is incomplete because it ignores the changes that

could affect the securitization market in general. As such we propose this study as a starting

point for a more robust research where time will not be a major constraint.

Based on our hypothesis using a two tailed test, we find our results to be highly statistically

significant as such we reject both null hypotheses.

5 Conclusions
We have presented an innovative model for credit risk evaluation; See-Through Leverage, we

have strengthened the theoretical model presentation with an assessment of its empirical

performance, based on the literature review. The model seems to capture and differentiate

between toxic and investment grade assets. Based on this, there are quite a number of

conclusions we can draw from this research paper.

For instance, we have seen how consumer and low grade securities can be pooled into a

portfolio through financial engineering and later tranched into AAA rated securities based on

the mathematical assumption of less than perfect correlation. In other words, the model

assumes that defaults are less than perfectly correlated as such it can only affect the

subordinated tranches in the capital structure.

39
We also found that a huge portion of securitization was more or less trying to get as much

debt which needed funding for various assets to the AAA rated level as possible so as to

make this investment favorable from the investors point of view whereas he is paying for a

toxic asset. The reason being AAA rated assets are the benchmark for most if not all assets.

As such, investors can easily compare relative safety between different asset classes.

It is also very clear that credit rating agencies did not focus on sensitivity to errors of their

ratings. The reason being subprime borrowers who more or less have a poor credit history

were issued mortgages which were later securitized into home equity ABS and were

eventually rated AAA. The whole essence of AAA rated security is its safety. However, this

intuition is defeated when a so called safe security is levered more than 500 times, one need

to question the transparency of the credit rating agencies and their models.

In this world where rating agencies assume to have a pre-knowledge of the probability of

default and the exact loss distribution, going by the words of Alan Greenspan, the credit

rating agencies should have the complete knowledge of the known unknowns as such, there

will be no room for unknown unknowns as such Taleb Nassim‟s black swan will be a myth.

In other words, credit rating agencies needs to put in their assumption that the future will not

always be a repeat of the past. Take for instance, drawing cards from a deck; there will

always be cards in the deck that are different from any of those ever drawn. As such, the

probability of default and loss distribution cannot be known with certainty as such, banks,

rating agencies and other regulatory bodies should always prepare for the unknown

unknowns.

Having said this, STL or credit rating should not be taken in isolation as one should see both

more like a Cartesian coordinates with x and y axes (Bassett R, 2010), the reason being once

40
you know one, there is a high possibility of determining the other. Perhaps, in order to judge

the riskiness of a security, one should know both the STL and credit rating.

5.1 Recommendation
All regulatory arms have to be on deck in order to restore market confidence. Confidence

needs to be restored in the risk ratings of securities and regulations and belief in the safety of

banks (Hyman P, 2008). We need to ensure that banks are no longer excessively levered and

the leverage inherent in any security should be used as the standard risk parameter. In other

words, investors need to be able to view credit rating agencies ratings from a different

perspective. Perhaps setting up a watchdog on the rating agencies could be a good idea. In

that way, they will ensure that the judgment they pass on any instrument, corporation or

country will be appropriate.

Also there is a need for change in the way banks, investment banks and funds most especially

money market funds are regulated like the case of the Glass-Steagall act of 1932 thus

separating investment banks from depository banks as one could attribute the repeal of this

act as one of the root cause of the global financial meltdown. The regulators could even be

stricter by enforcing narrow or limited purpose banking thereby ensuring fractional reserve

banking. However, HSBC Holdings, Barclays and Standard Chartered have stated they will

relocate their holdings in the UK if the government persists on splitting retail and investment

banking (Anstee N, 2010).

However, as no other economies have shown signs of following this path, it will pose a big

risk on the UK economy. Besides, we also need to establish the fact that it is not the

integrated banks that failed. Some economic historians have also suggested that commercial

banks with affiliates are less likely to fail than stand-alone commercial banks. In other words,

41
if this banks move their operations overseas, UK faces the risk of lower jobs and a huge cut

in its tax revenue which will have a high negative effect on UK‟s future prosperity.

The subprime crisis has brought to light the poor performance of CRAs in rating structured

financial products and reminded investors of CRAs past poor performance in predicting the

East Asian crisis, the excesses of the dotcom bubble, and the collapse of Enron. As a result of

this, there have been calls in recent months to regulate CRAs.

The New York State Attorney General Andrew Cuomo already reached an agreement with

credit ratings firms to change some features of the rating process (Durbin E and Iyer G,

2008). Also, the SEC was given authority by the United States Congress in 2007 to regulate

the credit ratings industry and has begun to propose rules in the summer of 2008. The

European Union is also pursuing regulations to resolve conflicts of interest in the credit

ratings industry. Although the Cuomo plan eliminates conflicts of interest for CRAs, we feel

prohibiting shopping by enforcing disclosure of all ratings will benefit naïve investors.

It is also worth pointing out that fire walls should be created in the financial system and the

un-anticipated crises which can occur thereby preventing a contagion effect whereby the

collapse of one financial institution will not have a significant impact on the entire financial

system as was the case of Lehmann Brothers.

5.2 The Emergence of Basel 111

The main idea behind prudent banking is ensuring that all eggs are not put in one basket. Like

we mentioned earlier, diversification is not only acknowledged by the financial theorist. It

was also acknowledged by Shakespeare, the Talmud and also in the scriptures. The only issue

here as was mentioned earlier is that diversification will only work if assets are not

correlated. Had the financial system held more capital two years ago and not relying on the

42
fancy models which allowed banks to operate with little or nothing set aside for the risk they

were taking, perhaps there would have been no market upset or bail-out.

The proposed Basel 111 reform seems encouraging at least to an extent as the regulators are

up from their slumber. Banks will have to hold tier 1 capital in the form of retained earnings

or equity equivalent to 7% of risk bearing assets (Bank of International Settlement, 2010).

Another welcome part is the fact that banks have between five to nine years to implement this

as they will have to take greater account and put cash aside for any credit exposure.

However, the Swiss regulators have asked UBS and Credit Suisse to go above and beyond the

Basel 111 banking rulings by holding core capital of about 12%, thus ensuring they are about

5% above their European peers (Dakers M, 2010). We feel it is a good move by the Swiss as

the regulators did not go far enough with their 4.5% of total assets, plus another 2.5% as a

buffer against financial shocks making a total of 7%.

Having said this, we need to establish the fact that there has been a Basel 1 and a Basel 11 in

the past and yet we had a banking crisis. The time line of eight years poses another flaw in

the current banking model itself. Having bailed out many weak banks governments are faced

with a problem which is that making them hold more capital weakens their profits and hence

delays any return to the private-sector. The lending capacity which is low at the moment will

reduce drastically.

The banking model is unchanged and might presumably break again as time progresses. As

financial crises appear to be becoming more frequent the next one looks likely to occur even

before the full operation of the new accord. I would imagine that the lunch-rooms of the

world‟s banks may even have a toast to this agreement today as rising share prices are

positively associated with higher executive bonuses.

43
In conclusion, the Basel 111 accord should be very robust and practical thereby creating a

stable and well-functioning financial market system through an examination of alternative

policy responses and the elaboration of corresponding policy recommendations (Charles W,

2008)

44
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48
Appendix
Risk weights by category of on-balance-sheet asset

Risk weight category

0% (a) cash

(b) Claims on central government and central banks

denominated in national currency and funded in that
country

(c) Other claims on OECD central governments and

central banks

(d) Claims collaterized by cash of OECD central

government securities

0, 10, 20, or 50% (at national discretion) (a) Claims on domestic public sector entities
excluding central government and loans guaranteed
by such entities

20% (a) Claims on multilateral development banks

(IBRD, IAD, AsDB, AfDB, EIB, EBRD) and claims
guaranteed by such banks

(b) Claims on banks incorporated in the OECD and

claims guaranteed by OECD incorporated banks

(c) Claims on securities firms incorporated in the

OECD subject to comparable supervisory and
regulatory arrangements

100% (a) Claims on the private sector

(b) Claims on banks incorporated outside OECD

with a residual maturity of over one year

49
Definition of Terms
1. Brownian motion: It is a mathematical model used to describe random movements. It
was previously known as the stochastic process.

2. Bond: It is a long term debt instrument evidencing the indebtedness of the issuer to the
holder.

3. Capital Structure: It refers to the way an institution finances its assets through a
combination of equity, debt or both.

4. Credit Risk: This is a risk that a party to a transaction will be unable to make payments
that are currently due.

5. Credit Rating Agencies: This is a company that issues credit ratings for debt issued by
corporations, governments and special purpose corporations. It may issue a rating for an
issuer and different types of debt issued by the issuer.

6. Correlation: It is a statistical relationship between two or more random variables.

7. Contagion: This is the susceptibility of an institution to have a spill over effect on the
entire financial system.

8. Derivatives: It is an instrument whose price is derived from an underlying asset.

9. Diversification: It is an investment strategy in which funds are allocated across numerous

different assets.

10. Financial Engineering: It is the process of designing, developing and implementing

creative financial contracts, usually involving derivative contracts for the purpose of
solving risk management problems.

11. Fractal: this is a shape or pattern whose parts echo the whole

12. Gaussian distribution: It is a theoretical frequency distribution representing the values a

variable may take on. It is symmetrical and bell shaped, and also known as the normal
distribution. Its creation is attributed to Carl Friedrich Gauss.

13. Leverage: The use of debt to magnify investment return

14. Marking to Market: it is the practice of revealing an instrument to reflect the current
values of the relevant market variables.

15. Premium: This is the additional rate risk averse investors expect for assuming risk

16. Probability of Default: It is a parameter used in the calculation of economic capital under
Basel 11 for a banking institution.

17. Portfolio: This is a basket of investments held by a private individual or an institution.

18. Risk: It is a measure of variability or uncertainty of a transaction or a portfolio

50
19. Risk Weighted Asset: This is a bank‟s asset weighted according to the credit risk of the
asset.

20. Securitization: It is the process of creating asset backed securities

21. Strike Price: It is also called exercise price. It is the price at which an asset may be
bought or sold in a derivative contract

22. Stochastically: It is a process whose behaviour is non-deterministic. Its subsequent state

is determined by both the process‟s predictable actions and a random element.

23. Shadow Banking: It is the system of non-banking financing entities and tools which
grew astronomically since the 1980s. It consist of structured investment vehicles,
commercial paper conduits, collaterized debt obligations to mention a few.

24. Sub-Prime Mortgage: These are loans that were in the riskiest category of consumer
loans.

25. Systemic risk: This is the risk associated with the market or an economy as a whole

26. Subordination: It is the order of priority in claims for ownership or interest in various
assets.

27. Tranche: It can be seen as a slice or portion of transaction. It is a number of related

securities offered as part of the same transaction.

28. Toxic Asset: They are assets whose value has fallen significantly and for which there is
no longer a functioning market. As such, it cannot be sold at a satisfactory price by the
holder.

29. Treasury Bills: It is a short-term pure discount bond issued by the U.S. government with
an original maturity of at least 10 years

30. Value at Risk: It is a dollar measure of minimum loss that would be expected over a
period of time with a given probability

31. Volatility: It is a proxy for risk. It is characterized by the fluctuations in price

32. Waterfall feature: These are cash flow payments that must be made to investors.

33. Yield: It is the discount rate on a bond that equates the present value of the coupons and
principal to the price

51
Glossary
1. ABS: Asset Backed securities

2. AfDB: African development Bank

3. AsDB: Asian development Bank

4. BIS: Bank of International Settlement

5. CDO: Collaterized Debt Obligation

6. CRA: Credit Rating Agency

7. EBRD: European Bank for Reconstruction and Development

8. EIB: European Investment bank

9. FASB: Financial Accounting Standard Boards

10. FI: Financial Institution

11. IBRD: international Bank for Reconstruction and Development

12. IRR: Internal Risk Rating

13. IRB: Internal Rating Based

14. LTCM: Long Term Capital Management

15. LTV: Loan to Value

16. LGD: Loss Given Default

17. MBS: Mortgage Backed Securities

18. MRA: Market Risk Amendment

19. OECD: Organisation for Economic Co-operation and development

20. PD: Probability of Default

21. RR: Recovery Rate

22. RMBS: Residential Mortgage Backed Security

23. RWA: Risk Weighted Asset

24. STL: See-Through Leverage

25. SPE: Special Purpose Entity

26. SPV: Special Purpose Vehicle

52
27. VAR: Value at Risk.

53