Wednesday, December 5, 2007

The Subprime Drama Continues, but for How Long?

From Knowledge@Wharton:

...Has the crisis run its course? Knowledge@Wharton asked that question and several more to Richard Herring, a professor of finance at Wharton and co-director of the Wharton Financial Institutions Center. Herring spoke recently at a meeting in Rome about "the darker side of securitization."

Knowledge@Wharton: Let's start with the headlines. It has just been reported that the investment arm of the Abu Dhabi government is investing $7.5 billion in Citigroup, one of the banks that has been hit harder than others by the subprime mortgage crisis. How serious is Citigroup's exposure, and what will this infusion of capital accomplish?

Herring: This is a striking example of the growing power of sovereign investment funds. In this case, they're going to be giving Citibank a bit of a breather from what has been a growing problem that has jeopardized its position as one of the strongest banks in the world. Citibank has been more heavily exposed to the subprime turmoil than any of the other U.S. banks. It's had more than three times as much exposure as Bank of America and J.P. Morgan Chase, the second two largest banks, combined.

The exposures to subprime have varied from actual loans to the most highly rated slices of the collateralized debt obligations that have been devised to hold some of these loans and pieces of these loans, and pieces of other collateralized debt obligations. It makes for extraordinarily complicated exposure, because some of it is on balance sheet, some of it is off balance sheet, and some of it, quite frankly, is in dispute.

People are, even today, arguing about whether some of the CDOs [Collateralized Debt Obligations] that Citigroup has developed in fact should come back on the balance sheet because they have experienced an event which has changed their very nature -- the event being that Citigroup has actually bought up a lot of the commercial paper and brought much of the funding back on the balance sheet. Citi has, so far -- as I understand it -- refuted this position by saying that they are only following their contractual obligation. But, it does raise the broader question of: When is off balance sheet really off balance sheet?

This is something that troubles the regulators because it relates very directly to reputational risk -- actions that financial institutions feel that they undertake to maintain their reputation in the marketplace even though they might not be contractually bound to do so. What worries the regulators is that capital adequacy requirements do not take this kind of risk into account. .

Because it has been so heavily exposed (they've sponsored more SIVs than any of the other banks) and because some of the CDOs and SIVs have been so badly downgraded, Citigroup has experienced very substantial losses, and the losses are still not necessarily known. I would guess that they are more likely to rise than to fall, because much will depend on what happens to house prices and what happens to interest rates, and there is substantial uncertainty regarding both.

Because of these losses, Citigroup's capital position has deteriorated. Although it was still technically above the U.S. threshold for being well capitalized, it was uncomfortably close to the margin, much closer to the margin than a bank that does substantial wholesale business should be. So, the capital injection from Abu Dhabi is certainly a very welcome one. And, it will give them some more time -- some breathing room to reorganize, find a new CEO, perhaps develop a new strategy and work their way out of their problems.

Knowledge@Wharton: I wonder if you could turn now to the background and dimensions of the subprime crisis. You recently spoke at a meeting in Rome about the "darker side of securitization." Could you walk us through how the subprime crisis overtook the banks the way that it did, and whether it seems to have run its course?

Herring: The subprime market was never that large and so the turmoil it has caused is a bit of a mystery....MORE