The headlines refuse to go away. Almost every day, a new twist seems to appear in the subprime crisis drama. This week, the investment arm of the government of Abu Dhabi announced an infusion of $7.5 billion to acquire a 4.9% stake in Citigroup, which has been slammed by enormous losses in the credit market. The announcement came on the heels of a report from Bank of America that the subprime mess is about to get messier as interest rates “reset” — or rise — on more than $360 billion worth of adjustable rate subprime mortgages. Has the crisis run its course? Knowledge at 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 at 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 at 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. It is perhaps best to start with a definition of what the subprime mortgage is. Basically, subprime mortgages are made to borrowers who couldn’t ordinarily qualify for a mortgage. They couldn’t get a mortgage because they have a weak credit history based on their credit scores and weak documentation of their assets and capacity to repay. Sometimes, these were “low documentation loans,” or, in some cases, “no documentation loans.” Many of them, in the end, became “Liar Loans” because there was no verification of the borrower’s repayment capacity. And, of course, they had little or no equity in their house.

One might ask why these loans were ever made. And, the reason, I think, is that both borrowers and lenders expected the increase in housing prices to continue and to make it possible to refinance these loans under normal terms in a relatively short time. Many of these loans also had very low initial teaser rates that got larger in time. This was certainly the most aggressive part of the market. But I think that it is fair to say that, pretty much across the board, underwriting standards declined during a very long period of very low interest rates and very stable macroeconomic conditions. 

Securitization is probably the most important innovation in post-war finance. More than two-thirds of consumer credit, retail credit, is in fact securitized these days. And, most of the securitizations are entirely sound and have added huge value, not only to financial institutions but also to retail customers and to investors as well. The darker side, however, appeared with regard to subprime because we are beginning to look at some securitization structures that are really too clever by half — they’ve become opaque.

How does that happen? It all begins with a special purpose vehicle that is designed to get assets off the balance sheets of financial institutions. These are designed to be bankruptcy-remote entities. They purchase mortgages from whoever originates them. It may be a bank, but it may also be a mortgage broker. The special purpose vehicle pools these mortgages and then issue securities against this pool of mortgages. These securities are designed to meet the preferences of investors.

One of the main driving forces behind securitization is that a number of large institutional investors prefer to hold (indeed may be required to hold) very highly rated debt. They prefer AAA or AA credits and there are simply not that many AAA or AA rated issuers. Securitization seemed to be a way to fill that deficit by synthesizing securities that would have a very high rating. How did they do it? How did they take a group of assets that were not in themselves AAA and convert them into AAA securities and AA securities? They used some fairly clever structuring that sliced up the claims on the pool of assets into tranches. They subordinated several of the tranches which would accept first loss, or next-to-first loss.

They also developed excess servicing requirements that could meet short falls. They over-collateralized many of the tranches and often employed monoline insurance to take away residual credit risks, so that the ratings agencies were satisfied that the tranches, at the very top of all this structure, were indeed AA and AAA credits.

Knowledge at Wharton: What do you mean by “monoline insurance?” 

Herring: A monoline insurer is an insurer that specializes in insuring or guaranteeing financial claims. In the case of securitizations it’s usually super senior tranches. These insurers are, incidentally, another kind of the entity that one worries about as this crisis spreads.

The creation of this mortgage-backed security or asset-backed security works well for those who want AAA tranches. Unfortunately, it relies on creating tranches that are substantially below investment grade. So the question is, where do you place those? Well, that’s where things got very clever.

One of the ways that they got placed was into collateralized debt obligations. This was an innovation that actually is often attributed to Michael Milken, who devised it to deal with junk bonds. His argument was that if you had a well diversified pool of junk bonds, then, indeed, you had a safer stream of cash flows than the cash flow from any one of the underlying bonds.  Indeed, you can tranche it in such a way that some of those cash flow streams would be legitimately AAA.

Investment bankers tried essentially the same thing with subprime mortgages. The problem is that it does not appear that diversifying across different originators of subprime mortgages, has really given them sufficient diversification. But the idea is that you can put these subordinated tranches into pools with other kind of assets and then develop slices or tranches against this pool that will also be rated and also available to sell.

So, you end up with, at the very base of it, the subprime mortgages, which were originated and pooled, and then you had collateralized mortgage-backed securities issued against that pool. And against the riskiest tranches of claims on that pool, you had CDOs.  And the riskiest tranches of CDOs could be pooled with other assets in other CDOs. You had CDOs-squared and synthesized CDOs as well. You end up with a very elaborate structure based on assets that are pretty deep down in the chain and very, very difficult for anyone to evaluate directly. It’s a very opaque structure, and that’s part of the reason why there has been such huge uncertainty.

Banks have also placed some of these instruments in asset-backed commercial paper conduits. These conduits could buy a similar range of securities and issue commercial paper against them. Another variation on this theme was the structured investment vehicle, which were a little bit more remote from the parent organization and also were actively managed. At their height, I think they numbered about 30 in total. They were all based on the notion that you could engage in arbitrage.  Essentially, you could issue short-term paper that would be regarded as very safe. And indeed, some of this was held by money market mutual funds and other entities that really do need to have safe, liquid, short-term paper. And, you could invest in a pool of assets that had longer maturity or greater risk, or both. This, at root, is really a very familiar model. It is essentially what banks have done for centuries — but banks have had the advantage of a safety net behind them, and these entities really do not. What we have learned is that these entities rely very heavily, in the event of distress, on their relationship with a lender who is willing to provide them with liquidity, and that has often turned out to be the sponsoring bank.

Knowledge at Wharton: What regulatory issues does this crisis reveal? For example, did the disclosure regulations show how much risk is extended in the financial markets?

Herring: I think it’s safe to say that the disclosure was really not what we needed. These structures very cleverly, redistribute risk — but, they don’t eliminate risk. But from the perspective of some investors, they appear to have concealed risk. Many investors thought that they had AAA securities that were the equivalent of AAA corporate bonds, but they simply were not.

So, one of the key issues in all of this is the role of the ratings agencies. The ratings agencies have been absolutely critical to the securitization process, because they really set the standards for tranching. It’s a sort of delegated monitoring situation, where people are relying on the ratings agencies to affirm the quality of the underlying pool of assets and to evaluate the terms of the tranching contracts, so that those who buy them are assured that they have something that is of sufficient credit quality.

Now, the ratings agencies have a little more guarded view of their role. They view themselves as essentially publishers and argue that they are protected by freedom of the press for the opinions they express and are not making financial guarantees or investment recommendations. And, in any event, they are only talking about credit risk, rather than market risk or liquidity risk. So, there is a sense, I think, in which ratings were abused and misused.

Knowledge at Wharton: They have been blamed quite a bit for not blowing the whistle earlier. Is there anything that the ratings agencies could have done differently?

Herring: I think there are many things that the ratings agencies could have done differently. But, to my mind, the root cause is less the ratings agencies than the tendency of regulators to rely on the ratings agencies for making judgments that are properly part of the supervisory process. We have a number of institutions such as insurers, pension funds and some mutual funds that can only hold paper of a specified rating. And, naturally, these entities all want to have a broader range of paper to buy. So, there is always a lot of pressure on the ratings agencies to provide a broader range of highly rated paper. And, as a result, we have seen what can only be described as “grade inflation”.  The phenomenon is not unknown in the academic world, but you saw grade inflation in the ratings world as well.

And, what we have seen is that the ratings really are not consistent across instruments. Corporate bonds that were rated Baa had five-year default rates of 2.2% from 1983 to 2005. So, that’s about what you should expect, if the future plays out like the past. If you looked at the collateralized debt obligations that were rated Baa, they had a 24% five-year default rate in the period over which we had a big enough sample, from 1993 to 2005. So, they really were a very different thing.

In addition, I think there is a certain amount of disingenuousness in the market as well. Market participants were getting substantially higher spreads on AAA rated CDOs than they were on AAA rated corporate bonds. Now, they might have thought that they got a special bargain, but anyone who is a sophisticated investor should know that you don’t get additional return without taking extra risk.

I think that the ratings agencies can be faulted, though, for using the same scale for very different kinds of structures. And, they have also, I think, failed to warn people that these kinds of securities are inherently subject to multiple notched-down grades when things go bad.

It’s not like a corporate bond where you may experience a recovery. If you have a low rated CDO tranche and the CDO blows through it, that’s it — you’re not going to have a recovery. And, that’s the reason why we have seen such aggressive downgrades, and the downgrades of course have led to misery for those who hold them, especially those who mark to market. But there are lots of institutions in the world that haven’t yet recognized the loss.  They are not obliged to mark to market, and we may not know who is holding them and how big the loss will be until they actually sell and recognize the loss. There are big questions about whether the ratings agencies made assumptions about correlations that were too low and therefore led to overly optimistic views of how diversified these pools of assets were.

And, the asset backed securities, I think, have also suffered from a tendency to use short cuts with regard to ratings. The ratings of asset-backed securities tend to be based on the ratings of the paper they hold rather than looking through and all the way down to what the actual earnings asset is at the base of the chain. That also contributes to the delays in downgrades. Essentially, before the CDO rating is reduced, the underlying mortgage-backed securities ratings have to be downgraded– and that takes time and accumulates, and the deterioration tends to compound.

What concerns me in this case is not that the ratings agencies made a mistake; anybody who remembers the Asian financial crisis, or Enron, or WorldCom knows that happens from time to time. What’s more worrisome in this instance is that the ratings agencies appear to have made a mistake with regard to an entire, very important, category of securities. So, it has systemic implications that really weren’t a factor when only a single issue or a very small group of issuers were involved.

To my mind, I think that there are a lot of very unhelpful things that are being suggested with regard to regulating the ratings agencies. I would not want to see an international agency, for example, that supervises the rating agencies. I think that there would be a huge improvement, however, if rather than relying on shortcut letter grades, the ratings agencies simply told us what their assumption was regarding the probability of default and the loss given a default for each issue.

If investors had focused on these two elements — which indeed the ratings agencies have computed — rather than relying on the shortcut letter grade, which the regulators let them get away with, then I think that it’s quite possible that much of the turmoil could have been avoided. And, it certainly would have been disclosure that was informative to investors, rather than pretending that all AAAs are created equal.

Knowledge at Wharton: How far will the crisis spread? Will the insurance industry be hit, or is a recession likely?

Herring: The short answer is that we don’t yet know. One of the problems with this process is that we are focusing on the down side, or the darker side, of securitization. But there are lots of good aspects of securitization. One of the real advantages is that it can broadly diversify credit risks that formerly were very heavily concentrated, usually in bank portfolios.

Had we had a similar kind of problem twenty or thirty years ago, we would have been talking first and foremost about a bank crisis. We may still, but at this point it looks less likely. On the other hand, we’re not entirely sure about where all of these bits and pieces of risk reside. They’ve been sliced and diced and redistributed in so many complicated ways that it’s very hard to tell. The hope is that they were redistributed into the hands of institutions that were better able to assess, manage and hold these risks. But it’s also possible that they ended up in stupider hands.  Only time will tell.

Knowledge at Wharton: Over the weekend, Bank of America pointed out that next year, interest rates will reset or rise on more that $360 billion worth of adjustable rate subprime mortgages. What do you think the repercussions will be?

Herring:  Well, that is, I think, an enormous problem, and it casts uncertainty that extends well beyond the subprime issue. It’s obviously going to be very punishing to subprime borrowers, because they tended to borrow at higher spreads and they’re going to have bigger resets. But, in fact, these new, more complex mortgage products really pervaded much of the market, and it may be that we are going to see increasing defaults not just in subprime and so-called “Alt A” mortgages, but also in some more conventional mortgages.

To the extent that these mortgages were taken out by borrowers who had considerable equity, it may not be a catastrophic consequence, unless home prices continue to fall. There is some doubt about how much home prices have actually fallen. The Case-Shiller Indices, which actually have options traded on them now, show quite an alarming fall, and they seem to continue on a downward path.

On the other hand, OFHEO [Office of Federal Housing Enterprise Oversight], which is the oversight agency, has collected a broader sample for a broader geographic region — it’s essentially all of the conforming mortgages in the U.S. It shows much less indication of a decline. In some regards, it’s a more relevant index because it includes all of the refinancing, and refinancing is critical because that’s what gives consumers buying power.

So, we don’t actually know just how far house prices will fall. Some of these markets have clearly gotten out of hand. Las Vegas has been a problem because it had experienced such incredible growth. There are certainly huge problems in parts of California and Florida. And for other reasons, there are some serious issues in the Midwest — where the problem is compounded by long-term industrial declines. But, whether this extends to a nationwide problem, I think, is as yet unclear.

Knowledge at Wharton: What’s your view on the outlook for the rest of the year and 2008?

Herring: First of all, just looking at this particular market, mortgages tend to have a period over which they have rising problems. You know they all look good when they are made. What has been alarming about the subprime sector is that the vintage issued in 2006 and 2007 began to go into default much more rapidly and at a much higher rate.

Now, typically, this doesn’t peak until about 24 to 36 months after the mortgage is made, which means that for mortgages that were underwritten at the peak of the euphoria about home prices in 2005 and 2006, and even part of 2007, there may be worse news ahead. We haven’t really gone through the period when delinquencies historically peak.

Now, it may be sped up, as in the case of some of these adjustable rate mortgages, where you will have the teaser rate disappearing more rapidly than it used to. But, you have a number of other mortgages that will simply be reset. That of course depends on what is happening to monetary policy and interest rates overall, and again there we have some real uncertainty.

The Fed has been remarkably expansive so far. But, we had even today an indication by the president of the Federal Reserve Bank of Philadelphia, Charles Plosser that he thought it was more likely that interest rates were going to go up than go down. So, it’s very murky. But two things that can make things a lot worse are declining home prices and rising interest rates.