The subprime crisis began in July 2007 with the suspension of redemptions by Bear Stearns and, a year later, its fallout has still not been fully quantified. Excessive cash-flow, the predominance of risk transfer and the lack of supervision gave rise to an unsustainable situation that has initially affected banking institutions and insurance brokers, but also private equity and, indirectly, investor activity with hedge funds, investment funds and pension funds.
In short, this crisis affects the entire financial sector, as explained in the technical note "Aspectos financieros de la crisis subprime" ("Financial Aspects of the Subprime Crisis"), prepared by Jorge Soley, professor of financial management at IESE.
The big question now is: How can financial institutions face up to the crisis and what measures can be taken to avoid a repeat occurrence? The first step is to know its origins.
The Causes
The crisis originated with subprime mortgages, which were high-risk mortgages given in the United States to people with a credit history of nonpayment, with little or no chance of financing part of the purchase of a home and low income in relation to the debt being assumed.
In order to understand how this situation came about, one must be aware of the economic context in which it was produced. For that, we must go back to the period prior to July 2007.
First, there was the popularization in the banking world of a distribution model known as originate-to-distribute, based on banking policies that immediately shed the risk by selling it to other institutions. This made it possible to globalize the products and bring in new investors through risk transfer.
But this also caused the loan's issuing institution to dissociate itself from the asset situation of the debtor, and meant that the new investor would blindly buy a security without actually knowing the risks involved.
The banking institutions ignored a basic principle of banking: repayment of the loan by the borrower, which gets complicated when that individual has little or no financial solvency.
Furthermore, the payment systems of bank executives gave priority to the volume of business over good use of the credit.
At that time, there was also excess cash-flow, very low risk premiums and a strong revaluation of real estate that guaranteed the mortgage loans. Within this environment, investors were searching for alternatives with high yields. They found what they were looking for with the appearance of complex, credit-derived "structured products," such as collateralized debt obligations (CDO), which were marketed through "special vehicles" (conduits and SIVs), with no bank supervision.
The lack of supervision was compounded, in many cases, due to high financial leverage, yet again going against banking orthodoxy: long-term investment and short-term financing.
Given this confluence of events and the overestimation of the recovery rates in the case of nonpayment, it's no surprise that the whole house of cards came tumbling down.
But how does a crisis in the financial system lead to a global economic crisis?
It's not hard to understand: It came about through the amplifying channels - risk premium, negative effect in the resources of the banking institutions and the systemic uncertainty - which led to a drop-off in the credit options available and tougher conditions for the granting of credit.
The New Financial Stage
All crises involve changes, and in this case, it has brought about, and will continue to do so, a series of modifications to the strategies and policies of financial institutions.
These changes, along with other factors - such as the implementation of the prudent regulations of Basel II, the new accounting standards (IFRS) and the Single Euro Payments Area (SEPA) - will end up creating a new banking environment that many experts believe will have its inflection point in 2010.
Since the banking sector represents approximately 10 percent of world GDP, these changes will also have an impact on companies and individuals, both borrowers and investors.
Moreover, the crisis will bring about changes to the systems for supervision and accounting, and in the role of the credit-rating agencies.
The IESE note offers several recommendations. First, there should be greater coordination among national supervisors. There cannot, or should not, be a parallel banking system, based on special vehicles, without supervision and which does not require certain solvency ratios, says Soley.
This will also affect accounting, which is closely tied to supervisory activity. Any accounting decision regarding the financial instruments that caused the subprime crisis should become subordinate to the policies of Basel II and not vice versa.
In addition, there should be increased uniformity in the accounting between the United States and Europe, so as to unify the different existing criteria.
With regard to the role of the credit-rating agencies, one must remember that a rating is a possibility, not a guarantee.
Moreover, there is a conflict of interests that should be combated, given that the agencies are paid by the issuers, which seek high qualifications, and not by the investors. Thus, it is necessary to improve many aspects of their operating procedures, demand transparency in the methods used and more neutrality in their payment systems.
The banking industry will also have to reconsider its strategies. The supervising organizations say that the success of the banking institutions will depend on demanding risk control, compliance with regulations, and certain ethical principles and good governance, particularly in a context in which every day more value is placed on reputational risk.
The subprime crisis has made it even clearer, if that's possible, that improvements are needed in terms of how things operate and the procedures, irrespective of the banking model chosen. Not only do credit risks need to be taken into account, but also cash-flow, a factor that was underestimated.
There needs to be a return to the origins: knowing the debtor well, thoroughly knowing the products being marketed and placing limits on the positions of the lenders themselves. In that regard, it is also essential to find new payment systems for banking executives that are not so tied to short-term results.
In short, improvements are needed in risk management, the compliance of regulations and governance systems. "Those with better overall risk management will be the ones to come out of this crisis victorious," says the author.