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5 CREDIT BUBBLE
BULLETIN Structured finance under
duress By Doug Noland
COMMENTARY
The market may
be been perfectly content to brush it aside. It
was, however, a brutal week for "contemporary
finance." Merrill Lynch, a kingpin of structured
Credit products, shocked the marketplace with a
$7.9bn asset write-down – up significantly from
the $4.5bn amount discussed just two weeks ago.
Much of the write-off related to the company’s CDO
(collateralized debt
obligations) portfolio, the
size of which was reduced in half to $15.2bn
during the quarter. But with proxy indices of
subprime and CDO exposures down between 15% and
30% since the end of the quarter, Street analysts
have already warned of the possibility for an
additional $4bn hit. Merrill is not alone.
Also hit by sinking CDO fundamentals,
Credit insurer Ambac Financial reported a
third-quarter loss of $361 million - it’s
first-ever quarter of negative earnings. The
company posted a $743 million markdown on its
derivative exposures, "primarily the result of
unfavorable market pricing of collateralized debt
obligations." Credit insurance compatriot MBIA
also reported its first loss ($36.6 million), on
the back of a $352 million "mark-to-market"
write-down of its "structured Credit derivatives
portfolio." These two Credit insurance behemoths –
and the "financial guarantor" industry generally –
would have been a whole lot better off these days
had they stuck to insuring municipal bonds and
fought off the allure of easy ("writing flood
insurance during a drought") profits guaranteeing
Wall Street’s endless array of new structured
Credit products.
October 26 – Financial
Times (Stacy-Marie Ishmael): "The perceived
creditworthiness of two of the largest financial
guarantors in the US on Thursday plunged to lows
not seen since the worst of the credit squeeze in
August. MBIA and Ambac are specialist companies
that guarantee the repayment of bond principal and
interest in the event of an issuer default -
including bonds backed by subprime assets. After
both companies this week reported third-quarter
losses, investors have begun to speculate that the
monolines, as they are known, might themselves in
default on their outstanding debt. Spreads on
five-year credit default swaps written on Ambac’s
debt widened by 50 bps to 300bp, according to
Credit Derivatives Research… In other words, the
annual cost of insuring a $10m portfolio of
Ambac’s debt over five years has risen by $50,000
to $300,000. The previous record of $238,000 was
set on August 16…"
It is worth noting that
MBIA and Ambac combine for about $1.9 Trillion of
"net debt service outstanding" – the amount of
debt securities and Credit instruments they have
guaranteed, at least in part, to make scheduled
payments in the event of default. Throw in the
Trillions of Credit insurance written by the
mortgage guarantors and you’re talking real
"money." Importantly, the marketplace is beginning
to question the long-term viability of the Credit
insurance industry, placing many Trillions of
dollars of debt securities in potential market
limbo.
With recent developments -
including the monstrous write-down from Merrill
Lynch, the implosion in the mortgage insurers, and
the losses reported by the "financial guarantors"
- in mind, I’ll revisit an excerpt from a January
article by the Financial Times’ Gillian Tett:
"…Total issuance of CDOs…reached $503bn worldwide
last year, 64% up from the year before. Impressive
stuff for an asset class that barely existed a
decade ago. But that understates the growth. For
JPMorgan’s figures do not include all the private
CDO deals that bankers are apparently engaged in
too. Meanwhile, if you chuck index derivative
portfolio numbers into the mix, the zeros get
bigger: extrapolating from trends in the first
nine months of last year, total CDO issuance was
probably around $2,800bn last year, a threefold
increase over 2005. These startling numbers will
certainly not shake the world outside investment
banking. For, as I noted in last week’s column,
the CDO explosion is occurring in a relatively
opaque part of the financial system, beyond the
sight - let alone control - of ordinary household
investors, or politicians."
Subprime and
the SIVs are peanuts these days in comparison to
the gigantic global CDO and Credit derivatives
markets. CDOs may lack transparency, trade
infrequently, and operate outside of market
pricing ("mark-to-model"). Nonetheless, CDO
exposure now permeates the entire global financial
system – exposure that regrettably mushroomed in
the midst of the most reckless end-of-cycle
mortgage excesses imaginable. Rumors this week had
major insurance companies suffering huge CDO
losses. To what extent the big insurance
"conglomerates" have exposure to CDOs and other
Credit derivatives is unclear today, but there is
no doubt that the global leveraged speculating
community is knee deep in the stuff. Importantly,
as goes the U.S. mortgage market, so goes the
CDOs. I’m not optimistic.
I don’t want to
place undue weight on one month’s data, but the
California statewide median home price sank
$58,140 over the month of September (down 4.7%
y-o-y to $530,830). This was by far the largest
monthly decline on record and the first
year-over-year fall "in more than 10 years."
September California sales were down 39% from a
year earlier. Weakness was statewide, led by a 63%
y-o-y collapse in the "High Desert." But even San
Francisco "Bay Area" sales dropped 46% y-o-y.
Ominously, the California Association of Realtors
"Unsold Inventory Index" surged to 16.6 months,
almost double the level from just six months
earlier and compared to 6.4 months in September
’06. "The impact of the credit crunch spread
throughout all tiers of the market in September,"
said California Association of Realtors Chief
Economist Leslie Appleton-Young. As far as I’m
concerned, there is sufficient evidence at this
point suggesting the Great California Housing Bust
has begun in earnest.
We’ve definitely
reached a critical point worthy of the question:
Can "structured finance," as we know it, survive
the California and U.S. mortgage/housing busts? I
don’t believe so. For one, the historic nature of
the Credit Bubble virtually ensures the collapse
of the Credit insurance "industry" (companies,
markets, and derivative counter-parties). The
mortgage insurers are now in the fight for their
lives, while the "financial guarantors" today face
an implosion of their "structured Credit"
insurance business. Worse yet, major problems in
municipal finance (certainly including California
state and municipalities) are festering and will
emerge when the economy sinks into recession. It
is worth noting that California revenues were $777
million short of expectations during the first
fiscal quarter (see "CA Watch" above).
Returning to the vulnerable CDO market,
some key dynamics are in play. With California now
at the brink, uncertain but huge losses are in the
pipeline for jumbo, "alt-A," and "option-ARM"
mortgages – loans that were for the most part
thought sound only weeks ago. The market began to
revalue the top-rated CDO tranches this week, a
process that should only accelerate. "AAA" is not
going to mean much. If things unfold as I expect,
a full-fledged run from California mortgage
exposure could be in the offing. And as the
dimensions of this debacle come into clearer
market view, the viability of the Credit insurers
will be cast further in doubt – with ramifications
for Trillions of securities and derivatives.
General Credit Availability would suffer mightily.
With global equities markets in melt-up
mode, it might seem absurd to warn that a
troubling global financial crisis is poised to
worsen. But Structured Finance is Under Duress.
The entire daisy-chain of liquidity agreements,
securitization structures, Credit insurance and
guarantees, derivatives counterparty exposures
and, even, the GSEs is increasingly suspect. Trust
has been broken and market confidence is not far
behind.
The big global equities and
commodities surge over the past few months
certainly has been instrumental in counteracting
what would have surely been a problematic "run"
from the leveraged speculating community. How long
this spectacle can divert attention from the
unfolding mortgage/CDO/"structured finance"
debacle is an open question. I can’t think of a
period when it has been more critical for stocks
to rise - and rise they have. Yet I suspect recent
developments will now encourage the more
sophisticated players to begin reining in
exposure.
The nightmare scenario - where
the market abruptly comes to recognize that the
leveraged speculating is hopelessly stuck in
illiquid CDO, ABS, MBS, derivative and equities
positions - doesn’t seem all that outrageous or
distant. Unfortunately, today’s Ponzi-style acute
fragility (as was demonstrated this summer in
subprime, asset-backed CP, SIVs and the like) and
speculative dynamics dictate that he who panics
first panics best. I don’t expect the
sophisticated players to hang around and wait for
securities to be properly priced and the full
extent of illiquidity and the unfolding Credit
debacle to be recognized. And while Bubbling
markets do delay the inevitable reversal of
speculative flows from
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