Page 3 of 5 PATHOLOGY OF
DEBT PART
1: Banks as vulture
investors Henry C K Liu
tranches of CDOs. It has no
information on which banks hold CDOs and how much,
since such instruments are held by the finance
subsidiaries of bank holding companies, off the
banks' balance sheets. Asian investors,
particularly those in Japan, had been eager to
seek off-shore assets yielding more than the near
zero or even negative interest rates offered at
home. Many Japanese as well as foreign investors
participated in currency
''carry trade'' to arbitrage
interest rate spreads between the Japanese yen and
other higher interest rate currencies and assets
denominated in dollars, fueling a liquidity boom
in US markets. The US trade deficit fed the US
capital account surplus as the surplus trade
partners found that they could not convert the
dollars they earned from export to the US into
local currencies without suffering an undesirable
rise in money supply. The trade surplus dollars
went into the US credit market.
The growth
of CDOs has been explosive during the past decade.
In 1995, there were hardly any. By 2006, more than
US$500 billion worth was issued. About 40% of CDO
collateral was residential MBS, with
three-quarters in subprime and home-equity loans,
and the rest in high-rated prime home loans. CDOs
became an important part of the mortgage market
because their issuers also bought the riskier
tranches of MBS that others investors shunned. The
high-rated tranches of MBS were sold easily to
pension funds and insurers. But the ultra-high
rated tranches paid such low returns because of
their perceived safety that few buyers were
interested, forcing the banks that structured them
to hold them themselves.
The issuers often
hold the more riskier tranches to sell at later
dates for profit when the value of the collateral
rose with rising home prices. But when the riskier
tranches could not be sold as home prices fell and
mortgage defaults rose, the higher-rating tranches
suffered rating drops and institutional buyers
were prevented by regulation to hold the ones they
had bought and from buying new ones. When
ultra-safe tranches held by banks are downgraded,
banks are forced to write down their value. With
CDOs withdrawing from the residential MBS market,
mortgage lenders were unable to sell the loans
they had originated for new funds to finance new
mortgages.
The chain of derivative
structures that turns home loans into CDOs begins
when a mortgage is packaged together with other
mortgages into an MBS. The MBS is then sliced up
into different CDO tranches that pay on a range of
interest rates tied to risk levels. Mortgage
payments go first to the highest-rated tranches
with the lowest interest rates. The remaining
funds then flow down to the next risky tranches
until all are paid. The riskiest CDO tranches get
paid last, but they offer the highest interest
rates to attract investors with strong risk
appetite.
In theory, all tranches have the
same risk/return ratio. As the liquidity boom has
gone on for years with the help of the Fed,
historical data would suggest that risks of
default should be minimal. Yet when losses
actually occurred from unanticipated mortgage
defaults and foreclosures, the riskiest tranches
were hit first, while the top-rated tranches were
hit last. But until losses occurred, the riskier
tranches got the higher returns. Over the years,
the riskier tranches generated big profits for
hedge funds when the risks did not materialize to
overwhelm the high returns. The problem was that
the profitability drove new issues of MBS at a
faster pace than MBS were maturing, with the
number and amount of outstanding securities
getting bigger with each passing year, exposing
investors to aggregate risk higher than the
accumulated gains. Because of the complexity and
opacity of the CDO market, institutional investors
were not alerted by rating agencies of the fact
that their individual safety actually caused a
sharp rise in systemic risk. They felt comfortable
as long as assets they acquired were rated AAA and
deemed bankruptcy-remote, not realizing the system
might seize up some Wednesday morning. That
Wednesday came on August 15, 2007.
CDOs, a
cross between an investment fund and an
asset-backed security (ABS), perform this slicing
process of risk/reward unbundling repeatedly to
keep money recycling and money supply growing in
the mortgage market. While CDOs lubricate the
credit market to make more home financing
affordable to more home buyers, the raise the
price of the home and its financing cost beyond
the carrying capability of almost all home buyers
when the bursting of the debt bubble resets
interest rates to normal levels, making a rising
default rate inevitable.
Hedge funds are
attracted by the high returns offered by the
lowest-rated tranches of subprime MBS unbundled by
CDOs, the so-called equity tranches that sink
underwater as home prices fall. Many hedge funds
arbitrage the wide return spread with low-cost
funds borrowed in the commercial paper market and
magnify the return with high leverage through bank
loans. They often hedge against risk by holding
derivatives, such as interest rate swaps, that are
expected to rise in value when housing prices
fall. They also hedge against defaults with credit
default swaps. These hedges failed when risk was
re-priced by the market at rollover time for
short-term securities, which could be every 30
days.
CDOs and commercial
paper Much of the money used to buy CDOs
come form the commercial paper market. Commercial
paper consists of short-term, unsecured promissary
notes issued primarily by financial and
non-financial corporations. Maturities range up to
270 days but average about 30 days. Many companies
use commercial paper to raise cash needed for
current transactions, and many find it to be a
lower-cost alternative to bank loans. Financial
companies use high-rated CDO tranches as
collateral to back their commercial paper issues.
Because commercial paper maturities do not
exceed nine months and proceeds typically are used
only for current transactions, the notes are
exempt from registration as securities with the
United States Securities and Exchange Commission.
Large institutions have since the early
1970s managed their short-term cash needs by
buying and selling securities in the money market.
Today, a broad array of domestic and foreign
investors uses these versatile, short-term
securities to help to make the money market the
largest, most efficient credit market in the
world, driving assets from US$4 billion in 1975 to
more than US$1.8 trillion today. This money market
is a fixed income market, similar to the bond
market, the major difference being that the money
market specializes in very short-term debt
securities.
The money market is a
securities market dealing in short-term debt and
monetary instruments. Money market instruments are
forms of debt that mature in less than one year
and are very liquid but traded only in high
denominations. The easiest way for an individual
investor to gain access is through money market
mutual funds, or sometimes through a money market
bank account. These accounts and funds pool
together the assets of thousands of investors and
buy the money market securities on their behalf.
Borrowing short-term money from banks is
often a labored and uneasy situation for many
corporations. Their desire to avoid banks as much
as they can has led to the popularity of
commercial paper. For the most part, commercial
paper is a very safe investment because the
financial situation of a large company can easily
be predicted over a few months. Furthermore,
typically only companies with high credit ratings
and credit worthiness issue commercial paper and
over the past 35 years there have only been a
handful of cases where corporations defaulted on
their commercial paper repayment.
ABCP
conduits Asset-backed commercial paper
(ABCP) is a device used by banks to get operating
assets, such as trade receivables, funded by the
issuance of securities. Traditionally, banks
devised ABCP conduits as a device to put their
current asset credits off their balance sheets and
yet provide liquidity support to their clients.
Conduits raise money by selling short-term debt
and using the proceeds to invest in assets with
longer maturities, such as mortgage-backed bonds.
Conduits typically have guarantees from banks,
which promise to lend them money up to the amount
of the structured investment vehicles that the
banks structure.
A bank with a client
whose working capital needs are funded by the bank
can release the regulatory capital that is locked
in this credit asset by setting up a conduit,
essentially a special purpose vehicle (SPV) that
issues commercial paper, such as the ones used by
Enron that led to its downfall. The conduit will
buy the receivables of the client and get the same
funded by issuance of commercial paper. The bank
will be required to provide some liquidity support
to the conduit, as it is practically impossible to
match the maturities of the commercial paper to
the realization of trade receivables. Thus, the
credit asset is moved off the balance sheet giving
the bank a regulatory relief. Depending upon
whether the bank provides full or partial
liquidity support to the conduit, ABCP can be
either fully supported or partly supported.
ABCP conduits are virtual subsets of the
parent bank. If the bank provides full liquidity
support to the conduit, for regulatory purposes,
the liquidity support given by the bank may be
treated as a direct credit substitute, in which
case the assets held by the conduit are aggregated
with those of the bank. ABCP conduits are also set
up by large issuers that are not banks.
The key weakness in the entire credit
superstructure lies in the practice by
intermediaries of credit to borrow short term to
finance long term. This term carry is magical in
an expanding economy when the gap between
short-term and long-term credit is narrower than
gains from long-term asset appreciation. But in a
contracting economy, it can be a fatal scenario,
particularly if falls in short-term rates raise
the credit rating requirement of the short-term
borrower, putting previously qualified loans in
technical default. Securities that face difficulty
in rolling over at maturity are known in the trade
as ''toxic'' in the trade.
Lethal
derivatives The credit default swap market
is a microcosm of investor confidence. Credit
default swaps are insurance for bad debt. Insured
creditors are compensated by the seller of the
insurance if a debtor defaults on a loan. When the
threat of default rises in the market, the
insurance premium rises, just as Katrina boosted
hurricane insurance premiums. This is known in the
business as re-pricing of risk. The cost of credit
default swaps written on investment banks such as
Bear Stearns and Goldman Sachs and on commercial
banks such as Citibank has soared in the past few
months amid worries that troubles in the
subprime-mortgage market and the leveraged-buyout
market could leave the banks with massive loan
defaults. The financial industry tracks
mortgage-linked securities via the ABX index,
which calculates the prices of baskets of assets
backed by subprime loans.
The ongoing
crisis in the US housing market has pushed the
ABX, a key mortgage-linked derivatives index, to
new lows, threatening to unleash a further bout of
credit-market upheaval. A price swing in the ABX
can reduce the value of ultra-safe credit
instruments that carry high credit ratings. This
has forced banks and other regulated investors to
make further large write-downs on their credit
market holdings, on top of the huge losses several
major US and foreign banks suffered from credit
turmoil that began in August.
As the US
mortgages market deteriorates, financial sector
losses will accumulate. Secondary market-price
movements indicate that losses on mortgage
inventory are likely to be larger in coming
quarters. Before July, the part of the ABX index
that tracks AAA debt was trading almost at face
value. However, in the last three weeks of
October, it fell sharply due to downgrades by
credit-rating agencies and continuing bad data
from the housing sector.
As a result, the
so-called ABX 07-1 index – which tracks AAA
mortgage bonds originated in the first half of
this year – fell to a record low close of 79 on
October 30, meaning that traders reckoned these
bonds were worth only 79 cents on the dollar. The
ABX "BBB" 07-1 index measures the performance of
loans made
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