Page 4 of 5 PATHOLOGY OF
DEBT PART
1: Banks as vulture
investors Henry C K
Liu
during the second half of
2006, when many home purchase loans were made to
buyers with shaky credit standings. The index
traded around 44, or 44 cents on a dollar, nearly
its weakest level ever.
The swing is
creating real pain for investors, since in recent
years numerous firms have created trading
strategies that have loaded large debt levels onto
these ''safe'' securities, precisely because
these
instruments were not expected to fluctuate in
price. Investors normally hold such ''safe''
securities to maturity, thus there is no demand
for a ready market for them. But as the credit
rating of these securities falls, investor cannot
find buyer for them at any reasonable price. The
last week in October saw the worst falls in the
ABX market this year, especially higher up the
capital structure with highly rated debt.
Pension funds and insurance companies hold
the less-risky, senior CDO tranches because
regulatory rules restrict them from investing in
lower-rated securities. When the low-rated
tranches default in large numbers, the high-rated
tranches lose rating and these regulated
institutions are forced to sell their
non-conforming holdings into a market with few
buyers.
Pension funds, insurance companies
and university endowment funds have also invested
in hedge funds that hold the riskier CDO tranches
to get higher returns. In recent years, CDO
issuance has exploded and many hedge funds have
been buying the riskiest tranches of MBS that are
backed by subprime loans. Mortgages closed by 4 pm
New York time were sent electronically to
back-office locations in India to be packaged into
CDO tranches and resent electronically to New York
at 9:30 am the next day to be sold in the credit
market, generating huge fees and profits for Wall
Street firms every day.
Rating agencies
under pressure Moody’s Investors Services,
an influential rating agency, warned in late July
that defaults and downgrades of subprime MBS could
have ''severe'' consequences for CDOs that
invested heavily in the sector. CDOs that Moody’s
rated from 2003 to 2006 had 45% exposure to
subprime MBS on average. But that varied widely
from almost zero to 90%, with recent CDOs having
the high concentrations of such collateral, the
potential downgrade for which could be 10 or more
notches in rating. The secondary market for CDOs
responded to these heightened risks, pushing
prices down and widening spreads - the difference
between interest rates on riskier debt and
measures of short-term borrowing costs such as the
London Interbank Offered Rate (LIBOR) or
commercial paper rates. Spreads on BBB-rated
asset-backed securities CDOs over LIBOR have
widened by roughly 125 basis points to 657 basis
points since the end of 2006.
Structured investment
vehicles Although the first structured
investment vehicles (SIVs) appeared in the
structured-finance world some 15 years ago, and
the growth of SIVs had been somewhat limited,
(there are fewer than 20 vehicles globally), there
is no doubt that these sophisticated
bankruptcy-remote structures have strongly
influenced other funding vehicles and asset
management businesses. Since 2002, there has been
renewed interest by different types of financial
institutions in starting up SIVs or SIV-like
structures with evolved capital structures
embracing new classes of financial instruments.
The first SIVs were founded in the mid-1980s
as bankruptcy-remote entities and were sponsored
by large banks or investment managers for the
purpose of generating leveraged returns by
exploiting the differences in yields between the
longer-dated assets managed and the short-term
liabilities issued. The balance sheet of a
structured investment vehicle typically contains
assets such as asset-backed securities and other
high-grade securities that are funded through
issued liabilities in the form of commercial
paper, medium-term notes (MTN) and subordinate
capital notes. SIVs typically hedge out all
interest and currency risks using swaps and other
derivative instruments.
Overall, CP and
MTN issuance rose dramatically in 2004, up US$25.7
billion to US$133.1 billion at year-end, with
capital investments at an all-time high. In
general, advances in capital structures and asset
portfolio management have invigorated interest
from investors and prospective sponsors.
SIV, conduits and asset-backed
commercial paper SIVs are typically funded
in the low-interest short-term asset-backed
commercial paper market to invest in high-return,
long-term securities for profit. The viability of
the stratagem depends on the ability to roll over
the short-term commercial paper when it matures in
typically less than 120 days. To keep the
liquidity risk at a minimum, issuers stagger the
maturity so that only a small portion of the loan
needs to be refunded in any one week. The credit
market crisis in mid-2007 created a break in
short-term debt rollovers to cause a funding
mismatch in long-term assets positions because
investors have stopped buying new ABCP issued by
some SIVs and conduits.
What separates an
SIV from other investment vehicles is the nature
of its ongoing relationship with rating agencies –
from the originating qualification process to the
continuous monitoring of its asset
diversification, risk management and funding
practices. These guidelines include frequent
reporting of operating parameters such as
portfolio credit quality, portfolio
diversification, asset and liability maturity,
market risk limitations, leverage and capital
adequacy requirements, and liquidity requirements.
The rigorous monitoring allows SIVs to be highly
capital efficient, enabling them to be leveraged
on an average of 12 times the capital base, with
exceptions. Unlike related traditional ABCP
conduits, SIVs do not require 100% liquidity
support and credit enhancement.
Many SIVs
faced trouble in the summer of 2007 as they were
hit by both sharp falls in the value of their
investments, mainly financial debt and
asset-backed bonds, and a lack of access to new
refinancing as investors shunned short-term
commercial paper debt linked to ABCP.
Most
CDOs are cash flow transactions not directly
sensitive to the market value of their underlying
assets as long as the cash flow is undisturbed.
But if a CDO manager needs to sell an asset
quickly even at a loss because of a ratings agency
downgrade, the CDO manager will be forced to carry
the remaining assets at a lower value, upsetting
both collateral for the agreed cash flow and the
balance sheet of the participants. While some
hedge funds have profited from the subprime
mortgage meltdown, other funds have been hit hard,
resulting in a deteriorating financial sector as
asset values plummeted faster than potential gains
by vultures.
Other big lenders that raised
warning flags earlier about bad-performing debt
portfolios included Washington Mutual, New Century
Financial and Marshall & IIsley Corporation.
Foreclosures jumped 35% in December 2006 versus a
year earlier. For the fifth straight month, more
than 100,000 properties entered foreclosure
because the owners couldn't keep up with their
loan payments. In January 2007, Washington Mutual
disclosed that its mortgage business lost US$122
million in the fourth quarter, highlighting the
weak sub-prime market.
New York
attorney general sues appraisal company New
York Attorney General Andrew Cuomo, a potential
Democrat gubernatorial candidate for New York, has
filed suit against eAppraiseIT (EA), a real estate
appraisal management subsidiary of First American
Corporation, for having ''caved to pressure from
Washington Mutual'' to inflate property values of
homes. Washington Mutual allegedly complained to
EA that ''its appraisals weren't high enough.''
Cuomo said in a statement that ''consumers are
harmed because they are misled as to the value of
their homes, increasing the risk of foreclosure
and hindering their ability to make sound economic
decisions. Investors are hurt by such fraud
because it skews the value and risk of loans that
are sold in financial markets.'' The bank is also
facing a number of class action suits from irate
borrowers.
Shares of government-sponsored
mortgage lenders Fannie Mae and Freddie Mac
tumbled after receiving subpoenas seeking
information on loans they bought from Washington
Mutual and other banks. Cuomo said he uncovered a
''pattern of collusion'' between lenders and
appraisers and is seeking documents that may prove
the lenders inflated appraisal values. The
subpoenas also seek information on Fannie and
Freddie's due diligence practices. If decided that
they own or guarantee mortgages with inflated
appraisals, company policy dictates that the
lenders buy back the loans. ''In order to fulfill
their duty to consumers and investors, Fannie Mae
and Freddie Mac must ensure that Washington
Mutual’s mortgages have not been corrupted by
inflated appraisals,'' Cuomo said. In 2007,
Washington Mutual is Fannie Mae’s third-largest
loan provider, selling it US$24.7 billion, and
Freddie Mac’s fourteenth largest at US$7.8
billion. Washingtom Mutual share fell 17% after it
announced it would set aside US$1.3 billion in the
fourth quarter of this year for credit losses, up
from US$967 million in the third quarter.
Mortgage lenders fell like
flies The handwriting had been clearly on
the wall. Back on February 6, New Century
Financial shares plunged 29% after the mortgage
services provider slashed its forecast for loan
production for 2007 because early-payment defaults
and loan repurchases had led to tighter
underwriting guidelines. A week later, Pasadena,
Calif.-based IndyMac Bancorp Inc, which sold Alt-A
mortgages for borrowers who were not required to
submit conforming income and financial documents
necessary to quality for conventional conforming
mortgages, warned that its quarterly earnings
would come in well short of analyst expectations
because of increased loan losses and
delinquencies. Other lenders were also squeezed by
deteriorating credit. Marshall & IIsley
reported a jump in non-performing assets in the
quarter, while Bank of the Ozarks reported a 69%
increase in problem loans. US Bancorp predicted an
increase in retail loan charge-offs and commercial
loan losses in coming quarters. Wells Fargo warned
it expected net credit losses from wholesale
banking to increase this year.
Britain’s
Barclays PLC, in the midst of an unsuccessful
takeover battle for ABN Amro, was reported as
among the banks that were having trouble with bad
loans and its hedge funds. Barclays Global
Investors was one of the world's biggest fund
managers, with some US$2 trillion in assets under
management.
The case of
Countrywide Non-conforming mortgages
securities packaged by Countrywide Financial
needed to be sold in the private, secondary market
to alternative investors, instead of the agency
market. On August 3, 2007, this secondary market
collapsed and essentially stopped the sales of
most non-conforming securities. Alt-A mortgages
completely stopped trading and the seizure
extended to even AAA-rated mortgage-backed
securities. Only securities with conforming
mortgages were trading. Unfazed, Countrywide
Financial issued a reassuring statement that its
mortgage business had access to a nearly US$50
billion funding cushion.
In reality, the
sub-prime mortgage meltdown put Countrywide
Financial, along with many other mortgage lenders,
in a crisis situation of holding drastically
devalued loan portfolios that could not be sold at
any price. Amid rising defaults, investors have
fled from mortgage-related investments, drying up
market demand. The ongoing credit crunch
threatened Countrywide’s normal access to cash.
After the collapse of American Home
Mortgage on August 6, the market’s attention
returned to Countrywide Financial, which at the
time had issued about 17% of all mortgages in the
United States. Days later, Countrywide Financial
disclosed to the Securities and
Head
Office: Unit B, 16/F, Li Dong Building, No. 9 Li Yuen Street East,
Central, Hong Kong Thailand Bureau:
11/13 Petchkasem Road, Hua Hin, Prachuab Kirikhan, Thailand 77110
