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2 PATHOLOGY OF DEBT Part 3: The credit guns of
August By Henry C K Liu
report said. The liquidity crunch
and turmoil in the credit markets highlighted some
of the risky structures set up by Barclays and
other investment banks in an effort to capitalize
on investor demands for highly rated assets that
offered an attractive yield.
Sachsen ran
into trouble in August when Ormond Quay, an
off-balance sheet funding vehicle, was no longer
able to issue short-
term
financing in the commercial paper market.
Sachsen was sold to LBBW, the rival German
public sector bank. In May, Barclays set up a
SIV-lite on Sachsen's behalf. The vehicle, Sachsen
Funding 1, had assets of $3 billion, backed by
prime and subprime US mortgages. S&P in
mid-August placed Sachsen Funding 1 on review for
a possible downgrade, warning that it might have
to wind down if it could not access sufficient
liquidity. At the same time, S&P also slashed
credit ratings for two other SIV-lites created by
Barclays and placed a third on review for
downgrade. Edward Cahill, the Barclays banker who
was responsible for setting up the SIV-lite
structure, and a junior colleague resigned in the
same month, prompting widespread speculation about
potential losses at the bank, the Financial Times
reported at the time.
Other non-US banks
were also hit by the US subprime market collapse,
particularly Britain's HSBC Holdings, which saw
its bad-debt provisions soar to $10.8 billion in
2006 as defaults in its subprime portfolio
prompted the first profit warning in the bank's
recent history. In explaining adverse results, the
bank disclosed that its own risk projections had
failed to predict how many borrowers would fall
behind on mortgages as interest rates climbed and
saddled them with higher monthly payments.
HSBC, one of the most aggressive players
in the US market for low-quality mortgage, in
February sent a pall through the financial world
with news that its bad-debt charges would be 20%
higher than forecast. It was the largest lender to
date, though it was not the first nor would it be
the last, to warn on credit problems. Higher
adjustable interest rates in 2007 were starting to
hurt borrowers, especially those with poor credit,
who bought homes using mortgages with low
introductory rates during the liquidity-driven
real-estate boom in the US.
The ability of
these borrowers to meet their mortgage payments
depended on rising home prices to enable them to
refinance their mortgages a year or two after
purchase into low fixed-rate loans before rates
climbed. By mid-2007, US home prices began to fall
as home financing became more difficult and more
expensive to obtain, causing a downward spiral.
HSBC announced a strong second quarter dividend
payout, and claimed that the subprime problem was
largely contained. The market was not convinced as
other distressing news surfaced.
Switzerland Union Bank of
Switzerland (UBS) announced in May that it was
shutting its Dillon Read Capital Management hedge
fund unit after subprime mortgage-related losses
dragged the bank's first-quarter profit down 7% to
3.28 billion Swiss francs (US$2.71 billion) from
3.5 billion francs. Dillon Read suffered only a
150 million franc loss from trading in the
collapsed US subprime mortgage market, but the
effect of the credit deterioration was
devastating. UBS share prices fell 4.5% in Swiss
trading and matched that decline shortly after the
opening of US trading on the day after the news.
The Dillon Read unit was launched in 2006 and had
benefited from significant investment with about
250 employees, more than half of whom were
transferred from UBS's investment-banking unit
when Dillon Read was launched.
Canada In Canada, Coventree Inc,
Canada's biggest issuer of non-bank asset-backed
commercial paper with assets of almost C$40
billion (US$40.2 billion), was unable in late
August to renew about C$5.12 billion of
asset-backed commercial paper after some investors
shunned the debt and technical problems prevented
others from buying as mounting losses on US
subprime mortgages led investors to avoid all but
the safest government debt. The company's
refinancing troubles were exacerbated by technical
glitches that made it difficult for some investors
to roll over securities, according to a spokesman
for a group of bank and pension funds that agreed
on a rescue plan for some commercial-paper trusts,
Bloomberg reported.
A group of
international financial institutions that included
ABN Amro, Deutsche Bank and HSBC, Merrill Lynch,
UBS, Caisse de Depot et Placement du Quebec agreed
to a plan to end the liquidity crisis in the
Canadian commercial paper market, staving off
immediate problems but throwing fresh focus onto
short-term funding troubles in other markets. It
involved the conversion of outstanding
asset-backed commercial paper (ABCP), which
normally mature in one to three months, into
five-year floating-rate notes.
This would
remove the immediate uncertainty about lenders'
ability to renew these debts. Investors also
agreed to remove triggers that forced the
underlying assets to be sold when they fell below
a certain price. This mechanism was thought to
have helped drive down prices, even though the
creditworthiness of the underlying assets had not
changed. The agreement, which covers about
two-thirds of Canada's outstanding ABCP, removed
some of the immediate concerns about liquidity in
the Canadian market but did not resolve the
long-term problem.
The agreement was seen
by some participants as a possible template for
resolving blockages in other ABCP markets around
the world. There was concern in Europe that banks
might have to absorb tens of billions of dollars
of ABCP on to their balance sheets. That would eat
into their capital reserves and could trigger a
broader credit crunch.
China Bank of China Ltd, the
nation's second-largest bank, said it holds almost
$9.7 billion of securities backed by US subprime
loans, the most of any Asian company. Bank of
China, which accounts for more than two-fifths of
foreign currency advances by Chinese banks, was
also weighed down by 1.2 billion yuan (US$162
million)in foreign-exchange losses in the period,
Bloomberg reported.
Credit-default swaps
tied to Bank of China's bonds widened by about 15
basis points to 68 basis points. Swap prices rise
when investors perceive higher risk of default.
Mitsubishi UFJ Financial Group Inc,
Japan's biggest bank, also said in September it
had about 300 billion yen (US$2.6 billion) of
investments that incorporate subprime loans.
Sixteen Taiwanese banks held a total of $1.2
billion in securities linked to such home loans,
the island's financial regulator said August 9.
PART 4: Lessons unlearned
Henry C K Liu is chairman of a
New York-based private investment group. His
website is at http://www.henryckliu.com.
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