Moody's' bullish
2005 report Moody’s Investors Service has
developed a rating methodology for structured
financial operating companies (SFOCs). The ratings
agency has recognized the similarities by which
various forms of
vehicle operate and has
developed a new classification and ratings process
for this group of structured finance entities.
SFOCs are operating companies that apply detailed,
pre-determined parameters to define and restrict
their business activities and operations. The SFOC
designation applies to a number of different
structures including:
Derivative product companies (DPCs)
Collateralized swap programs (CSPs)
Credit derivative vehicles (CDVs)
Structured investment vehicles (SIVs)
Structured lending vehicles (SLVs)
Interest rate arbitrage vehicles (IRAVs)
Issuers of guaranteed investment contracts
(GIC Issuers).
Moody's Special Report,
issued on April 14, 2005 states: "Under this
classification Moody's has assigned ratings to
more than 50 of these vehicles. To date, there
have been no rating downgrades on any of their
publicly-rated issued debt, which testifies to the
resilience and strength of the structures of these
vehicles and how robust they are to market
disruptions. This view on the unification of the
general rating approach for these vehicle types
provides a basis for the continual growth within
this market as the markets evolve and converge as
well as providing a basis for the introduction of
new or hybrid vehicle types."
Optimism
turned to panic By August 2007, this
optimistic statement was rendered inoperative by
events. Fed data show that the US$1.1 trillion
market for commercial paper (CP) used to buy
mortgages on homes, aircraft, and cars seized up
in August just as more than half of that amount
was to come due in the next 90 days. Unless new
buyers could be fund to buy new debt to replace
the old, hundreds of hedge funds and companies
would be forced to sell $75 billion of assets at
prices that reflected sharp losses.
Such
distressed sales would further drive down prices
in a market where investors have already lost $57
billion as estimated by the Merrill Lynch broadest
index of floating-rate securities backed by home-
equity loans. That would adversely affect the
position held by 38.4 million individual and
institutional investors in money market funds, the
biggest holder class of commercial paper.
Top-rated commercial paper is one of the safest
assets in normal times. But these are not normal
times.
The major players in the SIV market
by the end of 2005 were: - Beta Finance Corp
was sponsored by Citibank International Plc
(commercial bank) in 1989 with asset under
management (AUM) of $15.3 billion. - Sigma
Finance Corp was sponsored by Gordion Knot Ltd
(investment manager) in 1995 with $34 billion of
AUM. - Centauri Corp was sponsored by Citibank
in 1996 with $16.1 billion of AUM. - Dorada
Corp was sponsored by Citibank in 1998 with $10.5
billion of AUM. - K2 Corp was sponsored by
Dresdner Kleinwort Wasserstein (investment bank)
in 1999 with $20.6 billion of AUM. - Links
Finance Corp was sponsored by Bank of Montreal
(commercial bank) in 1999 with $13.5 billion in
AUM. - Cheyne Finance was sponsored by Cheyne
Capital Management Ltd (investment manager) in
2005 with $7 billion in AUM. - Cullinan Finance
Corp sponsored by HSBC Holdings (commercial bank)
in 2005 with $27 billion in AUM.
As of
March 2007, every one of the above SIVs was in
distress, plus a few more:
Eiger Capital (Orion Finance)
III Offshore Advisors (Abacas Investments)
West LB (Harrier Finance Funding Ltd., Kestrel
Funding
Standard Chartered Bank (White Pine,
Whistlejacket Capital)
Societe Generale (Premier Asset Collateralized
Entity)
Stanfield Global Strategies (Stanfield
Victoria Finance)
Rabobank International (Tango Finance)
Eaton Vance (EV Variable Leveraged Fund)
HSH Nordbank (Carrera Capital Finance)
MBIA (Hudson-Thames Capital)
IXIS/Ontario Teachers (Cortland Capital)
Axon Financial (Axon)
IKB KG (Rhinebridge)
Worldwide
investors with complex holdings By any
measure, this is a small number of issuers. But
the problem is that the ABCP they issued is bought
by large number of investors worldwide in patterns
that are difficult to sort out because of the
complexity of the collateralized debt obligations
(CDO) tranches and the variety of hedges employed
by investors.
On the liability side, some
SIVs experimented with the capital structure in
order to meet the risk/reward requirements for a
broader scope of new and traditional capital note
investors. This has been mainly through the
adoption of a three-tier structure similar to that
of CDOs - with senior, mezzanine and equity levels
of issuance - and some of the established SIVs
have been restructured to take advantage of this
new market trend. The issuance of junior tranches
by SIVs is not a new practice, but it has not been
widely adopted until recently. Asset Backed
Capital (ABC), one of the oldest SIVs, has long
achieved a Moody's A1 rating for its senior
subordinated notes, with a tranching ratio of
approximately 60 junior notes to 40 mezzanine
capital.
One new SIV trend has been the
rapidly growing demand for rated capital notes. As
the first loss piece of the SIV capital structure
(subordinate to medium-term notes and CP), capital
notes typically expose holders to first gains and
losses in the asset portfolio. According to rating
agency Standard & Poor's, over $11 billion in
capital notes have been rated to date, pointing to
the transparency and disclosure required by
investors as well as the expected impact of Basel
II on institutions holding unrated notes. Basel II
is second of the Basel Accords, recommendations by
the Basel Committee on Banking Supervision
intended to create an international standard on
how much capital banks need to put aside to guard
against financial and operational risks.
Shrinking spreads had led to innovations
to the traditional SIV structure. On the asset
side, some SIVs trended away from the absolute
practice of investing in high grade and liquid
asset-backed securities (ABS). They explored
less-liquid products such as CDOs and mezzanine
ABS (these are usually harder to get
marked-to-market prices and have larger bid/offer
spreads). Several existing and new SIVs received
approval from rating agencies to synthetically
purchase assets in lieu of highly-rated
ABS/mortgage-backed securities (MBS) by selling
credit default swap (CDS) protection on corporate
assets. As with conventional SIV portfolio
management, the vehicle would profit from the
credit arbitrage between long-maturity assets on a
leveraged basis and short-maturity liabilities.
Additionally, the ability to use repurchase
agreements (repos) as alternative asset-purchase
funding was incorporated into SIV mandates, as
they were within other structured finance
operations.
In 2004, Citigroup introduced
a new vehicle that takes this to a whole new
level. Sedna Finance incorporates a three-tier
liability structure, with AAA-rated first priority
senior notes (FPS), A-rated second priority senior
notes (SPS) and an unrated first loss piece.
Citibank raised 90% of the $1 billion capital
through its SPS notes with 150 times leverage,
exponentially greater than the 15 times industry
average leverage. In addition to funding the
purchase of various assets, proceeds from the
issuance of bonds and paper may also be used for
single-name CDS as either protection buyer or
seller. Sedna was approved to take up to 20% of
its total portfolio risk in synthetic instruments.
As the industry grew more adept with the
application of single-name corporate CDS,
credit-linked notes (CLNs) took on a more
significant role on the funding side as they could
be used to achieve lower funding costs. For
example, an SIV can issue a euro-denominated CLN
synthetically linked to the credit risk of a
BBB-rated entity, swap the euro to US dollar and
use the proceeds to acquire AAA-rated securities.
In effect, it has hedged out currency risks while
potentially improving net yield, at least in
theory.
The impact of the new Basel
Capital Accord The new Basel Capital Accord
will make the back-up liquidity
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