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4 PATHOLOGY OF DEBT PART 5: Off-balance-sheet
debt By
Henry C K Liu
worth in
changing market conditions because there is no
ready market for them, and no market for the
easily identifiable bits. Their value can only be
derived from the changing value of other
instruments through a complex network of hedging.
Banks are still allowed to assign to Level 3
assets the value they can rationalize, but they
are now obliged to tell regulators and the markets
of the holdings are in that category.
US
banks and brokers reportedly face as much as $100
billion of
writedowns because of Level 3
accounting rules, in addition to the losses caused
by the subprime credit slump. Estimates of final
losses from the credit crisis have suggested a
range of $250 billion to $500 billion. More
institutions are expected to revalue their
currently mark-to-market value downward.
Big Wall Street firms to date have written
down at least $40 billion as prices of
mortgage-related assets dwindle because of record
foreclosures. Morgan Stanley, the second-biggest
US securities firm, is said to have 251% of its
equity in Level 3 assets, making it the most
vulnerable to writedowns, followed by Goldman
Sachs at 185%. Citigroup, which has already
written down $11 billion, has 105% of its equity
in Level 3 assets. As market capitalization
shrinks from falling share prices, the ratio of
Level 3 assets to equity will rise.
Besides Citigroup, other banks may be
forced to write down as much as $64 billion on
collateralized debt obligations of securities
backed by subprime assets, up from about $15
billion so far.
ABX indexes and Level 3
assets ABX indexes, which investors use to
track the subprime-bond market, are showing
"observable levels" that would wipe out
institution capital if ABX prices were used to
value their Level 3 assets. ABX value reflects a
percentage of the instrument face value.
Ultra-safe AAA paper has lost 30% of its face
value, more than half of that in the last two days
of the second week in November. AA paper (Japan is
rated AA, as are the best banks) has lost more
than half its value. Lower-rated indices dropped
earlier, now hovering around 20 cents on the
dollar.
Adding to the banks' problems is
the amount of Level 3 paper private equity or
hedge funds bought with highly leverage financed
by banks. Many clients who purchased Level 3 paper
from banks are protected by "guaranteed sell back"
clauses in their initial purchase agreements. Bank
financing provided to real estate and construction
firms and private equity funds whose business
model was underpinned by cheap and easy credit is
destined to become non-performing loans.
No matter how finance engineers slice and
dice it, risk cannot be extinguished, it can only
be transferred or redistributed. In the asset
securitization process, companies un-bundle the
securities into a hierarchy of different tranches
by assigning varying degrees of credit risk out of
general pool of assets. The tranches produced in a
typical asset-backed deal range from AAA credits
down to BB.
With the number of
corporations still holding a AAA credit rating
dwindling, and with growth of money rising at a
faster rate than US sovereign debt, highly rated,
asset-backed paper is an easy sell with
institutional investors bulging with cash they
must invest. Securitization can lower the cost of
capital for companies than bank loans.
But
in most cases, the originator of the asset, such
as a manufacturing company financing trade
receivables or a specialty finance lender
securitizing loans, retains a residual interest in
the performance of the assets. This interest
obligates the issuer to cover losses in the asset
pool up to a certain percentage. If losses exceed
that percentage, other low-rated, subordinate
tranches of the issuance begin to absorb them,
with the loss climbing up the rating scale. The
post-Enron fear taught the market that there are
all sorts of toxic sludge out there hidden below
the surface. Lack of specific transparency coupled
with certain macro danger is an explosive mixture
in a jittery market.
The risks for banks
go beyond CDO exposure. The banks are also
obligated to provide liquidity support if cash
flow from the conduits they structured is not
enough to pay off the paper as it matures. If
enough loans in conduits go bad, the sponsor banks
could be liable beyond the amount their capital
can sustain. The US economy is strong and
resilient and can be expected to weather each and
every one of these financial problems separately.
But the US economy is now predominantly a finance
economy and a confluence of interrelated financial
market failures can put a mighty economy in
intensive care for a long time.
Even a
Triple-A-rated company like General Electric could
be vulnerable if it were unable to securitize
assets easily. Through GE Capital, its finance
subsidiary, GE uses sponsored SPEs and conduits to
securitize loans and receivables for itself and
for clients. In its latest annual reports, GE
asserts that if required in the event of an
accounting change regarding the consolidation of
SPEs, GE could use "alternative securitization
techniques ... at an insignificant incremental
cost". Still, skeptics say that GE’s statement in
its annual report about SPEs is misleading because
such an accounting change would likely affect all
off-balance-sheet financing alternatives. And if
GE has to finance the assets on the balance sheet,
the impact on its financial statements will be
more than incremental.
What has compounded
the problem is that nobody yet knows who holds the
commercial paper that is exposed to the US
subprime mortgage market and has been dubbed as
toxic. CP is typically bought by pension and
insurance funds, but until these funds can work
out their exposure, they are refusing to buy more.
It is this buying strike that has created the
liquidity freeze.
Skepticism over
SMLEC The Treasury constantly monitors
financial markets. By mid-year, key market
participants were telling Anthony Ryan, the
Treasury's assistant secretary for financial
markets, their rising anxiety over the ABCP market
from which SIVs roll over the short-term debt. The
market saw a massive restructuring approaching
with a potential for a disorderly unwind of many
SIVs. The Treasury became actively engaged in the
seeking a resolution by playing a lead role in
facilitating discussions among competing banks.
Citigroup, Bank of America and JP
Morgan/Chase, seeking to allay fears of a downward
price-spiral that would hit their balance sheets,
announced on October 15, 2007, their plans to put
up credit guarantees up to $100 billion for the
Single-Master Liquidity Enhancement Conduit
(SMLEC), which would buy mortgage-linked
securities.
Critics charged that the
Treasury was essentially helping big banks escape
from the financial pain of risky bets that turned
sour, banks that in earlier years had earned huge
profits. Ryan countered that the government's role
was merely to "facilitate market participants" and
that no public sector money was involved. At any
rate, the super SIV being created was "voluntary"
and no bank was required or forced to take part.
Still, a big promoter of the arrangement is
Citigroup, which has the largest risk exposure
from SIVs.
Citigroup, which is the largest
sponsor of SIVs with seven such affiliates, has
been criticized that its own SIVs would benefit
most from the plan. Bank of America will also
benefit. The Charlotte, NC, bank's mutual funds
are big investors of commercial paper, including
debt sold by the SIVs. Bank of America said its
concern wasn't whether the CP would be paid off
but rather the unnecessary seizing up of the
market. Reportedly, the price of admission for
SIVs will be high. SIVs will only be allowed to
sell assets rated AA or better and likely will be
unable to sell collateralized debt obligations:
pools of debt repackaged into slices with
different levels of risk and return, backed by
subprime assets. In addition, the SIVs will have
to pay a fee to the super conduit and accept a
discount in the price of the securities they are
selling. In return for that discount, the SIVs
will receive notes in the "junior" layer in the
conduit which will take the first hit if losses
are incurred.
The restructuring of SIVs
also raises the specter that certain SIV note
holders may find themselves stuck with unexpected
losses. Many fixed-income managers are intrigued
by the idea of investing in a "Super SIV" fund.
But some also say they are wary of its complexity.
The banks will essentially sell all of their
currently off balance sheet SIVs to the SMLEC and
use their own balance sheets to buy the CP issued
by the SMLEC to finance these purchases.
Participating banks will "insure" investors
against some portion of future losses within the
SMLEC.
In November 2005, Merrill Lynch
chief executive E Stanley O'Neal told investors
that the brokerage firm would shift its strategy
and would become more aggressive investing its own
money in increase profitability. Two years later,
asked how Merrill Lynch could lose so much money,
O'Neal said: "We made a mistake," as he resigned
from the company with an option and retirement
package of $161.5 million.
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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