Wednesday, November 28, 2007

Welcome to Conduit Hell

Tripped Up, While Just Passing Through

Fortune continues its series on ... how banks and brokers screwed themselves in the process of passing along junk credit.

Money quote (pun intended):

None of this would have been a dire problem for Merrill if it hadn't gone from simply manufacturing CDOs and reaping fees to becoming a huge investor in the CDOs it created - getting high on its own supply, you might say.

The hellishness of "the liquidty put"
What's in the pandora's box?

Here's my stylized summary.


In the old days (1980s), there was the novel creation of mortgage-backed securities (MBS), now often called residential-MBS or (RMBS) for precision. These were fancy new securities that promised to behave like tried-and-true, mostly, at higher yields. When rates rose, they didn't. Merrill Lynch took the largest ever single-day trading loss in history, at the time, in its mortgage business on its mortgage desk. Today, the RMBS market is 'well understood' and functions to the benefit of all involved. A great deal of the collateral for MBS is provided by Fannie and Freddie, who buy up "conforming mortgages", as defined by their regulator, and provide a backstop to help sell them on. This middle-man role keeps money flowing to home seekers and lowers the costs to them, when it works well.

Shortly thereafter, the collateralized-mortgage obligation (CMO) was created. These were just a re-package of the re-packaged, MBS stuff. CMOs are not securities, per se, they are conduits, or legal entities that buy assets and sell participation in those assets' returns, in one way or another.


In the mid and late 1990s, Wall Street had a spin with 'sub-prime', in the form of manufactured housing lending. This was a chance to try to price low-credit risk high enough to cover the costs of it. Luckily, the amounts stayed low, because ... well, the margin for error was not large, and folks took a bath, eventually, as the eagerness to book fee revenues ... (I don't know where the market for this stands today).

In the late 1990s, the CDO was "invented", as a way to get to higher yields, again promising the same performance as tried-and-true. The "traditional" CDO, if such a thing exists, has about 80% "good stuff", 10% medium-good (maybe alt-A mortgages), and 10%, "sub-prime". Unlike MBS, the "stuff" can be most anything.

Some of the credit agencies even slapped, reportedly, "AAA" ratings on these securities (I cannot confirm this). If one pretended that sub-prime defaults were limited to, say, 10% of 10%, or 1% of the total CDO value, it would all be good, even moreso since 10% would never be hit by all geographic locations at once (and 1% was small compared to 11% annual interest rates charged, too boot). By the end of 2006, delinquencies - not defaults! - on subprime debt had climbed to the 15-20% range. By mid 2007, some portfolios had been sold at 20% discounts, suggesting, perhaps, that no one was willing to pay for the 'other stuff' given its uncertainties, even if it had likely value.

It appears that even the agencies, Freddie and Fannie, got involved in buying alt-A and subprime credits. [I will check the proportions for you when I get a chance.]

There is more.


If you buy up stuff and re-package it for sale, it can balloon your balance sheet and cramp your style (and growth). The "answer" is to create a legal entity to put the stuff off balance sheet. These are "SIVs", special investment vehicles, or "SPVs", for special purpose vehicles. They can also be "hedge funds", which are special legal vehicles for certain types of investors.

They have no capital requirements (that I know) and little regulation, certainly not bank regulation, directly. Some of the structures may have capital ratio requirements, by design, as may be suggested by HSBC indicating this week that it would rather put assets on its balance sheet than recapitalized because of a decline in value.

Anyone can try to set-up an SIV to get into the game. The big banks all have them, reportedly, as well as most if not all the big brokers. (Even the mortgage bond-insurance firms may have been tempted to get involved as well. So far, I don't know any insurance companies that took a spin.).

According to Fortune, you run an SIV like a Broadway show. Someone, a producer, gives upfront money (for a fee), you hired someone to direct the show (buy "stuff" AND carve it up into structured products to sell), then you sell tickets (get investors to buy the carved-up stuff). It appears that some of these SIVs run like mini-banks, in which the upfront money stays in the conduit, refinanced in the short-term commercial paper market.

Whether these SIVs, also called "CDOs", stuck to the 80/10/10 formula, no one knows for certain. There is some indication that they may have, from prior sales that came in at 20% discounts.

there is more

The producers appear to have also 'sold tickets' that could be returned. "Attaching liquidity" is something that has been done a long time, as a way to enhance a bond enough to entice buyers. This is done by offering to buy-it-back (giving a put to the investor), if something adverse occurs, like a credit downgrade in the next 24 months or so, say.

According to Fortune, these return tickets appear to have been part of what happened to Merrill Lynch. Someone should have been keeping track of how many were sold ...

there is more

If the tickets sold were 'put' back to the SIVs, you can see the problem. Suddenly, you have to raise financing (sell new tickets) or sell assets (stop producing the show).

It appears that something of both is going on. The inter-bank markets and the commercial paper markets suggest that people are worried that these SIVs are being financed in the money-markets (short-term, ahem!). I don't know how much of that is true. Also, some of the assets appear to have made their way onto the balance sheets of some companies, say, Merrill Lynch.

It's not clear (to me), whether "stuff" was returned directly to Merill or to the SIVs (in the end, some of the "stuff" may just be contracts, rather than securities, I'd guess, but I don't know). But you can see the issue. When it comes back, it needs to be financed (or financed again)... AND marked to market.

We appear to have a variety of cases. Goldman's hedge fund took in additional capital to keep financing the assets and to avoid fire-sale. Merrill appears to have used its own balance sheet. Bear Stearns appears to have sometimes worked without providing recourse, simply liquidating its hedge funds, leaving the investors holding the bag, this summer.

there is more

Whether or not stuff stays off balance sheet, sooner or later it has to be marked-to-market and the realized losses (if any) must be recognized - in whole or in part, and over time.

There are two big problems.

Almost no one wants to buy subprime, so there is probably no traded market value. A 20%-35% haircut might estimate the losses outside of the "good stuff" inside a CDO, based on a ultimate default and recovery assumptions, that will play out over the life of the loan, but most significantly, it would seem, in the next few years. [update: the market is trading now, well below that, indicating that people are not willing, perhaps rightly so, to 'pay up' for scenarios that may not be as bad as expected.]

The second part is potentially just as large. Prices on the good stuff have fallen, not just related to a flight-to-quality and sensible repricing of risk, but also to legitimate worries about recession (loss of employment) and adverse (and stupid) loan terms (resetting interest on low-credit loans) leading to record level delinquencies and defaults. That might be 10-25% on 80%, or a 8-20% "hit", which is just as large as the credit-related hit on subprime.

there is more

As life went along, a non-cash or derivatives market for CDOs developed AND took flight.

In this case, you don't have to take up financing (find a producer), getting your hands dirty with cash up-front.

In a synthetic CDO, you just reference the securities prices in question, like a futures contract might or like a credit default swap (CDS) might do. Oh, yeah, I think these are all off balance sheet risks, too, but I'm not 100% sure.

Derivatives markets are a good thing, but they have to be well capitalized. Many of the well developed derivatives markets trade several times the notional value of the cash markets, meaning that they can grow fast, and require adequate growth in risk capital. (see chart for growth estimates)

One can hedge the risk in regular-way credit protection on a corporate or municipal bond, say, with pretty good success. Well see how well people hedge away mortgage credit risks, including subprime risks. Also, we'll see who was on the "wrong side". So far, it seems like Goldman was ahead of the curve in using derivatives protection, but someone had to write that protection...

The overall CDO market might be $2 trillion. I could guess that synthetics might be one-third to a half of that. A 20% mark-to-market loss seems steep to me, on this, but if OAS spreads have doubled on a 20-year instrument, it might be right. That could get one to $200 billion dollars, spread out over the combination of market makers and investors, in some unknown set of proportions.

Of course, if the general level of rates falls and credit spreads tighten, too, some of that could get offset. If rates fall as part of an expectation of a growth slowdown, however, it's not at all clear that the price of credit will fall alongside. Spreads could simply widen...

Whatever the case, it is still possible to at least estimate a floor.

The emergence of synthetic deals has clearly boosted the CDO market. The market is dominated by synthetic deals, and today 75% of CDOs issued are synthetic CDOs. This marks a clear evolution in the CDO market. In fact, the two most recent products, single tranche CDOs and ABS-backed CDOs, now account for, respectively, 66% and 25% of the synthetic CDO market. The market is moving toward "on demand" credit risk, where an investor can specify a product’s risk/return and the bank originates the "raw material" (bonds, ABS, etc.) and then distorts the risk/return ratio of its portfolio and delivers a new product to its client.

The development of the synthetic CDO market on the back of the CDS market is having a tremendous impact on the credit market, reorganizing the credit value chain. The development of the credit derivatives market and especially CDOs has had a tremendous impact in the positioning of banks in the risk management value chain," says Pierron. In the medium term, regional and smaller banks will concentrate on sourcing risk (especially via loans), while brokerage houses and investment banks will focus on deal structuring. The distribution will be shared between various players, from large banks to insurance companies, he adds. - pic link

No comments: