When placing blame on the latest bubble without a doubt the rating agencies are near the top of the list. Ongoing denial seems to permeate the credit landscape and after further review we know why.
Even after downgrading almost 10,000 subprime-mortgage bonds, Standard & Poor’s and Moody’s Investors Service haven’t cut the ones that matter most: AAA securities that are the mainstays of bank and insurance company investments.
None of the 80 AAA securities in ABX indexes that track subprime bonds meet the criteria S&P had even before it toughened ratings standards in February, according to data compiled by Bloomberg. A bond sold by Deutsche Bank AG in May 2006 is AAA at both companies even though 43 percent of the underlying mortgages are delinquent.
Sticking to the rules would strip at least $120 billion in bonds of their AAA status, extending the pain of a mortgage crisis that’s triggered $188 billion in writedowns for the world’s largest financial firms. AAA debt fell as low as 61 cents on the dollar after record home foreclosures and a decline to AA may push the value of the debt to 26 cents, according to Credit Suisse Group.
The 20 ABX indexes are the only public source of prices on debt tied to home loans that were made to subprime borrowers with poor credit histories. About $650 billion of subprime bonds are still outstanding, according to Deutsche Bank. About 75
percent were rated AAA at issuance.
Regulators require banks to hold more capital against lower- rated securities to protect against losses; a downgrade would force them either to sell the securities or bolster reserves. While most banks haven’t disclosed the ratings of their subprime holdings, S&P estimated in January that losses on the debt may exceed $265 billion. American International Group Inc., the world’s largest insurer, has $20.8 billion invested in AAA rated subprime-mortgage debt, not including asset-backed securities that caused the company’s biggest-ever quarterly loss last period, according to the New
York-based company’s disclosures.
Further analysis of the AAA rated structured paper market clearly illustrates significant downgrades are on the way over the next few months.
My Comments: When 74 of 80 “AAA” bonds fail the investment grade test one should realize the Wall Street machine is beyond broken. Of course that same machine actually owns this paper with leverage beyond belief. Is the US taxpayer the buyer of last resort? Or are US and foreign savers the patsies of last resort?
The three amigos, (Citibank, JP Morgan and Bank of America), have agreed to support Treasury Secretary Paulson’s Super SIV fund by the end of 2007. Details to follow but it seems the $75 billion fund will purchase any type of SIV collateral.
The fund could start operating before next year, the person that the newspaper cited said, and the banks could be asking financial institutions to contribute as soon as Friday.
The fund could restore some liquidity to the market for asset-backed securities by establishing a buyer, even if no SIV uses it, the newspaper said. The proposed still must obtain the approval of credit-rating agencies.
Can a $75 billion fund stop the bleeding in the $320 billion SIV market?
The average net asset value of SIVs rated by Fitch fell to 73 on Sept. 28 from more than 100 in July. A 0.5 percent drop in value of assets is equivalent to a 7 percent decline in the so- called NAV, Fitch said.
Once an SIV’S net asset value falls below 50, a clause is typically triggered requiring the fund to liquidate.
My Comments: The rapid decline of SIV net asset values since the credit crunch began in July may put most of this asset experiment in liquidation mode just in time for Christmas. Of course, Bernanke assured the markets last week he would offer 90% financing to the banks participating in this Super SIV. Can Bennie and the Jets prevent the unwind of insolvent structured finance “securities”?
Over the last week or so we’ve witnessed a rude awakening within the credit complex. Recently, Merrill Lynch found religion in admitting a slight error in estimating “subprime write downs” when the final tally was twice the original $4.2 billion. Following this announcement the board forced CEO Stan O’Neal to the Hamptons, permanently but don’t shed any tears for Stanley. Stanley O’Neal was the same guy who accepted several hundred thousand stock options 3 days after the 9/11 incident and then sold most of this stock in January 2007 which coincided with a financial services conference where he touted Merrill’s expertise in subprime lending and structured finance. Since then mother Merrill has destroyed roughly 22% in shareholder equity while watching the stock decline some 42% YTD.
Today, we learn of an SEC investigation into Merrill’s hedge fund practices tied to structured finance.
In a further sign investors’ confidence in the firm’s creditworthiness is deteriorating, credit-default swaps tied to Merrill Lynch bonds climbed 30 basis points to 135 basis points, according to broker Phoenix Partners Group. The contracts, which protect bondholders against default, are trading at the highest level in more than five years, Credit Suisse Group said.
The SEC will probably examine whether dealings with hedge funds complied with accounting rules or whether Merrill “tried to engage in what looks like sleight of hand,” said Peter Henning, a former attorney in the criminal division of the U.S. Justice Department who teaches at Wayne University in Detroit. The deals may be legal, depending on how firm Merrill’s obligation was to buy back assets or the likelihood that it would be forced to do so, he said.
The SEC’s “concern will go back to what happened at Enron,” the Houston-based energy-trading company that collapsed in an accounting scandal in 2001, Henning said. “Are they temporarily offloading assets or securities to dress up their balance sheet in the short term?”
My comments: Merrill Lynch is no different than most of the other broker dealers who refused to mark to market. According to FASB 157 the 15th of November makes mark to myth part of the history books so expect a few more CEOs to be ousted before year end. Hint: One plays bridge with Warren Buffett.
Returning from New York this past weekend I opened the Wall Street Journal on Monday to discover yet one more chapter in the structured finance shell game. Evidently Treasury Secretary Henry Paulson picked up the bat phone to several of the largest US banks, begging them to work together in order to facilitate an orderly unwind of numerous off balance sheet structured investment vehicles (SIVs). The proposed Super SIV will try to float one year capital notes with proceeds earmarked for the purchase of SIV assets originally created by Citigroup. Thus Citi avoids two problems, an increase in reserve requirements from assets returning to their balance sheet and ongoing reputational risk.
At this point, the rational investor is throwing up his hands, and why not?
“I have never seen Treasury play this kind of role,” said John Makin, a visiting scholar with the conservative American Enterprise Institute in Washington and a principal with hedge fund Caxton Associates LLC. The banks made “riskier investments that didn’t work out. They should now put it back on their balance sheet.”
Paulson and Co have their hands full lately as trust and confidence in structured finance have been waning. Apprehension and/or the inability to mark securities to market have sent a shock wave through the credit markets. More recently we witnessed the following acts of desperation:
- Increased injections of liquidity by the Fed
- Broadening the collateral accepted (to include asset-backed commercial paper) and terms (from 7 to 30 days) of the repo market
- 100 basis point cut (two separate actions) in the discount rate and 50 basis points to fed funds
- Encouraging use of the discount window (formerly stigmatized) because banks no longer trust collateral being posted when lending to each other
- Proposed Super SIV whereby roughly 20% of the total SIV market is re-tranched
Clearly the credit markets are faced with unprecedented circumstances due to countless players and massive leverage. Unlike LTCM which required a NY Fed bailout, the credit markets today have grown incredibly opaque while derivative exposure has gone parabolic.
It’s obvious the SIV assets won’t be priced at market rates because there’s not much of a market to begin with (and why the super SIV exists in the first place). But where exactly do they get priced? To whose benefit? And by which standard?
Unlike the Bernanke induced rally two months ago, Paulson seems to be striking out in spades. The banking index is probing 52 week lows while Citigroup has dropped over 6% in 3 days.
This latest scheme, to which the ex-Goldman Treasury Secretary gives his blessing, attempts to put off the structured finance day of reckoning even further. Could the Super-duper SIV create the inevitable mark-to-market across most aspects of the securitization world leading to a run on the bank? Note to Hank: Beware the law of unintended consequences.
Now that the dust has settled regarding the latest Fed rate cuts, most bond fund managers seem rather unenthused. According to PIMCO group:
“The reality is the fundamentals haven’t gotten any better, and, if anything, they’ve gotten worse,” said Mark Kiesel, an executive vice president at Newport Beach, California-based Pimco who oversees $85 billion in corporate bonds.
While concerns from many professional money managers involve credit disruptions.
About three-quarters of 30 fund managers who oversee $1.25 trillion expect a hedge fund or credit market blowup in the “near future,” according to a survey by Jersey City, New Jersey-based research firm Ried, Thunberg & Co. dated Oct. 1.
Is it fair to say a return to normal (pre Fed) market behavior is out of the question?
More than 65 percent of investors in mortgage-backed securities are struggling to find bids for their holdings, according to a survey of 251 institutions last month by Greenwich Associates, a Greenwich, Connecticut-based consulting firm. Among holders of CDOs, the figure is 80 percent.
The U.S. commercial paper market is shrinking. The amount of debt outstanding that matures in 270 days or less fell $13.6 billion the week ended Sept. 26 to a seasonally adjusted $1.86 trillion, according to the Fed. It’s down 17 percent in the past seven weeks.
My comments: There is maybe $6 trillion in mortgage-backed securities outstanding so 65% of that amount would be $4 trillion. In addition, there is approximately $2.5 trillion in CDOs outstanding so 80% of that amount would be $2 trillion. We are probably very close to reaching a situation where there would be NO BID on these securities. Can someone tell me how the world financial system could even function with NO BID on $6 trillion in securities stashed in financial institutions worldwide?
Recently, the negative news impacting structured finance seems to hit the news wires sometime after 5:00 PM EST when most of the Wall Street gang has departed for the local tavern. Today was no different as the illustrious TCW came clean on some of their CDO investments.
Terms of the CDO created a forced sale:
A decline in the price of securities in the market-value CDO, formally called Westways Funding X, managed by TCW triggered a clause that demands assets be sold so holders of the highest- rated pieces don’t incur losses, TCW said today in an e-mailed statement. TCW was unable to amend the clause, according to Moody’s Investors Service, which cut the credit ratings on six classes of the Westway CDO.
Most CDOs can hold assets until they mature. Others such as Westways have tests based on the price of their holdings that are designed to protect investors who buy higher-rated portions of the securities from losses in lower-rated classes.
“Westways X did not experience any delinquencies or credit performance issues, but did experience widening spreads consistent with all non-Treasury fixed income sectors,” TCW said in the statement. “The resulting pricing declines, while modest by most financial market standards, have been sufficient to cause the structure’s net asset value to fall below a critical threshold.”
Rating agencies reluctantly continue the downgrade process:
Moody’s downgraded $40 million of notes from the Westways Funding X CDO that were rated A2, four levels above investment- grade, to Caa2, eight levels below. Moody’s is continuing to review those securities for further downgrades, as well as the CDO’s AAA securities. Bonds rated below Baa3 by Moody’s are considered high-yield, high-risk, or junk. Fitch Ratings last week said another five Westways Funding CDOs might have to sell assets under the CDOs’ rules.
My Comments: Fitch, S&P and Moodys have downgraded approximately 1% of the outstanding structured finance world. Any doubt about much more in the near term?
Last month the WSJ reported that SEC examiners would be analyzing valuation techniques related to structured finance in order to verify brokerage securities and loan positions.
According to Chris Whalen:
The Fed’s decision to waive Section 23A of the Federal Reserve Act (Reg W) and allow Bank of America (NYSE:BAC), Citigroup (NYSE:C), and JPMorgan Chase NYSE:JPM) to make large loans to their broker dealer units may be a sign of impending trouble. These loans, which are apparently to support collateralized debt obligations (“CDOs”), are an indication of mounting liquidity problem among the larger Sell Side shops.
The table above, courtesy of Richard Bove of Punk Ziegel & Co, displays data on holdings of these firms which are subject to Fair Value accounting (FASB 157 and 159). Fair Value accounting breaks holding into three categories:
- Level 1 holdings are relatively easy to value since they are traded daily. Holdings include stocks, treasuries, or commodities.
- Level 2 holdings are more opaque. This group trades intermittently so holdings are determined by computer models. Holdings include anything from loans, derivatives, restricted stock and thinly traded debt securities.
- Level 3 holdings are valued solely at the discretion of the holder since there are no comparable issues being traded. Holdings include private equity, residuals from securitizations or complex derivatives.
The past 60 days has truly tested mark to model (Level 2&3) and the results are disastrous. How do we know this? Because mark to market or broker has resulted in transactions well below what supposed book or model values were. In some instances investment grade paper sold for 25 cents on the dollar. Thus, the market has implicated the brokers, banks, hedge funds and rating agencies for obvious reasons.
Looking at the table above we see $5.6 trillion in holdings being held by 8 firms. There is $0.3 trillion that cannot be valued objectively. This is 63% of the combined firms’ common equity. There is $4.1 trillion in Level 2 holdings which we would say are overstated by a minimum of 8-10%. This is 7.9x the combined firms’ common equity.
In summary, the banks, brokers, auditors, SEC, rating agencies and hedge funds will have their hands full trying to value $5.6 trillion in securities, 78.9% of which do not trade on a regular basis.
Allowing the free market to force a mark to market will create relentless write downs for this sector over the next few years. On the other hand continued denial results in perpetuating the twilight zone economy.
Barclay’s provided $1.5 billion to Golden Key, another highly geared commercial paper fund undergoing liquidity issues.
It is the third SIV-lite arranged by Barclays to announce a restructuring, following in the footsteps of vehicles managed by Britain’s Cairn Capital and Solent Capital Partners.
These structures use short-term funding to invest in portfolios of longer-term securities, mainly in the asset-backed bond market. They have suffered a double hit as investors have shunned their commercial paper, and the value of their investments have fallen sharply due to contagion from the U.S. subprime mortgage market to all forms of structured finance.
My comments: Over the next several days over $100 billion in commercial paper is scheduled to rollover. Bottlenecks should persist as brokers, hedge funds and investors refuse mark to market on the underlying CDOs. In November, FASB changes go into effect on many mark to model securities creating another headwind for the twilight zone economy.
From today’s Bloomberg: “Moody’s Cuts Outlook on $14 Billion of Commercial Paper Funds.”
Moody’s Investors Service said it had downgraded or placed on review for downgrade $14 billion of bonds sold by funds known as structured investment vehicles.
The credit rating firm also changed the way it rates the funds, citing ”unprecedented market volatility”.
This is the equivalent of shutting the barn door in Idaho when the horse is already in Montana.
State Street, the largest money manager for institutions, revealed potential liabilities of $27 billion today almost four times shareholder equity. Evidently, the Boston based firm has experienced difficulty in refinancing asset backed commercial paper potentially forcing off balance sheet liabilities back to the parent companies’ books. Many of these conduits, especially European entities, were prevented from rolling over short term asset backed commercial paper leading to another bottleneck in the structured finance assembly line. More importantly, these off balance sheet liabilities ($891 billion) may end up back on the balance sheets of commercial banks creating another layer of credit contraction hence the Fed’s recent discount window panic.
Lenders have about $891 billion supporting asset-backed commercial paper funds and similar investment pools, Fitch Ratings said last week. Some funds, including those managed by KKR Financial Holdings LLC, haven’t been able to refinance by selling new commercial paper. Their lenders may seize assets to get repaid, though the assets may not fully cover the loans if prices have fallen amid the subprime-mortgage crisis.
“There is a growing recognition that there is a crisis in the commercial paper market,” Bove said. “This is a big risk for State Street.”
My comments: Over the past several weeks global central banks have pumped over $400 billion into the system to re-liquefy vulnerable commercial banks exposed to asset backed commercial paper. How much longer before questionable collateral impairs lending abilities of commercial banks?
The market is now in the process of repricing risk in the structured finance world while the credit arb game runs out of players. Welcome to a modern day run on the bank.