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October 17, 2007
Enron, Subprime and the Derivative Disease
The Institutional Risk Analyst
October 16, 2007
"In the mortgage backed securities market, one can argue that tranching securities by the maturity of the cash flow does create economic value for the investors even if ratings are correct. In the collateralized debt obligation market, however, what economic value comes from tranching losses from four percent to six percent of notional principal? None. Some say 'CDOs create more AAA securities to buy' but that fact, while true, means nothing. One might as well create AAA risk by putting $99 million in U.S. Treasuries and $1 million in a BBB-rated bond. That creates no value at all because it's 100 percent transparent. Value to the structurer comes when either the end investor or rating agencies or both make errors in valuation, and that is easiest to do when the transaction is complex. "
Donald van Deventer
"The History and Future of the Rating Agencies"
www.riskcenter.com, September 18, 2007
That Treasury Secretary Henry Paulson is leading efforts to organize an $80 billion or so pool of private capital to finance four times that much in illiquid subprime assets controlled by some of the largest US banks is not a good sign. Looks to us like a prelude to a federal bailout.
Led by names like Citigroup (NYSE:C) and JPMorgan (NYSE:JPM), the supposed "super conduit" seeks to make attractive assets which now seem dead orphans. A number of banks and other dealers are increasingly illiquid and face losses on supposedly off-balance sheet conduits or structured investment vehicles ("SIV"), losses that in extreme cases could damage their solvency. Thus Hank Paulson is back in deal mode, but this last minute window dressing may be too little too late to stop the inevitable market based resolution.
Orchestrating the pooling of hundreds of billions worth of illiquid assets into a single conduit strikes us as a bad move. In analytics, we call such proposals a "difference without distinction." Instead of seeking to restore the abnormal and manic market conditions that prevailed in the world of structured finance prior to Q2 2007, we think Secretary Paulson and his Street-wise colleagues should be trying to reach a more stable formulation.
The subsidiary banks of C, for example, have about $112 billion in Tier One Risk Based Capital supporting 10x that in "on balance sheet" assets, assets which typically throw off 3x the charge offs of C's large bank peers. A modest haircut of C's total conduit exposure of $400 billion could leave that capital decimated, forcing C into the hands of the New York Fed and FDIC. Of note, looks like the ratio of Economic Capital to Tier One RBC for C at 3.75:1 calculated by the IRA Bank Monitor was not so severe as some Citibankers previously have suggested.
The fact that much of the debt issued by C-controlled SIV's was maturing in November seems to have prompted the Treasury to act, yet another example of "limited government" under President George W. Bush. Apparently there are some people at the Treasury who think that aggregating large bank conduit risk into a single subprime burrito will somehow draw foreign and domestic investors back to the structured asset trough. This notion would be laughable were the situation not so perilous.
For the past three months, ever since Countrywide Financial (NYSE:CFC) CEO Angelo Mozillo sounded the retreat back "in the bank" (See The IRA, "When Flying to Quality, Be In the Bank"), some of the largest financial institutions in the world have been choking on the flow of all kinds of collateral into their private conduits, flow which they have not be able to refinance via asset-backed CP sales. Now existing facilities are threatened and the regulators are scrambling to fashion yet another short term fix.
So far, many SIV sponsors have refused to realize losses on supposedly arm's length financing relationships with their captive conduits, hoping, against evidence to the contrary, that investor confidence in same will be restored. But as in the case of Enron, LTCM, Amaranth and now CFC, once market confidence is disturbed it is very difficult to regain. The derivative assembly line of originate, structure, sell has broken down.
Not only do we believe that the Treasury's effort to resuscitate the market for SIVs and other structured assets likely will fail, but we think Paulson already knows it will fail. We fully expect that the banks, insurers and broker-dealers involved in the asset-backed CP market obstruction will eventually forgo the fiction of SIV separateness and take these assets back "on balance sheet," creating a potentially crippling mark-to-market event. It is no secret that many conduits were rated according to the sponsor's ability to pay, not the collateral in the SIV, raising the same legal and operational risk issues for the banks as once caused Enron to collapse.
The odious combination of a public policy partnership to enhance "affordable housing," loose money policy from the Fed post 9/11 and the derivative virus exemplified by the use of off balance sheet entities a la Enron, threaten not only the solvency of some large US banks and funds, but are forcing many of these organizations to restructure themselves "on the fly." As we see it, the lasting threat to banks and other entities dependent upon the origination and sale of derivative assets like SIVs for revenue is not just big valuation losses this quarter or next, but the need to restructure assets, business units and people to fit a different business model going into 2008.
Some of the organizations likely to be hit the hardest by the forced adjustment in business models are the ratings agencies, particularly Moody's (NYSE:MCO) and S&P, a unit of McGraw Hill (NYSE:MHP). Cast your eye over the five-year revenue growth rates for MCO and MHP and consider that a large portion of this growth came because of the surge in demand for structured assets. Then ask how this trend line is likely to look in 2008 or even Q4 2007.
Sector leader MCO went from $440 million in revenue in Q2 2005 to over $646 million in Q2 2007. The financial services segment of MHP, which includes S&P, delivered 21% revenue growth in Q1 & Q2 2007, for $800 million in revenue and $400 million in Q2 operating profit.
Given the implosion of the structured finance markets, entire segments of the financial industry must be reconfigured. We have no doubt that markets for commercial paper, MBS and even whole loan collateral are recovering and will recover further in coming months, based upon greater transparency and less reliance on derivative trickery. There are plenty of buyers of subprime paper, but when the risks are priced accurately and explicitly.
Regulators in the US and elsewhere need to devote some attention to describing the characteristics of this future market and determining how to help US banks make that adjustment while putting in place additional regulations to kill the derivative disease. We suggest starting with the "Interagency Statement on Sound Practices Concerning Elevated Risk Complex Structured Finance Activities," adopting the key recommendations of the statement into regulation as normative standards of behavior, and dropping the legal safe harbor which prevents civil claims based on deviations from same.
The cure to the derivative virus behind the subprime structured asset fraud is transparency and accountability. As our colleague van Deventer notes above, a dealer will only bring a structured asset deal if it is mispriced vs. the rating and to the detriment of the investor. Tell us again, Secretary Paulson, why this market is worthy of salvage?
Questions? Comments? info@institutionalriskanalytics.com
Posted by whalenc at October 17, 2007 08:14 PM
hmm... from the enron mess, I seem to recall that the idea behind the off balance sheet treatment was that the risk was off balance sheet. Seems odd, that when/if an off balance sheet entity fail(s), that the shareholders would lose $. Pretty sure this contingent corporate/credit support will be considered in conferences and risk discussions to come -maybe the super fund salvage saves the need to have these conferences? Pretty sure this would not be a pleasant discussion while a discussion on a superfund seems a lot nicer.
The other analog about buying a bad car on a clean "carfax" report only to come back and blame carfax for a jalopy seems like wanting to both have-and-eat your cake. While I don't believe there should not be any hallway passes issued, what part of sub prime sounds high quality?
Posted by: Frank Hayden at October 29, 2007 03:11 PM
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