Issue 40 - November 21, 2007

Dealing with Uncertainty

As we have noted in previous newsletters, financial markets truly struggle in periods of uncertainty. In many respects, uncertainty has been the hallmark of 2007. The ramifications of shabby lending policies combined with persistent trade imbalances and growing global consumption of basic commodities came home to roost in the summer and fall. On the positive side of the ledger, most corporate and financial institution balance sheets are strong and well positioned to weather this turbulence. But sustainable forward investment progress requires conviction and reliable information both of which are in short supply currently. While the daily “mea culpa” write-downs of banks and broker dealers are a step in the right direction in restoring faith in the underlying strength of their balance sheets, it is also disturbing that it has taken months for these firms to get to these answers and it is fair for investors to question whether this is the beginning or end of the bad news. This is not the first but only the most recent episode of a series in which the financial system goes too far down a path. The ultra low interest rate environment encouraged a quantity over quality mindset in underwriting and the basic home loan has managed to create mischief literally all over the planet.

From King County to Hong Kong and back again

What happens when a homeowner defaults on a loan? In olden days – it meant that the lending institution would either re-work the terms of the loan or repossess and sell the property to recover their money. Now, with 21st century underwriting and financial engineering, it means that investors from as far apart as King County and Hong Kong may have been impacted depending on the path of securitization that the loan took.

Securitization has been with us for over 20 years. It is the process by which a lender can bundle a pool of loans together and sell them as a package, thus being able to deploy their capital in another round of lending. The package typically has a top layer which is rated AAA and represents the majority of the loans. The subordinated layer or tranche, as they are known, is a higher yielding part of the package. In return for the higher yields, the bond holder of this tranche understands that they will absorb the initial losses on the debt, typically a sum which far exceeds the historical default rate – thus protecting the top layer. Further enhancements included insurance offered by single line insurers to the top layer debt. The combination of the insurance and the subordination provide the rating agencies with the comfort to rate these top tiers as AAA. Traditionally, the loans that were packaged up were limited to high grade mortgages, auto loans, and credit cards. The default rates and prepayments of these pools were well understood and could be reasonably modeled by bond buyers. There were strict underwriting standards and documentation requirements. However, there was always a moral hazard imbedded in this engineering. Given that the underwriter was not going to be the ultimate owner of the loan and their income stream was simply a processing fee, the temptation to cut corners loomed large: the broader the pool of potential borrowers, the larger the stream of income. With the motive in place, all that was needed was the means; enter ultra low interest rates and the latest engineering marvel, “The Collaterized Debt Obligation” or CDO.

With the advent of the CDO, a structure which featured additional subordinated tranches, mortgage loans could be made to those with less than prime credit scores (sub prime) and employment verification and down payments became a historical footnote. The housing market was fueled by an entire new class of first time buyers and the gift of fear was lost as the loan was passed along to the next owner.

As interest rates rose back to more normal levels, many of these first time borrowers found themselves in over their heads. Not every sub prime borrower is going to default, but the percentage is substantially higher than any of the engineers modeled out. And it is the implications of these much higher defaults which roiled the markets this summer.

Silk from a Sow’s ear

Consider the magic of turning sub-prime loans into AAA rated bonds. After the casually underwritten loan was sold to a bank or broker dealer, it would then be packaged into a CDO and its respective tranches would be either sold to an investor or retained by the bank or broker dealer for its own investment portfolio. In the brief history of dealing with sub prime loans, default rates had topped out at around 8%. Default rates are now running in the mid 30 %’s and accelerating. The subordinated tranches have been in many cases entirely wiped out and losses are now invading into the AAA top tier. But recall that our top tier had an additional level of insurance. It now appears that these insurers may be called upon to make payment on claims. It also appears that the unprecedented level of claims may impact the claims paying ability and thus the rating of these insurers.

If our CDO was purchased by an investor, there may potentially be a loss depending on the tranche that was purchased and the leverage that was involved. Losses in this area have not been limited to the US. A number of international money center banks were also involved in CDO underwriting and a number of sovereign funds such as those in the Far East were buyers of the AAA tranches as alternatives to other AAA-rated US dollar denominated assets.

If our CDO was retained by the bank or broker dealer, it might have very well found its way into an off balance sheet vehicle known aptly as a “SIV”, or a “structured investment vehicle”. The financing of these positions was accomplished through short-term obligations known as commercial paper: an instrument maturing within nine months and one which is widely used by all manner of short term investors. The commercial paper was backed by the CDO’s and were thus rated AAA. With the defaults in the underlying collateral, it is unclear whether the commercial paper holders will see a complete return of their principal. King County was recently featured in an article as they own a modest amount of this type of instrument in one of their short-term investment pools. Additionally school boards around the nation are also finding out that a small percentage of their short-term investment pools are also potentially subject to loses.

Tangled Web

Now things get really convoluted. These same insurance firms which provide the enhancements to the CDO’s are the same firms which provide enhancements to the Municipal Bond market. On the face of it, a downgrade to a bond insurer would not seem like a material event to a municipal borrower, they could just go out and work with another firm in the future. But there are a large percentage of Municipal bond buyers who by charter must own only AAA-rated bonds. If an insurer is downgraded, the bonds will be as well. And if that were to happen, then those bonds could potentially come up for sale. It might also call into question the overall viability of these insurers and that could drive up the cost of municipal borrowing in the future. Credit markets are now inexorably bound together as a result of all of the engineering. Consider just one hypothetical example.

• A sub-prime loan finds its way into a CDO which is retained by the bank in their SIV and financed by the issuance of asset backed commercial paper.
• King County issues a bond which is rated AAA through insurance enhancements provided by one of the mono line insurers. While the proceeds of this bond were waiting to be deployed, they were invested in the county short term investment pool which is required to hold high grade assets.
• Our sub prime home owner moves into default as their mortgage now carries a rate of interest that they can not service. As a result of their default along with others in the pool, the losses have now exceeded the level of subordination and the AAA tranche is now experiencing losses.
• The bank is forced to mark down the value of the CDO it owns as much of the value of the instrument has been consumed by the defaults.
• The insurer of the CDO may be subject to a downgrade as a result of its total exposure to the AAA tranches which are now experiencing defaults.
• King County may find its borrowing costs are higher in the future as insurance premiums will be higher to recover from the CDO experience and they may have also suffered a loss in their short term investment pool as a result of holding a small amount of commercial paper backed by these loans

Economic Slowdown

All of the uncertainty surrounding credit markets is certainly not good for economic growth in the short-term. However, reliable lending practices and stronger risk controls that will result will certainly provide better foundations for the future. There is much ongoing debate surrounding the probability of a US recession. Individual IRS withholdings however remains robust through October. A slowdown rather than a reverse seems at least as likely an outcome. Equity markets will take their cue from the Federal Reserve who has demonstrated their willingness to assist financial markets through the unwinding process.

When we consider the backdrop of global growth coupled with the new found relative reliability of emerging markets there is much to look forward to in the coming year. We do not mean to minimize the challenges of the short-term; they are considerable. However the markets are forward-looking and as the markets gain confidence in the information stream, there will be numerous opportunities as a result of the recent dislocations. As always, we focus on the long-term and our approach is always to build portfolios which can weather these types of markets effectively.

• Dealing with Uncertainty
• From King County to Hong Kong
• Silk from a Sow's ear
• Tangled Web
• Economic Slowdown