Feature Stories | Jul 20 2007
By Greg Peel
There is a crisis going on at present in the global financial markets. In essence this crisis revolves around what may or may not be the potentially disastrous bursting of an asset bubble. The bursting of asset bubbles occur regularly in history, and has included everything from tulips to internet stocks. While such a concept may be simple enough to grasp for the average investor, a crisis that involves the financially complex concepts of subprime mortgages and collateralised debt obligations probably isn’t. These are assets that take one into the dark and clandestine world of unlisted financial derivatives.
The average investor will, however, most likely have appreciated by now that this CDO thing has Wall Street very jittery, despite the determination of US stock markets to push to ever new highs. One gets the feeling there might just be some rather significant correction on the horizon. It would be nice to know just precisely what is going on. Probably the best place to start such an explanation is to take one’s mind back to Sydney 2000, for this momentous showcasing of Sydney to the world is measured as the point at which Sydney (and ultimately Australian) property values really began to take off.
It also, however, coincided with the bursting of the dotcom bubble in the US. And the following year gave us 9/11. Worried that the US economy would never recover, the US Federal Reserve slashed its interest rate to as low as 1%. The rest of the financial world followed suit to some degree. Over in Japan, interest rates were already zero percent. Thus began what we now know as the period of “excess global liquidity”. It is a period that has brought us the great emerging markets boom. And it is a period that has seen money so cheap that investors have been desperate to find anything and everything – from stocks to bonds to property to commodities – to invest in, in order to create a return. It is a period that fuelled an already buoyant Australian property market. It wasn’t long before the same property boom was experienced in the US.
Ridiculously low interest rates meant that banks and mortgage lenders were desperate to lend money to anyone to buy a house. As property values surged, this seemed like an easy and safe deal from both sides of the equation. Americans were keen to stretch to bigger and better houses, just as Australians have been, and they could do so because money was cheap. What’s more, you can’t go wrong when the property market just keeps going up.
But when everyone who wants and deserves a mortgage has one, what do you do? The answer, from the lenders’ point of view, was to make mortgages that much more accessible. Bad credit history? No problem. No deposit? That’s okay. Don’t want to give us your financial details? No worries. In Australia we know such things as “lo-doc” and “no-doc” and high loan-to-value ratio mortgages. While these loans are considered of lower quality (and as such attract a higher interest rate) than traditional mortgages, they are nevertheless beholden to mortgage insurers. If an insurer won’t come to the party then there’s no deal.
In the US, however, low quality mortgages have been issued without insurance. These are the lowest of the low quality, high risk mortgages, and are known as “subprime”. Such mortgages, which again would have no documentation and may include loan ratios of up to 120% of a property’s value, reputedly make up some 10% of the US mortgage market. However, given that there is little homogeneity when it comes to loans, some commentators look at it another way and say up to 25% of US mortgages are not of traditional quality.
In Australia we appreciate that housing bubbles never go on forever, and nor do low interest rates. Many Sydneysiders in particular have found themselves paying a price for overstretching. The housing market has been weak, and mortgage defaults are on the rise. The US housing market has been suffering the same problem over the last several months. Defaults are climbing steeply, and there appears no immediate bottom in sight.
This is where the crisis began.
Banks and mortgage lenders usually make allowances for defaults. Property markets have risen and fallen for centuries. What makes this one so perilous?
The answer to that question brings us now to collateralised debt obligations, or CDOs.
To understand a CDO, consider the old-fashioned concept of a finance company debenture. Finance companies, which were often subsidiaries of banks, would lend money to average punters as, for example, a car loan. The car itself was the collateral behind the loan, and the interest rate reflected the risk on the punter’s regular pay packet. To raise the money to offer the loans, the finance company would sell interest bearing debentures at a competitive rate to investors, which were a form of low quality bond. The finance company would bundle up the car loans as the source of income on the other side.
Move to about 1995, and Australia witnessed the birth of a new form of mortgage lender. A company by the name of Aussie Home Loans began competing with the big banks by offering mortgages at a cheaper rate. To provide the finance for such loans, Aussie bundled up groups of mortgages and “securitised” them. In other words Aussie sold to investors a form of mortgage debenture or bond. Previously, only banks were in the business of making money from mortgages.
Of course, John Symonds got his idea from the US. Mortgage securitisation had been going on there for several years.
Jump ahead another decade or so and we’re into the era of excess liquidity and cheap credit. The securitisation of loans has become an enormous global business. And mortgage loans form a significant part of that business. But while global interest rates have been ticking up now as inflation fears flow from higher commodity prices, cheap money is still available – particularly in Japan, the world’s second largest economy (Japanese interest rates are still only 0.5%).
Financial markets needed to come up with more and more ways of creating assets and luring investors. At the same time such assets were becoming more and more financially complex, exploiting not only underlying assets but derivatives of those assets. In such an environment the CDO was born, and overnight it became extraordinarily popular.
A CDO is created when a “sponsor”, such as a bank, other financial institution or investment manager creates a “special purpose vehicle” which pools together various classes of loans with varying degrees of quality. These loans could be collections of corporate bonds, or simple business loans, or, as is the case in point, mortgages. Once pooled, the sponsor then separates the loans into three distinct groups or “tranches”: the “senior” debt, which on a commercial basis might be equated to secured debt; the “mezzanine” debt, which might be equated to unsecured debt; and the “equity”, which is clearly equated to holding shares which rank at that bottom of any liquidation scale.
In the case of mortgage CDOs, the first tranche is the high-quality traditional loans, the second the more loosely issued loans, and the third tranche is the subprime. Ratings agencies are called in to apply their typical ratings to these instruments, resulting in ratings ranging from AAA to A at the top, B to BBB in the middle and BBB to no rating at the bottom. The collateral behind the CDO is, in this case, the properties.
While the term CDO is generic, it is very rare that any two CDOs are in any way identical. In fact, some 40% or so of CDOs include in their pools other CDOs. They are indeed more akin to snowflakes. The typical life span of a CDO begins when the sponsor raises funds and spends about a year assembling the tranches. There follows typically about five years of interest payments to investors. Many CDOs are actually “managed”, meaning the sponsor spends that five years buying and selling mortgages in and out of the CDO as it sees fit. At the end of the period, the CDO matures and everyone walks away happy – particularly the sponsor, who has also taken a management fee.
Trouble only begins when the interest payments on the mortgages are not forthcoming – that is when a mortgage becomes delinquent. In this situation, the lowest tranche investors will find their income the first to halt. While this then effectively causes the value of that investment to fall, as with any debt instrument there is no problem unless delinquency moves to actual default – just as if a company went into receivership with outstanding corporate bonds. And therein lies the crux of the matter – the US housing market is in a major recession and this is causing a rash of defaults. Naturally the first to go under are the subprime mortgages.
But that is not where the problem ends. We are not about to see the global financial markets tip over just because a few low-income Americans were a bit greedy on their McMansions. The exacerbating factor in this subprime crisis is a matter of leverage.
Leverage has become a by-word in financial markets as more and more complex financial derivatives are created. A simple example might be margin lending, where an investor borrows an amount of money to buy shares while only putting up part of that money. The shares themselves become collateral. The leverage allows the investor to buy more shares than otherwise possible, and thus make more profit. Or, of course, make a greater loss.
The real problem in the subprime crisis has not been a simple case of defaulting mortgages. It has been a case of the investors who have purchased the CDOs – mostly hedge funds – being leveraged anything up to ten times. While this was a great money spinner when the US housing market was strong and life was good, things quickly turned sour when the market started looking not quite so good. And as a testament to our now heavily “globalised” world, the first signs of trouble came out of China.
One day in February the Chinese stock market fell 9%. In the greater scheme of things, this was really no big deal, and the market quickly recovered. But what this little blip did achieve was a sudden “risk scare”. Hedge funds across the globe, in their mad rush to invest in all sorts of risky assets in a time of excess liquidity, had set positions in everything from risky emerging market stocks to risky “junk” debt. In the latter case, this included subprime CDOs.
The result was that investors looked to divest some of their riskier stuff, just to bring things back into perspective a little. Hence subprime CDOs came up for sale. The problem was, no one much wanted to buy them. If no one wanted to buy them, then how much are they really worth? Never mind – the world bounced back from the February thing and we all largely forgot about subprime mortgages.
However, those hedge funds holding the unpopular CDOs didn’t forget. There was no point in making a fuss. CDOs are not listed, not exchange traded, and rarely ever change hands. They are usually just held to maturity. The US Securities Exchange Commission requires CDOs on the books of hedge funds to be “marked to market”, that is revalued at the market price at the end of the accounting period, but there is no real “market”. Hedge funds would normally “mark to model”, which meant plugging some numbers into a complex mathematical algorithm in order to arrive at a price. Or they would simply ask the issuer how much they should be worth, or their friendly CDO broker.
In all cases, it is to the benefit of those involved that the CDOs are valued at the best possible price. This is particularly true when one considers that fund managers are rewarded on performance, so why mark down the value of an asset when there’s no way of confirming it anyway?
The reality is, however, that while stock markets might have recovered from the China scare and pushed on to new highs, the risky debt market never really did recover. Lenders and investors alike decided to become a little more prudent in what sort of assets they dealt in. Banks became less inclined to hand out loose subprime loans. This meant there weren’t as many prospective buyers in the housing market, which meant property values continued to fall. As property values fell, so did the number of defaults begin to rise. While the subprime market seemed to go away for a couple of months, in reality the value of subprime CDOs were falling all that time. No one really knew that, because CDOs were not actually changing hands.
Last month, however, the crunch came. Two high risk hedge funds, initially worth a total in excess of US$9 billion, were bleeding heavily. Loaded to the eyeballs on subprime CDOs which were suffering major defaults, the hedge funds could not service their own leveraged debts. It was at that point that the hedge funds lenders decided to go out and sell the collateral, being itself the collateralised debt. Both funds came under the umbrella of investment bank Bear Stearns.
Reputedly (and it is reputedly because this is all an off-market market), investment bank Merrill Lynch tried to sell US$800m of debt, hoping to at least achieve 85 cents in the dollar. Rumour has it Merrills could find only bids of 30 cents in the dollar. At the same time, Deutsche Bank was touting a further US$600m. When this news got out, all hell broke loose.
As US stock markets suffered a significant fall on the rumours, Bear Stearns went into damage control. It entreated all the investment banks involved, which also included JP Morgan Chase, Goldman Sachs and Bank of America, not to try to sell their collateral. As it turned out (again reputedly), the two hedge funds in question had already been marked down back in March to values of US$925 million (from US$1.3 billion) and US$638 million (from US$6 billion). Bear Stearns announced it would put up US$3.2 billion to save the first fund, which was the less risky of the two. The second fund would be left to go under. Shortly after, for reasons unknown, the rescue figure was revised to US$1.6 billion.
There was panic in the CDO market. The Bear Stearns debacle exposed the fact that subprime CDOs may only be worth 30 cents in the dollar. And if everyone started to sell them – less. Most CDOs would have been sitting on books across the US, and across Europe as well, at much higher valuations. If marked to market, the losses would be extraordinary. The subprime CDO market, a few months earlier, was supposedly worth some US$800 billion.
But again, the situation appeared to be contained. The US stock market wavered briefly, but then set off for new highs again.
This is a bubble that just doesn’t seem to want to actually burst. For as we all know, bubbles burst spectacularly and usually without warning. There has been plenty of warning now, but still no crash. This would tend to suggest that the bulls are right – this subprime mortgage thing is contained within a small section of the market that will result in a few losses and that’s all. The people who lose all the money will be hedge funds and the obscenely rich who invest in them. Tough luck. Who cares?
There are two problems with this argument.
The first is that, contrary to popular belief, it is not only the obscenely rich who invest in hedge funds, and hence CDOs. Former SEC commissioner Harvey J. Goldschmid told Associated Press earlier this month:
“In theory, hedge funds are about wealthy people investing. But, by practice, pension funds, endowments, and other financial institutions invest in them, and a few big hedge funds going down can spread an awful lot of harm among real people.”
In other words, this “crisis” could potentially be a crisis for the little guy as much as it is the big investors.
The second problem is that the wheels of the mortgage business turn very slowly.
It is standard practice that a US homeowner may be delinquent on mortgage payments for up to three months before foreclosure proceedings begin. Even then, the process can be slowed if bankruptcy is declared or the borrower appeals against eviction. Only after the property has been sold will the mortgage lender actually write down the value of the property. Only then does the collateral in a CDO effectively become devalued.
And that is when the ratings agencies come into play. Ratings agencies such as Moody’s and Standard & Poors have become major characters in the theatre of the subprime. They have come under heavy criticism for not downgrading their ratings when it was clear that valuations were severely overstated. However, the agencies have defended themselves by pointing out that they have never been about de-rating a financial asset based on rumour. Only when, in the case of CDOs, the collateral falls below a pre-set value will the agencies move into action. And given the first point above, this takes time.
Were Moody’s and S&P to begin de-rating various classes of mortgage-backed security, large public investors such as pension funds would be forced, under their own investment policies, to sell those assets. If they could. Across the board de-rating would be a trickle that turns to a flood of market revaluation of all risky debt, whether subprime mortgages or not.
Earlier this month Moody’s announced the downgrading of 399 subprime mortgage-backed securities. To make matters worse, colleague S&P announced it was changing the way it evaluated subprime securities due to “unprecedented levels of misrepresentation and fraud, combined with potentially shoddy initial loan data”. Now it had become really nasty. But the worse was yet to come.
At the close of business last Tuesday, Bear Stearns announced that its two hedge funds (which, when we last left them, were supposedly worth 30 cents in the dollar) were close to worthless. Indeed, the riskier of the two funds was worth nothing. The other was valued at 9 cents in the dollar.
The implication from this is that there might be assets out there that were once worth about US$800 billion that are actually worth close to zero. But that is just the subprime mortgage assets. All credit instruments are inexorably linked by an overall concept of credit risk. If it’s subprime today, what’s next? There could be a contagion that spreads to all markets, and ultimately has very, very serious ramifications for all asset valuations.
Already there is pain being felt in the private equity leveraged buyout game. It is LBOs that have helped drive stock markets in the US, Australia and elsewhere to enormous returns in a short space of time. Major US investment houses which underwrote some of the biggest deals completed earlier in the year by the Blackstones and KKRs of this world are reputedly sitting on some US$11 billion of unsold “junk” bonds – those which provide the “leverage” in “leveraged buyout”.
And as we speak, Australian hedge fund Basis Capital has announced to its financiers that it cannot meet its margin calls. Basis is a heavy investor in CDOs.
Are we staring at the end of the world? Not necessarily. While the bulls maintain that the subprime crisis will all blow over quickly , the more prudent reality is that this particular crisis is a slow-burn that hasn’t run out of oxygen just yet. Indeed the worst is most likely still in front of us.
What is clear is that risk for risk’s sake has been crimped, and there will need to be asset revaluations, and lot of losses, and a lot of soul searching going on before the dust can settle and we can get back to the business of calling a long term bull market trend in earnest. Just how little or much we may need to fall is, at this point, still uncertain.
What we do know however, is of a little problem potentially brewing in the US called “adjustable rate mortgages”, or ARMs. Unlike Australians, Americans have in the past almost exclusively signed up to fixed rate mortgages. This means that they have not thus felt the pain of interest rate hikes (of which there have been seventeen in the US since the low). But just as the rush to lend money has bred the subprime mortgage and the CDO thereupon, it has also created the ARM. An ARM works a bit like a credit card that gives you a low interest rate “honeymoon” for the first year, before jacking up the rate significantly thereafter. In this case, there are borrowers in the US about to find the interest rate on their mortgage jump by 50-100%.
Mortgage defaults in the US are presently running at the highest rate in 37 years. They have only been keeping records for 37 years. The first ARMs will reach the end of their honeymoons soon. There have been some US$2,000 billion worth of these issued.
