Debt instruments: US sub-prime debt has become a dirty word in the financial world, as indeed has its sister phenomenon, the CDO, writes Peter Pontikis FCPA.
The recent collapse of the US sub-prime mortgage lending market and the global CDO market that accompanied it has seen a large wave of credit repricing that has permeated most corners of the worlds financial system.
Its a ripple effect that has come to include the stock and money markets here in the Asia-Pacific region. In the process it has threatened the very viability of our own credit markets and payments system.
US sub-prime debt has become a dirty word in the financial world, as indeed has its sister phenomenon, the so-called CDO.
CDO stands for 'collateralised debt obligation'.
A CDO is typically issued by a company or securitisation vehicle that buys a 100 or more types of collateral (such as bonds and mortgage-backed securities and other types of loans). It then on-sells these packaged bundles of 'collateral' in the form of debt securities (the actual CDO) classified into sub-groupings called 'tranches', which each have different risk and return characteristics.
Each tranche of a CDO issuance is often given different credit ratings. Ostensibly this is to reflect the risk quality of the loans backing and its ranking in case of default of the underlying loans. They are usually ranked from AAA investment grade down, with the riskiest tranche going unrated.
These unrated portions have kindly been called the 'equity' tranche because it is the sub-issue that is most exposed to the risk of default. To the cynical it has been deemed 'toxic waste', and in the whole CDO structure was the first to bear a loss when the US sub-prime crisis escalated.
Often these CDOs (constructed of sub-prime debt) are partly insured by mortgage insurance, and therefore will often appear to be promoted, for instance issued as '95 per cent AAA rated'.
This means in effect that a CDO is 'mostly' but not all AAA, and carries an implicit risk on the residual. Its an excellent example of financial packaging reflecting the needs of the papers buyer, while not necessarily going into the detail of the bundled risk components of the CDOs parts. As one local government treasurer described it, in some instances its a case of 'putting lipstick on a lemon'.
For a variety of reasons, in recent years these CDOs were exceedingly popular for US investment banks and originating lenders to issue. Banks and lenders made hefty fee income and were granted access to funds otherwise denied them by the high cost of borrowing from conventional sources.
The system allowed those who would otherwise not have access to loan funds from the banking sector the poor and credit-challenged to borrow money sourced indirectly from the worlds money markets to buy (usually) their homes.
To encourage and facilitate these credit-deprived US borrowers, an army of something like 600,000 mortgage brokers and agents worked tirelessly (on a commission basis).
Tales of their activities and behaviour are now surfacing. There have been accusations of greed and of unethical lending practices, for instance lending to vulnerable groups such as ethnic minorities.
Of course, from the point of view of the broad buyer spectrum of investors, these CDOs offered investment-grade securities (which included and were backed by sub-prime debt), with returns that exceeded the yields on junk or high-risk corporate bonds.
According to US-based business and financial news service Bloomberg, something like US$100 billion of the $375bn of CDOs sold in the US last year were sub-prime-backed securities. Thats from a global turnover of something like US$530bn.
The US CDO sales made up 75 per cent of global CDO sales, and Moodys reported in March that something like half of them contained sub-prime home loans.
We must at this point draw the distinction between CDOs and the sub-prime loans that in many cases backed them.
The thing to remember is that these US sub-prime loans were in the vast majority of cases mortgages that had been underwritten or originated in the non-bank sphere, and not by banks or semi-official US federal government agencies such as the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation or the Government National Mortgage Association.
For their part, the lenders in the sub-prime market were in effect speciality finance companies that were, practically speaking, unregulated entities. The 'markets' were therefore the only regulator of a loans soundness.
The connection of these sub-prime lenders to the CDO market is underlined by their role. The speciality sub-prime mortgage lenders borrowed pools of investor funds in the wholesale money markets via the CDO structures, and in practice transferred the end risk of the loan to whole investors, albeit diffused via CDO structures.
Its a win all around (in good times), with the poor getting access to cheap housing loans, the investor getting a stellar return 'backed by mortgages' and the lender/originator taking a cut on the loan but crucially passing on the risk to the investor.
Yet the crucial discipline of strict lending practice is missing. In fact, the risk- management incentive on the part of mortgage lenders was the blind side of the whole structure, and comes to light (as with most financial risks) only when cycles turn down.
It should be noted that sub-prime loans in the US comprise only 8 per cent of total homeowner mortgages, so we are looking at only a small segment of the US mortgage market, relatively speaking.
That said, by its very nature it is this segment that is most exposed to the housing cycle. The US housing boom of the early part of this decade crested from a new-home-sales point of view in the middle of 2005. It has since seen a steady decline in housing activity and housing prices to the point that many of the riskier mortgage borrowers (namely of the non-bank/sub-prime variety) have been pushed into default.
This defaulting of sub-prime loans was something like 16 per cent of the pool of sub-prime debt, and may amount to something like US$150bn in total of loans at risk.
Matters are made worse when we add to this one of the technical nuances of sub-primes loans: the expiry of their 'honeymoon' interest rates. For the next two years US$2025bn of these loans will have their monthly interest rates jacked up by an average of 2.5 per cent for capped and 4 per cent for uncapped mortgages.
Normally a cyclical slowdown in the US housing market should not have too severe an effect on the global financial markets aside from the normal adjustment of relevant sector stocks and bonds. What made the slowdown different this time, including the presence of an accelerated contagion was the part sub-prime loans so crucially played in the construction of the CDO market, which until recently happily supplied Wall Street financing to the credit-challenged in the US.
For the structured financing departments of many premium investment banks, the explosion of CDO issuances in the first half of this decade has been a boon, bringing with it fees and underwriting revenue.
Yet the growth of this vehicle of financial engineering was not without its critics, as the bundling of loans in the form of CDOs went to the next level.
So-called 'CDOs squared' were the creation of CDOs that were in effect backed by an underlying portfolios of CDOs. Taking the diversification concept to absurd levels are 'CDO cubes', which are bundles of packaged CDOs squared.
Criticism also has been levelled at the credit ratings agencies for the part they played in the structuring of CDO issues. They were said to frequently provide guidance on optimising the credit ratings of the mix of tranches in any particular issuance, though publicly the rating agencies dispute this.
Their usual charge for rating a CDO was typically twice (if not three times) as much as a conventional corporate bond issue. This was a complex component in the symbiotic relationship between issuer and rater, and of course added to the general unease in relation to the reliability of the whole universe of CDO securities issues.
The controversy of precise ratings aside, as the square and cubic CDO structures suggest, the precise pricing of these securities (particularly those backed ultimately by credit-doubtful sub-prime loans) becomes a practical, technical and mathematical nightmare. And it was made worse under conditions of market stress and illiquidity.
Despite these misgivings, until early 2007 the investor market had an avaricious appetite for this type of debt, which promised high rates of return from the theoretical risk diversification of the CDO structure.
Returns greater than that of junk bonds, and which were backed by a 95 per cent AAA rating, were hard promises to resist. The more complex CDOs squared and cubed offered even higher returns albeit with an even more ambiguous risk structure.
It was the ambiguous and complex structure of these elaborate instruments that were ultimately to be their undoing. That, and the often-wobbly security of the sub-prime loan collateral backing them up. In the volatile conditions of late July and early August the brewing sub-prime loan problems of the US finally began to cascade onto whole defaulting loan portfolios, which had backed the leveraged and opaquely priced and held CDOs. Were talking about CDOs that had been up until then widely sold into the global marketplace.
Suddenly, what central bankers had been warning about during several years of aggressive price credit risk began to blow back.
Many funds and backers of these funds found they could not sell nor value their substantial portfolios of CDOs. And even if they had none on their books, a great fear and risk aversion avalanched the marketplace, as many banks for prudential reasons began to stop funding institutions that had even hints of sub-prime loans or CDOs on their books.
Of course, hedge funds (including at least two in Australia) were the highest profile of the casualties but they were not alone. The CDOs in the preceding years had been sold widely across the global marketplace. The problem of the poor US mortgagees became a problem for the world that lent them the money.
And so the contagion began, and it appeared not to have a geographical or institutional limit. From defaulting loan payments of poor Americans mortgages, it had been transformed and transferred to the global investment marketplace as reconstructed (apparently) AAA-rated paper.
Along the twisting distribution path, the risk correlations of mathematical models that backed these portfolios began to break down as the whole sub-prime problem fast-tracked on CDO vehicles into the doubtful debt provisions of the worlds financial institutions.
It was for this reason that when BNP (Frances third-largest bank) stated publicly in early August of this year it could not value three of its CDO sub-prime-laden funds, the previously localised US housing loan problems exploded onto the world financial scene.
The August shock to the financial system is hard to overstate.
On the night of the BNP announcement the price of overnight inter-bank cash rate in the Euro-zone, which was normally priced around the 4 per cent, European central bank cash rate shot up to 6 per cent. The spike in rates was a pure function of banks scrambling for cash to protect themselves from the possible default of other counter parties.
The negative confidence effects were immediate. Sharp falls in related stock and bond markets in the northern hemisphere (including the US) wiped out something like four trillion dollars in equity values at the nadir of the equity dip or 30 times the value of the sub-prime loan book at risk.
The global financial system had became a far less secure place.
No longer the problem of the poor US home mortgagees, pension funds and financial institutions across the globe that had taken up the CDO promise were now faced with the prospect of a market breakdown and substantial write-off of their CDO portfolios.
There were also investments in other asset classes to think about. Investor confidence gave way to fear and stress selling.
The spike in money rates and the August collapse in currency and stock markets around the world posed the real possibility of a lock-up of both local and global financial systems.
In the second part of this article next issue, we look into the immediate consequences, effects and central bank reactions to the implosion of the sub-prime and CDO bubbles.
Peter Pontikis FCPA is group treasury strategist for Suncorp banking. The opinions stated in this article are his own.
Reference: December 2007, volume 77:11, p. 50 - 53
