Thursday, February 14, 2008

Securitisation "Fear and loathing, and a hint of hope" Economist

Nice summary from the Economist. I´m pretty sure that lots of this financial alchemy will never return to the markets. At least for a few years........ ;-) . Here is an excellent take via Naked Capitalism Securitization Reform: Don't Hold Your Breath

Nette Zusammenfassung vom Economist. Bin mir sicher das wir einen Großteil dieser Finanzakrobatik demnächst nicht mehr ertragen müssen. Zumindest für einige Jahre..... ;-) . Hier ein extrem lesenswerter Artikel von Naked Capitalism Securitization Reform: Don't Hold Your Breath


Economist Not all is lost for the structured-finance business. But it faces further discomfort before it can start to recover some of its past sheen

The limits of gonzo finance
Securitisation has greatly enhanced the secondary market for loans, giving originators, mainly banks, more balance-sheet flexibility and investors of all sorts greater access to credit risk. Both have embraced it. By 2006 the volume of outstanding securitised loans had reached $28 trillion (see chart 1). Last year three-fifths of America's mortgages and one-quarter of consumer debt were bundled up and sold on.


Along the way, banks cooked up a simmering alphabet soup. The ingredients included collateralised-debt obligations (CDOs), which repackage asset-backed securities, and collateralised-loan obligations (CLOs), which do the same for corporate loans, as well as structured investment vehicles (SIVs) and conduits, which banks used to keep some of their exposure off their balance sheets.

The breakneck growth of this business went into reverse last summer, when it became clear that defaults would undermine the structures built around America's mortgage markets. So tarnished has the subprime-mortgage market become, because of shoddy loan underwriting and fraud, that investors are likely to shun securities linked to it for months if not years. Securitisation of better-quality “jumbo” mortgages—too big to be bought by government agencies—is also at a near-halt. “Mortgages were traditionally seen as very safe assets. Now all but the very best are stamped with a skull and crossbones,” says Guy Cecala, of Inside Mortgage Finance, a newsletter.

CDOs are unlikely to regain a following in a hurry (see chart 2). Still less popular are CDO-squareds (resliced and repackaged CDOs) and higher powers. CLOs have also been battered as the leveraged loans they are linked to have tumbled in value. However, their collateral is sounder than that backing subprime CDOs, being based on company financials rather than the blandishments of mortgage brokers.


The prospects for SIVs are bleaker still. SIVs borrow short-term to invest in long-dated assets; and investors will no longer tolerate such mismatches in vehicles shielded from standard banking regulation. With the disappearance of the SIVs' funding sources, notably asset-backed commercial paper, banks had to bring over $136 billion-worth onto their books. That comes on top of over $160 billion, so far, of subprime-related write-downs, over a third of which has come at three banks: Citigroup, Merrill Lynch and UBS.

Though few bankers worked in structured finance, it was a huge earner, accounting for 20-30% of big investment banks' profits before the crisis, according to CreditSights, a financial-research firm. Banks such as Bear Stearns, Lehman Brothers and Morgan Stanley, which bought or built mortgage-origination businesses to fuel the securitisation machine, have rushed to close or pare them. Merrill, whose fees from CDOs alone peaked at $700m in 2006, said recently that it would stop packaging mortgages altogether.

Alongside the banks, the “gatekeepers” who were supposed to lend stability and credibility to the new originate-and-distribute model of finance have also been found wanting. Rating agencies' models underplayed the risk that loans from different lenders and regions could turn sour at the same time. Bond insurers, too, misjudged the risks lurking in CDOs. That failing has undermined the worth of their guarantees and strained their own credit ratings—and hence financial markets.

George Miller, the ASF's executive director, accepts that this crisis of confidence will lead to a degree of “re-intermediation” for a time, as some banks go back to balance-sheet lending. But he insists that it highlights the dangers of lax lending standards in a particular market rather than fundamental faults in securitisation itself.

A study by NERA, an economic consultancy, commissioned by the ASF before the crunch, offers some support for this view. Preliminary results, based on data from 1990 to 2006, suggest that increased securitisation leads to lower spreads in consumer credit and softens interest-rate shocks for banks, especially smaller ones. On the other hand, in a recent paper two economists at the University of Chicago's business school conclude that securitisation encouraged mortgage originators to lend to dodgy borrowers.

Stresses and strains
What is not in doubt is that the subprime crisis has exposed four deep flaws in the practice of securitisation. The first is that by severing the link between those who scrutinise borrowers and those who take the hit when they default, securitisation has fostered a lack of accountability.

A debate has been rumbling over how to ensure that lenders have more “skin in the game”. Some think they should set aside a sliver of capital even for loans they sell on. Andrew Davidson, a structured-finance consultant, suggests an “origination certificate”, guaranteeing the quality of the underwriting, issued by the lender and broker, which stays with the loan. Alex Pollock of the American Enterprise Institute thinks that securitisers should be required to guarantee the quality of their loan pools, as are America's government-sponsored mortgage giants, Fannie Mae and Freddie Mac. Others counter that most such exposures can be neutralised these days through derivatives markets.

The second flaw is the sheer lack of understanding of some instruments. Not long ago investors took too much on trust. They are now clamouring for more “transparency”. Some want a central trade-quoting facility for lumpy asset-backed products: regulators have approached the New York Stock Exchange. CME Group, which runs the world's largest futures exchange, is also looking to expand its clearing of over-the-counter securities.

Yet reams of information already accompany mortgage-backed securities sold in public markets. Even SIVs provide a steadier stream of data to investors than most of the banks backing them. So some interpret calls for greater disclosure as whimpering by investors who did not do their homework.

However, more information about the performance of loans after origination would help, particularly those in leveraged structures such as CDOs. This opens up opportunities: fewer banks were at the ASF conference this year, but more data-analytics firms turned up. Clayton, the largest mortgage-surveillance company, unveiled a partnership with Experian, an information-services firm, that will help mortgage-servicers to package subprime loans for modification under a plan backed by the ASF and America's Treasury. Later, it hopes to offer a swathe of data to buyers of structured products.

Understanding the underlying assets is, or should be, at the core of securitisation. Securitisation is really an arbitrage: with surplus collateral, assets can be bundled into an entity with a supercharged credit rating. But if investors fail to spot the jiggery-pokery with credit scores and the outright fraud that permeated the subprime market, that cushion of safety quickly disappears. Witness the speed with which losses have spread into supposedly safe, “super senior” tranches of CDOs.

This points to the third flaw: that some securities were poorly structured, often because their risks were not fully understood. The upper layers of a well-designed securitisation vehicle should be all but impervious to loss. But poorly structured deals, like those stuffed with subprime and marginally less iffy “Alt-A” loans in 2006 and early 2007, have crumbled as the weakness of the collateral becomes clear.

The fourth flaw was the market's over-reliance on ratings as a short cut to assessing risk. In the go-go years, people wrongly assumed that an AAA-rated mortgage bond—even one with a high yield—would never lose value. But the rating agencies, paid for their appraisals by the seller not the buyer, were compromised from the start. Moreover, their quantitative models appear to have ignored “fat-tail” risks—the possibility that large losses are likelier than standard statistical models predict.

Though the agencies do not have to suffer giant write-downs, they have paid a high price. Before the market imploded, almost half the revenue of Moody's, a leading agency, came from structured finance. Now the agencies are revising their rating criteria in a bid to head off tougher regulation. “Either deals get less complex or we have to find a better shorthand for measuring risk,” says Ron Borod of Brown Rudnick, a law firm. The rating agencies say they were never supposed to substitute for investors' own due diligence. That is disingenuous, given their past self-assuredness. Still, wise investors will take future ratings with a pinch of salt, as most hedge funds have long done.

As the market grapples with change, some is likely to be imposed from above. Separately, international regulators and the President's Working Group (comprising America's Treasury, the Federal Reserve and others) are looking into securitisation's part in the crisis. By co-operating over loan modifications, the ASF may have gained favour with the working group.

The industry is more worried about two bills in America's Congress. Securitisers can live with much of the one that has been passed by the House of Representatives. What alarms them is an “assignee liability” provision that would hold them partly responsible for lax lending by originators. This, they say, would send a chill through secondary markets, cutting credit to thousands of worthy borrowers. Precedent is on their side. Georgia introduced assignee liability, only to back-pedal after the state's subprime market started to seize up. Not all bankers are against it: in Las Vegas, Bianca Russo of JPMorgan Chase argued that some form of it was needed to counter the perception, if not the reality, that securitisation was harmful.

The other bill would allow bankruptcy judges to alter the terms of struggling borrowers' mortgages. The industry argues that this would be an intolerable violation of the sanctity of loan-pooling contracts. In addition, securitisers face probes by several state attorneys-general, the Internal Revenue Service, the Federal Bureau of Investigation, the Securities and Exchange Commission and the Justice Department, as well as lawsuits from investors and a rising number of stricken municipalities.

Bankers will tell you that the subprime meltdown was just that: the product of irresponsible lending to, and borrowing by, flaky consumers, not a broader crisis of securitisation. Maybe, but the severity of the credit crunch points to broader pain ahead. More will come from housing: much of the 30-40% of American home-equity loans that have been securitised looks wobbly, as does a growing chunk of the $800 billion of Alt-A paper outstanding. Loans for offices are an even bigger worry. The spread on the AAA tranche of an index tracking bonds backed by commercial mortgages has tripled since the turn of the year. New issuance is frozen.

Trouble is also brewing for securities tied to non-mortgage consumer assets, such as credit-card debt, car loans and student loans, which make up a good slice of the asset-backed market (see chart 3). Credit-card delinquencies are creeping up as the economy turns down. The sharp slowdown in card borrowing, reported recently by the Fed, will mean less raw material for securitisation. Standards for car loans dropped in 2006-07, though not as dramatically as they did for mortgages.

One ominous sign is that structured instruments tied to student loans are coming unstuck, although the loans typically carry a federal guarantee. Recent auctions of such securities by Citigroup, Goldman Sachs and others have failed. Normally the banks would have bought in whatever did not sell. But they have declined, because they dare not cram even more assets onto their already strained balance sheets.

Yet securities of these types should be more resilient than those tied to subprime loans. Their structures are tried and tested, having evolved, along with performance data in their markets, over many years. In contrast, subprime mortgages with only a short record were shoved into many-layered structures that depended on house prices holding up. “They started from the other end entirely, asking how can we create CDOs, backed by mortgage-backed securities, themselves backed by collateral with barely any history, and their stress tests assumed house prices would be stable and the loans in the pools uncorrelated,” says Mr Borod.

Encouragingly, credit-card receivables are still being bundled and sold. There are even shoots of hope in the mortgage market, thanks to a refinancing mini-boom in the wake of interest-rate cuts—though most new deals are backed by the giant agencies, Fannie Mae and Freddie Mac, not Wall Street (see chart 4).

> A reader points correctly out that this comment from the Economist could easily come from "the Socialist"

> Ein Leser weist mich zurecht darauf hin, das dieser Passus eher dem"Sozialisten" und nicht dem "Economist" gut zu gesicht stehen würde.

"Also, I don't see it as "encouraging" that debt risk is being concentrated in the GSEs, with their implied taxpayer guarantees. Especially now that they've upped the conforming limit. This is just another variation of socialized costs."

Thanks/Danke !
Saunter down the strip
It is also worth remembering that securitisation has not been confined to consumer and corporate loans. In the past decade financial engineers have found ways to package and sell tobacco-settlement and mutual-fund fees, sports and fast-food franchise rights, life-insurance premiums, intellectual property, music royalties and much more. Hollywood studios use securitisation to help finance film-making. With intangible assets accounting for an ever-growing share of corporate value, this trend looks likely to continue.

That may be scant consolation to the banks whose bets have gone so spectacularly wrong. Their fingers are still being singed by mortgage-backed securities and CDOs that continue to burn. Those hoping for a recovery face a long wait, maybe 18 months or more for out-of-favour collateral such as non-agency mortgages. Some once-enthusiastic cheerleaders are turning gloomy: Bear Stearns said recently that its net short position on subprime loans and bonds had risen to $1 billion. Others are redeploying staff and capital to fee businesses that don't put a strain on the balance sheet, such as merger advice.

But it would be a mistake to write the obituary of structured finance. Even its sternest critics accept that securitisation has brought real economic benefits, and that it would be wrong to throw away the whole barrel because of a few subprime apples. Some students of financial innovation think the market will come back even more inventive after scorching its less attractive pastures. “As with past forest fires in the markets, we're likely to see incredible flora and fauna springing up in its wake,” says Andrew Lo, director of the Massachusetts Institute of Technology's Laboratory for Financial Engineering.

So it may just be a matter of hanging on. As any punter in Las Vegas will tell you, every losing streak ends eventually, if you can only stay solvent for long enough. AddThis Feed Button

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14 Comments:

Anonymous eh said...

Encouragingly, credit-card receivables are still being bundled and sold.

Personally, I don't like and seldom read The Economist. First because it seems they are, as the expression goes, 'full of themselves'. Second because they are IMO in many ways a cheerleader, just more subtle about it, as lines like the above show. Also, I don't see it as "encouraging" that debt risk is being concentrated in the GSEs, with their implied taxpayer guarantees. Especially now that they've upped the conforming limit. This is just another variation of socialized costs.

12:56 AM  
Blogger jmf said...

Moin Eh,

i missed this paragraph.

Thanks for the hint. I totally agree that this kind of comment is a farce.....

1:00 AM  
Blogger jmf said...

Moin again,

i´ve updated the post.

Is this ok for you?

1:06 AM  
Anonymous eh said...

J-M,

Ja, ganz OK -- prima. Aber es ist nur meine Meinung...

Clearly one can say it is, in one sense i.e. liquidity, 'encouraging' that the secondary mortgage market is working, meaning sucking up mortgages. But to achieve this by having the GSEs, with their taxpayer guarantees, take on even more of the debt, which means more of the risk, no matter what underwriting standards being used, and then trumpet this as if things are really working again e.g. in a market sense, seems at best disingenuous from The Economist.

1:50 AM  
Blogger jmf said...

Moin,

i totally agree with your point.

In the meantime the $ is once again up to test new lows...

What happenend to the folks that meant the rate differencail doesn´t matter any more...

I hope they have make bit bets on their "expert" view....

Also nice to see that the 10 year yields have spiked quite dramatically.... It remains to be seen if any rate cur will help the long end...I doubt it

1:57 AM  
Anonymous eh said...

J-M,

Great comment here.

3:04 AM  
Blogger jmf said...

Indeed.

MBIA´s comments/argumenets are sounding almost comical.....

Slapstick at its best....Overstock like....

I hope there will be lawsuits ripping every cent from management...

3:39 AM  
Blogger jmf said...


Nataxis


Exposure to US monolines:

Natixis assets which benefited from credit enhancements by monoline insurers were written down at December 31, 2007 to take into account the impact of the crisis on the credit quality of said insurers.

The counterparty risks of these insurers (economic exposure) was calculated based exclusively on market values and amounted to 1,143 million euros3 at December 31,2007. Net exposures thus totaled 763 million euros. The main counterparties are MBIA
(51% of economic exposures), XL (14%) and Assured (11%).

The amount of write-downs (individual and collective) due to these exposures will amount to 380 million euros.

Almost half of its exposure is to MBIA. Natixis though is well acquainted with the plight of the bond insurers. Its own bond insurance business, CIFG, had to be bailed out in November by Natixis’ controlling shareholders( Caisse d’Epargne and Banque Populaire), who pledged to inject the $1.5bn required for it to maintain its crucial AAA rating

4:46 AM  
Anonymous Anonymous said...

Nataxis operates a lot of synthetic GIC's for retirement funds such as state retirement plans.

5:31 AM  
Anonymous eh said...

Oops. European equity indexes really turned south when US futures did. I always get a laugh out of that -- 'decoupling', don't you know.

5:47 AM  
Blogger jmf said...

I have tried to watch CNBC

The first face i saw was Tobias Levkovich..... One of the worst out there.

Every time i see him he is bullish. The only difference was today that he said that recession is a probability. The same guy didn´t see anything other than a strong economy just a few month ago....

To make things even worse the next guy was a permabull called Jack Berugian....

It doesn´t matter how bad the news, data, earnings report ist ... in his view it´s all good and bullish...

Too bad that he said the same when the down was hitting new highs and the S&P traded close to 1600....

Needless to say that after i saw and heard him i switched the TV of...

How people like this can stay in business is beyond me.....

5:55 AM  
Blogger jmf said...

"Sovereign wealth funds eye bond insurers:NY insurance chief"

When you reac headlines like this you know it´s too late....

Game OVER!

6:01 AM  
Anonymous eh said...

J-M,

Every time i see him he is bullish.

It's most likely his job. CNBC deserves the blame for the people it puts on the air.

9:58 AM  
Anonymous Anonymous said...

Who should I get in contact with about a states own laws about mortgage broker bonds and as such, how would I get a mortgage bonds form? I life in England and am considering moving to America, don’t know where yet however I was doing some general reading about housing and came across the term mortgage broker bonds and am a little confused, is it a mortgage or a loan to acquire a mortgage?
Also if I want to set up life insurance do I need insurance bonds? Or can I simply open a policy with a company? Im a little confuse by some of the jargon. I am not moving anytime soon but thought I should be aware of things I will need to understand.

5:30 AM  

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