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Every day we watch people blame sub-prime. Sub-prime is neither contained nor, is it the essence of present trouble. Discussing sub-prime as the cause of asset re-pricing has become ubiquitous. I would liken this line of explanation to the way that American urban violence is often discussed as “gang related” or “drug related”. In short, it is a lazy catch all employed to avoid scratching below the surface. Sub-prime mortgages- especially those of post 2004 vintage- are in trouble. About 15% are in various stages of the default pipeline with 5% in final stage default. This is truly alarming and merits some serious, mortgage backed securities (MBS) re-pricing. Alt-A loans, low disclosure mortgages, option ARMs, balloon payment mortgages, some prime jumbo mortgages and the housing sector are in trouble. All of this matters. $2 trillion in mortgages without any government guarantee face valuation, liquidity and repayment risks. This is only one strong gust in the storm roiling global asset markets. Housing distress is now and will continue to drag down the US economy. We are increasingly confident that the drag from housing will pull the US into recession by late 2007 or early 2008.
A huge credit bubble exists and extends far beyond sub prime mortgage distress. The global bubble is enormous and has many sub-component bubblettes. The internationalization, integration and expansion of finance extended and distributed the effects of overly cheap and easy credit. Innovation of new products, thin opaque markets in credit vehicles and voracious appetite for leveraged yield have transformed balance sheets and portfolios. This mountain of gas soaked rages was ignited by the credit concerns in sub prime. Now the credit bubble is burning. Years of euphoria, easy money and asset inflations built to dizzying heights. Massive, cheap and easy debt was taken on to buy houses, currencies, bonds, equities, mortgages, leveraged loans, credit default swaps, real goods and services. Credit burdens were taken lightly, rolled over, bundled and sold. As long as lenders, buyers, ratings agencies and faith held, bubbles formed and swelled. The size, volatility and interconnectedness of international asset inflation was unprecedented. The downturn has been similarly correlated. Sub-prime credits and the collateralized mortgage obligations comprised of them deflated- the match was struck. The fire is never really caused simply or exclusively by the match that lights it.
Global asset markets are now being re-defined by risk aversion, illiquidity and credit backwash. Individuals and institutions that rely on (1) roll-over financing, (2) liquid (always open) credit markets, or (3) investor faith are in trouble. American homeowners count on new debt and house price appreciation. This credit line has become a noose. The most vulnerable are busting now. What makes them most at risk? Recent mortgages were made at the end of the housing boom. Little or no money was put down, teaser intro rates and weak underlying finances conspired to leave these folks least able to weather a storm. They are less unique than ahead of the curve. As house prices fall further and adjustable rates rise, others will join them. This matters suddenly because sub-prime problems are now driving market psychology. The present turmoil is just as psychology driven as the hyper-extension of gains we saw after April-July 2007. Sub-prime went into serious difficulty in April. The markets soared in response. What is different today, fear has spread to the entire “originate to distribute” financial universe as problems in the mortgage space have multiplied and grown. US Treasury, Federal Reserve and expert testimony promised this would not happen. It did. Ratings agencies and researchers recommended and applauded the safety and wisdom of new structured debt product. They got it wrong. Questions started getting asked about the true value and risk of innovative, engineered products in mid July. Many still await answer. Investors no longer wait patiently and liquidity has dried up.
All these innovative new mortgages were written because there was great money to be made in bundling them into mortgage backed securities (MBS) and collateralized mortgage obligations (CMO). Lenders cashed in on a "originated to distribute" bonanza. All types of finance companies wrote mortgages- and many other types of credit contracts- only to sell them off. A popular final destination was in collateralized obligations. This industry swelled as trillions of dollars in mortgages were written over the past few years. Every obstacle to further lending was innovated around to allow profits to continue to flow. The risks of all this lending were less pressing as mortgages loans were made to be sold- not held. All the available credit bid up house prices and led to the false conclusion that houses were always safe, appreciating assets. Questionable loans and sub-prime mortgages were sold and reconfigured into AAA rated product. Risk vanished from consideration and discussion. Transformed mortgages became credit vehicles and were sold all over the world. Part of the mad dash now involves finding these hidden gems hiding on books and ascertaining their real value.
Let’s take a look at a stylized "originate to distribute" production process. How do structured products transform lead assets into gold? Mortgages are written, the bank/finance company agrees to first loss provision (FLP) and then sells. A special purpose vehicle (SPV) is established and buys the assets-mortgages- with the bank assuming the first few percentage points of loss through the FLP. SPVs issue CMO structures backed by the assets-mortgages- as collateral. Mortgage originators are left to service the loans and absorb any first loss. They no longer ride the risk on the loans they made. Protections are variously offered and careful capital structuring occurs to comfort investors and obtain an investment grade rating from the ratings agencies. In many instances, wraps or insurance on default is offered to cover some portion of risk. Generally, the special purpose vehicle is over-capitalized. The underlying mortgage values sum to a greater amount than the valuation of the assets sold by the SPV. The total returns on the mortgages are greater than the yield offered on the structured product. Two forms of protection are offered. In the first case, the total value is understated, in the second case an investor beneficial mismatch between asset and liability income streams is built into the vehicle’s capital structure. Last but not least, the collateralized debt is chopped into tranches. In declining order of risk and return, the tranches are commonly referred to as senior, mezzanine and equity. There are risk cascades or waterfalls that separate the equity from mezzanine and senior portions. All loses are absorbed by the lowest credit grade and highest yield portion before any loss passes up to the higher grade. Much time, effort and expertise was expended in designing capital structures. Top investment grade credit ratings were given to senior portions. Lucrative deals hinged only on placing the equity portions. Hedge funds and other aggressive yield hunters obliged- with their own leverage in tow.
This process allowed lenders to offer more credit at better terms to a greater number and diversity of borrowers. Risk was not and can not be created or destroyed by changing ownership. The delusional fantasy that risk had been reduced slowly became the greatest risk of the new financial product stream. The more safe your assets seem to you- and the safer the ratings attached- the greater risk you can and will take on elsewhere. In reality, risks were just redistributed. The trouble grew with the confidence that we had entered or could design deals so as to reduce risk. There is great value and potential in the new diversified risk architecture of structured finance. However, transparency and valuation integrity have lagged in development. The enhanced ability of lenders to sell risk reduces credit origination risk. Originator risk is simply sold on to other parties. Mortgage writers’ see their risk reduced unless they keep doing it again and again, running their newly freed capital back through the same process to jack up earnings.
Each round of risky "originate to distribute" lending was used to fund the next round. Every obstacle to further lending was innovated around. Thus, the risks multiplied systemically. So much air pumped into these instruments that ever more daring capital structures, pricing demands and raw debt material was sought. A very similar set of actions is unfolding in the leveraged loan markets and the mortgage markets. Why? The innovations and products are remarkably similar. Increasingly exotic, less restrictive loans are made to sub investment grade enterprises and then packaged into collateralized loan obligations (CLO). These are similar in almost every regard to recent risky innovations in mortgage markets, save one. Few people are fully aware of this corner of the market and defaults remain very, very low. For now, that is. There was $500 billion in CLO origination in 2006.
Sadly this story is repeated all across the credit landscape. What many folks forgot was that the quality of the underlying assets should never be lost sight of. All the creativity and innovation in the world can only offer so much protection if the underlying loans and assets are bad. Suddenly everyone is realizing this. Thus, a scramble to reduce leverage and raise cash is underway. This is driving fear and asset sale. Hedge Funds heavily into CDO, CLO and equity tranche mortgage backed debt are going bust and selling assets to raise cash and de-leverage. Insurance companies, global banks, and pension funds are combing complex books. This creates downward pressure on assets and spreads distress and loss. Raising cash means selling. Hiding loss and surviving means selling into strength to raise maximum cash and minimum suspicion.
Finance companies, banks and investment managements relied on liquid markets and fast sales. Short term financing and excessive leverage transfer risks from structured finance into the markets that they buy from and sell to. Valuations have been generous and have come from models employed by the firms creating vehicles. Ratings agencies were intent on certifying new products based on historically accurate assumptions about the probability of various events. They failed to adjust their models for the brave new world of structured products that they were helping to create. Over confidence and stretching of untested new risk protection spun out of control. Rapid declines in high profile quantitative hedge funds- statistical arbitrage funds- offers further evidence of modeling problems. Investors and managers are trying to determine the true value of their assets and the size of their losses. Markets have lost faith in the ratings agencies. The designation of so many collateralized debt obligations as AAA rated is creating anger and suspicion. Many sub-prime mortgage securities retained investment grade ratings weeks into punishing price declines. In the midst of this stress test, faith in the models, ratings agencies and regulators is at low ebb.
Leverage has been a cheap easy, always available yield booster, until recently. Now debt vehicle creation has stalled. Originators are stuck with unsold inventory. Liquidity and demand have dried up. Market prices for credit vehicles are much, much lower than the models predicted. Demand is absent and discounts demanded are huge. Sudden interest in the underlying asset quality is raising dangerous and unnerving questions.
This raises the specter of further declines as assets over correct looking for accurate valuation. Until recently, regulators spent their public comment opportunity aggressively spinning increasingly absurd reassuring yarns. Now, late in the game, they will have to spend more money and rebuild trust. So far they are busy injecting liquidity in the wrong areas and offering the absurd assurance that losses are contained. It spread far and wide over the last 6 years!
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