PrefBlog

I have developed a hypothesis regarding sub-prime that I will be researching more carefully over the next month or so, with the idea of writing an article about it. I don’t think there’s a full book in the idea – but I can quite easily see it becoming somebody’s master’s thesis, or a chapter in a book.

Hypothesis: A sub-prime-crisis-equivalent has almost happened before. It has also been deliberately avoided before

Abstract: So far, the nasty bits of the crisis have not had much to do with sub-prime mortgages themselves, or even their RMBS (Residential Mortgage Backed Security) pools, but with highly leveraged pools of RMBS – see, for example, the sad stories of Cairn High Grade Funding I and Global DIGIT. These vehicles failed not through any problems with the RMBS themselves, but through the fear of such problems and the subsequent evaporation of a market for ABCP (Asset Backed Commercial Paper) with such underlying security.

This may be compared with the market on Bank Perpetuals in the ’80’s. The basic idea behind the perps was for a bank to offer a 100-year Floating Rate Note at a spread to the appropriate floating rate. At the time (I confess, I’m not sure about right now) such issues could be considered equity by the banks; simultaneously portfolio managers could consider them short term instruments due to their floating rate coupon. At least one such issue made its way into a money market fund.

I wasn’t a market participant at the time these things were sexy, which was somewhere around the 1983-88 period when rates were coming down quickly and banks wanted long money but didn’t want to pay long rates for a long time. But very scrappy recollections involve the idea that the problem with these things was that the market was too homogeneous … all the issuers were all issuing them for the same reasons; all the buyers were all buying them for the same reasons. When the reason for the buyers went away, so did the market.

Nowadays, for instance, I’m seeing a chunk of RBC FRN Oct 1, 2083, which pays CDOR + 40bp  being offered at $94.50. I suspect that a buyer willing to take the whole block could put in a stink bid and be filled, but what do I know? Anyway, a salesman whom I respect (at a firm other than the one stuck with these turkeys) had to be prodded to remember the existence of such things. It would appear that they are the by-appointment-only traders to end all by-appointment-only traders.

Now, in the ’80’s when they were sexy, rates were still pretty high. What if they’d been low (like they have been, relatively, for the past five years)? Would it not have been a tempting idea to put together a vehicle that, with $100 equity you went out and bought $1,000 of these perps and financed with $900 commercial paper at, I don’t know, CDOR + 10? That’s a pretty good return, provided you can roll your paper for 100 years!

There are two reasons I can think of right away that this didn’t happen:

• There was not so much innovation in the markets then. Hell, at that point the junk bond market hadn’t even been invented.
• There was lots and lots of government issued short term paper at the time, which (to an extent) was crowding out more innovative issues

Food for thought.

The part where I’m thinking this was deliberately avoided before is the bond futures market. Bond futures are not the easiest things in the world to analyze quantitatively. The big problem is that there’s a basket of deliverables and a cheapest to deliver. The Cheapest to Deliver bond can change since the bond delivered against a contract is at the seller’s option, which gives the contract negative convexity. There are also delivery options that confuse the issue.

It is my understanding that this complexity was introduced deliberately when the contract was being designed. The CBOT wanted complexity so that it would be hard to analyze so that the fair price would vary by a bit depending on what assumptions you plugged into your model. This ensured that there would be disagreement over what the thing was worth depending on your views, which in turn ensured that there would be an actual market with some depth.

After all, if something’s known to be worth $110.87 and everybody knows that, who’s gonna trade? It will be quoted at $110.86-88, zero volume, forever.

The complexity helped develop a heterogeneous market which has been quite successful, to say the least.

The evaporation of the ABCP market has a tipping-monkey (or is it “100th monkey”? You know, where there’s a very rapid change of state of a large system once you reach the critical point) feel to it.

I’m thinking it would be most interesting to compare ABCP with the above two markets – especially the Bank Perps market – with a view to isolating the similarities and seeing if any conclusions may be drawn relating market risk and market homogeniety … and who knows, maybe doing a little forecasting!

In what must rank as one of the fastest restructurings on record, Cairn Capital & Barclays have announced:

the successful restructuring of Cairn High Grade Funding I (“CHGF”). The restructuring was made necessary by the closure of the ABCP market on which CHGF had relied for funding.The restructuring has eliminated market value triggers and the reliance of CHGF upon the ABCP market. CHGF has now been converted into a cash flow CDO. As a result, the full notional of outstanding ABCP will be redeemed as it matures and replaced by term funding.

Barclays Capital will provide the senior financing on the restructured transaction and has fully hedged its credit exposure from this financing. This restructuring has received all required investor consent. Investors have agreed to full participation in the costs of the restructuring.

The problem was triggered in a now familiar way: the ABCP market is no longer functional. Barclays is extending a $1.6-billion line.

S&P has announced:

The ratings were placed on CreditWatch with negative implications on Aug. 21, 2007.
 
The ratings on the original Tier 1 and Tier 2 mezzanine notes were lowered to ‘D’ and removed from CreditWatch negative, since Standard & Poor’s considers the restructuring of the notes in a manner that does not pay accrued interest in accordance with the terms of the notes to be a default.

…

Under the new structure, the Tier 1 and Tier 2 notes bear no interest, but are entitled to a ratable distribution of excess cash flows after the principal is reduced to $1. Receipts on the underlying asset pool are used first to pay interest on the CP and liquidity facilities and then to pay down the Tier 1 and Tier 2 note principal sequentially until the principal is reduced to $1. Thereafter, the remaining cash flows on the underlying assets are allocated 60% to the Tier 1 notes, 20% to the Tier 2 notes, and 20% to the capital notes. Standard & Poor’s ratings do not address the likelihood of receipt of excess distributions.
…
US$1,638 million Euro/U.S. commercial paper, US$126 million mezzanine notes and US$36 million capital notes

This may well turn out to be a very good deal for the Tier 1 and Tier 2 noteholders but I wouldn’t want to commit to that statement without ripping apart the structure’s financial statements, which I have no intent of doing!

Essentially, their deal is:

• They lose the accrued interest on their notes that has been earned but not yet paid. I assume the notes had a semi-annual coupon, but I don’t know this for sure; I will further assume that the notes paid 6%, but I don’t know that for sure either. If both assumptions are true, that’s a maximum 3% loss
• They are gaining what is, essentially, an equity interest in the underlying portfolio.

The difference between this and the Montreal Proposal is that there is a line being extended to refinance the CP; thus, the underlying portfolio remains leveraged to hell-and-gone, like about 10:1 according to the S&P reporting of the principal amounts … this is almost certainly better for them than the alternative of a forced sale of assets to redeem the CP. Whether or not the Montreal Proposal (in which the CP would not be refinanced, but would gain a proportional interest in the underlying) would be better for the noteholders depends a lot on the quality of assets and on the terms of the Barclays refinancing.

It’s not clear to me how much Barclays is charging for the line, or what the interest rate on the line will be set at … presumably some frightening spread to LIBOR. It’s also not clear from the information above how the principal on the credit line gets paid down. These are kind-of crucial questions!

There will be many who consider the Triple-A Jump-to-Default to be a black eye for S&P … I’ll be the first to agree that it doesn’t make them look good! But here, as we are seeing so much of nowadays, the structure was acting like a bank (borrowing short and lending long) and hence was subject to the great terror of bank treasurers: a run. Depending on the quality of the assets, they have a chance at a recovery after default in excess of 100% … we shall see!

I gave an example of tranching when looking at the Bear Stearns product a few days ago. Now I want to clear up some possible confusion regarding the practice.

Quality is Very Expensive

Let us say, just for the sake of an argument, that we have a pile of AA rated securities that we want to securitize. We have two choices:

• We can securitize them in one big bucket, rated AA, or
• We can divide it in two tranches. The first gets priority in distributions and will be rated AAA; the second will be junior and rated A

The second choice will be familiar to preferred share afficionados – it’s the same process that is used in split share corporations. The holders of the senior tranche (the preferred shares) don’t really care a lot about the underlying portfolio, as long as it’s reasonably good quality and there’s a lot of it! The junior tranche holders care a lot, because they’re taking the risk they’ll get paid less than expected in exchange for an expected reward of getting paid more.

It will always be more profitable to the underwriter to split the issue because bond investors pay up for quality. I might get 10 cents less than base price for the junior tranche, but I’ll get 25 cents more for the senior tranche.

This is even more important with the mortgages, because it’s not a 50-50 proposition … there is a better than even chance any particular mortgage in the underlying pool will behave exactly as expected. There is, shall we say, some debate over just what the default probability is, but let’s make up some numbers. The mortgages are all one-year term. I expect  10% of the underlying to disappear completely; interest is received equal to 20% of the original pool; therefore, my return on the overall pool will be 10%.

These numbers are obviously very exaggerated. If anybody wants to make up better numbers – or, even better, wants to dig through ratings reports to get actual numbers – be my guest and let me know what you come up with. Put it in the comments or eMail me and I’ll put it in the post.

OK, so I look at the market and I see that AAA instruments yield 5%, while A instruments yield 20%. So what I do, is I create two tranches. The first tranche is senior and comprises $80 of the original pool of $100. It gets an AAA rating because the pool as a whole can lose 20% of its original value and this tranche won’t even notice. That’s double the loss rate I expect.

On the senior issue, I pay only 5% interest, which comes to $4.

The second tranche, worth $20, takes the first loss, which is expected to be 10% of the original pool, or $10. If the end value of the second tranche is $24 at the end of the year, it will have yielded 20% on invested capital. So on this tranche, I pay $14 from my interest receipts and the expected value of the tranche is $20 (invested) – $10 (loss on pool) + $14 (interest) = $24.

Now I work out my expectations: I’m going to receive $20 interest from the underlying pool. I pay $5 interest to the first tranche and $14 to the second tranche. Hey, looky looky! There’s $1 left over! I’ll invent an IO (Interest Only) tranche to receive that interest and keep that tranche for myself!

Bingo! Financial alchemy!

Why is Quality Expensive?

The basic reason is segmentation, which will be familiar to readers of my paper on Portfolio Construction. There might be some investors who don’t have a portfolio big enough to diversify. Maybe they can buy only one bond; maybe they’re just a little bigger and are only buying 5 bonds to make a ladder. Five bonds is not a lot. If one goes bad, that’s 20% of the portfolio. Such players, too small to diversify away specific risk, should stick to higher quality instruments so that their portfolios have a greater chance of behaving as expected. So these players are logically restricted to higher quality instruments and shouldn’t invest in our junior tranche. They have to buy the senior tranche virtually irrespective of how much extra they could expect from the junior, because they are highly risk-averse.

Another reason for quality segmentation is fiduciary policies. Maybe the East Podunk Widows’ and Orphans’ Fund has a set policy: AAA only. They’ll go to jail if they buy our junior tranche.

There’s liquidity as well. The senior tranche is worth $80, the junior tranche $20. It’s not unreasonable to expect four times as much trading of the senior tranche in the secondary market. Market timers, for instance, will have a prediliction for the senior tranche because they’ll be able to trade out of it more cheaply if the market moves their way and they want to realize a capital gain.

All these factors conspire to ensure that interest rates on the lower grades of paper will (normally) be higher than they would need to be if default risk was the sole consideration. Therefore, an investor who (i) has no arbitrary limits, and (ii) can purchase a well diversified portfolio and (iii) has no intention of trading a lot can (normally!) achieve excess returns by moving down the quality scale.

This was exploited in the late ’80’s, when the junk bond market was invented.