Affordable Housing Institute : US

[Continued from yesterday’s Part 1.]

Yesterday we saw that every financial transaction creates two new sets of risks, one for each party: Borrowers can lose their collateral, and lenders can lose their principal. Indeed, typically when one loses, the other loses also, so while they have opposed economic (every buck goes to one of them or the other), they have a shared interest in the borrower’s success.

We both wants profits to grow

Though risk is an abstract concept, it is a financial commodity, so it is traded via derivatives, of which the largest chunk is housing. As the Economist puts it:

Derivatives known as collateralised debt obligations (CDOs) are a clever way to satisfy every taste. They are like a mutual fund that bundles together bonds, loans or swaps. But unlike a mutual fund, a CDO has different tranches that give investors different rights over this portfolio.

For example, as interest payments on the underlying bonds come in, they will first be allocated to the senior tranches. Only when these have been paid will the more junior tranches get their share. And if defaults occur, the junior tranches take the first hit.

In other words, creation of derivatives is a variant of basic securitization.

This tailoring can turn coarse corporate cloth into investment-grade haute couture.

How dare you call me coarse corporate cloth, darling.

Take a bunch of companies, with bonds rated A (not the best credit-rating, but reasonably secure). Assemble them in a portfolio and give one group of securities rights over the first 70-80% of the cash flows from the bonds (and protection against the first 20-30% of defaults).

Again, securitization. As Mycroft Holmes put it:

“That is a principle of securitization; each time the banker slices offer a lower tranche — as a concession to the Bourse, we have adopted their term — the remaining junior security is on the one hand higher yield, and on the other, a distilled or more concentrated residue of risk.”

Concentrating the risk

Mycroft would have thrived in the twenty-first century

Since it is highly unlikely that 20-30% of the A-rated bonds will go bust, the rating agencies will give such securities the highest AAA appellation. In a world where very few individual companies can command such a lofty rating, this transmutation makes such instruments highly appealing.

Paradoxically, by slicing risk into different pieces, we can then assemble lots of the same kind of risk spread across many, many properties. That gives us diversification of location, residential market, and even of asset type. Blending many different properties of the same ‘proof’ yields a smoother liqueur-like risk profile, even if it’s of knockout strength.

Knock you out with a smile on your face

Of course, it concentrates the risks in the rest of the portfolio. The lowest-rated securities (the last to get the cash flows and the first to bear the brunt of default) are known as “equity”.

Because they have all the characteristics of equity — variability of payment, subordination to all other capital claims. They really are equity.

That’s an important discovery — equity can be extracted out of debt, squeezed as if wrung through a clothing mangler.

We’ll press that equity out yet

It’s a kind of alchemy that has always been inherent — what are ratings, except indications of the increased percentage of variable-payment equity embedded in a single debt issue? — but is now rendered visible, and therefore quantifiable, and therefore more manageable.

Such rarefied activity occurs on the high floors of the money store:

Toxic waste? Fifth floor, sir

Although they are not strictly shares, they do tend to offer share-like returns of 15-20% or so. The securities in between the equity and the senior securities are known as mezzanine.

With a mezzanine, there’s always an overhang

The bottom tiers of these CDOs have been called “toxic waste”.

“Fumes, filth, toxic waste — it’s all mine!!“

But they have been almost nourishing in recent years, thanks to the low default rate on corporate bonds. Their buyers have enjoyed the rewards without seeing much of the risks.

That now seems to be changing—in one part of the market, at least: CDOs that buy asset-backed securities and in particular those linked to subprime mortgages.

Now I see the connection!

Subprime lending was always a great candidate for derivatives and securitization, for the assets were small and complex, and the interest rates obtainable from borrowers much higher than those for so-called ‘prime’ loans.

These loans were bundled together and sold as residential mortgage-backed securities (RMBS); in turn those securities were bought by the issuers of CDOs.

I remember this whole system being invented, back in the mid-Eighties.

Conduits, Rico; they’re the future of finance

At the time, I thought little of it. Silly me.

Too much risk makes me silly

A study by Moody’s, a credit-rating agency, of asset-backed CDOs found that, on average, slightly less than half their portfolios were invested in subprime RMBS. But in some cases, the exposure was nearly 90%.

As housing becomes a financial asset, so too does housing debt become a financial commodity — the nation’s largest financial commodity.

Losses will be magnified for investors in the junior tranches. At worst, Moody’s says, the vast majority of tranches in such CDOs would be downgraded to junk-bond status.

Michael Milken saw money in junk

With all that risk concentration comes enormous leverage:

Imagine a geared hedge fund owning the riskiest tranches of CDOs exposed to subprime debt. Lombard Street Research reckons that the combined gearing could reach 54-fold, implying that a 2% price drop could wipe out the entire portfolio. There are no signs, as yet, that any hedge funds have taken such a big bet; the best known casualty is a London-listed fund, Queen’s Walk, which has seen its shares fall by 40% this year. [Warning: “US residents are not permitted to view this web site.” — Ed.] Anecdotal evidence suggests many hedge funds were quick to realise the dangers of subprime lending—and to profit from the market collapse.

Smarter participants move faster, and while bully for them, it also serves as a highly sensitive rapid-response indicator. A market where smarter people win is a smarter market, which means that fewer people lose, and those that lose, lose less.

Yet the damage may take time to be felt. Many 2006 mortgages are not yet in default. Many CDO tranches are rarely traded, so prices may not have registered a hit. Investors may not write down holdings until the rating agencies downgrade them—which could take months.

Are we out of the woods then?

It takes a lot of logs to make the paper this blog is printed on

[Continued tomorrow in Part 3.]

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