Indigestion on Wall Street
The ability to create credit now extends far beyond the reach of the traditional banking system. A revolution is transforming the credit markets, establishing links among borrowers and lenders that previously would have been impossible.
Every imaginable stream of future cash flow — from car and mortgage payments to the loans that fund private equity deals — can be “securitized” and sold to the highest bidder. Securitization is simply the process whereby a stream of future cash flow becomes pledged to a separate legal entity, which then divvies up the cash flow among different “tranches,” or classes, of creditors.
The growth of securitization has truly altered the global economy, and most choose to focus only on the positives. But like everything in life, the securitization revolution has its positives and negatives.
One negative consequence is that financial markets are starting to shape the destiny of the real economy, not the other way around. Storied currency speculator George Soros was one of the first to speak publicly about the phenomenon of markets shaping economies. He calls it the theory of “reflexivity” and described it when testifying in front of Congress in 1994:
The generally accepted theory is that financial markets tend toward equilibrium and, on the whole, discount the future correctly. I operate using a different theory, according to which financial markets cannot possibly discount the future correctly, because they do not merely discount the future; they help to shape it [emphasis added]. In certain circumstances, financial markets can affect the so-called fundamentals which they are supposed to reflect. When that happens, markets enter into a state of dynamic disequilibrium and behave quite differently from what would be considered normal.
In Soros’ view, the judgments and emotions of today’s financial market participants can alter future economic fundamentals. For example, as a company’s stock grows more coveted by wild-eyed speculators, its cost of capital gets lower and lower as its stock skyrockets; the higher its stock price, the more capital a company can raise in a secondary stock offering by issuing a set amount of shares. So its ability to reinvest capital and grow — its future — is shaped by the whims of speculators.
Another negative consequence of the securitization revolution: The further a lender is separated from a borrower, the more potential there is for fraud on the part of the borrower and underestimation of risk on the part of the lender. Very bad loans tend to be made when this is the case, as those who’ve dabbled in subprime mortgages are discovering, and the process of discovering just how many doomed-to-fail mortgages were written is far from over. On one end of the lending chain are plenty of fraudulent “liars’ loans” yet to default, and on the other are plenty of lenders who don’t fully understand the risks they are taking.
The “Bond King” on the Dark Side of CDOs
Bill Gross, the most accomplished bond fund manager in the world, recently published his views on the subprime debacle. In his July Investment Outlook, Gross acknowledges that securitization and derivatives diversify risk and:
Direct it away from the banking system into the eventual hands of unknown buyers, but they multiply leverage like the Andromeda strain. When interest rates go up, the Petri dish turns from a benign experiment in financial engineering to a destructive virus because the cost of that leverage ultimately reduces the price of assets…
The flaw, dear readers, lies in the homes that were financed with cheap and, in some cases, gratuitous money in 2004, 2005, and 2006. Because while the Bear [Stearns] hedge funds are now primarily history, those millions and millions of homes are not. They’re not going anywhere…except for their mortgages, that is. Mortgage payments are going up, up, and up…and so are delinquencies and defaults. A recent research piece by Bank of America estimates that approximately $500 billion of adjustable-rate mortgages are scheduled to reset skyward in 2007 by an average of over 200 basis points. 2008 holds even more surprises, with nearly $700 billion ARMS subject to reset, nearly three-quarters of which are subprimes [emphasis added]…
The housing market will remain sluggish far longer than most expect. $800 billion of ARM resets can only add to the supply of distressed sellers in 2008. This will further depress an already sluggish housing market that’s having enough trouble working through a huge supply overhang. To say the least, this scenario will weaken demand for securities backed by residential housing.
Up until now, hedge funds have been creating a great deal of the miraculous “liquidity” sloshing around the globe. By buying the highly leveraged equity and mezzanine tranches of collateralized debt obligations (CDOs), they’ve greatly strengthened the buying power that’s been bidding up the prices — and lowering the yields — of risky debt instruments. Soros’ theory of reflexivity was at work during the financing stage of the housing bubble; now it’s working in reverse to “de”-finance the housing bubble. Let me explain with an illustration…
A Picture of Leverage Piled Upon Leverage
This diagram of a typical collateralized debt obligation structure helps illustrate how hedge funds have magnified investment demand for all types of debt-based securities. Like companies, CDOs have balance sheets. Only instead of factories, natural resources, or inventory, a CDOs’ assets usually consist of securitized debt instruments — an alphabet soup of exotic, synthetic securities like MBSs, ABSs, and CLOs. And just like companies, the CDOs’ assets generate recurring streams of cash flow paid to creditors and equity holders in order of seniority:
The most senior creditors, or tranches, get paid first, but normally receive returns that barely exceed Treasury bonds. At the very bottom of the capital structure, the mezzanine and equity tranches get paid last, but can receive returns well into the double digits. If the value of the assets on the left side of the balance sheet decline, or if the cash generated by these assets declines, the mezzanine and equity tranches are in trouble.
To use a simplified example, if a CDO’s assets generate an average yield of 6.5%, all creditors are paid a fixed 5% and the CDO is financed with 90% debt and 10% equity, those holding a piece of the equity tranche can receive a 20% annualized pretax ROE (asset income minus interest payments divided by equity). But if the market for the CDO’s assets sours, and they decline in value by 10%, those holding a piece of the equity tranche will be wiped out.
While the leverage involved in this example may sound extreme, this type of strategy has been popular with hedge funds in recent years, because the assets (collateral) backing these CDOs — ultimately, residential housing — haven’t declined in value. Now that housing prices are flat or negative, the game has changed entirely.
Take another look at the typical CDO structure diagram. Because they’re under such pressure to deliver good investment returns each quarter, hedge funds have a huge incentive to speculate in very risky asset classes like equity tranches of CDOs. This elevated demand for CDO equity creates a magnified increase in demand for CDO collateral — including junk bonds, corporate loans, and subprime mortgages. Higher demand for CDO collateral drives up prices for all types of debt, thereby lowering credit spreads and yields.
After years of this phenomenon, we are now in a situation where credit spreads — the extra bit of interest required by buyers of junk bonds to compensate for default risk — are at unprecedented lows. To top it off, holdings of CDO equity are being carried on the books of many hedge funds at “mark-to-model” values because there’s no liquid secondary market for them.
The situation for the financial markets in the coming months is bleak; the economy is slowing, and the supply of debt instruments, especially CLOs to fund private equity buyouts, will expand by hundreds of billions of dollars in the coming months — just as demand for these instruments continues to soften. Morgan Stanley’s structured credit research details the coming supply in a recent research note:
There is a very large [high-yield] bond and loan calendar on investors’ doorsteps over the next three months: $66 billion and $180 billion, respectively. Potentially at risk is the “inverted pyramid” — the analogy we have used to highlight how a small amount of CLO equity and mezzanine funding supports a much larger CLO market, which supports a much larger loan market, which supports an even larger high-yield market. We would even venture to say that a healthy loan market is supporting equity valuations by making today’s large LBO possible. Case in point: Of $246 billion of total issuance that is inbound, almost two-thirds are LBO-related.
Increasing supply and decreasing demand is not a prescription for higher CLO prices.
Indigestion Is Lowering Speculative Appetites
Wall Street investment banks like Goldman Sachs and Bear Stearns have long outpaced traditional commercial banks in the race to originate the most profitable loans. Proliferation of CDOs has enabled the best salesmen on the Street to stuff all manner of debt down the gullet of formerly unsuspecting institutional buyers. But ever since these buyers started refusing unfriendly provisions like payment-in-kind (PIK) toggles, investment banks have had to retain far larger morsels of LBO debt than they had planned.
Indigestion tends to lower an appetite, and institutional investors’ appetite for junk bonds is spoiling just as Wall Street tries to serve them heaps of acidic securities. While CDOs have shifted risk away from the banking system by linking borrowers with lenders from around the world, they have not lessened default risk; they’ve merely transferred it to unsuspecting lenders that are just beginning to push back.
Dan Amoss, CFA
September 13, 2007