Tuesday, October 13, 2009

Rewriting the alphabet soup

Posted in the Financial Times by Jennifer Hughes:

Financial innovation played a key role in the crisis that led to the near collapse of the global banking system last year.

The alphabet soup of CDOs, CPDOs, CDS, ABS, ABCDS, ABCP and RMBS (see panel) that were so popular during the boom years became the poison that infected the entire financial system. A series of markets froze and values plunged, forcing banks and investors to write off hundreds of billions of dollars in lost value.

These markets are only now beginning to thaw. Some of the more complex structures – CDO squareds, for example – are not expected to return for a long time, if ever. But bankers have been sifting through the wreckage desperate to salvage the basic elements of securitisation.

“It has taken time,” says Gareth Davies, head of European ABS research at JPMorgan. He has spent much of the past 18 months explaining securitisation to government officials and company executives to help them distinguish between the more exotic and distressed corners, such as CDOs of ABS, and the essential securitisation principle of parcelling up loans or bonds into saleable securities.

“We’ve gone from a time where everyone bought ABS and fought for every extra basis point through a knee-jerk period where you couldn’t sell these deals at all. Now the debate about the future is becoming more reasoned and forward-looking,” he says.

Two deals last month heralded a tentative opening of the markets in Europe and provided a benchmark for other issuers. Lloyds sold £4bn ($6.3bn) of residential mortgage-backed securities and Volkswagen issued €500m ($740m) in car loan ABS.

Brad Craighead, head of European ABS origination and structuring at JPMorgan, who worked on both deals as a joint-bookrunner, said the two drew more than 100 different investors. Buyers were top name “real money” investors who buy bonds to hold them, rather than so-called “fast money” investors – who often sell deals quickly in the secondary market for quick profit. “Both deals were bought by investors actually trying to increase their exposure,” he says. “The two being priced alongside each other really reinforced the message that there is broad demand.”

Investor appetite is one thing but the market is not expected to return to its pre-crisis habits where new, complex structures with exotic acronyms appeared regularly. The Lloyds and VW deals were structured in simple so-called “plain vanilla” terms.

Another factor likely to change will be the amount of data buyers get. Part of the market freeze has been attributed to investors not knowing exactly what loans lay behind each security. This led some to boycott the entire sector for fear they might be holding the bad loans.

Since then, the European Central Bank and other institutions have called for investors to get more data to make the market more transparent.

Ratings agencies say they are happy to share the information they are given but issuers’ reluctance, coupled with data privacy laws in Europe, make the reality more difficult.

“If we’re presented with information, there’s no reason in our book why we’re the only ones to have that. There is some commercial sensitivity around some information but there is a dichotomy between that sensitivity and giving people the confidence to invest,” says Stuart Jennings, group credit officer at Fitch Ratings.

The ABCDS of securitisation acronyms

Asset Backed Securities The basic form of securitisation where debt is parcelled up and sold as securities backed by the repayments from those loans. The biggest sector is Mortgage Backed Securities, including Residential (RMBS) or Commercial (CMBS). Other popular ABS are backed by car and credit card loans.
Asset-Backed Commercial Paper

Short-term debt, usually issued by investment vehicles who parcel up assets with cash flows such as consumer loans, then sell the new paper to investors.

Credit Default Swaps A form of insurance against corporate default. Buyers of protection pay a premium for a set period to cover themselves against the risk a company goes bust.

ABCDS CDS protection on ABS.

Collateralised Debt Obligations Structured vehicles that pool different sorts of loans and bonds, funding themselves by issuing new bonds whose price and return depend on the level of risk taken. A synthetic CDO is a CDO of derivatives such as CDS.
Constant Proportion Debt Obligations Essentially leveraged bets on a group of high-quality US and European companies. These vehicles issued securities and aimed to generate the funds they needed to pay out by selling protection on the two main indices of credit default swaps.

Even if the issue with data is overcome, few expect the market to roar back to anything like its pre-crisis size. One reason for this is the disappearance of so many buyers, particularly Structured Investment Vehicles and bank conduits – shady, off-balance sheet entities that bought many of these toxic securities and funded their purchases by issuing short-term asset-backed commercial paper.

Their disappearance, however, is no bad thing, according to market insiders.

“If there was one group of investors who over-relied on ratings and did relatively minimal credit work, it was SIVs and conduits, especially in Europe. Their investing strategy was a funding arbitrage [borrowing at low short-term rates and investing at higher ones]. Now they’re gone we’re left with a greater proportion of investors who are doing the credit work to analyse the bonds,” says one securitisation professional.

These quality investors were evident in July in the US in a striking $1.2bn RMBS deal for American General, a subsidiary of AIG. The deal was arranged by Credit Suisse which, partnering with PennyMac, the mortgage investor, sold the bonds without any credit rating.

Ben Aitkenhead, co-head of structured products at Credit Suisse, who worked on the deal, says the bank could have sold twice the amount of bonds on offer.

“You need the ratings agencies to give you the deepest pool of buyers but we proved investors are comfortable doing their own credit analysis and not outsourcing it,” he says.

Investors did, however, demand a far deeper credit enhancement – the cushion that soaks up losses before the most highly-rated tranche is hit. Before the crisis, a deal might have consisted of 10 per cent of junior paper below the senior bonds. This time, investors demanded a 40 per cent cushion.

“Investors weren’t asking for more loan-level information than normal, this cushion was about having observed the market over the last 24 months. They now demand more protection and this is likely to continue at some level,” Mr Aitkenhead says.

That the market is re-opening, even in this gradual way, is welcome to regulators and politicians as well as bankers and investors. Issuance in the US, for example, accounted for about a quarter of all credit before the crisis and an active, if reformed, market is seen in both Europe and the US as a crucial part of any lasting economic recovery.

Insiders are still publicly cautious. Most – bankers, issuers and investors – characterise the recent deals as only “baby steps” in the right direction. But all seem sure there will be a future and that, after the freeze, it is beginning to unfold

No comments: