Posted tagged ‘hedge funds’

Commercial Developers: Not a Credible Threat

January 9, 2009

Ok, I’ve been tardy in posting. I’m very sorry about that, lot’s of things are going on. This post is, obviously, a bit delayed, but I think it’s important that people realize why this is amongst the dumbest ideas ever and will demonstrate how one can try to pull the wool over the eyes of the public.

On December 22nd I was startled to see a WSJ news alert title “Developers Ask U.S. for Bailout as Massive Debt Looms” in my email. This is potentially the most ridiculous thing I’ve ever heard of.  There are a few reasons I believe this. First, though we’ll need to know a few things about commercial properties and how they are financed…

1. Unlike residential mortgages, there are multiple metrics for value and credit worthiness of a commercial property. Residential properties can be looked at with a few paramters in mind, but there is a certain amount of behavioral science that undergirds mortgage models. For residential mortgages, one mainly considers FICO score and LTV (ratio of loan amount to value). However, these are not created equal: FICO is used to ascertain probability of default and LTV is used to figure out loss severity with a binary “under water or not” input into default probability as well. The intuition here is that how much one expects to lose is the probability you lose anything at all times the severity (percentage of loan value) of that loss. We can debate if the world is this simple (it isn’t, I’ll win that one), but that’s how one analyzes individual mortgages in the context of a pool. Note what is NOT in there, the actual rate of interest or income of the borrower (theoretically contributes to FICO, but FICO is largely a black box).

Commercial mortgages, on the other hand, are sized to two parameters: LTV and DSCR. DSCR is the Debt Service Coverage Ratio and is net cash flow (NCF) from the property divided by the monthly interest payment, and has traditionally been constrained to 1.20x as the minimum acceptable ratio. Further, the cashflow is the result of a detailed underwriting process where every line item (most important being rent, obviously) is analyzed and researched to find the correct assumptions. Values, unlike residential properties which are dollars per square foot, are determined by capitalization rates or cap rates for commercial properties. The cap rate is the NCF divided by the value of the property. So, if a property that generates $10 million “trades” at a 10% cap rate (which is ridiculously high, bubble cap rates were around 4% and normal cap rates are around5-7% for regular properties), it would “trade” at $100 million (trades being used to denote the theoretic level it could be bought or sold).

What we see here is that there are three elements of analyzing a loan here: the actual cashflow the property generates is scrutinized, the ability to service debt from that cash flow constrains the size of the loan, and the valuation of properties constrains the size of the loan along a different, but not unrelated, dimension.

2. The riskiest properties in the commercial mortgage market are structured as much shorter-term loans. If you are a developer and you aren’t refinancing a mortgage on a cashflowing property, you don’t get a 10-year fixed-rate loan. You get a two-year loan whose interest rate floats (although there is a cap purchased, so the property or developer has a maximum payment) and is extendable if you meet certain conditions and pay certain fees. These sorts of loans are made on newly-constructed complexes with no current cashflow, properties undergoing a severe renovation or being repositioned in such a way as to introduce a lot of uncertainty (adding floors, changing building type, etc.), and other risky properties.

Less risky properties get 10-year fixed rate loans, but they aren’t 10-year amortizing loans, they are 30-year amortizing loans that come due in 10 years. This is called a 10-year balloon payment. This means that in ten years the average commercial property will only have paid back 20% of their loan when the remaining 80% comes due. Clearly this is a regime meant to discourage unlevered ownership.

3. For very large loans, in addition to floating rate loans, commercial properties have low leverage mortgages and the additional debt comes in the form of mezzanine debt. Why is this important? Well, mezzanine debt, for those who aren’t familiar with the term, is debt against equity–the owner puts up his/her ownership stake as the collateral of the debt. So, if one fails to make a payment on the mezzanine debt, the mezzanine debt holder can take the property. Note, however, this is unlike a bank foreclosing on your house–the mortgage in this scenario is above the mezzanine debt and is undisturbed by the default of the mezzanine debt. The mortgage holder is still owed money, but from whom the checks are coming is irrelevant to the mortgage holder. This structure exists for a number of reasons, including tax and accounting reasons, but one reason it is to often used is that mezzanine debt makes it much easier to transfer the property’s ownership versus having one large mortgage.

It shouldn’t surprise anyone, though, that this complexity allows investment banks to get deep into the process of lending and distributing debt. The buyers of the lowest pieces of mezzanine debt are completely different than the buyers of the AAA bonds backed by the senior mortgages (yes, the mortgages are securitized, but mezzanine debt cannot be–for boring details on this to look into REMIC rules and other minutia).  The natural buyers of the lowest pieces of mezzanine debt are firms that, in the event of default, can own the property and operate it well. This is an important fact. Some buyers of commercial mortgage debt will refuse to purchase debt on a property, especially large or complex properties, if a smart firm with a good track record of operating properties isn’t in the first in line to take over the property in the event of a default (called the first-loss debt position).

Now, let’s explore what actually happened over the past few years. 2006 was the year underwriting standards totally died. Highly levered transactions became the norm, case-in-point is the EOP transaction. This was financed with floating rate debt and was very highly levered–EOP’s portfolio was yielding about 4% to 5% on the purchase price (although, this was on the final purchase price which was settled on in 2007, but the underwriting and debt commitments were all negotiated in 2006). Here’s another dirty secret about Blackstone’s buyout of EOP: the rating agencies, to rate debt, have to do their own underwriting of the properties and come up with their own, conservative, cashflow. Most, if not all, of the underwriting the rating agencies used was directly from Blackstone. This was not uncommon when the rating agencies were involved in a transaction with a large client who had a good brand name. EOP is merely illustrative of a top-of-the-market deal. Although, there are other huge examples.

Benchmark underwriting standards went from a 1.20x DSCR to 1.15x or 1.10x, although LTV’s stayed at 80% (although valuations were sky-rocketing).  A huge percentage of loans were interest-only, so the balloon payment went from 80% of the loan to 100% of the loan. Think about that… A borrower is constrained by their ability to make payments on the debt, but they are only constrained to 1.10x their debt payments, which don’t include amortization payments, and the constraint is based on your expected future cashflows (which, obviously, assume rent growth!), not your current cashflows. Starting to get the picture? Properties became over-levered in the instance where any problems developed.Who pushed for this? Developers and property owners. As a matter of fact, the push to grow market share and revenue meant that banks needed to lend more so they could sell more debt and securitize more. 2006, for these reasons was the peak of lending on commercial properties. Between 2005 and 2006, I would estimate, 40-50% of all the currently outstanding commercial mortgage debt was originated (the chart in the WSJ article bears this out).

2007 was the year that problems began to occur. Spreads blew out to record levels (at the time, those records are being smashed all the time). Within six months of relaxed standards being instituted, they were rolled back. It was also during this year that supply of debt, including the unsold inventory referred to as hung debt, far outstripped demand. Because of the large percentage of “fast money,” or hedge funds, in the real estate debt markets (see #7 in that post), when spreads moved against them the largest players took huge losses and shut down (“blew up”). Also, CDO’s were a huge consumer of this sort of debt, and the non-corporate CDO market stopped completely in 2007. Seeing the headwinds for reduced demand? So, in essence, the marginal buyers of debt who could live with relaxed underwriting standards, because they needed to get enough debt to issue a CDO or invest their new $1,000,000,000 they raised, disappeared.

2008 was, in essence, more of the same. The same pressures and lack of demand persisted and debt prices continued to sink. Also, more buyers of debt left the market or shutdown, compounding the problems.

So, now, we can examine the request for bailout funds by developers. In the next three years, there is, according to the article, citing some firm I never heard of, $530 billion coming due ($160 billion in the next year). Well, I can count, so let’s count backwards. The vast, vast majority of mortgages are 10 year mortgages with a balloon payment, so those loans made in 1998 with this structure will be coming due. Rents are up significantly since then (page 23), perhaps 40%. Cap rates have also compressed significantly. Taken together, these two facts mean that someone with a stable property, who got a mortgage in 1998, is coming due  this year and has 40% more cash coming in from the property and can lever that cashflow much more now. I think those people will be fine refinancing. Ditto for all normal loans coming due in the two years after that.

What’s left? Well, all the risky, shorter term loans. These are 2 year loans that can be extended by one year up to a total term of five years, traditionally. In my estimation 95% of the floating rate loans I’ve seen conform to this structure.  Well, two years ago means originated in late 2006 or early 2007. Three years ago is 2006 or 2005 (very top of the market). You see the pattern. These loans are the riskiest projects, undertaken at the top of the market. These loans were made with aggressive assumptions underlying their underwritten cashflows, top-tick valuations, and higher levels of allowable leverage than at any other time in recent memory (certainly in the time this market has been considered mature). Seems like I just made the case for the developers, no? Absolutely not. Common sense tells us that these risky loans aren’t the normal apartment buildings, malls, retail space, and industrial space–those are the 10-year loans we talked about. These risky loans are for acquisition and re-positioning of hotels, construction projects resulting in marginal increases in commercial space, and highly levered purchases of portfolios of properties. Not exactly the sort of properties that are the backbone of our economy.

Even worse for developers is the fact we discussed above: short term loans are designed to transfer owners. Defaulting on a highly levered property usually means the property owner becomes someone as good, if not better, at running that same property type. No one will come to their office to see the front door padlocked and the bank selling the building for the majority of these loans. Oh, and the majority of those 40-50% of loans I estimated were made in 2005 and 2006, based on frothy valuations and underwriting, will be coming due in 2015 and 2016–those numbers, then, can’t be in the numbers presented by developers.

The conclusion? Devleopers are using big numbers to scare people into putting money up to backstop the riskiest of their highly-levered projects. As a matter of fact, there was quote in the WSJ article.

“The credit crisis has got so bad that refinancing of even good loans may be drying up,” says Richard Parkus, head of commercial-mortgage-backed securities research at Deutsche Bank.

(Emphasis mine.)

HA! “Even good loans” … The unread part of that is, “Not just bad loans, but…”

Further, this just can’t be true at all:

There’s widespread agreement that a record volume of commercial real-estate loans made during the boom years are starting to come due. According to Foresight Analytics, the $530 billion of commercial mortgages that will be maturing between now and 2011 includes loans held by banks, thrifts and insurance companies as well as loans packaged and sold as commercial-mortgage-backed securities — or CMBS.

(Emphasis mine.)

Unless we are defining “boom years” as 1998 to 2001, this isn’t just suspect it’s patently false. No significant amount of loans turned into CMBS is coming due between now and 2011. At least the WSJ is consistent…

Unlike home loans, which borrowers repay after a set period of time, commercial mortgages usually are underwritten for five, seven or 10 years with big payments due at the end. At that point, they typically need to be refinanced.

[…]

At the heart of the financing scarcity is the virtual shutdown of the market for CMBS, where Wall Street firms sliced and diced commercial mortgages into bonds. During the recent real-estate boom that took off in 2005 and lasted through early 2007, that market fueled the lending to real estate because banks could sell easily the loans they made.

(Emphasis mine.)

Wow! Five, seven, and ten year loans, made between 2005 and early 2007 are coming due between now and 2011! The disproving of these are left as a simple exercise for the reader.

Look, as a reader of Dear John Thain, you know that I’m not always right. I’m probably missing something. Let’s see what else the WSJ has to say:

What’s not clear is how soon the crunch will come. The Real Estate Roundtable, a major industry trade group, predicts that more than $400 billion of commercial mortgages will come due through the end of 2009. Foresight Analytics estimates that $160 billion of commercial mortgages will mature next year.

Jeff DeBoer, president and chief executive officer of the Roundtable, says the group came up with its estimate by looking at the $3.4 trillion of commercial real-estate loans outstanding. It’s not unusual for roughly 10% of the industry’s debt to roll over every year, he says, referring to refinancings.

This year, some $141 billion worth of commercial real-estate debt owed by property owners and developers to lenders came due, according to Foresight Analytics. Most of that was refinanced or extended by existing lenders. The lion’s share of those loans was made between five and 10 years ago. Despite the recent decline in property values, the underlying buildings were still worth well more than their mortgages and were generating sufficient cash to pay debt service.

(Emphasis mine.)

Well, I guess not. So, the larger number is a guess based on the “take a large number and multiply it by 10%” rule. The smaller number is similar to what was experienced in 2008, where most of the debt was refinanced or extended by lenders. Further, those properties that make up the “lion’s share” were worth much more than their mortgages and generating sufficient cash to pay their debt service. Oh, and they were originated between 5 and 10 years ago, as I conjectured above. Seems like there is no justification, whatsoever, for spending a dollar on “bailing out” commercial mortgage developers. (I really want to put a Q.E.D. here…).

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Detailed Causes of the Crisis and Post-Crisis

November 9, 2008

Since this is a political season, and with the economic crisis, I think everyone in finance understands there is a sort of “silly season” that ensues. We certainly noted the sort of irrational behavior that would immediately make an economist question their beliefs. To me, though, the most offensive form of this stupidity comes from those who believe the Community Reinvestment Act and Fannie and Freddie sparked the whole crisis. Mr. Ritholtz rails against this notion over and over again. Oddly, I haven’t seen anyone else tackle this issue… Of course, I’m also way behind on reading my feeds. I even wrote Mr. Ritholtz an email (something I always tell myself is useless afterwards, since I don’t ever get a response, but is usually cathartic) noting that he was being very informative by setting the record straight. Well, maybe I expressed this sentiment with a tirade…

Every time I hear a Republican talking head on a news program saying Fannie and Freddie caused the problem I want to jump through my T.V., explain that the answer “betrays not even a modest understanding of the contributing factors to the current crisis, it’s scope, and magnitude” and begin to rattle off about flawed ratings agencies, excessive leverage (for investment banks and funds), over-reliance on models, a flawed compensation model for Wall St., managements needs to one-up their own earnings and those of competitors, explosive year over year growth of unproven financial technologies, over-reliance on “fast money” to distribute risk, fund’s need to earn outsized returns to attract assets, funds’ need to buy crappy bonds to build a “relationship” that would allow them to get “good” bonds from banks, poor disclosure from companies (specifically investment banks, as I’ve discussed on my blog), and extremely low rates for a very long time. Of course I’m just a normal guy who actually knows what’s going on, I don’t get invited onto these shows.

(Emphasis added, mine.)

Let’s tackle these, shall we?

  1. Excessive Leverage — If the plot of the credit crisis had included a deus ex machina it would have been an instant de-levering of troubled investment firms. This didn’t happen and several collapsed. I don’t want to be repetitive, but the Deal Professor says it plainly when he says, “Sometimes, You Can Only Raise Capital When You Don’t Need It” … If a firm is highly levered, as Bear was, Lehman was, Fannie was, Freddie was, and A.I.G. was, then when the market gets bad, losses pile up, and credit tightens it’s a death spiral. There’s a large distance between well-capitalized and insolvent, but once you move from adequately-capitalized to under-capitalized it’s probably impossible not to hit insolvent or bankrupt. Oh, and let’s not forget how this became a problem in the first place … the rules were relaxed in 2004.
  2. Flawed Rating Agencies — This is pretty obvious. Moodys errors. Rating agencies noting any deal, even one “structured by cows,” would be rated. And lastly, the smoking gun that seems to be the largest caliber, the fact that … well, I’ll let Mr. Raiter speak for himself:… “Mr. Raiter said that the residential mortgage rating group at S.& P. had captured the largest market share among its main competitors — 92 percent or better — ‘and improving the model would not add to S.& P.’s revenues.‘” Wow! Honesty, stupidity, incompetence … all on display. Now, to be honest, I have no idea what difference these problems made. What I do know is that the rating agencies were used as a means of outsourcing risk management and credit analysis. While it shouldn’t be a huge shock that the rating agencies missed the mark, the magnitude by which they missed is a huge problem if everyone took their ratings as fundamentally true. What these “statistical rating agencies” should have been doing is running securities and mortgage loans through abhorrently conservative scenarios and fixing ratings based on those…. they didn’t. They were argued down to “realistic” scenarios based on past experience. The issues above merely compound the problem.
  3. Over-Reliance on Models — Related to the rating agencies’ issues, this one is a great catchall for terrible risk management. Let’s be honest, no one saw the fundamentals in housing getting so bad. That’s not the issue, I didn’t see it so I can’t exactly blame others for not seeing it. What I can do, however, is blame risk management professionals for not preparing for it. When you have, as Citi did, tens of billions of dollars in highly correlated assets, you should know there’s a risk of tens of billions of dollars in writedowns. When you have tens of billions of dollars in commercial mortgages, as Lehman did, you should realize the risks there. Similar lessons for WaMu, Wachovia, and CountryWide. Instead, though, like the rating agencies, there was a push to have “realistic” or “back tested” results. Let’s go to Mr. Viniar, C.F.O. of Goldman, for his take: “Even scenario analysis, which can address some of VAR’s deficiencies, came up short … [This] ’caused us to look at more-extreme scenarios than we used to look at,’ says Viniar. ‘It made us expand out the tails of what we deemed a realistic possibility.'” Logical, concise, and conservative. It seems Goldman didn’t attempt to show lower risk numbers so that they could deploy more capital or be looked upon as safer by the stock market. No, they looked at more extreme scenarios. They reacted quickly. However, in quoting this passage I sandbagged you, dear readers. This quotation is actually much more relevant to this situation than one would think–it comes from 2001! Mr. Viniar, people probably won’t remember (seems like a lifetime ago), but I noted before, was the guy who convened a firm-wide meeting on exposure to the housing markets. The takeaway is that the firm that looked at the most extreme scenarios, not the ones that models said were most likely, weathered the storm the best.
  4. Flawed Compensation Model — This one is pretty obvious. Lots of money flowed into people’s P.A.’s (that’s “personal account”) each year based on fees and mark-to-market gains for complex structured products. In many instances these risks were distributed and off the balance sheets of investment banks. However, these businesses were grown, and none of the risks were well understood–the people in the lead, though, lead the charge to increase their compensation. I was personally aware of a senior trader/banker/whatever that pushed a firm, one that has seen tens of billions in writedowns and may or may not still be alive, who pushed for balance sheet commitment of 2-3x the current size in the C.D.O. business. This would have exposed this institution to writedowns larger than most firms equity base. This proposal was shot down, but still… Clearly making eight digits was going to someone’s head. Now, we all know that I believe one should be accountable for their decisions, so it shouldn’t be a surprise that when one has made tens of millions of dollars in bonus and salary, but their decisions lead an institution to take massive losses, reduces shareholder value significantly (keeping in mind shareholders might be woefully unaware of the risks being taken), and leads to thousands of people losing their jobs, merely being fired isn’t enough. Especially since these issues are only beginning to be understood when these people are fired, usually. Becoming an instant millionaire is a huge, huge problem. It’s the “swing for the fences if you’re down” mentality, and it’s also the “worry about the tail events if they happen” mentality. Put simply, there should be the ability to claw-back compensation based on performance for years. Perhaps a ten year lockup of wealth is extreme, but given these issues and famous blowups in the past, and taking into account the tradition of good times to last several years, maybe ten years is harsh but not extreme. Maybe employees should be allowed to hedge exposure to stock prices after a few years, but still have risk if negligence is discovered or things go wrong that were set in motion by that person. Obviously something drastic needs to be done, perhaps merely paying less is sufficient, but I doubt it.
  5. Management Pressures — Highly correlated to the flawed compensation model, it’s the case that management was pushed hard to get earnings up. Having seen the “budget” process (an odd name, I thought, since a budget, to me, merely means expenditures) up close, I saw people come up with reasonable numbers, submit them to senior management, and be told, “More!” Well, guess what <expletive>s? If someone tells you they can reasonably deliver something and you always add 10-20% to those numbers, there is more risk taking and less rationality to how that profit is achieved. Maybe the long term effects of pushing the envelope are much worse than not taking those risks to begin with. This is one reason Goldman seems to outperform so often, they understand what they are getting themselves into. They truly work together and achieve revenues through teamwork instead of edict. Now, underperformance is punished, but setting reasonable goals is step one when trying to exceed them. The next generation of management should fight their bosses tooth and nail not to set unreasonable baseline expectations and should figure out objective measures that reflect an employee or business’s effectiveness. The tyranny of quarterly earnings shouldn’t make grown ups act stupidly because they can’t “just say no.” Here’s a hint: if you run a company with a nine- or ten-digit balance sheet and you don’t realize your business is complex enough that you shouldn’t manage to the next ninety days, then you should step aside. Seems simple to me. Maybe that’s why Google doesn’t bother with quarterly guidance.
  6. Explosive Growth of Unproven Financial Technologies — Being a bit of a purist I am hesitant to call financial products or methods “technologies,” but I’ll use that word for now. The truth of the matter is, these products had never seen a massive downturn. Sub-prime loans as we know them today hadn’t seen a recession until now. C.D.O.’s backed by structured products hadn’t existed during a protracted period of fundamnetal credit distress before. This was known and talked about often. For as much as this was talked about, it was an observation that was never extrapolated. Hedging and risk management still looked at historical levels of distress and credit problems. The market had grown by orders of magnitude, but that wasn’t part of the equation. Quite simply, the fact that these markets grew so much so fast meant no one had a good handle on the feedback effects of this growth. This is somewhat obvious and very moot, so I won’t dwell on the problems of such massive growth.
  7. Over Reliance on “Fast Money” To Distribute Risk — Anyone who knows structured products understand this point. Basically, the fair-weather buyers are “fast money.” This client based is distinct from “buy and hold” or “real money” accounts. Here is where the shell game of wall street really kicked into high gear. Hedge funds would buy bonds with the intention of selling at a profit later. Investment banks would, to show strength of the market, put out “bids” or interest to purchase securities they had just created at a higher price than they had just sold said securities at. Hedge funds would then immediately sell back to Wall St. firms, at a profit, to take advantage of their desire to show the market their securitizations “trade well” or “at a premium.” When firms are making money on the securitization, they can afford this. Speaking more generally, hedge funds just “trade bonds around” more. In recent years insurance companies and banks, the institutions that buy securities and rarely sell them (for a myriad of reasons), went from 70+% of the buying base for structured products to 20-30% of the buying base. This means that in a bad market 70-80% of the bonds that exist can be sold (dumped?) at a moments notice. Add in the fact that during this period there was explosive growth (as noted above) and you see why when the markets hit trouble the huge wave of selling occurred, liquidity dried up, and prices plummeted.
  8. The Flawed Model for Relationships Funds have with Wall St. (coupled with Funds’ Needs for High Returns to attract Assets) — The way a bank figured out if a hedge fund was a good customer was, basically, how much a fund helped that bank get out of risk (stupidly, as stated above, since banks were likely to be more hurt by a fund owning assets and were more likely to wind up needing to repurchase those assets, but I digress…). However, when assets were in short supply relative to demand, only the top clients were able to purchase securities banks were creating. So, one might wonder, how did a nascent fund, at the bottom of the food chain, get access to the desirable securities? Easy solution: they purchased the undesirable securities to “help out” a Wall St. firm. These were more risky, although they were generally carried a higher rate of return in the event of no credit problems. These new funds, then, showed higher returns, attracted more money, and bought more securities from banks. Net effect? Most funds had a poor mix of products–higher risk bonds or assets that would get hit much harder than generic securities and more generic securities. Keep in mind that, to get high returns, funds were buying C.D.O. products and other structured products that had higher returns in general, but funds also levered these products and thus funds were much more exposed to moves in the market. Funds, as everyone knows, get paid a percentage of assets under management and returns, so to grow their revenue stream many funds just had to buy lots of securities (and, to establish a strong enough relationship to be allocated enough securities, plenty of lower quality securities). This was the prisoner’s dilemma of the syndicate system–funds cooperated every time. (Just to put some numbers on it, when a fund would try to buy residential or commercial mortgage backed securities it was possible for demand to outstrip supply 2- or 3-to-1. Accounts with strong relationships usually got 100% to 80% of the requested amount of bonds being issued. Weak relationships or smaller firms could receive as little as 10-20% of their desired allocation.) This is a complex process and nuanced point, feel free to email me for more explanation.
  9. Poor Disclosure from Companies — This is a point I’ve raised before. I won’t go over it again. The short story is that firms got away with a lot because they didn’t tell anyone what they were doing.
  10. Extremely Low Rates for a Very Long Time — I’ve raised this point before as well (between the numbered lists). Rates were very low and, suddenly, a product that trades at 50-100bps over L.I.B.O.R. traded 50-100% higher than L.I.B.O.R. If your benchmark was treasury rates to outperform your benchmark meaningfully you needed to get much higher spreads, and thus take higher risk. This is why C.D.O.’s experienced such explosive growth (see the problems the growth cased above). Low rates also made it more attractive to get a floating rate mortgage, which a huge majority of sub-prime mortgages were. This was part of the ex-post concern with Alan Greenspan’s encouraging people to take out A.R.M.’s.

In short, Fannie and Freddie were part of the problem, but not in and of themselves. In fact, if Fannie and Freddie had caused these problems by selling banks their bonds, then we wouldn’t have a problem at all. Why? Because Fannie and Freddie would be “on the hook” for the bonds they guarantee. If these bonds went bad no firms would have taken losses on them (since the government stepped in to keep them solvent and backstopped their obligations). Okay, now that I’m done ranting I’m going to rant on something new. The post-crisis narrative of what went wrong… (don’t you love the rise of the word “narrative”?).

  1. The failure of rating agencies, risk managers, and risk management models. This has been getting the most press because it’s easy to explain (not why these things failed, but the fact they failed).
  2. Sheer size. This is pretty silly, if you ask me. Bigger doesn’t have to mean riskier. The practices that get a firm to a massive size could be an issue. Super-concentrating the health of the markets with very few players could be a huge problem. The “Too Big to Fail” issue might fit some situations, but didn’t cause this crisis. No one wants to have to rely on the government to save them.
  3. Executive pay. This is a limited view on the actual problem. In fact, in most firms, C.E.O.’s aren’t the highest earning individuals.
  4. Hedge funds and short selling. Really? Let’s trace the logic here (or lack thereof): a firm runs it’s business poorly and I bet it will decline in value. Clearly I am at fault there. The “free markets at all costs except losses” crowd, like those currently at Treasury, are putting a band aid on an amputated leg here. Especially with the very firms begging to be protected turning around and getting fees from products circumventing the bank on short selling. (What a stupid move, some firms deserve to be in worse trouble.)
  5. Everything else. Why get into the details of the actual causes when you can distill down issues to “good” versus “bad” and simple fights? No one has…. so I’m doing it! But I doubt all the other things will make it into the popular understanding of what went wrong.

There you go. My hands are tired, so I’ll stop here. Feel free to comment and ask questions.

In The Year 2010: C.D.O. Edition

October 21, 2008

In another installment of the series called “In The Year 2010″ I will sit here and guess what will be going on by the end of 2010 with respect to various products. (Inspired by the Conan O’Brian skit “In The Year 2000″). This is a thought experiment, nothing more.

This edition, as the title would seem to suggest, is about C.D.O.’s. Please sit down, because I’m about to argue something very counter-intuitive. C.D.O.’s will be alive and well in the year 2010. Now, I’m willing to claim this victory on a technicality–corporate C.D.O.’s are still being issued. Now, safe in my assured technical victory, I’ll go farther out on the limb

It’s somewhat instructive to understand what have been the various motivations behind the C.D.O. market, historically (some of these obviously no longer exist)…

  1. There was the reach for yield. If one could get AAA C.D.O.’s for a higher yield than other AAA bonds, it was a no brainer. Both were AAA, obviously! No extra risk.
  2. A highly customized risk profile. If I looked at a pool and thought 6% of the balance was going to written off, but no more, I could buy the 7%-10% tranche and get a higher return. Obviously this higher return would need to match whatever threshhold I established, but that was most likely related to the market anyway. Some people referred to this as taking a position in the collateral with leverage. C.D.O.’s are, in essence, leverage on leverage, but this is a complicated, technical, and largely semantic argument. The surface intuition is that taking a levered position increases your return if nothing defaults, but less has to default for the buyer to lose money.
  3. C.D.O.’s were used to finance bonds or other debt positions. “How?” is what I heard you say, in the back? Well, think about it this way: an investment bank requires 50% of the purchase price of a set of bonds and charges LIBOR+100bps on the other 50%. We say that you’ve financed the purchase of the bonds two to one at a rate of one hundred basis points over LIBOR. Now, using our example, let’s say one could issue a C.D.O. and sell enough bonds to get 50% of the purchase price of the underlying bonds up front. Let’s also assume that the liabilities have a weighted average interest rate of LIBOR+10bps. Using the C.D.O. instead of a traditional loan, especially since the C.D.O. can’t be cancelled like a loan can and, most likely, contains much more lax terms than a loan, is much more cost effective. Taking this a step further, it was even possible for C.D.O.’s to be issued that allowed more bonds to be put into the C.D.O. or allow bonds that were sold to be replaced. This effecive made the C.D.O. a credit line with an extremely cheap interest rate. Keep in mind the “equity” or “most levered tranche” or “bottom” of the C.D.O. generally was structured to have a very high return, somewhere in the 15-25% range.

Also, the backdrop of the boom in C.D.O.’s, don’t forget, was a very low rate environment. If one could get LIBOR+10-15bps on AAA bonds when rates were, in 2004 for example, 1% (for USD LIBOR and the Fed Funds), that was a major out performance for a AAA security (AAA, how much risk could there be?!).

Now that the historical context is out of the way, it seems pretty clear that some of these reasons for isssuing C.D.O.’s will not diminish in importance. Funds and money managers will always need more yield. Investors that are smart about credit analysis will always want to take the risks they understand and get paid for taking said risks. Funds and other “levered players” will always need financing. So, let’s examine how the landscape changes rather than disappears.

  1. Complexity will die. There are a number of reasons for this. Part of the reason is that buyers of C.D.O.’s will begin to realize that structure adds a layer of complexity that no one really can grasp fully. Why have dozens of triggers and tests at every stage of the waterfall (the way cash is distributed in order of seniority)? In some deals, I’m sure, this complexity helped some tranches of the C.D.O. In some other deals, I’m sure, this complexity hurt some tranches of the C.D.O. The one  constant is that it’s nearly impossible to tell the right levels and specific mechanics beforehand. Hence the complexity will die and structures will simplify. Likely this also means less tranches. Why have a $4 million tranche size in a $400+ million deal when you can’t even predict losses within an order of magnitude (1%, 9%. or 20%? Who knows?!)? This is hardly a new concept, I introduced it already when discussing residential mortgages.
  2. Arbitrage C.D.O.’s will reign supreme. This one is controversial, and the term “Arbitrage C.D.O.” almost takes on a different meaning each time it’s defined. The intuition, though, is that a hedge fund taking advantage of a market dislocation by issuing a C.D.O. is an “Arbitrage C.D.O.” Why will these be popular? Well, C.D.O. shops, or firms that are serial issuers of C.D.O.’s, have mostly blown up and are done. Traditional money managers will be shying away from C.D.O.’s for a long time. So, in order to sell the C.D.O. equity, the most levered risky piece, the firm issuing the C.D.O. will need to also be willing to take on the equity–this leaves only hedge funds. Arbitrage C.D.O.’s also come together more quickly and generally are backed by corporate bonds. Funds and other accounts that, as a core competency, already analyze corporate credit won’t have to go “outside the comfort zone” to buy into arbitrage C.D.O.’s.
  3. C.D.O.’s or C.D.O. technology will become part of the M&A world more and more. Aha! Maybe too clever for my own good, but while all these specialty finance companies used to be able to issue a C.D.O. for funding purposes on their own, now they will need an investment bank to connect them with hedge funds or take on the debt, and thus the risk, themselves. These C.D.O.’s will likely be simple too (see #1), but will be an efficient way for these companies to finance assets or move them off the balance sheet. Here’s an example: a diversified finance firm, with a large lending presence, for example (most likely with a R.E.I.T. subsidiary, a popular structure of the past eight years) will be looking to sell itself. However, because the assets on it’s balance sheet look risky the leveraged finance groups will need to arrange some financing against those assets. The structure? Most likely a C.D.O. with hedge funds providing the cash and getting a “juiced” return on their money. This is essentially the covered bond product, but with an extra layer of complexity (tranching) on top.

Okay… that’s enough prognosticating for now. Still deciding which product is next. Drop me a line if you have a favorite!