My neighbour and I were again talking over the fence.
‘When do you think this financial crisis will be over? If the major central banks have poured in so much liquidity into the system, as you told me before Christmas, and international short term interest rates have fallen a little, doesn’t this mean we’ll be back to normal soon.’
I replied: ‘The central banks may have solved the liquidity issue, but there is no plan to provide a solution for the solvency issue. So, the crisis is still a long way from finishing.’ ‘What do you mean,’ the neighbour asked. Isn’t liquidity and solvency related?’ ‘No, the’re not,’ I replied. ‘Solvency is the ability of an entity to pay its debts with available cash.
It’s a statement of fact. You can pay, or you can’t. Now we know that a number of major banks and investment banks have sold equity to powerful allies among the sovereign investment funds to prop up their capital after disastrous losses from the credit crisis.
‘The largest stock broker in the world, Merrill Lynch after getting US$6.2 billion in equity from Temasek Holdings of Singapore and asset manager Davis Selected Advisers in December is already back into the equity market for more, opening talks with Middle East and Chinese sovereign wealth funds. In Merrill Lynch’s third quarter 2007, it was forced to write down $8.4 billion in mortgage related debt and lost $2.2 billion company wide. ‘The speculation is that there will be another huge write down in the fourth quarter of around $8.6 billion and more overall company losses.
Merrill’s share price in 2007 fell over 40 per cent. ‘While Merrill Lynch and the others can shore up their capital with new equity funds, what worries the banks is whether the counterparties to mortgage backed securities, particularly relating to collaterised debt obligations (CDOs), which have large holdings of subprime debt in their makeup will come good in solvency terms if required to do so.
‘Wolfgang Munchau, a columnist with the Financial Times in London (December 16 2007) was definite about the “solvency crisis that has arisen because two giant and interlinked bubbles burst simultaneously- one in property, one in credit, leaving banks and investors on the brink of bankruptcy, some hanging on by their fingertips.” In a later report dated January 1 2008, Munchau summed it up: “financial actors no longer have blind faith in the solvency of the counterparties.”
My neighbour said: ‘To understand what this is all about, where does the counterparties come in with CDOs?’ ‘ Let me try and explain. CDOs pools assets such as bonds, loans, asset backed securities, credit derivatives, and issues liabilities, which are divided into several slices called tranches with varying degrees of risk and income. They are then sold to investors based on their risk-return objectives.
A special purpose vehicle is set up governing the separation of the seller/originator of the CDO from the asset pool, with a trustee to monitor the performance of transactions. ‘The structuring of the CDO will involve a range of external counterparties. These are third party entities, who for a fee stand behind the CDO to provide protection to investors in relation to income and capital.
‘Generally, rating agencies will look to control the risks arising from the exposures to the various counterparties by requiring them to be of a certain rating. The general rule is that the long term unsecured debt rating of the third party must be at least equal to the rating of the issue. ‘As a debt king, I don’t like CDOs because they can be used to conceal toxic securities such as subprime mortgages among the assets.
Using a monoline insurer to provide credit enhancement allows the CDO to rank as a triple A rating permitting a lowering of borrowing costs. A further layer of respectability is the engagement of a rating agency to rate each of the tranches. The CDO has all the trappings of being sound, but the detailed structure can be so complicated that both the monoline insurer and the rating agency sign off, missing the elements of toxicity.’
The neighbour said: ‘some time back, my broker sold me a parcel of high yield securities, which included a very complicated CDO structure. I must confess I didn’t understand it Should I sell?’ ‘I would, but you’ll lose out of it. American sales people were so persuasive that they sold these complicated toxic securities to a whole lot of local government councils and other investors around Australia. The councils which aren’t the most sophisticated were attracted by the high yield income, without understanding the complicated structure and fine print about the risks involved.
‘One of the councils, Tumbarumba which “invested” A$7 million of its assets in CDO toxic securities is situated in the foothills of the Snowy Mountains, a long way from the snake oil salesmen on Wall Street. ‘Fortunately, the council had its money returned by the local unit of Lehman. They were lucky, but others had their fingers burned.
For example, US money market funds invested $11 billion in CDOs backed by subprime debt, which was being managed by the Wall Street fixed income specialist Bear Stearns. Money market funds are usually very safe. But this fund manager was impatient to increase its earnings by investing in CDOs, rather than in boring government securities. It was a very dangerous thing to do.’
‘Are you able to estimate how many CDOs have been issued, asked the neighbour.’ ‘The best estimate I’ve seen in the absence of a method for reporting on CDO issuance is one made by the Financial Times. The global CDO issuance in 2006 alone was said to be $2.6 trillion. If you add this guesstimate to Moody’s rating agency estimate that half of the CDOs in 2006 had subprime debt, there are a lot of solvency issues, which can’t be easily swept under the carpet.’
‘I’m beginning to feel weak in the knees,’ said the neighbour. Let’s pick the story up in a few days.’
