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IMF Funds Victory & Earnings Reports are up, so why aren’t Investors buying?
Monday, April 30 2012 | 08:16 AM
Ron D'Vari
CEO & Co-Founder,
NEWOAK CAPITAL LLC | Christine Lagarde of IMF failed to make her goal of $600 billion in pledges, yet it’s a victory to have reasonable funds to put away for a rainy day.
Still IMF will have key new challenges ahead driven by confluence of new geopolitical, economical and regulatory forces all coming at the same time.
On the geopolitical front, IMF for the first time will have to officially acknowledge increasing direct involvement of key contributors such as Japan, China, and Brazil in the overall decision making process. This is further complicated with the need for growth capital both in developing countries as well as Europe which is hit with full force of the austerity measures.
Parts of Europe will continue facing recessionary forces that will impact global growth. Many European banks active in project finance in BRICs and South Asia find themselves short of capital due to sovereign and other credit issues in Europe itself.
Given slower growth abroad, China’s domestic economic policies will take on greater importance and there will be less Chinese investment capital available to fuel growth internationally.
Another big unknown is the impact of the new regulations globally coming on line at the same time.
The world once again will be looking at US economy to pull the world out of potentially spirally destabilizing forces.
Given these issues, IMF and most policy makers globally will be preoccupied with growth. Austerity measures need to be carefully balanced with other stimulus policies to avoid what is characterized by some as the ice ages.
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ABS Market Pricing Research
Thursday, April 26 2012 | 12:45 PM
Douglas V. Long
EVP Business Strategy,
PRINCIPIA PARTNERS | ABS/MBS secondary pricing and data challenges continue to be a major topic of discussion by the securitisation industry. I’ll be moderating a lively session at Global ABS in Brussels this year examining the innovations in structured finance data and what we can expect as the market searches for greater commoditization and data standardization.
In conjunction with this, Principia is garnering feedback from the market about the key issues in secondary market pricing for ABS, the use of performance, issuance and loan level data and the range of analytical and cashflow models available to investors in ABS and structured credit.
The first of three short surveys we are conducting can be taken here.
I would greatly appreciate your input; the results will then be shared at Global ABS and sent to you should you be interested.
Our aim is to build a comprehensive and completely independent view of the key services available to investors throughout the ABS valuation process - from initial price discovery, through ongoing evaluation, forecasting and accounting. The plethora of vendors collating and distributing market data, performance data, cashflow models and granular loan level information is overwhelming. As an investor who should you choose for which asset classes? Who is using what, where? We would like to provide detailed answers to those questions.
When asked what technical challenges investors faced over the coming year in our last survey, the CIO of a major UK Credit Investment Fund stated: “as far as our firm is concerned, streamlining trade information capture and reducing the number of stand-alone spreadsheets will be a major priority in the next 12 months.”
Consolidation, standardization and operational efficiency in the access and management of multiple sources of data is a real and present challenge. In our last market survey, 35% of investors stated that managing their global structured finance exposures in a single integrated environment was the biggest operational hurdle to overcome. We hope the results will demonstrate how the market can better streamline and make the most of the vast amount of data available today and help investors to choose the best pricing providers across the ABS asset classes and geographies in which they invest.
Take the survey here.
I look forward to sharing the results with you shortly.
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U.S. Equities: Vulnerable to Pullback?
Friday, April 13 2012 | 09:17 AM
Ron D'Vari
CEO & Co-Founder,
NEWOAK CAPITAL LLC | The first-quarter earnings reporting season starting this week will be watched carefully - and most likely profits will fall across most sectors.
Despite Q1 earnings contraction, the market expectation is that growth will be accelerated toward 4th quarter and will continue in to 2013. However, near term the key to market direction will be the guidance provided by management, as well as how many companies beat expectations and by how much.
While the ISM reported a modest rise in March manufacturing activity, Friday’s US employment numbers disappointed the markets by non-farm payrolls rising by just 120,000 in March vs. expectations of a 205,000 rise. This has validated Chairman Bernanke’s concerns about the sustainability of the last six months US job growth. Despite these concerns, the latest U.S. FOMC comments tried to guide down markets’ expectations of a potential QE3.
Furthermore, stress levels in European markets have been ratcheting up and the spot light is coming back on Spain and Italy’s structural and banking issues. Markets also believe that it is unlikely that the ECB will continue to provide liquidity to banks to simply finance governments’ budget deficits. Given the uncertainties of growth and government liquidity policies, both Equity and Bond markets are expected to be volatile.
While equities and credit spreads are vulnerable to pullback, the overall global growth is bound to accelerate. Therefore, we are constructive on select growth equities and non-government bonds, especially emerging markets.
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Emerging Market Investing: Implications of New East-to-East Trade Growth?
Tuesday, April 03 2012 | 10:31 AM
Ron D'Vari
CEO & Co-Founder,
NEWOAK CAPITAL LLC | A whole new pattern of global investing has emerged following changing global trade trends accelerated by the financial and European sovereign crises.
With the global markets rally of the last 6 months, helped by narrowly avoiding a systematic major disaster in Europe, investors are looking for further diversifying away from the developed markets into the fast growing emerging markets. However, this doesn’t mean investing just in BRICs primarily driven by west-to-east trade growth. The world trades having recovered strongly, investors are developing new strategies reflecting the new global trade patterns.
Focusing just on individual emerging markets, such as China and India, misses the far greater growth opportunities arising from accelerating intra-regional business and trades. There are unique opportunities in Southeast Asia’s frontier markets but they come with a high degree of risks, such as corporate governance, political and legal.
Economies such as Indonesia, Vietnam, Malaysia, Thailand, Cambodia, Laos, and even perhaps Myanmar offer enormous potential for growth given that their GDP per capita still ranges from as low as $800 to slightly over $9000 per annum and have a lot of room to expand. By contrast for example Singapore’s GDP per capita is over $50,000. However, Singapore’s economy is fairly open and hence will be subject to the volatilities of global economy and not much diversification in general.
The new investment opportunities initially tend to follow the foreign trade patterns, hence they are focused in agriculture, natural resources, energy, infrastructure, transportation and tourism. Over time they will naturally expand into manufacturing and services.
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Greece and Credit Default Swaps: Bucking the ISDA Cartel - Part Two
Monday, March 19 2012 | 09:28 AM
Janet Tavakoli
President,
TAVAKOLI STRUCTURED FINANCE | Leverage and Language
Since I wrote the first edition of my book, Credit Derivatives and Synthetic Structures in 1998, (John Wiley & Sons, second edition 2001), nothing has changed for the better in the credit derivatives market. It is the first trade book about credit derivatives and stresses that these products are primarily used for leverage. The overwhelming problems are pricing and the risk of misinterpretation of the meaning of the contract language.
Language "Arbitrage"
Sometimes contracts are maliciously written to disadvantage the unwary; this is also called "language arbitrage," because manipulating the language makes a risk-free gain for the perpetrator. In April 2005, I explained to the International Monetary Fund (IMF) that no one in the credit default swap market should trust ISDA "standard" documentation. One has to rewrite the contract language to protect one's own interests.
The following is from my March 12, 2010 post, "Washington Must Bank U.S. Credit Derivatives: Games and Gold," on problems with U.S. credit derivatives, but it applies to the problems with credit default swaps on Greece today.
Sovereign Credit Default Swap Contracts: Tower of Babble
The credit default swap market has a history of conflicts, and the worst of them occur when it is time to settle up. For example, hedge funds Eternity Global Master Fund Ltd. and HBK Master Fund LP thought they purchased protection against an Argentina default and sued when J.P. Morgan refused to pay off on Argentina credit protection contracts Eternity had purchased.
J.P. Morgan's posture was different when it wanted to collect on the protection it bought from Daehon, a South Korean Bank. J.P. Morgan claimed the slightly different contract language met the definition of restructuring under the credit default protection contract it had with the South Korean Bank.
The problem today is that some owners of credit default protection on Greece think they should be able to declare a credit event, but the ISDA cartel has issued an opinion that according to its interpretation of the documents, there has been no default. The problem has always been that contract language is subject to both abuse and "interpretation."
Greece and the ISDA Cartel: Language Games
There are a variety of problems that arise with credit default swap language. The two biggest are disputes about the definition of a credit event and disputes when it's time to settle up after everyone finally agrees a credit event has occurred. Settlement disputes arise over the value of the physical instrument delivered (for physical settlement) or with the calculation of the cash settlement amount (for cash settlement).
Recently the ISDA committee, which is stacked with the large financial institutions that dominate the trading of these products, ruled that no credit event has yet occurred for holders of credit default protection on Greece, if one used "standard" ISDA documentation.
The committee is controlled by the largest banks and financial institutions that trade these products. You can view the list here. For the Americas, the committee includes Voting Dealers: Bank of America / Merrill Lynch, Barclays, Citibank, Credit Suisse, Deutsche Bank, Goldman Sachs, JPMorgan Chase Bank, N.A., Morgan Stanley, Societe Generale, UBS, and Voting Non-dealers: BlueMountain Capital, Citadel LLC, D.E. Shaw Group, Elliott Management Corporation, and Pacific Investment Management Co., LLC.
Credit Default Swaps: A Speculators Dream of Leverage
Given all the problems for hedgers, why has the credit derivatives market grown like crazy to notional amounts in the tens of trillions of dollars?
Speculators poured into the CDS market because of its tremendous leverage. If you think a bond might go down in value, or if the bond is downgraded, the credit default swap will gain in value, even if no default occurs. A speculator who gets in early enough can exit the trade at a huge profit and is out only the amount of the premiums paid in the meantime.
It's as if you bought a life insurance policy on your sovereign neighbor, known to those paying attention to be a reckless-driver, and then made a killing when your neighbor had a fatal accident. Obviously, you know it wouldn't be fair play to tamper with your neighbor's brakes, but others who stand to make a huge gain might be tempted.
Speculators look for huge swings in value. Some speculators aren't too fussy about how those swings in value occur and sometimes try to help it along by say, stoking a rumor mill or other market machinations.
Since credit derivatives often allow speculators to get the benefit of high leverage for very little initial outlay, credit derivatives, which were once touted as hedging tools, have become dominated by speculators.
Pricing is Always an Issue: You Can't Trade With a Screen
If a speculator bought credit default protection on Greece a couple of years ago, the speculator wouldn't have paid much in premiums and today can make many times the initial outlay. For example, during the past couple of years (depending on when one entered and exited) a few hundred thousand dollars could net a gain of several million on a $10 million trade.
But the trade is for people with deep pockets, because the pricing is controlled by a handful of traders, and when you ask for a price, the screen price becomes irrelevant and all of the "market makers" suddenly offer you the same lousy price. In one recent example, a speculator with a $10 million notional CDS claimed that he was being ripped off for $500 thousand after being low-balled in a bid for the protection he had purchased long ago. That $500 thousand isn't merely 5 percent of the notional amount, since it represents a much larger percentage of the gains to which he believed he was entitled. This sort of thing happens all the time, since pricing is controlled by a small group of market makers who often have a buyer lined up on the other side. Any money the "market maker" middleman squeezes out of buyers and sellers becomes profit.
Speculators aren't as fussy about language, because unlike hedgers, they aren't trying to match off risk. Often the interests of speculators and hedgers are misaligned, since hedgers often prefer that the underlying bonds (or other risk) recovers -- the risk is rarely completely hedged, because hedges are expensive. But speculators often make a naked bet. If a speculator is long credit default protection, the worse things get, the more the speculator makes.
Protect Yourself
There are so many issues in the credit derivatives market, that it's impossible to cover them all in a post. The Dodd Frank Act won't resolve the problems in the credit derivatives market, and bank lobbyists were successful in neutering effective change.
The disputes over credit default swaps on Greece highlight the fact that most participants in the credit derivatives market are at the mercy of ISDA when it comes to interpretation of ISDA's language. The only solution to that is to exercise one's rights, and insist on a custom-made over-the-counter contract that protects one's interests. As the past few years have shown, "regulators" won't protect investors either before or after the fact. You have to protect yourself.
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Greek Bond Restructuring - Do Bondholders Understand the Complexity?
Monday, March 12 2012 | 09:14 AM
Ron D'Vari
CEO & Co-Founder,
NEWOAK CAPITAL LLC | Greek sovereign bond restructuring has been both a prisoner’s dilemma and a game of chicken.
By next Thursday private holders of Greek bonds must decide if they accept a ‘voluntary’ bond exchange to reduce the face value of Greece’s overall debt by about €100 billion, involving a variety of sweeteners.
The restructuring proposal is a complex game of chicken by both sides. The deal will collapse if the holdouts exceed one third of private bondholders. Greece has to get at least two thirds of holders to participate or the Collective Action Clauses they have inserted becomes invalid. In actuality, Greece needs over 75% of the bondholders to endorse the proposal. Otherwise, both sides will lose as there appears to be no other solutions offered, making a default the de facto scenario.
Most of the posturing has already happened and presumably pre-negotiated via the Institute of International Finance representing a large body of investors. The bondholders had more leverage when the world was afraid of Greek default and/or ISDA declaring the exchange an Event of Default triggering a host of other defaults. But that has changed.
The entire process is a great learning experience in implied options and pre default collective bargaining. Most investors didn’t consider the borrowers’ option not to pay! In distress, what’s not in the documents can play as big a role as what’s in black and white!
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Greece and Credit Default Swaps: Bucking the ISDA Cartel - Part One
Monday, March 05 2012 | 09:59 AM
Janet Tavakoli
President,
TAVAKOLI STRUCTURED FINANCE | Credit derivatives were originally hyped as hedging tools to protect the value of a portfolio. For example, if you own a bond, you can buy protection against the possibility of default by paying a protection premium, similar to the premium you pay on an insurance policy. The difference between insurance and the credit derivatives known as credit default swaps (CDS) is that you don't actually have to own the bond in order to "buy protection." But like an insurance policy, you have to negotiate the terms of the contract.
Leverage and Language
Since I wrote the first edition of my book, Credit Derivatives and Synthetic Structures in 1998, (John Wiley & Sons, second edition 2001), nothing has changed for the better in the credit derivatives market. It is the first trade book about credit derivatives and stresses that these products are primarily used for leverage. The overwhelming problems are pricing and the risk of misinterpretation of the meaning of the contract language.
Language "Arbitrage"
Sometimes contracts are maliciously written to disadvantage the unwary; this is also called "language arbitrage," because manipulating the language makes a risk-free gain for the perpetrator. In April 2005, I explained to the International Monetary Fund (IMF) that no one in the credit default swap market should trust ISDA "standard" documentation. One has to rewrite the contract language to protect one's own interests.
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US-China Commerce: Is It Going Local?
Monday, February 13 2012 | 01:00 PM
Ron D'Vari
CEO & Co-Founder,
NEWOAK CAPITAL LLC | Increasingly cities and states are building their own direct commercial relationships with Chinese entities, sometimes directly contrasting the overall US human rights, trade, currency, and geopolitical agenda.
Given the importance of new investments and jobs, US local governments are aggressively pursuing their own strategies to develop direct commercial channels with China attracting capital and promoting trade. The general perception is that China is stealing jobs away from Americans and people from other developed countries. However, the internal growth of the second largest world economy has been driving demand for agricultural products (corn, beef), commodities, transportation, and luxury goods. Recent visible examples of that are Apple iPhone and iPads.
Furthermore, given a strong Yuan, Chinese companies are making direct US investments and creating jobs. Chinese billionaires have also invested in areas US investors have begun to shy away from, such as Hollywood movies and US media companies. Yet on the other hand, many US firms and conglomerates have increasingly established a local presence in China, such as GE, Citigroup and US auto companies.
While on the surface the US-China trade deficit is still growing, the actual US export to China itself is flourishing. This is due to growing overall volume of trades. As long as that is the case, states and cities will continue to expand their ties, and rightly so.
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RMBS: Who is the Servicer? (And Does it Matter)
Wednesday, January 25 2012 | 08:08 AM
Ron D'Vari
CEO & Co-Founder,
NEWOAK CAPITAL LLC | There are no national mortgage servicing standards. Score cards based on actual observed performance indicate servicing standards matters substantially. In the case of RMBS servicing data doesn’t lie.
Performance varies dramatically along various measures such as modification, short sale, balance reduction, foreclosure procedures & time lines, stop advancing, and REO liquidation strategy and recovery rates. They all affect magnitude and timing of cash flows that flow through RMBS waterfall.
The servicing industry is going through another wave of consolidation for non-agency sector. This creates variations in trends in even pools post transfer, not to mention servicing interruption impact.
Servicers’ incentives and economics are critical to the loss mitigation, default management process, hence recovery performance. Under current model (fixed-fee), servicers don’t have much incentives to dedicate optimal resources as their fees are limited. The performance is also affected by volume of troubled loans and corporate strength. The legacy servicing fee model is being questioned by regulators and investors for future securitizations and is expected to change.
There are several proposals to create an alignment of interest and better servicing incentives. Until then investors need to take that into account security by security and servicer by servicer.
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Volatility in 2012: Will It Linger Longer?
Tuesday, January 17 2012 | 10:18 AM
Ron D'Vari
CEO & Co-Founder,
NEWOAK CAPITAL LLC | While European woes have led to investors’ fears and market volatility, a host of other hazards pose potential dangers. Despite the US markets recent positive trends in GDP and employment, key uncertainties remain: housing market, foreclosures, budgetary political impasse, tougher regulations and legacy mortgage litigations. We should not forget that several trillion in planned budget cuts are still ahead. The impact of the slowdown in BRICs, jointly due to the European crisis and their own natural economic evolution, may not be compensated by the US economy and emerging markets.
The potential in rapidly expanding BRICs’ credit markets, particularly in China, should be watched. As an example, the first domestic AAA default in China had the potential to send shockwaves through the Chinese economy but was cured by the bond guarantor. The Arab Spring, Egypt’s election, and potential Iranian blockade of Strait of Hormuse are still looming.
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How Issuers can Increase Investor Interest in CMBS2 Mezz
Monday, January 09 2012 | 08:34 AM
Malay Bansal
Managing Director,
CAPITALFUSION PARTNERS | Why New Issue CMBS deals see little interest in Mezz classes and what Issuers can do about it.
A year ago around this time, the mood amongst CMBS market participants was quiet optimistic. Estimates of new issuance for 2011 from market participants generally ranged from $35 Bn to $70 Bn or more, on the way to $100 Bn in a few years. However, over the course of the year, the optimism has faded. New issuance totaled just $30 Bn in 2011, and forecasts are not much higher for 2012.
With more conservative underwriting, higher subordination levels from rating agencies, and wider spreads, new issue CMBS was expected to be attractive to investors. Yet, investors seem to have pulled back, and spreads have widened for both legacy and new issue deals. Macro level issues, especially uncertainty about Europe, are part of the reason. However, CMBS spreads have been far more volatile than other sectors including corporate and other ABS. As the table below shows, even new issue AAA CMBS spreads widened a lot more than other sectors. This spread volatility not only deters investors, but also loan originators from making new loans as they do not have a good hedge to protect them while aggregating loans for securitization. It also requires wider spreads for CMBS loans which makes them less attractive to borrowers.
One of the main reasons CMSB spreads widen quickly is that the sector has far fewer investors than other ABS sectors and corporate bonds. The reason there are fewer investors is that, with fewer loans, CMBS deals are lumpy and investors need the expertise to analyze collateral at the loan level. Not every investor has that expertise. So, they can feel comfortable analyzing RMBS, Credit card, Auto, Equipment, and Student Loan etc deals, but not CMBS. The creation of a super-senior AAA tranche helped bring more investors to AAAs by making the tranche safer needing less analysis. That is part of the reason AAA spreads have tightened.
Spreads for classes below AAA, however, continue to be very wide, as the mezz tranches have even fewer investors. Unfortunately, Insurance companies, which are perhaps the most knowledgeable commercial real estate investors and ones with resources to analyze the CMBS deals at loan level, tend to buy mostly senior tranches. Mezz tranches are left to a very small set of buyers. That means lower liquidity for these tranches, and less certainty about receiving a decent bid if needed. An additional issue is lack of transparency on pricing, as these are small tranches that do not trade frequently and each one is different depending on deal collateral. These factors make these classes even less attractive to buyers.
The table below shows the structure of a recently priced CMBS deal. The $674 mm deal has $118 mm of senior AAA, $55 mm of junior AAA, $104 mm of mezz tranches and $44 mm of B-Piece.
What makes Mezz tranches more difficult for investors is that they have lower credit enhancement than AAAs and they are generally very thin tranches representing about 3% to 4% of the deal. In other words, a 3% higher collateral loss could result in 100% loss on the tranche. That means investors require even more conviction and expertise to invest in these classes. The thin tranches are also more susceptible to rating downgrades if any collateral in the deal faces problems. This fear of ratings volatility is another big concern for investors.
One idea, that addresses both the spread volatility and the potential ratings volatility, is to do the opposite of what we did for the AAA – combine all the Mezz tranches into one single class. In this deal, instead of creating classes B, C, D, and E, there could be just one Mezz class. It will be a $104 mm class with average rating of around A-. At a thickness of 15% of the deal, this class will not be at risk of 100% loss if collateral loss increased by mere 3%, and so will be much less susceptible to spread and rating volatility. Also, with just one larger class, there will be more owners of that class and there is likely to be more trading and visibility on spreads, enhancing transparency and liquidity. If the combined Mezz tranche is priced around 640 over swaps or tighter, the issuer will have the same or better economics as with the tranched mezz structure. This will still be a significant pickup in spread for the same rating compared to other sectors and will probably bring in some new investors who were considering CMBS but were hesitant. At about 15%, the Mezz tranche is thicker, but still a small part of the deal. So, even a small number of new investors will make a difference.
And the issuers can try this structure without taking any risk at all. That is possible by using a structural feature that has been used in residential deals (which are also REMICs): Exchangeable Classes. The deal can be setup so that some investors can buy the tranched classes while others buy a single Mezz class. The structure allows owners of one form to exchange for the other form at any point in future using the proportions defined in the documents. This has been used for a long time. I used exchangeable classes extensively in $52 Bn of new CMOs when I was trading and structuring CMOs. Freddie, Fannie, and Ginnie deals regularly have them under the names MACR, RCR, and MX respectively.
There is no single magic bullet, but small changes can sometimes make a big difference. Some, like this one, are easy to try with a little extra work, no downside, and possibility of enlarging the pool of CMBS investors with all the benefits that come from it for investors, issuers, and people employed in the sector.
Note: A version of this article was published in Thoughts on Markets & Economy
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China Home Prices Cooling Off: Is It a Blessing?
Tuesday, January 03 2012 | 10:30 AM
Ron D'Vari
CEO & Co-Founder,
NEWOAK CAPITAL LLC | The latest home prices data in China confirms the broad-based falling trend for home prices in China. New home prices dropped from the previous month in 49 of the cities monitored by the government, according to the Chinese national statistics bureau. The dampening of home sales and falling prices is a natural outcome of government real-estate industry curbs. Despite the European crisis and other easing measures, the government has reiterated its tightening property policy and intensified the restrictive measures this year by raising down payment and mortgage requirements, and have imposed further home purchase restrictions in key cities. Analysts expect the real-estate policies are targeting home prices to fall by as much as 20% from their peaks in 2011.
The government’s main goal is to reduce speculation in the sector and avoid a drastic credit bubble burst induced by real estate. The restrictive measures seems to be working gradually and are expected to further cool off Chinese property markets throughout 2012. The controlled and gradual falling of Chinese home prices may prove to be a blessing and not cause for concern. In retrospect, it would have been wise if the US government had followed a similar path and imposed more restrictive mortgage lending measures starting in 2004 to prevent the precipitous and uncontrolled home price fall in 2007.
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Collateral Management Rules: Flawed or Too Complex?
Tuesday, December 13 2011 | 01:40 PM
Ron D'Vari
CEO & Co-Founder,
NEWOAK CAPITAL LLC | MF Global clients’ unaccounted segregated funds case indicates that re-hypothecation can be potentially used as a loophole.
The international rules for movements of cash and collateral accounts for brokerage firms are complex. With the off-balance-sheet accounting for sale-and-repurchase agreement (”repo”), it is usually hard for the regulators to get a really transparent picture of the capital adequacy and liquidity of larger broker dealers.
Depending on each account’s permission settings, brokerage firms may be able to purchase U.S. treasuries, and in some cases non-U.S. sovereign bonds in their own name using the unencumbered clients’ segregated funds and re-hypothecate them to back their own trades.
The U.S. re-hypothecation rules are much stricter than the UK rules. Hence many prime brokers’ agreement terms allow for a U.S. client’s collateral to be transferred to the prime broker’s UK subsidiaries under a Global Master Securities Lending. This typically shows up under ‘Consent to Loan or Pledge’ provision.
The Dodd-Frank Act attempts to bring in more transparency to the middle and back office operations involving the mechanics of the clearing and settlement of cash and derivative trades, the movement of cash and collateral, and risk management. It remains to be seen if the new rules avoid re-hypothecation loopholes.
It is clear that collateral management rules will remain complex, however, the jury is still out if they would be less flawed.
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Global Malaise: Is Free Trade in the Asia-Pacific Region the Savior?
Wednesday, November 16 2011 | 08:07 AM
Ron D'Vari
CEO & Co-Founder,
NEWOAK CAPITAL LLC | While all eyes have been focused on the financial troubles in Europe and looking for a quick monetary fix, President Obama and Asia-Pacific leaders have been concentrating on forging a free trade regime and touting it as the main engine for the global economic recovery going forward.
The fallout from Europe’s crisis is the lowering of global growth expectation. This would further exacerbate the fiscal and monetary issues across the developed world. The Global leaders have been desperately looking for real sources of global economic stimulation. While China has hinted on economic policies growing their imports in balance with their exports, the market has been skeptical due to economic contractions elsewhere. With the rapid growth of the middle class across the Asia-Pacific region, job growth in western economies will have an enormous dependency on not only domestic economic competitiveness but also free and open trade across the region.
A U.S.-backed plan to bring about an Asia-Pacific free trade zone has gotten somewhat of a boost by Japan, Canada and Mexico, expressing preliminary support despite China’s cool reception. To be realistic, agreements on free trade rules are hard to achieve politically, invariably because the protected economic sectors (typically unionized) will lose their advantages, hence politically resistance, while others get to benefit from their ability to export. Given the complexity of the job market and public opinion dynamics, it is naive to expect the Asia-Pacific free trade initiative as the cure to the current problems, but the hope is it will be the long term savior.
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Clear and Present Danger
Tuesday, November 01 2011 | 10:44 AM
Janet Tavakoli
President,
TAVAKOLI STRUCTURED FINANCE | The United States is the largest debtor nation in the history of the world, and our borrowing is increasing. In 1950 spending for social programs was only one percent of the total Federal Budget. As the economy grew, social programs expanded to include Social Security, Medicare, Medicaid, Food Stamps, Unemployment Compensation, Supplemental Security for the Disabled, and educational programs. In 1983 as the United States pulled out of an ugly recession and brought inflation under control, social programs consumed 26% of the budget. In fiscal year 2012, they'll eat up an estimated 57% of the budget.
The original idea was that if everyone agreed to chip in a small percentage of ever growing income, the percentage of social spending would never have to change even if the programs grew. The percentage for social programs could stay constant because if income doubled every twelve years or so, the amounts available for welfare would also double. Military budgets soared, the U.S. waged unfunded wars, the banking system was bailed out of the consequences of unwise lending more than once, and government bureaucracy grew rapaciously. All of this would likewise be covered by taxes assessed on growing income, or so the theory went. Like many academic economic theories, it was a convenient but misguided story. No country has ever managed to create a perpetual growth machine for its economy.
Time and again U.S. growth was brought to a standstill by (among other things) oil shocks of the kind the U.S. experienced in 1973 and 1979, monetary shocks of the kind the U.S. experienced in 1981, and systemic financial crises of the kind the U.S. experienced in 2008 and will likely experience again in the not too distant future.
Growth in the U.S. has been hobbled by moving many of our smokestack industries and soft manufacturing industries offshore. Traditionally weakening the dollar relative to stronger currencies like the Chinese yuan (the renminbi) stimulated growth as relative labor costs sank in the U.S. Today, much of the benefit of this strategy leaks to offshore manufacturing facilities.
Periods of anemic growth meant the U.S. had to raise taxes, but there is a limit to how much the economic engine and the population will tolerate. Hiking tax rates invites inflation, and artificially low interest rates are a hidden tax that punishes savers while food, energy, and medical care costs have soared. The U.S. can impose consumption taxes on liquor and other discretionary items, impose higher taxes on the rich, and possibly impose a confiscatory wealth tax, but eventually the U.S. will reach a point where this will be counterproductive.
U.S. debt now approaches 100% of GDP. In the long run the U.S. will have to cut social programs and increase taxes, but in the short run the U.S. cannot adjust quickly enough. If the U.S. has to pay its debts and it can't tax more, then it must borrow more. In fact, we are borrowing more, and how we borrow matters.
High rates of debt to GDP are the chief danger to any country's economic future, and any method of borrowing holds its special brand of danger. There are only three ways to fund a government deficit: foreign borrowing, domestic borrowing with monetary expansion, and domestic borrowing without monetary expansion. The U.S. has chosen a combination of the first two. Of the three, the way to get into big trouble very fast is to become dependent upon foreign borrowing. Treasury note and T-bill issuance as of second quarter 2011 was around $14.4 trillion, and the total bond market size estimate by SIFMA (less intergovernmental debt held by the Federal Reserve and Social Security Trust) was around $9.2 trillion. Total foreign holdings of $4.5 trillion represented around 31% of total Treasury issuance or around 48% of SIFMA's estimated government bond market. China's and Japan's combined holdings represent around 14% of total issuance or around 22% of SIFMA's estimated traded government bond market. As of June 2011, Japan held $911 billion or around 20% of U.S. foreign U.S. Treasury holdings, and China held around $1.16 trillion or approximately 26% of foreign U.S. Treasury holdings.
Why are foreign borrowings such a huge risk for the United States? The funds are currently kept in dollars a lot of which is with American banks. That money is yankable and that can cause a run on the dollar. Military leadership addresses the threat of attacks, and administrative leadership must address the clear and present danger of financial withdrawals. The dollar is still the world's reserve currency, but that advantage doesn't make the dollar bullet proof. U.S. dollars can be converted to yen or to euros. On October 17, China took a key step to internationalizing the yuan and making it an alternative to petrodollars if not an alternative reserve currency; Hong Kong's Chinese Gold & Silver Exchange Society now offers gold quoted in yuan.
This might have been worth the risk if foreign borrowing had been invested for roads, high speed railroads, new industries, cheap energy, airports, and to fund scientific research. The debt would self-liquidate. Instead, some of the debt has been used for transfer payments to fuel current consumption or for items like farm subsidies. It's as if you mortgaged your house to buy groceries. Eventually you'll have no house and no food either. Moreover, a very large chunk of the debt has been monetized through Federal Reserve Bank purchases and used to fill gaping holes in bank balance sheets. Unrepentant banks resist reform and dilute attempts at regulation while soaking up ongoing subsidies. All of this is dead-end financing at the expense of citizens that saved their money and pay taxes.
Greece's distress is an extreme example of what happens when debt service is high but investment in the economy is insufficient. According the Wall Street Journal, "Parliament member Panagiotis Kouroumplis...supported the first bailout, but, he says, 'every single euro we got went for debt. We haven't spent a single euro on development.'" The U.S. has a bigger and broader economy, but our bailouts--and the financial malfeasance that preceded and follow them--have nonetheless given our producing economy a body blow while chiefly benefiting fee-seeking dead-end financiers that eat up an outsized percentage of the nation's GDP.
In 1978, we averted a near-crash of our financial system after Kuwait refused to renew a more than $1 billion deposit with J.P. Morgan (then Morgan Guaranty). The Federal Reserve intervened to stabilize the dollar and averted a "19th Century financial panic" that would have triggered a "genuine depression."[1] In 1979 as tensions escalated with Iran, the U.S. sequestered Iranian assets to prevent a repeat of the near-crash in 1978. In the first years after these events, the U.S. seemed to have learned its lesson and reduced foreign borrowings--including borrowings from the Saudi's and Kuwait--to around 7% of total borrowings. Decades of bad policies, unfunded wars, and uncontrolled chaos in the financial system ballooned our debts and our foreign borrowings. Today's foreign borrowings are 31% of total issuance or 48% of the estimated government bond market. The U.S. is in hock to foreigners again, particularly to Asia.
How does the U.S. try to counter the danger represented by foreign borrowings? After exporting our profligate spending to China with no intention of reform, we wield the implied threat that if China doesn't continue to lend to us, it will go down with us. The Chinese may not see it that way as they feel the pinch of inflation, experience inevitable cyclical growth slowdowns, and develop new trading partners.
Foreign borrowings of the United States represent a clear and present danger to the U.S. dollar and to the U.S. financial system. Potential dumping of U.S. dollars would start a run on the currency and a financial panic that would tip our already precarious economy into a deep depression. No matter how much currency central banks use to try to manipulate exchange rates, the market always has more. The U.S. needs contingency plans against a large scale withdrawal of funds from the U.S. and from U.S. financial institutions. In the gravest extreme to avoid a run on the U.S. currency and a collapse of the U.S. economy, the U.S. requires a standby plan to sequester a foreign nation's funds, just as we have done in the past.
1 Janssen, Richard F., and Levine, Richard J., "A Threat to Economy Was Factor in Pressing U.S. to Defend Dollar," Wall Street Journal (Front Page), November 6, 1978.
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EU Theater: Halfway Mark!
Thursday, October 27 2011 | 01:27 PM
Ron D'Vari
CEO & Co-Founder,
NEWOAK CAPITAL LLC | Progress has been made in the first of two EU summits to tackle the EU crisis, as Germany has won its way to rule out tapping the ECB’s balance sheet to leverage the EFSF rescue funds.
The various approaches now seem to be converging. The estimated €100 billion bank capital deficiency will first be met by banks, then by national governments, and lastly by the EFSF, under strict conditions. The EFSF will also guarantee new government bond sales as a way of leveraging its firepower. However, we don’t believe ring fencing alone will be the full solution. The EU needs to build enforcement mechanisms for fiscal discipline that have real teeth. It also needs a lender of last resort with a real financial mandate. Private conversations between leaders, such as those with Berlusconi over the weekend, are ultimately not the way to go. Markets have been demanding explicit enforcement mechanisms that are currently lacking. The EU is starting to acknowledge that its governing treaties need to be revised to ensure better management in the future. However, no one expects meaningful changes anytime soon, so we should expect more of the same EU theater ahead.
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Understanding Markit’s TRX.II Index for Hedging CMBS Loans
Friday, October 07 2011 | 09:19 AM
Malay Bansal
Managing Director,
CAPITALFUSION PARTNERS | Newly launched TRX.II may seem complicated, but is not difficult to understand.
Markit launched TRX.II or TRX 2 indices this week. Details and various documents can be found on their website, but for those not familiar with the working of the index, or if the details on upfront payment and dynamic nature of the index are not clear, this article might help understand the mechanics and the underlying logic.
The Basic Concept
The concept is simple. Going long or buying the TRX.II (or TRX) index is similar to buying a bond. If you buy a bond, you get the coupon. Also, if the spread goes lower or tightens, resulting in lower yield, the bond price increases. Same is true with going long the TRX index. If you go long the index, you get a coupon, and if spread tightens, the value of your position goes up. And just like a cash bond, if spreads widen, the value of the position goes down.
The concept is similar, but there are some differences in implementation as the TRX is a contract (Total Return Swap contract) rather than a physical bond. For one party to go long, there has to be another party to take the short side. All that is needed for a TRX trade are the two parties wanting to take the opposite positions, and neither has to actually own or find the underlying bonds to initiate or close a position. TRX contracts will trade with quarterly expirations with a maximum length of one year. Since the contracts will be standardized, the trade may be initiated with one party taking the other side, and may be closed before expiry, if desired by either party, by doing an opposite trade with a third party. This ability to short easily is what makes it possible for loan originators to hedge their loans being aggregated for securitization.
Once they enter into a contract, at the end of every month, the short party pays the coupon equivalent to the long party. Also, if the spread is tighter at the end of month than at the beginning, then the short side pays the price appreciation calculated based on average duration and spread change to the long side, and vice versa. These payments take place at the end of every month, or till the end of contract. Each month, the spread at the beginning of the month becomes the new starting point for spread change for that month. Also this spread is the coupon that the long party gets for that month. It is paid by the short party and represents the cost of hedging.
Upfront Payment
The main purpose of the upfront payment in TRX is to handle trades initiated in the middle of the month.
For example, if someone goes long on 11th day of month, they should get the coupon only for the remaining 20 days in the month, even though the short will pay full 30 days interest or coupon at the end of the month. So, just like in cash bond, the buyer pays an accrued interest for 10 days to the short. Net result will be the short will pay and the long will get net 20 days of the coupon for that month.
Similarly, upfront payment adjusts for spread movement and traded spread. An example may help. Let’s assume the spread at the beginning of the month was 200, at the time of the trade was 230, and at the end of month was 220. In this case, spread tightened from 230 at the trade date to 220 at the end of month. So, the long party should get payment for the value of 10 basis points tightening at the end of the month. However, the standard payment mechanics will see widening from 200 at the beginning of the month to 220 at the end of the month, and will require the long party to pay the value of 20 bps. The upfront payment provides the adjustment that enables the normal end of month payments to take place in the usual manner. In this case, the upfront payment will be the value of 30 basis points (30 bps widening from 200 at the beginning of the month to 230 trade spread) paid by the short to the long. The net effect will be the long getting the value of 10 bps tightening, as he should.
Revolving Nature of TRX.II
One big difference between TRX and TRX.II is that TRX.II is a dynamic index and has a revolving underlying portfolio whereas the original TRX or TRX.I was a static index. The TRX.II will be rebalanced every quarter to include recent deals meeting the inclusion criteria. The initial TRX.II index has 18 bonds. The index rules specify a maximum of 25 bonds. Once the index reaches 25 bonds, the older bonds will be removed as new bonds are added.
The dynamic nature introduces some complexity, but key points to keep in mind are that all TRX.II trades for a specific maturity are fungible with one another and each payment calculation references spreads and average duration for the same set of index constituents. What that means is that when the index changes, the end of month spread for payment at the end of that month is based on the old index, and the starting index for next month is based on the new version of index with new bonds. To enable this, Markit provides numbers for both the old and new version of the index. Rest of the mechanism stays the same.
Spread Determination
The spreads used for monthly settlements are calculated and provided by Markit based on spreads provided by the ten participating dealers for the underlying cash bonds. The fact that the TRX.II will settle every month to actual cash bond spreads means that it will be expected not to stray too far from cash bond spreads. The resulting high correlation with spreads on recently issued cash bonds makes the TRX.II a good hedge for loan originators.
The dealers provide spreads on the individual constituent bonds, not the spread for overall indices, which are computed by Markit. This ensures consistency between spreads for the old and new versions of the index, when the index is adjusted to include new deals.
For the more technically oriented, Markit’s calculation methodology involves using individual bond cashflows to calculate prices from the average bond spreads for each bond and then using aggregated index cashflows and average price to generate index spread, weighted average life, and duration. The end of month calculation of price change from spread change uses the averages of beginning and ending durations and index prices, which captures the majority of the convexity effect.
Outlook for TRX.II
I have asked for creation of a new TRX index for a long time (Restarting CMBS Lending, Feb 9, 2010). So I am happy to see it getting launched. I also like that Markit created a dynamic index which will always reflect spreads on new issue bonds, though that makes it more attractive to hedgers than to investors who may prefer to go long a known set of bonds.
TRX.II is a much better hedge than CMBX as it settles every month based on cash spreads and so is correlated with cash bond spreads, unlike CMBX which pays only when there are actual defaults (far into the future) and can trade purely based on technical factors with no correlation to new issue cash bond spreads. TRX.II is also a better hedge than TRX.I which references the old legacy CMBS deals and does not correlate well with new issue CMBS spreads.
One question on the minds of many people is if the index will gain traction. The general view is that the demand from originators will be there to short to hedge loans being aggregated for sale via securitization, but there may not be enough demand from the long side. It may turn out to be the other way. With spreads wide at present and few deals in the pipeline, the index may see more demand from long side than short side. Hedging of loans for spread movement today is not an almost mechanical process it used to be (CMBS Hedging Requires a New approach, July 5, 2011) and different originators favor different strategies. However, no matter what method is used, hedging has a cost. When spreads are wide and expected to tighten, many originators prefer to hedge just the interest rates and not the loan spreads. Barclays created a CMBS 2.0 index earlier in the year, but it has not been used much, partly for that reason. The TRX.II may benefit from the fact that some originators are now being pushed by their risk management groups to be fully hedged, and TRX.II will have higher correlation with actual cash bond spreads than any alternative. Also, TRX.II has ten licensed dealers. So, there may be more liquidity and more openness by their internal origination groups to use it for their hedging.
Note: A version of this article was published in Thoughts on Markets & Economy (http://marketsandeconomy.wordpress.com/ )
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Crisis of Confidence - Opportunity for Adding Alpha in Debt and Volatility?
Monday, October 03 2011 | 11:41 AM
Ron D'Vari
CEO & Co-Founder,
NEWOAK CAPITAL LLC | While there have been significant signs of a slow-down in economic growth since May, you wouldn't know it by looking at U.S. retail sales – up 0.5% in July, 8.5% higher than last year, and up 8.2% for May-July.
Retailers have grown their earnings on average by 11% in the second quarter.
However, there are a lot of clouds on the horizon as consumer confidence is weakening, which is heavily influenced by exogenous factors such as the stock market, political uncertainty and negative headlines.
As a result, many are bracing for a much weaker second half due to consumers confronting the prospect of losing their jobs.
This is primarily a crisis of confidence rather than the much deeper financial crisis in 2008 and 2009, driven by the balance sheet of banks being bloated and over-leveraged with bad real estate debt.
Most concerns today are attributable to one of the following key issues:
1) Eurozone Identity Crisis - fiscal union or breakup of euro
2) Poor US Budget Gap Management – political stalemate and age of austerity
3) US Structural Problems - shadow housing inventory and poor employment mix
4) Central Bankers Dilemma – price stability vs. growth
5) Harsh Regulatory Environment – over regulation, e.g. risk retention rules, collateral margin requirements for OTC derivatives
Despite all the negatives, there are vast global opportunities to add alpha in debt-like investments with stable cash flow or take advantage of the much higher volatility than normal to accumulate diversified global equities and manage the beta risk.
Of course those looking for undiscovered sources of alpha in over-picked public markets must work harder and possibly retrain themselves as riding the beta waves of return has gotten riskier than ever.
Despite the unprecedented low base yields across the curves, there are very unique opportunities created due to the availability of credit for certain out-of-favor fixed-income asset classes.
The opportunities can be categorized in two ways – short-and-juicy and long-and-stable.
Examples of high alpha but short maturity include:
1) government guaranteed mortgage warehouse equity funding
2) single-family REO rehab finance
3) supply chain finance (factoring)
4) consumer durable leases
5) fully-collateralized premium finance.
In most of these cases the average life is less than one year and as short as 1-2 months. The yields for these opportunities are double digit, depending on the position in the capital structure.
Alternatively, investors can consider Norwegian 3-month NIBOR at 2.93% and 2-year Norwegian Government bonds yielding around 2.20%. The risks in the former opportunities are operational in nature and controllable. The risks in the latter entail leverage, currency and rate differentials.
Examples of the longer term opportunities with stable cash flows requiring non-traditional infrastructure include:
1) newly-originated non-agency residential whole loans
2) newly-originated commercial real estate loans
3) senior-secured loans to specialty finance companies
4) middle market senior secured loans
5) municipal revenue bonds
6) esoterics including structured settlements
7) renewable energy project finance
8) tenant improvement finance for commercial tenants
9) nonperforming residential, student and consumer loans (non- securities).
Both short-and-juicy and long-and-stable opportunities require special infrastructure for understanding the underlying fundamentals, disciplined management of the origination, credit due diligence, funding, closing, servicing, workout, and investor transparency.
Further, it requires a special origination operating platform and tight operational and financial risk management.
In the highly volatile world of global equities, managing portfolios requires systematically assessing both alpha potential as well as non-linear transaction costs to be able to take advantage of them in a timely fashion.
The necessary quantitative equity tools provide disciplined formulation of driving fundamental and technical factors and allowing the estimation of each stock's return potential and constructing optimal portfolios.
NewOak's transparency, risk and portfolio management tools (OpenRisk and Stratus) are designed to enable its clients to source and execute high alpha opportunities in highly granular and hard-to-value assets along with the traditional fixed-income and equity portfolios. They provide full transparency for the risk and reward for portfolios as well as help manage process flows.
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U.S. Banks – It Ain’t Fair!
Tuesday, September 13 2011 | 07:57 AM
Ron D'Vari
CEO & Co-Founder,
NEWOAK CAPITAL LLC | When one of the largest US bank’s chiefs cries “it ain't fair”, it must not be fun anymore to run a US-based global bank. The challenge banks face is how to position themselves optimally to face Dodd-Frank, Basel III, litigation fights, and a deteriorating economy, all at the same time.
In addition to Dodd-Frank's regulatory reforms on their home turf, large US-based global banks will incur additional costs due to Basel III, including higher capital requirements, less favorable treatment of US government-guaranteed RMBS vs European covered bonds, restrictive securitization framework and tougher consumer-lending regulatory compliance requirements.
To complicate matters, most US banks must also deal with convoluted structured product litigation matters from a variety of angles including servicing, origination, packaging, distribution and management, which will be costly to the overall economy. The playing field seems to be tilted more favorably toward the large Asian financial institutions benefiting from faster growth and less onerous regulatory requirements. It is not just Basel III that is "anti-US", but Dodd-Frank and where the US is on our cycle of fiscal and monetary policies.
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How to Finance Infrastructure and Clean Energy Investments
Tuesday, September 06 2011 | 08:17 AM
Malay Bansal
Managing Director,
CAPITALFUSION PARTNERS | Investments in clean energy and infrastructure projects can help address the unemployment problem and make American business more competitive. The challenge is financing these investments in the current environment. There is a creative solution available that does not require new taxes, printing more money, or increasing the deficit.
The President is set to propose investments in infrastructure and clean energy in his jobs speech next week. There are several reasons that make spending on infrastructure and clean energy a good idea at this time: the jobs created are local and cannot be exported, the jobs created are in sectors like construction that are facing higher unemployment, it generates demand for products and services from a variety of industries creating more jobs, deteriorating US infrastructure is sorely in need of maintenance, and now is a good time to make these investments as raw materials and labor are cheap (maintenance is necessary and overdue - not doing it now just means that it will have to be done at a later time when it will likely cost more).
Even though infrastructure investment is a good idea, it faces two big problems.
First is the need to finance these investments. With the focus on reducing deficit, it will be difficult to get everyone to agree on spending money on these projects. The President has made similar proposals in the past. Republicans are almost certain to oppose more spending and any taxes to pay for it this time too. The bankruptcy filing this week by the solar power panel maker Solyndra, which had $527 million in loans from Federal government, and had been praised by the President, will be held up as an example by many of a poor government investment that put public money at risk, and a reason why government should not get involved.
The second problem is picking projects that are productive and not just a waste of money. Government may not be the best judge for picking the best projects.
The solution to both problems is increased involvement of private sector.
However, to get the private sector to invest in infrastructure projects, the government has to provide incentives, but in a way that does not increase deficit or taxes. One creative possibility for doing this may be by using the estimated $1 trillion of unrepatriated profits US companies hold in foreign subsidiaries.
American companies can generally defer paying taxes on foreign profits as long as they keep the money outside US. When they bring the money back to US, they have to pay the top corporate tax rate of 35%. To defer taxes, US companies generally have left large sums of profits in their foreign subsidiaries. These untaxed profits are part of the reason large multinationals have lower overall tax rates for which they have been criticized at times.
The administration has proposed taxing worldwide income of US companies, but faced strong opposition since that would put the US companies at a competitive disadvantage.
On the other end, US companies are arguing that they could bring back the earnings in their foreign operations if the US government offered a tax amnesty and permitted them to repatriate foreign earnings at a low rate of around 5% instead of the 35% federal tax they face at present. They argue that 5% tax could bring $1 trillion back to US for increased economic activity and could generate additional $50 billion in federal tax revenue.
The tax amnesty will not result in an increase in deficit or taxes, as government is giving up what it is not getting anyway - without it, these funds will not come back into the US economy, and the Treasury will not get the additional tax revenue.
However, the tax holiday idea has been opposed by many as the funds brought back will not necessarily be used to generate jobs. The companies could use the money for M&A activity, stock buybacks, and paying out dividends. A similar tax-amnesty program was implemented in 2004. However, of the $362 billion that was repatriated, very little was used for actual investments to create jobs.
A better idea, one that addresses this concern, will be to offer the tax amnesty only to the funds brought back that are actually invested in infrastructure and clean energy projects in the US. However, money is fungible, and it can be easily moved from one bucket to another. To ensure that the tax break really results in investments that create jobs, the repatriated money has to be separated from the other funds of the repatriating company. Hence, for this idea to be effective, the funds brought back must be invested with third-party private fund managers for a minimum number of years to qualify for the tax break.
A limited time tax amnesty will encourage US companies to repatriate earnings back to US quickly. A requirement to invest in infrastructure projects for a minimum fixed number of years (say something between 3 to 5 years) will ensure that the funds brought back create jobs. Companies will be allowed to invest in either debt or equity depending on their risk-reward preferences. Government will not be involved in making investment decisions. All investments will be chosen and managed by private fund managers, who will pick projects and investments based on sound economic calculations of cost-benefit and expected returns. The companies will be free to pick any fund manager based on their judgment of manager’s capabilities and investment strategy.
This basic framework could be enhanced in several ways. Companies could be encouraged to invest for a longer period by offering to reduce any taxes on the earnings from the infrastructure investments, if the investments are held for say 7 to 10 years or more. Also, companies could be allowed to use part of funds brought back to build new plants for their own use, or setup funds that finance purchases of company’s products.
This proposal is a middle of the road approach which addresses the problems the US economy is facing in a productive way and should be acceptable to both sides. Even if there are plans to change rules to tax worldwide earnings of US companies in future, it still makes sense to address the past earnings that are held outside US.
Longer term, the US needs to develop regulations that clarify and encourage private sector investment and involvement in the clean-energy and infrastructure sectors, both of which are essential for the growth and competitiveness of the US economy in the longer term. The areas that need attention from lawmakers and regulators include Public-Private Partnerships, securitization of infrastructure financing, and eligibility rules for MLPs and REITs.
Note: I originally wrote about this idea in November 2010 and shared it with several policy-makers, elected officials, industry chieftains, think-tanks, and members of the media. Given the state of the economy, the idea is more timely and urgent now. The original, more detailed, article is at http://marketsandeconomy.wordpress.com/2010/11/23/tackling-the-us-unemployment-problem/.
A version of this article was published in Thoughts on Markets & Economy.
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CLO Manager Consolidation: Is The Timing Right?
Wednesday, August 31 2011 | 08:14 AM
Ron D'Vari
CEO & Co-Founder,
NEWOAK CAPITAL LLC | After 4 years of anticipation by investors, we are finally seeing CLO manager consolidation occurring in a meaningful but yet modest way.
The CLO market had gone from being driven by equity-investors/managers seeking leverage in early years, to an asset management/structuring fee play by the mid 2000’s. This led to a proliferation of smaller managers hanging on for the market re-opening for new issuance post-2007. Because of the pending Dodd-Frank’s risk-retention rules requiring issuers to keep 5% of equity and debt, smaller CLO managers without an outright equity capital or sponsorship are more willing to sell out.
The timing of these consolidations may appear unwise in light of the volatile markets, lower expected growth and uncertainties about European bank capital issues. However, since the funding spread of the existing CLOs are fixed, wider loan spreads for reinvestment will lead to higher equity cash flows and returns. Depending on the combined price of management fees and purchased equity cash flows, the strategy of acquiring smaller CLO managers could make sense today for larger managers.
Longer term, CLO manager consolidation is a negative factor for the corporate loan issuers as it reduces their investor base and their pricing power. Higher spreads due to a weaker economy is already expected, so the only good news for corporate issuers is that Libor will stay low for quite a while and keep their overall funding costs low.
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Investing: Bad News, Good News, and What's Next
Tuesday, August 30 2011 | 02:14 PM
Janet Tavakoli
President,
TAVAKOLI STRUCTURED FINANCE | The manic depressive market wildly swings up and down on each new news story: The Fed is meeting at Jackson Hole on August 27 possibly to discuss QE3 (or not), and that news may pump up the stock market. But China's banks seem to be using Enron's accounting manual, Europe's banks need liquidity and are loaded with bad debt, and U.S. banks only temporarily TARPed over trouble. Gaddafi's regime in Libya appears over, but Libya's oil output may not fully recover for years. Venezuela wants banks to open their vaults and send back its gold, but Wells Fargo says gold is a bubble. Pundits say gold is a barbarous relic, but exchanges and banks are now using gold as money. The U.S. is headed for hyperinflation with skyrocketing stock prices, but on the other hand, we seem to be deflating like Japan and doomed to a deflating stock market for another decade. Whom do you trust and what should you do? No one knows where the stock market or U.S. Treasury bonds are headed tomorrow, but in my opinion, here are some fundamentals to consider.
The Bad News Isn't Going Away
Until we have real global financial reform and restrain the banks, we won't have sustained growth. The stock market hasn't hit bottom. There's a crisis of confidence in banks and all currencies. We haven't taken effective steps to tackle the U.S. deficit through productivity. We haven't examined spending to eliminate fraud and waste, and we haven't addressed our need for more tax revenues by eliminating the Bush tax cuts (for starters).
Savers are punished by "stranguflation:" negative real returns on "safe" assets, declining housing prices, and rising costs of food, energy and health care. The Fed touts the falling cost of I-Pads, but how often do you buy one of those, and how often do you eat?
Good News (for Now)
The USD is still the world's reserve currency. Even though we devalued the USD, there has been a global flight to U.S. Treasuries pushing down our borrowing costs (yields). No one in the global financial community feels the U.S. has done its best to correct our problems, but severe problems in Europe, China's inflation, and Middle East unrest has money running to the U.S. Since we've devalued the dollar, we appear to be a bargain for foreign investors, even though they are terrified by our money printing presses and the potential for inflating commodity prices in the long run.
How did I play this? My own portfolio is currently more than 20% gold with some silver, and I bought out-of-the-money call options on the VIX when it was in the teens with maturities of 4-6 months. This is "short" stock market strategy, one could have also done well buying puts on the S&P a few months ago. In the first big stock market downdraft in August, I sold the options when the VIX hit the high 30's, and I'll buy more options again if the VIX falls again. Many investors are not comfortable with options, and this strategy isn't appropriate for everyone. The rest of my portfolio is chiefly in cash or deep value opportunities.
What Happens Next?
No one knows for sure, and anyone who tells you he or she does is selling snake oil. The situation is fluid. We tried to reflate our deflating economy. Our massive dollar devaluation may encourage investment, because it's protectionist. It reduces our cost of labor, among a few other "benefits." The problem is that the Fed has printed money, and we haven't done anything to position the U.S. for greater productivity. We're trying to inflate our way out of a problem without investing in productivity. This is a very dangerous way of attacking this problem. Even more "stimulus" would just be an attempt to inflate our way out of our long-standing deep recession. That's the foolish and unsuccessful strategy we've adopted so far. That could lead to runaway budget deficits (our deficit already looks intractable) and bring us to double-digit inflation. Even the European flight to US Treasuries may not save us from a deeper recession in that scenario.
If we don't overreact -- and we may have already overreacted -- our dollar devaluation results in our foreign trade situation first getting worse (as it has now) before it gets better. Now is the time (actually, we should have started years ago) to spend capital to increase U.S. productivity. The dollar's plunge relative to other currencies will eventually make us more competitive. This will be good for blue chip companies, in particular those that own real assets and manufacture items. The Fed and Washington may do anything, however, so one must watch the news.
What does this mean for the U.S. stock market?
In my opinion, it is currently not good value and feels like the 1970s when we experienced a recession followed by inflation. One should consider staying mostly in cash and expect stocks become cheaper. One might miss an interim rally, especially if the Fed announces QE3 (more "stimulus" and money printing) or more bank bailouts, but that is like using Kleenex laced with sneezing powder. We will see stock prices even lower than they are today. The old paradigm dictated that stocks were a buy when P/E ratios were 13 or less (and many are well above that), dividends at 4%, and book values at 1.3 or less. (This excludes oil companies, which tend to trade at lower P/E ratios in general.) I believe we'll see much better deals in coming months. In 1978/79 P/E ratios sank below 7 for blue chip companies.
Should one buy U.S. Treasuries with long maturities? The long end of the bond market doesn't reward investors due to the potential of rising interest rates. If interest rates spike to double digits, then one can reassess the situation.
Long term investors should consider buying commodities or companies that own physical commodities. We're running out of key commodities especially related to agriculture and fertilizer. Washington's brand of the latter isn't the type we need.
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The Stalling US Economy – Should the Focus Turn On Trade Pacts?
Thursday, August 25 2011 | 01:40 PM
Ron D'Vari
CEO & Co-Founder,
NEWOAK CAPITAL LLC | After spending months focusing on the U.S. debt ceiling and worrying about a possible U.S. downgrade, it is time to turn our attention to what really matters – reversing the stalled US economy through expanding trades. While the rest of the world has relatively free access to the U.S. markets, U.S. companies’ market access is restricted in many countries in the Americas, Asia, and Europe. Bi-lateral free trade pacts can open the doors for U.S. companies and create new jobs at home. Many ideas to stimulate the economy have centered around tax incentives or new government spending. In contrast, stimulating exports relies mainly on leveraging our existing foreign and military aids and considerable open access to our markets. It is crucial that the U.S. Congress makes a concerted effort to pass the long delayed free trade pacts with South Korea, Panama, and Columbia in September and the administration looks to forge new ones.
Given the grim prospects for the domestic demand, boosting U.S. sales overseas will be crucial to propel the economy and avoid a double dip recession. While Congress has been quibbling over passing trade agreements for several years, our trade counterparts have enjoyed free access to our markets. We are hopeful that the current economic setbacks will create a strong catalyst to a fundamental shift from reliance on domestic consumption and government spending to a more balanced approach with focus on exports and private initiatives. While cautiously watching the near term market dynamics and European debt crisis, we are long term positive on the US prospects and look for companies with good foreign sales growth potential.
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A New Kind of Risk
Thursday, July 28 2011 | 08:52 AM
Ron D'Vari
CEO & Co-Founder,
NEWOAK CAPITAL LLC | While the global markets are preoccupied with how to account for obvious risks such as breaching the US debt ceiling, Greece default and their domino effects. There are many risks that are not even in the minds of many investors let alone being priced-in by the markets.
There is a real risk of potential cyber attacks targeting companies or attempting to paralyze the global financial systems as a whole to achieve radical political goals. The recent Sony and Lockheed cyber attacks illustrate the degree of vulnerability of even some of the most technologically advanced companies. Given the lack of comprehensive models of cyberspace and absence of general appreciation of the overall financial markets’ vulnerability to a widespread attack, investors don’t seem to be so much focused on the risks and pricing that in their valuation. Just the fear of it will create regulatory, operational and legal risks that will cost companies a great deal in both capital and management distraction. We are far from fully understanding and pricing of cyber attack risks and the possible implications for the overall global markets.
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Leveling the Playing Field for Clean Energy & Infrastructure
Wednesday, July 27 2011 | 11:47 AM
Malay Bansal
Managing Director,
CAPITALFUSION PARTNERS | Historical factors sometimes result in favoring Oil & Gas over the newer renewable energy technologies. Eligibility for MLPs is one such area that can be easily fixed.
The need for additional capital to flow into renewable energy is clear. The sector has a strong dependence on government incentives while it develops towards price parity with conventional energy sources. Recently, Section 1603 Cash Grant program and the section 1703 and 1705 loan guarantee programs have provided some support. However, many of these programs are scheduled to expire in near future. In the past, the sector depended on tax-equity market for financing of projects. But, with lower profits especially at commercial banks which were active in the tax-equity markets, that market will not be able to play the same role as in the past. The clean energy sector needs more help.
The traditional energy sector has available to it a source of capital in form of MLPs (Master Limited Partnerships) that can invest in Oil and Gas. The MLP structure was created by Congress following the energy crisis of the 1970Œs to spur investment in the energy sector for oil and gas exploration, storage, refining, and transportation by providing specific tax advantages to investors. The MLP structure provides the tax benefit of a limited partnership and at the same time provides liquidity of common stock since the PTP (Publicly Traded Partnership) units trade on exchanges just like common stock. Since the MLPs generally hold income producing assets, the resulting high dividend attracts a lot of investors, providing capital to the sector.
Income earned from renewable energy projects, however, is not considered eligible for MLPs. This is because of historical reasons more than anything. When this law was passed in 80s, renewable energy sources were not in the same state as today. This historical factor results in favoring the old energy over the newer renewable sources. Political factors aside, a simple legislation by Congress can correct this to level the playing field. Infrastructure is another sector that is in need of capital, and could also be included.
This, by itself, will not be sufficient, but will be a logical and helpful step in the right direction.
Note: This summary presents the key points of the article The Case For Master Limited Partnerships (John Joshi & Malay Bansal, July 20, 2011) published on AOL Energy.
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Bond Markets: Sending Mixed Messages?
Wednesday, July 20 2011 | 08:19 AM
Ron D'Vari
CEO & Co-Founder,
NEWOAK CAPITAL LLC | While US treasuries have rallied and demand for them has risen, bond funds are holding the highest level of cash over the last three years. Congress is debating how to reduce the ballooning US budget deficit by cutting spending and increasing taxes, while the demand for US treasuries has gone up by global investors seeking refuge from the European sovereign debt crisis. On the other hand, mutual funds in the US are setting up for an abrupt price drop in treasury prices and higher yields by increasing their cash positions and giving up yield in the interim.
Despite warnings from the rating agencies of a potential US downgrade if the debt ceiling is not raised in time, US treasuries are still viewed as a safe haven to protect against sovereign defaults in Europe and political uprisings in the Middle East. Regulatory changes in OTC derivatives’ collateral requirements are also adding to the demand for US treasuries. Of course a solution to the Greek debt crisis and a few signs of growth could lead to an abrupt sell off in treasuries, and that is what mutual funds and some of the US institutional money managers are betting on.
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CMBS Markets: Are They Normalizing?
Tuesday, July 12 2011 | 09:25 AM
Ron D'Vari
CEO & Co-Founder,
NEWOAK CAPITAL LLC | Many aspects of the newest Deutsche Bank’s CMBS deal points to the market normalization and speaks well to the resilience of the CRE and CMBS asset classes.
According to Dow Jones, the $685 million CMBS deal is backed by the restructured loans on the Whitehall's Tharaldson portfolio of 168 business hotels, covering 42.8% of the appraised value of properties and interest coverage ratio of 2.88. The restructuring was made possible by the Abu Dhabi Investment Authority capital injection as a preferred equity. The fact that institutional investors are open to single-asset-type CMBS and a sovereign fund single-handedly jumping in to take on the entire preferred position indicates the investors are confident in the economy long term and are attracted to the asset class. Another element that reflects back-to-the future attitude is Morningstar’s assignment of AAA rating to all three top tranches of the deal, while the other agencies placed a lower rating on the second and third tranches.
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CMBS Loan Hedging Requires Care and Creativity
Wednesday, July 06 2011 | 06:43 PM
Malay Bansal
Managing Director,
CAPITALFUSION PARTNERS | CMBS loan hedging issues have often tripped even smart real-estate lenders. The current environment requires a careful and different approach than in the past.
Recent spread widening and volatility in CMBS market have drawn attention to hedging issues for loan originators in securitization shops. An article in this week’s Commercial Mortgage Alert (New Markit Index May Solve Hedging Woes) reported comments from market participants that the recent spread widening, which was equivalent to about 3% decline in value of loans held, hit all lenders, though to different extent depending on their hedging approach. In an increasingly competitive market with declining profit margins in loans, a 3% hit is clearly very significant for any origination business.
Last week, a Bloomberg news story reported that spread volatility was as an important factor in Starwood Property Trust’s decision to back away from originating debt that would be sold entirely into securitizations.
Hedging issues, even when people believed they were hedged, have tripped many very smart real estate lenders in the past. During the previous crisis, after the Russian debt problems in late 90s, the hedges made a huge difference. At the time, many CMBS lenders hedged using only treasuries. Only some used swaps. Those who used only treasuries were hurt doubly as treasury yields declined increasing the prices of treasury hedges they were short, while swap spreads jumped higher decreasing the value of their assets which were valued at a spread over swaps. Those who had hedged using swaps did not suffer that much. Those who did not use swaps had devastating losses. After that painful experience, everyone in the market moved to hedging with swaps.
Hedging with swaps still left the risk of adverse movements in CMBS bond spreads, a smaller risk most of the time. Few years later, as competition increased and profit margins declined, some started using total return swaps on the Lehman CMBS indices (now Barclays Indices) to hedge that risk too. Those legacy indices are not useful now as they contain old deals. Some people have turned to CMBX1 for hedging, as it is closest to the new issue bonds amongst the five CMBX indices. CDS on IG Corp indices have been used at times by some, and I have heard people exploring use of other tools like equity indices. However, all of these approaches need to keep in mind that any hedge used needs to have a very good short-term correlation with new-issue CMBS bond spreads – longer-term relationships do not mean anything. If the hedge can move in the opposite direction of the asset in the short-term, it’s not really a hedge.
Lack of a good hedge was one of the reasons that delayed restarting of CMBS lending. Last year, I suggested to Markit to create a new TRX 2 index based on the few new deals that had been done so far (Restarting CMBS Lending, Feb 9, 2010). The idea did not get much traction then. Julia Tcherkassova, who heads CMBS research at Barclays, articulated the need for a CMBS loan hedging mechanism internally, resulting in Barclays creating a US CMBS 2.0 Index earlier this year. That index provided a mechanism to hedge loans but it was not used much.
An instrument existed to allow hedging of loans but no significant attempt was made to use or develop liquidity in it by the industry. The reason is probably as simple as the fact that new issue spreads were generally in a continuous tightening mode till the recent sudden widening episode, and that made spread hedging seem not that important. Another factor is that the hedging is expensive. In the past, the cost of hedging with Lehman index was around 30 bps (on an annualized basis). With CMBS2 indices, that cost would have been about 110 bps. Given that the loan volumes are lower, giving up profitability becomes tougher. So the new Barclays index came, but was not met with a strong demand and remained unused. The wider bid-ask spreads also make hedging expensive. Commercial Mortgage Alert reported that Markit is close to rolling out a new TRX index, dubbed TRX.2. Since it is coming out after a widening that was painful for many, it might attract more attention. Hopefully, it will provide a liquid instrument that can be used effectively for hedging loans being aggregated for securitization.
However, another point to think about is that the new TRX index will likely come with or be followed by new CMBX indices. It remains to be seen if the new synthetic CMBX indices will introduce more volatility in cash markets as did the legacy CMBX indices. One thing is sure though – hedging is as important as anything else for loan originators and needs to be given proper attention. All the careful real estate analysis while making loans can come to nothing if sufficient attention is not paid to hedging while loans are being aggregated for securitization. Mechanically following the past methodologies will not be the best approach. The current environment calls for adjustments and creative ideas for hedges to be effective and less costly.
Note: A version of this article was also published in Thoughts on Markets & Economy.
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'Extend and Pretend' Policies
Wednesday, June 29 2011 | 08:40 AM
Ron D'Vari
CEO & Co-Founder,
NEWOAK CAPITAL LLC | The jokingly named ‘extend and pretend’ policies have worked in a few cases. But they could lead to much bigger systematic risk if the ultimate resolution of the European sovereign debt crisis is delayed further. The beginning of a potential domino effect is already being felt in the interbank lending, Euro, and money markets. Fear of a Greece default and subsequent spreading to Ireland, Portugal, Spain and Italy has started to cause US banks to curtail lending to European banks and has led to the weakening of the Euro. Since European banks debt constitutes a significant portion of non-government money market funds, there has been a recent trend of withdrawals from these funds. European bank credit is also causing T-Bill yields to trade in the negative to 1bp range, despite concerns about US fiscal ills and potential temporary default arising from a delay in increasing of the US debt ceiling. Continuation of these trends would make the pan-European systematic risk scenario more plausible by the week.
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CRE CDO Opportunities
Wednesday, June 22 2011 | 04:06 PM
Robert S. Sainato CFA, CFP, CIC, CAIA
Managing Director, Structured Credit & Mortgage Group,
ADVISORS ASSET MANAGEMENT | CRE CDO COMMENTARY: General
CRE CDOs are extremely individual in nature (similar to older vintage ABS/Mult-Sector CDOs) and should only be analyzed using a "bottoms-up approach". Risk-adjusted yields can range from the extremely safe short 1-2 yr WALs earning mid single-digits yield, while longer WAL/Cuspier credits can earn high singles to low teens yield.
Each CRE CDO is unique in collateral: CUSIPed collateral (CMBS & REIT) and non-CUSIPed collateral (Whole loans, A-Notes, B-Notes, & Mezz Loans). In addition, deals are unique by vintage. For example, 2006 CMBS Mezz bonds may be trading in the 20s and 30s with significant losses expected while 2004 Mezz CMBS will be trading near 100 with little chance of loss. This type of mix between collateral and vintage can create a wide variety of risk/reward opportunities that may be difficult to source in other products.
CUSIP-Backed CRE CDO Opportunities:
These deals are very interesting as risk adjusted returns can range from mid singles to low teens. Well-covered deals backed by Dupers/older mezz CMBS generally trade in the 90s while deals backed by newer mezz CMBS trade in the 10s and 20s.
1) One opportunity in these deals, in our opinion, is the ability to source cuspier paper that is generally unavailable in the market. What we are talking about here is the ability source pooled assets that have significant potential upside while mixing some very solid assets/structure that can give you a potential floor on the downside.
2) WAL Risk/Opportunity: Careful analysis of loans and modifications can reveal potentially shorter or longer WALs for 1st Pay CRE CDOs. The Street is broad brushing extension and modification risk which could create opportunities or risks.
Loan-Backed & Mixed CRE CDO Opportunities:
Loan deals share similar opportunities and pitfalls as mentioned above but have further unique characteristics. These deals, although simpler in number to analyze (100ish loans in the whole CRE CDO deal) vs. a typical CMBS-backed CRE CDO of about 15,000 loans (150x100), can be somewhat difficult due to the lack of data on the underlying loans, especially when the loans are not found in CMBS deals. This lack of clarity further complicates these deals but also brings potential opportunities for the careful investor.
Maturity Wall & Extensions:
As seen below, CMBS investors and CRE CDO investors have a formidable wall of maturities on loans that need to be refinanced. Although the commercial real estate market seems to be stabilizing, the market still faces extensive refinancing risk. This risk is more formidable, in our opinion, than in the CLO market.
Borrowers in the CLO market have been able to refinance, as defaults remain low and balance sheets/income statements remain strong. In addition, when refinancing has not been an option, borrowers have then resorted to loan modifications and extensions. The CRE CDO market is different with little chance for refinancing existing loans. To refinance an existing loan the borrower would have to inject a significant amount of equity as real estate prices have dropped and NOIs have fallen. Therefore, we are seeing most CRE borrowers resort to mods (see below). We expect this trend to continue and mirror the maturity profile listed below.
Loan Extensions Reduce CRE CDO Delinquencies:
There has been a lot of talk about loan extensions and mods causing delinquencies to drop but little talk about the alignment or misalignment of interest that CRE CDO managers may have that can cause them to make seemingly irrational decisions to "extend/amend and pretend". What many are seeing is that some loan extensions and mods do not make sense and that the loan should instead be liquidated. This type of situation seems to arise more often in whole loan deals in which the manager had used the CDO as a financing tool and retained a significant portion of equity and mezz classes. By prolonging the pain via modifications & extensions, managers are maximizing payments to them and prolonging the life of the CDO. Payments (in the form of sub manager fees) and value (equity/mezz retained) are maximized while 1st priority note holders suffer. It is important to note that, in loan-backed CRE CDO deals, managers can have a lot or little say, depending on the seniority of the loan. For example, CRE managers owning whole loans have extensive decision rights in terms of modifications and extensions. These rights do not extend mezz loans, B notes, A notes, and CMBS deals.
Delinquency Rates Across Asset Types:
As seen below, delinquency rates for commercial real estate continue to increase (over the past 5 months), although at a decreasing rate, with multifamily and hotels leading the pack.
CMBS Loss Estimates Across CMBX Indices:
For those CUSIP CRE CDO investors, we list below loss estimates for CMBX published by Blackrock, BAML, and JPM for 2006-2008 CMBS. We compare this to defeased-adjusted credit support of AJs to As. For example, early 2006 originally rated AJs look well-supported with 6.8% cushion (13.5-6.7%).
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State Budget Gaps: Rosy Assumptions or Real Cuts?
Monday, June 20 2011 | 08:46 AM
Ron D'Vari
CEO & Co-Founder,
NEWOAK CAPITAL LLC | Governor Jerry Brown of California vetoed the state budget that the California Legislation had just passed, stating that the plan increased the budget deficit short term and covered over the long term public finance issues.
Politicians seem unwilling to make cuts or increase taxes to achieve a balanced budget. The hope seems to be that by making rosy assumptions the problems will go away. States seem to be balancing their budget by not raising taxes or making deep spending cuts, but by making unrealistic assumptions on savings and underestimating expenses. The fundamental political differences between the democrats and republicans are not leading to spending cuts nor tax hikes, hence leaving large real budget gaps.
Political divide between parties is partially responsible for the states' fiscal mess. The US municipal bond markets are no different than the Greece sovereign bond situation when it comes to the outcome - ultimately the markets will force what needs to happen if politicians don't close the actual budget gaps before that. The political divide has delayed the adoption and implementation of the needed actions of higher taxes and more responsible spending.
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Investor Due Diligence: Seeing the wood and the trees
Thursday, June 09 2011 | 10:08 AM
Douglas V. Long
EVP Business Strategy,
PRINCIPIA PARTNERS | How addressing investor due diligence requirements today demands operational control across the entire credit investment business.
In January 2011, Article 122a of the revised EU Capital Requirements Directive went live imposing a direct responsibility on investors and issuers to perform an adequate level of due diligence for any securitization transaction. Hubris continues to overshadow important technical considerations that are fundamental to an organization complying with new investor requirements. Directions are given in the implementation guidelines of Article 122a by The Committee of European Banking Supervisors (CEBS), now the European Banking Authority (EBA). However, implementing those considerations across the credit investment operation amidst a complex network of systems, information and processes to comprehensively and assuredly satisfy the regional supervisors is no small task.
Much focus is placed on understanding ABS, MBS and CDO investments on a deal by deal basis, but for a credit institution investing in these securities, due diligence is not only a deal by deal job. It requires a portfolio and business unit wide operational approach to understanding investments in context, alongside detailed and thorough deal analysis. Without this, credit institutions won’t be able to see the wood for the trees.
Before entering a position and in an ongoing manner, EU banks must demonstrate a thorough understanding of any given deal and that they have implemented ‘formal policies and procedures…commensurate with the risk profile of their investments in securitized positions’ to analyze and monitor any exposures arising from the performance or collateral underlying a deal. This demands a strong backbone to unify the necessary portfolio management and risk management activities but also the operational sophistication and business wide controls to establish due diligence processes and maintain compliance with internal investment guidelines.
Depending on the severity of a breach, an additional risk weighting of anywhere between 250% to 1250% can be applied to a securitization exposure. A revision to risk weighted penalties in the latest guidelines also states that the regulator, “shall increase the risk weight with each subsequent infringement” over time. The penalties are now clearly outlined in national supervisor’s implementation handbooks too, for example the Financial Service Authority’s (FSA) Handbook, BIPRU 9.15.16R.
What’s an investor to do?
Monitor and track risk exposures
At the deal level, understanding the risk characteristics of individual tranches means monitoring issuance details such as seniority level, cashflow profile, historical performance and credit enhancement.
Diligent investment analysis under today’s CRD means implementing consistent ways to analyze and manage all of the data relating to a deal’s structure and credit enhancement, the individual tranches of that deal and the performance of its underlying collateral pools. To avoid penalties, large credit institutions with growing exposures to different securitizations, will seek to find ways to consolidate the various data sets for all the deal information and performance data across its assets. This is the basis for sound investment analysis and risk management for individual deals, but also for effectively managing the entire portfolio and reporting to parent operations.
Know the structure
Investors must also understand, or be able to analyze the structural features of deals such as the waterfall, transaction triggers, embedded hedging counterparties or liquidity facilities.
A detailed understanding of the waterfall structure and strong cashflow models, alongside accurate, timely performance data is a pre-condition to informed and independent assumptions about the future behaviour of assets and proof of independence. Investors need to have the integrated cashflow models, performance data and analytical flexibility to forecast future performance for all the securities they hold, as well as for any potential investment. This demands the operational backbone to efficiently and consistently bring together all of these elements and incorporate internal credit research within a single view of credit and market risk factors surrounding the structured finance and fixed income business.
Underlying exposure statistics…and loan level if you have to
This requirement does not specify that investors track each loan underlying a deal. Rather, it defines collateral pool characteristics and stratifications, depending on the granularity of underlying pools and the asset class. If the risk profile of the deal requires an investor to analyze individual loans, then that must form part of the due diligence process but it is not a direct requirement each time. The EBA guidance highlights Key Performance Indicators that should always be considered, such as delinquency, default, prepay and foreclosure rates and other metrics like pooled credit scores and geographical diversification. Investors need the clarity and tools to make assumptions based on the pool performance exposures most relevant to every transaction type.
Ensuring comprehensive asset coverage and the comparability of performance measurements across asset classes, geographic regions and sectors is a major operational challenge in ensuring comprehensive credit analysis. The difficulty of incorporating performance data for multiple deals and asset types, from multiple internal and external sources and normalizing it for consistent analysis can be operationally complex and resource intensive to setup and maintain. Implementing a flexible infrastructure to consolidate this analysis sits at the heart of satisfying the requirement effectively and with confidence.
In-house due diligence
Where relying on third party financial models, the credit institution must be running equally adequate models itself with the ability to change inputs and stress levels as appropriate. While deal analytics providers provide tools like this for the assets they cover, a credit institution looking to analyze across the breadth of its structured finance and fixed income securities will require an integrated way to calculate future cashflow across the entire portfolio. Analyzing different asset classes in isolation leaves gaps and analytical limitations when attempting to perform due diligence at the portfolio wide level.
For each asset, being able to layer in model assumptions to independently verify and project future valuations is imperative. Institutions require the systems flexibility to be able to first see a complete view of the deal and its performance to make strong assumptions and then apply their assumptions to a cashflow model, both initially and then in an automated way over the longer term. Importantly though, this needs to be performed across all assets and data sources within a single environment to make fully informed investment decisions and proactively manage risk exposures.
On an ongoing basis…
All the information and calculations needed to make independent assessments over time, must be accessible on-demand in a timely and comprehensive way, and recorded for reporting purposes. Credit institutions need the operational rigor to see everything at once, bring in all the information required for analysis and then, with a fully informed view of the detail, have the confidence and tools to layer in assumptions regarding stressed scenarios.
Stress testing appropriate to each securitization position is key to satisfying the requirements. Doing so also provides an ongoing framework for due diligence when combined with the establishment of operational guidelines, risk limits and controls. Stress testing portfolio sensitivities and collateral performance exposures requires there is first a view across the breadth of risk exposures and an ability to define and analyze any combination of exposure parameters. Alongside the consistent integration of cashflow models and data, stress testing by business line; portfolio exposure (e.g. asset type; geography, sector, ratings etc) or performance exposure (e.g. delinquency rates; default rates; prepayment rates; foreclosure rates) can be sustainable and complete. Warning flags can be set for the most appropriate metrics of each asset class to automate early risk signals at the collateral, deal and portfolio level and highlight exposures demanding more in depth analysis. Future valuations can more effectively be projected under many different scenarios to inform prudent choices across the entire structured finance business.
The original Basel II enhancements to the securitization framework phrased due diligence as, ‘operational credit analysis criteria’. While credit institutions must prove they know every investment to satisfy the regulators, today they must also demonstrate they have the full operational sophistication required to do so, across all deals, portfolios and business lines.
Then if a tree falls in the wood, you can be there to find out if it makes a noise or not.
*as published in Structured Credit Investor, June 8th 2011
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TruPS CDOs
Tuesday, June 07 2011 | 11:40 AM
Robert S. Sainato CFA, CFP, CIC, CAIA
Managing Director, Structured Credit & Mortgage Group,
ADVISORS ASSET MANAGEMENT | TruPS CDOs: Positive Convexity for Seniors, Mezz Tranche Optionality?
The TruPS CDO Market continues to underperform all other CDO markets to date, but this could change as soon as this year. We believe that certain TruPS CDO tranches could start to outperform due to substantially shortening WALs. At present, the market is assuming 0% CPR, translating to very long WALs. The market may be significantly overestimating the WALs of certain 1st priority tranches, especially if prepayments increase due to increased M&A activity, refis, and the Collins Amendment (see below). This effect could be even more pronounced in deals that have older bank TruPS paper in it.
For certain mezz tranches that are currently PiKing (those with only 1-5% negative OC cushion), we are bullish on certain cuspy tranches that may turn on in the future. The catalyst driving this is the new trend of deferring TruPS paper starting to pay again (see below). A careful fundamental analysis of the underlying deferrals could reveal significant upside in these cuspy TruPS CDO mezz tranches, as only a small number of deferral cures can greatly affect your return on these tranches.
Bank TruPS CDO Quotes (Assume 2005 or later)
Potential Increase in Prepays on the Horizon: M&A, Basel III/Collins Amendment, and Refis
Over the past six months, a new positive trend emerging is a pick up in M&A activity among small banks. Recently Iberia Bank took over ailing Omni Bank. Omni TruP debt, although paying at the time, was effectively prepaid.
Last year the Collins Amendment and Basel III passed, resulting in the loss of bank trust preferred debt TIER I status. This could result in many TruPS getting called beginning in 2013. Under the Collins Amendment, phase out of trust preferred Tier 1 credit begins in 2013 and ending in 2016. Although few banks have called their paper yet, this is likely to pick up in the near future.
Many older TruPS CDOs (pre-2006) hold bank TruP debt, strong with a high coupon. Some of these banks can easily refinance some of their paper. As defaults and deferrals continue to bottom and the new issue market picking up, we could see a significant number of banks prepaying.
Deferrals Beginning to Pay Again
Between M&A, new equity capital from third parties, and improvement in banks' asset quality and liquidity needs, we are seeing a number of issuers that were formerly deferring curing to pay again (see example list below). Corporate activity and equity injection have been major reasons for cured deferrals. In these cases, the new equity capital is received either through acquisition or injections from third parties. When this occurs, the deferred TruPS interest must be repaid before the new investors/holding company can be paid. Still, other banks are paying again due to better performance. For example, Inland Bancorp Illinois and Lawson Financial Corp (deferring TruPS) cured due to better performance (not M&A).
Some examples of banks that were deferring and have been since cured can be found below.
Tender Offers: A New Trend
Last year there were several requests for noteholder consent from distressed banks to tender their securities. All requests until this January have been denied. According to Fitch, they have received notification of the first tender offer ($20 bid) that was accepted. This is the first successful tender offer we have heard of and may be the start of a new trend. These types of transactions need to be analyzed carefully as it may or may not be beneficial to noteholders.
Optionality Down the Cap Structure
Some original AA-A rated PiKing paper has been underwater (negative OC Cushion) due to deferrals and defaults. Many of these tranches are underwater between 1%-10%. For those tranches that are "at the money" where they are only underwater by between 1-5%, there could be significant opportunity here. Given the trend in some bank deferrals curing, potential refis (especially on older deals), M&A activity, and slowdown in new deferrals/defaults (see default/deferral index below) there may be some tranches that get turned on in the coming months or years. If these tranches start paying again, returns could be extremely significant.
Swap Drag--Significant Drag on Deals but Should Improve Over Time
Hedge drag has been a significant factor hurting interest cash flow to date. Significant asset deferral/defaults combined with the low level of LIBOR have impaired many tranches. These imperfect hedges to date have been problematic, but it is important to note that as time goes by hedges "roll off" and as LIBOR rises (eventually), this mismatch may even help the deal (if LIBOR rises enough). Under the right circumstances, this problem now could reverse itself!
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Greece and the Sovereign Debt Crisis
Wednesday, June 01 2011 | 10:37 AM
Ron D'Vari
CEO & Co-Founder,
NEWOAK CAPITAL LLC | European Union finance officials are discovering the benefits of financial engineering in considering Collateralized Bailout ("CBO") as an alternative to sovereign debt restructuring. As the European Union finance chiefs explore various options to deal with the worsening Greece sovereign debt crisis, some EU countries suggest making any additional aid collateralized with national assets.
At this point officials deny any particular options. Given public opinion in Germany and Finland has been against further outright aid to Greece, any option to mitigate the impact of a Greece default would be attractive to the officials. Asset sales by governments to avoid default or raise needed cash have a long history, with an example being that a significant portion of the geographic area of the United States, such as Louisiana, was acquired through sale of land by other governments for cash. Yet a sovereign bond collateralized by a specific land or a national monument would be new. Structured finance traders may joke about a due diligence trip on a new "Apollo CBO" if it was a sovereign bond of Greece collateralized by Mykonos Island, though Greek nationals may not find that quite as funny. Given the financial conditions, we may also see collateralized or structured debt solutions considered in other public finance cases such as US municipal markets.
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Three Misconceptions about Issuer-Paid Ratings
Friday, May 27 2011 | 10:34 AM
Malay Bansal
Managing Director,
CAPITALFUSION PARTNERS | By Malay Bansal & John Joshi
The issuer-paid model for ratings is widely seen as one of the most significant aspects of the process that needs to be reformed. Yet, no good solution to reform this process has emerged. Part of the reason for that are three widely held misconceptions.
Issuers select which NRSROs will rate their deal, and they pay the rating agencies rating their deals. Many blame this dynamic for causing a conflict for the agencies, and enabling ratings-shopping by issuers. This is perhaps seen as the biggest problem in the current ratings system. Dodd-Frank and other rules in the US and Europe are trying to reform the process. Some proposals suggest removing references to rating agencies from rules, while others suggest regulating them more heavily. The former leaves a hole; the latter increases the perception that the ratings have official approval. No good solutions have emerged.
A previous article in this blog and in Structured Credit Investor (The Unrecognised and Unaddressed Ratings Issue, Malay Bansal, 7 July 2010) made the point that the ratings reform is proving to be intractable because the real issue is not being recognized or addressed in any of the reform proposals. The real problem is that the rating agencies are combining two roles into one. The first role is to provide a rating based on statistical analysis of historical performance of the assets (remember that the ‘SR’ in NRSROs stands for Statistical Ratings). The second role is that of a research analyst to provide an opinion on what might happen in the future. Currently, rating agencies combine the two. The ratings are a mix of statistical analysis and somewhat subjective opinion on the future. This allows rating agencies to downgrade companies or countries even while they are in the process of attempting to improve their financial condition. The official NRSRO status gives their subjective opinions extraordinary power and can actually have an impact on the outcome, making the ratings more pro-cyclical.
The logical solution is to separate the two roles. NRSROs should be doing Statistical Ratings – based on past performance of assets, known facts, events that have already taken place, and statistical models and methods that are well disclosed. They can put bonds on watch for upgrade or downgrade if a financial event is in progress or expected, but cannot downgrade or upgrade till the event actually happens. So they will not be precipitating events.
The second role of providing credit ratings in the form of opinion on future performance should be separated from the NRSRO role, and should be open to any research provider, including NRSROs. These credit ratings could be designated as ‘Informational Ratings’, without any legal or official role impacting investor charters, debt covenants, and so on, which will only use the ratings designated as NRSRO Ratings. This will take the non-NRSRO rating agencies back to sort of where rating agencies started – as market researchers, selling assessments of corporate debt to people considering whether to buy that debt.
The conflict of issuer-paid ratings could be avoided if issuers paid the fee for NRSRO ratings, which will be freely available to everyone, but investors paid the fee for research and informational rating available to subscribers only. Availability of the second will serve as the important function of checks and balances on the NRSRO ratings paid for by the issuers. However, neither issuers, nor the rating agencies seem to find that suggestion appealing. This is partly because of three widely held misconceptions about issuer-paid ratings.
Misconception 1: Issuers Pay for Ratings
Investors, naturally, don’t like the idea of having to pay for ratings, especially since they get it for free in the current system. However, the reality is that they are really the ones paying for it even now. The bankers for the issuer select, engage, and pay the rating agencies, but the payment comes from the money paid by investors for purchasing the bonds. By letting the bankers pick the agencies, investors tilt the balance of power to the issuer. Since they are paying for it anyway, investors should be open to paying for ratings more directly. This will reduce their concerns about the conflict of interest.
Some have criticized the high fees charged by the raters. However, there is another factor investors need to consider in this regard. If they want good quality output from the agencies, they need to be paid sufficiently to be able to attract and retain talented people. Lowering the fee is not the solution. Any scheme which involves investors selecting and paying for research from the agencies that provide better information and analysis will increase competition and provide the right incentives.
Another point in this regard is that only investors who purchase the bonds at initial issuance pay for ratings at present. Cost for investors will be lower if it was spread over all the investors. Subscription fees could be partly based on AUM, making it easier for smaller investors to subscribe.
Misconception 2: Investor-Paid Rating System will be Bad for Rating Agencies
Many, though not all, on the rating agency side, do not like the idea of having to rely on investors for their earnings. It is much better to get all the fees upfront, which sometimes includes the fee for surveillance of the deal throughout its life. However, the preference for upfront payment misses some important considerations.
First, there are a lot more investors than issuers. Even smaller payments from investors could provide the same or more revenue. Also, a smaller charge will cause more investors to sign on for the service.
Second, if the revenue is coming from investors, it is not dependent on the volume of deals, and will not fluctuate dramatically based on volume of issuance. This will provide more stability to those organizations, and allow them to focus on the quality of their work.
Third, more stable revenue would mean a higher multiple for the valuation of their businesses, which will be a positive for their owners and investors.
Fourth, if payment for rating is at the time of issuance, the agencies have to be picked to rate it. This does not align the interests of rating agencies with those of investors, creates a credibility problem, and leaves them open to criticism. By reducing the incentive to be picked to rate the deals at issuance, agencies will be better off, as will be the overall financial system, including the issuers.
Misconception 3: Ratings have to be either Issuer-Paid or Investor-Paid
Almost everyone seems to think that ratings have to be either paid by issuers or investors. However, it does not have to be one or the other. Just a sufficient portion of fee has to come from investors to provide the right incentives. Especially in structured finance transactions, where it is expensive to perform the right amount of due diligence to rate the deal, some amount of upfront payment may be necessary. However, if payment from investors is a significant portion of total revenue of rating agencies, investors and the financial system will benefit from the proper alignment of incentives that would create.
Clearly, splitting the rating agency role into two is a significant change. However, if done thoughtfully, it can be a significant improvement to the current system, and work for the benefit of everyone.
Notes: Views expressed are personal views only, and not of any affiliated organization or group. This article was originally published in Structured Credit Investor.
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Fasten Your Seatbelts, We're Going to Have a Bumpy Ride
Monday, May 23 2011 | 09:48 AM
Ron D'Vari
CEO & Co-Founder,
NEWOAK CAPITAL LLC | Emerging signs suggest the U.S. (currently the largest economy) is on a steady growth path, but big issues loom ahead. These include:
•high energy and commodity prices
•a gradual shift from doves to hawks in the monetary policy area
•further budgetary restraints
•working out an anemic housing market in limbo due to the overhang from the legacy non-performing mortgage loans resolution
•crisis in public finance
•further potential geopolitical curve balls in the Middle East and Africa ("MENA")
•potential sovereign debt restructuring (Greece, Ireland, Portugal)
•unrest in China due to unsustainable household income disparities.
One key uncertainty is the impact of the new regulations on the banking and financial systems and how it would impact market volatility and availability of credit during the transition period and the long term.
Many factors can dampen the above risks, yet the system has recovered enough stamina to survive the bumps. While energy and commodity prices are expected to continue to rise, the supply and demand will tend to meet in the long run through increased production and adjustments in consumption behavior, resulting in potentially moderate price shocks. The monetary policy makers will be cautious and walk a fine line between dampening energy-driven inflation with a fragile economy.
The municipal finance issues appear daunting. Yet if done wisely there are a variety of options, including reducing costs, improving efficiency, raising additional revenues, and utilizing innovative structures. Many of these risks can be smoothed out if the economy as a whole runs in 4th gear. These measures will reduce the level of public service, but the desire is that some of those services can be picked up more economically by the private sector. This is a step in the right direction.
The political issues in MENA will continue to brew and create headline news. However, major powers and the international community will come together in taking steps to keep the oil supply uninterrupted and reduce its impact to the global economy.
Chinese policy makers fully recognize the income disparity issues and have already established programs to moderate the imbalances in rural vs. urban income distribution, and to continue to stimulate internal consumption. There is also fear of a real estate bust and subsequent credit crisis in China, reverberating shock around the financial system. Given the massive Chinese reserve and controlled economy, this has not become a major issue. Many actually would like to see some correction in real estate and continued credit tightening to keep the inflationary pressures on commodities while expanding revenue and consumption in rural areas.
There seems to be a common belief developing among the Euro zone, ECB and IMF that a Greek debt restructuring is a strong possibility in 2012. Depending on form and terms of the restructuring of the debt, the knock-on effects to the rest of the financial system can be kept under control. The key is to make sure it doesn't bring down other major financial institutions holding the obligations.
The biggest uncertainty in the housing market is the manner and timing of the workout and servicing issues of the non-performing loans ("NPL") and REOs. The NPL and REO issue and the lack of clarity in the Dodd-Frank rules ultimately inhibit the normalization of the non-agency mortgage market and securitization. Given that housing is one of the critical pillars of the economy, we expect these issues will be worked out between the major banks and various regulatory and law enforcement agencies to pave the way for capital flows to the sector.
Last but not least, regulatory reforms impact on the financial systems will add a level of uncertainty that needs to be assessed as the rules become clearer. While the ultimate goal is to get to a better and more transparent financial system that would provide for more long term growth, short term they will have some unintended consequences that needs to be worked out.
Despite the challenges ahead, we believe these issues, combined with legacy matters, will be favorably resolved but it will take time. Hence, we remain constructive and view the environment as positive for investment in the intermediate and long term.
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ABS CDO Commentary
Tuesday, May 10 2011 | 07:31 AM
Robert S. Sainato CFA, CFP, CIC, CAIA
Managing Director, Structured Credit & Mortgage Group,
ADVISORS ASSET MANAGEMENT | NAV Anomalies
Relying on NAV from outside sources (IDC/Mgr Marks etc.) can be a dangerous game as this can mislead investors. We strongly believe that Marks cannot be relied on. Spending additional time to independently mark the portfolio can help avoid potential pitfalls and can help investors spot significant misvaluation. This part of the analysis is especially important for cuspy and longer-WAL tranches. It is imperative that NAV is correct before asset-level assumptions can be used for deal-level cash flow analysis.
ABS/Multi-Sector CDO Opportunity: Buy Credit I/O ABS CDO's with Non-Agency Mezz. & Sub. Paper Underlying
The suspension of the foreclosure process has profound effects on non-agency credit I/O paper. By slowing down liquidations, cash flows to sub. and mezz. non-agency RMBS can continue for at least another 6 months which can have a profound effect on valuations of this underlying. Over the past few months, sub. and mezz. have been rallying (reflecting) longer timeline, but ABS CDO Credit I/O's (1st-pay '05-'07) ABS CDO's and 2nd-pay '04 and earlier paper haven't moved enough to reflect this improvement in cash flow.
ABS/Multi-Sector CDO Market Overview
The ABS CDO secondary market continues to trade up due to lack of supply and significant relative value. At this point, we are now seeing 1st-pay CDO risk-adjusted returns range from 7% (well-supported deals) to very low double digits (weaker deals). Investor interest for most of last year was mainly in older pre-2003 multi-sector deals, but we have seen this appetite change as of late. The lack of supply, rising forward rates, and foreclosure timeline extension have pushed many investors into "credit I/O" type investments. In terms of credit I/O bonds, these risk-adjusted returns did range from high teens to mid-20's but have now rallied to mid-teens returns (in general). Given the rising forward curve and lack of supply, we believe ABS CDO's will continue to outperform, especially at the credit I/O level.
Potential Supply & Basel III
Supply to date (secondary--no new issuance) has been relatively muted but this could change. On our trip to Europe, we spoke with several clients that have been beginning to talk about lightening up and having reluctance to buy ABS CDO's that are rated CCC. Basel III (although not in effect yet) is driving this decision-making. As most know, the big change in Basel III is treatment of CCC's for banks. Specifically, capital charges for banks will be a function of leverage. For example, if a bank is twelve times levered, the bank will have to hold 12 x 100%. Specifically, if the risk-adjusted return on the CCC ABS CDO is 12% and the bank has twelve times leverage, their effective return is negligible. This would make it prohibitively expensive to hold these types of assets. We need to monitor this trend very carefully since many European banks hold Legacy ABS CDO's and many European US banks have been a buyer of this paper.ABS/Multi-Sector CDO Opportunity: Buy 1st-Pay Seasoned Multi-Sector CDO's with Seasoned CMBS that are Cuspy
We mentioned this strategy in our last commentary, and it has performed significantly better than expected. At current levels, we still believe that the trade has more room.
The trade we mentioned in our last commentary involves the idiosyncratic loss surface/return profile of each one of these deals (ABS CDO's). To us, deals can fall into several camps. We have looked at deals that are very digital in nature (i.e. 25% return or 100% loss) and also deals that have a risk-adjusted yield of high single digits to low double digits with 5% to 0% downsides. However, there are deals that have a significant number of assets (ex. Seasoned CMBS) in them that are very option-like combined with other very solid assets. This mixture of assets is extremely hard to duplicate as most of these assets are difficult to find. The risk-adjusted return of this type of portfolio could be base case low double digits with a downside of 5%. The upside to this trade is in its optionality. On an optimistic scenario, potential upside could be over 20%.
We continue to encourage all investors to look for these types of deals. The way we uncover this is by running various scenarios and not just "base & stress" scenarios. This type of scenario analysis will help reveal "The Potential Optionality" of a trade.
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Manufacturing-Led US Economy At Last, But Don't Count On It!
Monday, May 02 2011 | 03:45 PM
Ron D'Vari
CEO & Co-Founder,
NEWOAK CAPITAL LLC | Be careful what you wish for, you might just get it. Most economists prefer a more manufacturing-based US economy vs. a service and consumer dominated one. Well, it took a credit bubble, economic crisis and Dollar falling to get there. While we all feel poorer, manufacturing growth has been a positive factor keeping the economic recovery alive. However, this has been primarily driven by foreign demand, a cheap Dollar and some increased corporate spending,
Japan's natural disaster has introduced a few bottlenecks but China and Brazil have helped to more than balance that. If this continues, the general hope is gradually the unemployment will adjust to a more normal range. We may even get back some of those folks that had given up on the job market. Of course, the residential and commercial real estate markets will be key to the ultimate health of the economy. By then, we may even be tempted to regain some of our old bad habits and let others produce and save while we enjoy consumption.
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US Economic Recovery? Yes, But...
Tuesday, April 26 2011 | 02:57 PM
Ron D'Vari
CEO & Co-Founder,
NEWOAK CAPITAL LLC | I attended a recent conference concerning the asset management sector held by Moody’s Investor Service. Their chief capital markets economist, John Lonski, presented an excellent macro view of financial markets. In Lonski’s view, the US is making some progress in economic growth, though tentative and not yet clearly sustainable.
There are several factors suggesting that domestic conditions are improving. First , the unemployment rate has been falling. According to government data released on April 1st, the rate has fallen to 8.8%, the lowest in two years. Payroll employment rose by 216,000 workers in March, after a gain of 198,000 in February. If such gains of 200,000 plus per month can be sustained for, say, six months, then both consumer and business confidence measures should also show significant improvement. Unfortunately, a large percentage of workers have stopped looking for work, which is not reflected in the official unemployment rate, a measure only of those actively seeking jobs.
Lonski also highlighted improvements in capacity utilization–a measure of the use of our productive capacity—which is running about 83.5% versus a recessionary low of about 68%. More normal capacity utilization should lead to higher business profits, which can allow companies to reduce their debt and improve their balance sheets. This would be favorable for the fundamental quality of the corporate bond sector and particularly for high yield bonds.
But there are some troubling factors that could endanger an economic recovery. The first is sharply rising energy prices. One measure of affordability is the ratio of gas station sales to employment income. In Febuary, this ratio reached 6.2%. Recessions began after this ratio reached 7% in 1980-81 and 2008. Crude oil is currently trading (West Texas Intermediate quality) at about $108.30 per barrel, versus a recessionary low below $40, an enormous increase.
Another retarding factor is the decline in home equity. The collapse in residential home prices has cut homeowners’ equity by $5 trillion, or 45%, versus the average level during the period between 2003 and 2007. This is not merely a sense of lesser wealth. Owing to the increasing importance of equity lines of credit to consumer spending, this contraction in home values directly impacts the ability of homeowners to make purchases. A favorable factor is that home affordability measures have been improving nationally, and affordability should be a leading indicator of recovery in values. Weakness of credit availability is compounded by the long-term aging trend of the U.S. population; older workers tend to spend less as they anticipate a lower level of income after retirement.
Lonski also expressed caution about the ongoing crisis in continental Europe. There is a great danger, he thinks, if the credit difficulties of Spain and Italy, large countries, approach those of Greece, Ireland and Portugal.
Because the unemployment rate remains relatively high, housing remains weak, and energy prices are high, Lonski doesn’t see a major risk of inflation in the US economy at this time. Indeed, under certain conditions, we run the danger of falling back into recession.
Lonski emphasized the centrality of residential housing in understanding the relatively anemic recovery that is underway in the United States.
Ron D'Vari CFA, CEO of NewOak Capital, and Andrew Szabo CFA, Managing Director of NewOak Solutions
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Finding Relative Value in CLOs
Tuesday, April 19 2011 | 10:07 AM
Robert S. Sainato CFA, CFP, CIC, CAIA
Managing Director, Structured Credit & Mortgage Group,
ADVISORS ASSET MANAGEMENT | Generally speaking, we remain bullish on AAA to BBB CLOs and negative on Equity, as mentioned in the last blog. However, not all CLOs are created equal. For this piece, we would like to explore some nuances that are involved in CLO investing.
Asset-Liability Arbitrage
As seen below, the general CLO market trend over the last 6-8 months has been positive.
Even after this positive trend, from an asset-liability arbitrage perspective, CLOs still remain cheap (overall) as loan prices are around $96 while the weighted average price of all of the liabilities and equity in the CLO structure are ~$90.5. We believe most of this value is locked into the AAA to A tranches with the best risk/reward in the AAA's and AA's. During the CLO rally in February to early March, the asset-liability arbitrage (see below) closed its gap to around 3.2 pts at its lowest, but has since widened back out to 5.5 pts post-Japan/Middle East.
CCC's Overvalued? Defaults Understated?
Recently Deutsche Bank released its annual default study, which analyzes CCCs on a historical default/risk adjusted basis. The study concludes that current CCC loan prices do not adequately compensate investors for risk. The risk we are referring to is associated with the next economic downturn. We believe, as does DB, that cycles are going to become significantly shorter (we are in the 3rd year of the current bull move) because the government no longer has the necessary ammunition, i.e. rates at 0% cannot go lower and budget deficits are bloated and unlikely to go higher. In the past the US government, specifically the Fed and Congress, and foreign cooperation (via no inflation) was able to prolong economic cycles and give us a “Goldilocks” economy. In our opinion, this Pollyanna situation is long gone and reality (risks) will set in with substantially lower growth and shorter economic cycles. Additionally, defaults have been understated due to many extensions and prepays. Although the default wall has been pushed back as companies have prepaid, defaults are still likely to rise. Remember the long-term high-yield default rate averages over 4%, NOT 1-2% as most are modeling.
Arbitrage in PiK Risk
Currently, we see the average Junior OC cushion around 2.5% in the US CLO universe, which has increased considerably over the last two years due partly to managers being able to build par but also increasing CCC prices. If CCCs are overvalued and understated, as we explored above, a price correction and ratings migration in this part of the curve would have a negative effect on CLOs’ OC tests, causing some deals to PiK. However, down the cap stack (where PiK risk matters), in our opinion the market has forgotten deal language and is not pricing accordingly. PiK risk is important and deals with lower PiK risk should trade better.
For those that are taking these binary risks, thorough reading and understanding of CLOs’ indentures is essential. While most CLOs take CCC haircuts for OC tests across all parts of the capital structure, there are some deals where these haircuts vary from the senior OC tests down to the junior and interest diversion tests. We have seen some deals in the universe where CCC haircuts are only used for the junior OC and interest diversion tests. These deals can offer extra cushion to the notes above these tests as they will more easily divert excess interest from the equity to delever the structure, while not PiKing the single As, BBBs, and BBs in some cases.
Prepays and WAL: Smart Investors Can Outperform but Document Work is Essential
Relative outperformance can be gained by taking advantage of the different non-modeled WALs (where the manager can/cannot extend the WAL of the deal) via reinvesting beyond the reinvestment period/OC trigger avoidance/extension language etc. A lot of research has recently come out from the bulges regarding prepays in CLOs as the headline numbers, on an annualized basis, have been in the mid-20s for the index and mid-30s for CLOs. Many of these analysts suggest that these high rates are generally good for AAA/AA post-reinvestment and equity pre-reinvestment, and bad for AAA/AA pre-reinvestment and equity post-reinvestment.
In general, we believe these statements to be true but want to caution investors on many of the nuances to this. We strongly believe that investors must read the indentures closely to determine the effect as many deals allow for prepays to be reinvested post-reinvestment date, as long as certain criteria are met, with some even allowing unrestricted reinvestment of prepays.
The following restrictions typically apply to the reinvestment of prepays: Sr. Notes must not be downgraded from their original ratings and Mezz./Jr. Notes must not be downgraded more than 1 notch from their original ratings. Some deal language use both Moody's & SP ratings, while others only use Moody's. Below, we explore the possible effects of the Moody's upgrades in relation to prepays and WAL.
The recently proposed Moody's methodology changes could also an effect on which deals are able to reinvest prepays post-reinvestment date. Its new proposal, if accepted, would upgrade Sr. Notes 0-2 notches and Mezz./Jr. Notes 0-5 notches. Performing a quick back-of-the-envelope analysis, we see 76% of the Sr. AAA universe currently within 2 notches of their original ratings and 30% of AA's within 2 notches. In the Mezz./Jr. area, we see 85% of A's within 5 notches of the one-notch downgrade limitation, followed by 63% of BBB's and 43% of BB's. Although many deals can be upgraded, as seen above, deal quality and indenture language should be monitored closely to determine the extent to which prepays can be reinvested post-reinvestment date. This is an ironic case where, if upgrades do occur, some of the AAAs from cleaner deals could actually underperform some of the dirtier AAAs as the cleaner deals will be able to continue to reinvest and extend the deal, negating the higher prepays and driving AAA WALs up and DMs down.
See below for Moody's rating transition table, showing the percentage of each part of the cap structure across the US CLO universe and how many notches are currently downgraded from their original ratings. For example in Sr. AAA's, 36.91% are currently rated Aaa (their original ratings), while 19.66% are rated Aa1 (1 notch downgraded), 19.66% are rated Aa2 (2 notches downgraded), and 12.2% Aa3 and below (3+ notches downgraded).
If all of these restrictions are passed, then typically after the reinvestment date the proceeds from the prepaid loan must still be reinvested in a loan that is inside the maturity and has the same or better rating of the prepaid loan. This could effectively cause deals to run at a 0% prepay post-reinvestment (all prepays would be required to be reinvested in similar loans, maturity-, spread-, and rating-wise, simulating a similar asset to that which prepaid as noted above), extending the deal and lowering DMs at the top of the cap structure, while increasing yields on the equity for these deals. Investors should pay careful attention to the language in deals in which they are buying AAA/AA and equity.
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Irrational Exuberance 2.0 - CLO Equity Edition
Wednesday, April 13 2011 | 08:44 AM
Robert S. Sainato CFA, CFP, CIC, CAIA
Managing Director, Structured Credit & Mortgage Group,
ADVISORS ASSET MANAGEMENT | CLO Equity Overvalued? Can Investors Earn 20's and 30's Cash on Cash Returns and Sell Before the Next Credit Cycle?
Credit Opp/Hedge Funds have been clamoring for CLO equity, attracted to the very high cash on cash returns seen so far. We are seeing cash on cash returns on many deals producing 20's%/30's% returns. This cash flow is enticing investors similarly to how the Sirens lured Odysseus (for those familiar with The Odyssey). Equity/BB's and some BBB's in our opinion have run their course and caution should be warranted (especially for long-term hold investors).
We believe that the I/O & P/O parts of equity/BB's are overvalued in general. In our opinion, the I/O part is overvalued due to the likeliness of excess spread to drop because of a combination of high prepays (empirical loan prepays 25-35% CPR vs. valuation 15% CPR in models); all resulting in lower leverage and lower WAS of future Libor floor loans which will be invested in. Real IRR on the I/O is likely to be substantially lower than the cash on cash returns received thus far.
In addition P/O valuations are extremely levered (at the bottom of the cap stack) to loan prices, defaults and CCC's loan prices and percentages. Small negative changes in these can have profound effects on sub tranche and equity prices by making a cash flow positive investment stop paying. The significant OC improvement throughout the past 1.5 years will begin to wane as this improvement was the product of discount purchases, CCC price appreciation, and low defaults. As mentioned previously in section II, we firmly believe that defaults have been artificially held at bay due to prepays and overly optimistic CCC loan prices. We believe that this is not a normal cycle (as we have seen in recent years) and can see a downturn sooner than most are assuming in their valuations.
Incentive Mgr. Fees (IRR Hurdles) Hurting CLO Equity Cash Flows?
In many deals, we've seen that future equity cash flows can be affected by incentive mgr fees beginning to kick in over the next few years. This is a common feature in CLO's that causes the manager to be paid an additional fee out of the excess interest once the IRR, since inception, has reached anywhere from 10-15%. Most only begin accruing once the hurdle is hit, while some deals have accrued this incentive fee since deal closing, accumulating fees between as much as $6-8mm that will be released once the hurdle is hit. With most deals now cash-flowing to equity and excess spread having increased, this issue is beginning to arise in cash flow and pricing analysis.
The higher quality deals that continued to pay throughout the cycle will be first to hit these targets, as expected. There are a few deals that are close to hitting their 1st IRR hurdles within the next 2 years. Babson 2006-2 and Stone Tower V are two deals we see kicking in as early as this year, with 7% of the universe observed by us with hurdles (20 deals) having hit their hurdles by 2013. We project many more will hit their hurdles over the next 3-4 years, 30% by 2014 and 50% by 2015, as cash flows begin to tail off because of the reinvestment period ending, exacerbating the drop in cash flow to equity.
Investors should run the prospective cash flows to determine if hurdles are being hit, how the fees are paid/accrued, and how that affects equity return. Deals that are currently cash-flowing robustly could drop off suddenly upon the passing of this IRR hurdle, especially on those deals that accrue since closing – which can divert 50-60% from equity to pay off this accrual. A simple back-of-the-envelope analysis of collateral, reinvestment, and current cash flow is no longer sufficient, and we suggest investors have a very strong grasp of the deal's indenture and all of its intricacies before purchasing.
US CLO Equity Analysis from BWICs dated 2/15-4/8
BWIC volume for CLO equity spiked in February and March (as seen below), giving the market more clarity on where different types of deals’ equity tranches are trading.
Using these prints, we compiled a datasheet below including a few relevant datapoints for each deal’s equity tranche that traded. Included below is the Bloomberg ticker for the equity that traded, color for where it traded (if at all), the reinvestment date, Junior OC cushion, underlying weighted average asset prices, and then yields at six different scenarios using generic reinvestment assumptions. This data should help investors find out where comparables have been trading when looking at CLO equity offers, BWICs, or current holdings.
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Prudential Supervision
Monday, April 11 2011 | 03:46 PM
Ron D'Vari
CEO & Co-Founder,
NEWOAK CAPITAL LLC | There are several forces that might govern a bank’s behavior and keep it from taking reckless risks in lending and investing, possibly endangering the safety of its depositors and investors. First, there is the market: investors who don’t like lending policies can sell the bank’s stock and bonds, causing their prices to fall. Second, there is the oversight of the bank’s management. Third, there is the oversight of the bank’s Board of Directors. Fourth, bank regulators act as watchdogs, seeking to protect the interests of the depositors; this oversight is sometimes called “prudential supervision.”
In the wake of the recent worldwide financial crisis, it appears that the controls exerted on many banks by the market, by management, and by the board, were not enough to prevent gross excesses in bank lending, particularly in the real estate markets.
These problems quickly became those of the government and taxpayers, because of national systems of deposit insurance and the perception that some banks and financial institutions were “too big to fail.”
Consider our own country, where the federal government bailed out commercial banks such as Citibank, Wachovia, JP Morgan/Chase and Bank of America, as well as investment banks and other financial institutions, notably AIG. Similar dilemmas have faced the European Union, including Greece, Italy, Spain, Portugal and Ireland (and others, such as Iceland, which are seeking membership).
These shortcomings have led to calls for more stringent prudential supervision. In the United States, one aspect of the new environment is the far-reaching Dodd-Frank legislation. Internationally, the Basel Accords, promulgated by the Bank for International Settlements, are now entering a proposed third stage (Basel III).
The Dodd-Frank legislation is so far-reaching that banks are still scurrying around trying to understand how to comply. One striking aspect, as emerging in regulations under the 2010 Interagency Guidance Appraisal and Evaluation Guidelines, is that affected financial institutions will need to establish more objectively the value of their illiquid collateral, such as whole loans, real estate owned and derivatives, preferably by third party (arm’s length) evaluators ( disclosure: this is one area where my own firm consults). There has been militant talk by Republican Party spokesmen to roll back key provisions of the legislation, so the legal situation will remain in flux. Tea Party representatives particularly deplore the emerging Consumer Protection Agency.
As to Basel III, the proposed revisions are intended to increase the quantity of quality of banks’ required regulatory capital. More specifically, there will be greater clarity about eligible Tier I and Tier II capital, and the lowest quality category, Tier III, will be eliminated from eligibility. There will be required stress tests, which are hypothetical projections assuming adverse conditions such as economic recession and declines in real estate markets.
Of course, there are real questions about the ability of regulators to anticipate problematic lending, any more than stock investors, managers or boards. At the least, though, such regulators experience different economic incentives from the other players and may be more fearful of the inexpensive borrowing power that is available to depository institutions, multiplying the profit or loss from lending and investing activity.
Ron D'Vari CFA, CEO of NewOak Capital, and Andrew Szabo CFA, Managing Director of NewOak Solutions
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What's Ahead for CMBS Spreads?
Monday, April 11 2011 | 08:23 AM
Malay Bansal
Managing Director,
CAPITALFUSION PARTNERS | A revived CMBS market, with new deals getting done, is helpful to REITs and other commercial real estate owners as it has started making financing available again. Spreads had generally been narrowing which helped loan originators by reducing the hedging cost and has been good for owners of CMBS bonds. However, recent spread volatility has left some people concerned, and wondering about the future direction of spreads and how to look at spreads on the new CMBS 2.0 deals in the context of 2006-7 legacy deals.
I always find it useful to start with views of market participants, and historical data for some perspective. Also, for legacy deals, estimates of losses are an important element. Below are forecasts for spreads for 2007 vintage CMBS for June 2011 published by industry’s weekly newsletter, Commercial Mortgage Alert at the beginning of the year, along with some other data. Comments and thoughts follow.
Recent Spread Widening
To focus first on what had people worried most recently – widening of GG10 A4 bonds by 50 basis points from mid Feb to mid March, it is important to step back and look at the bigger picture. GG10 spreads are more visible because it is a benchmark deal and trades more frequently. As the table “Recent Spread History” shows, (i) spreads did widen out, but are generally back to where they were before widening, and (ii) even when they widened out, they were inside where they were at the beginning of the year.
Another factor to look at is where spreads are compared to market’s expectations. The table above shows average prediction for 2007 vintage A4 bonds to be 184 over swaps. Mid March wide was swaps + 190 and the current spreads are swaps plus 165. Again, not as alarming when looked at in that context.
CMBS 2.0 Spreads
Spreads for new CMBS 2.0 deals widened out too, but not by as much. They went from 110 over swaps at the tight to 120 and are back to 110, compared to swaps plus 130 at the beginning of the year. Spreads did not widen much, but where could they go now? One perspective is looking at the history. The underwriting, leverage, and subordination in the new deals are comparable to what they generally used to be in 2003 to 2005 period. However, looking at spreads over swaps at that time will not be as helpful because of the impact of recent events in swap markets. A better approach will be to look at spreads over the risk-free rate, or the spread over treasury notes. In the 2003 to 2005 period, CMBS AAA bonds averaged around T+75, whereas generic single-A industrial corporates averaged T+77. Currently, new CMBS spreads are swap plus 110 or T+117 and single-A industrials are T+97. This back of the envelope analysis would suggest that new CMBS AAA spreads could tighten by 20 basis points from the current levels. The demand for bonds is there and there is not a big supply in the pipeline. So the technicals favor continued tightening.
CMBS 2.0 Vs Legacy CMBS
Legacy CMBS deals are a bit more complicated given the losses expected by market participants (see table above). In general, expectations of losses seem to average around 11.5% for 2006-8 deals. One simple way of looking at the deals would be to assume subordination remaining after expected losses. On that basis adjusted subordination for legacy A4 bonds goes from 30 to 18.5, which is similar to the subordination for AAA bonds in new deals. Subordination for legacy AM bonds with loss taken out goes from 20 to 9.5. That is roughly between single-A and BBB bonds in new deals.
This simplistic approach ignores several other factors that also come into play, but does the market see these as comparable? Market spreads for legacy AM bonds at swap plus 280 seem wider than 190 and 270 for new deal single-A and BBB bonds. Similarly, legacy A4 spreads at S+170 are much wider than S+105 for new issue AAA bonds. However, if you look at yields, legacy A4 is around 4.65, close to the 4.60 on new issue AAA. Similarly 5.80 yield on legacy AM bonds is between 5.42 and 6.22 on new issue single-A and BBB bonds.
Logical inference from above is that, in this yield-hungry world, the legacy bonds are generally in line with the new issue bonds in terms of yield, and legacy bonds should tighten along with new issue. The choice between them comes down to investors preference for stability, hedging, leverage, duration, etc.
The above would suggest that a general widening in legacy but not in new issue bond spreads, unaccompanied by any deal specific news, as happened recently, may be an opportunity to pick up some cheap bonds if you can do detailed deal analysis and are confident in ability to pick better deals.
Note: This article was originally published in Markets & Economy (http://marketsandeconomy.wordpress.com).
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Auto ABS: Turbocharged or Stuck in Neutral?
Friday, April 08 2011 | 08:08 AM
Stephen Whelan
Partner,
SNR DENTON US LLP | On March 29, 2011, several federal agencies issued a notice of proposed rulemaking (NPRM) to implement the Dodd-Frank Wall Street Reform and Consumer Protection Act provisions regarding mandatory risk retention by “securitizers” of various asset classes. The Act established a baseline five percent risk retention, but authorized the agencies to establish higher (or lower) thresholds for identified asset classes. In the NPRM, auto loans received particular attention. The question remains whether the agencies’ proposals will turbocharge auto ABS--or leave it stuck in neutral.
Page 159 of the NPRM proposes “a zero percent risk retention requirement (that is, the sponsor would not be required to retain any portion of the credit risk) for ABS issuances collateralized exclusively by loans from one of the asset classes specified…and which meet the proposed underwriting standards.”
The good news is that the agencies recognized that “establishing a risk retention requirement between zero and five percent…may not sufficiently incent [sic] securitizers to allocate their resources necessary to ensure that the collateral backing an ABS issuance satisfied the proposed underwriting standards”. Other welcome news is that the NPRM added that “[t]o facilitate compliance…supervision and enforcement of the rule, the proposed standards are generally prescriptive, rather than principle-based.” That enables securitizers to avoid a regulatory guessing game.
However, ABS sponsors who have included commercial auto loans or leases in their securitized pools will be disappointed at the narrow approach taken by the agencies “to establish conservative requirements that are consistent with underwriting standards commonly used by the industry for unsecured [emphasis added] installment credits.” The proposed rules would exclude any lease financing and any loans to finance fleet sales or the purchase of a commercial vehicle. So the reduced risk retention would appear to be available to the larger auto consumer finance companies and not to ABS sponsors which finance commercial auto loans and leases.
The rules would force originators to determine that each obligor has a monthly total debt to income ratio of less than or equal to 36%. Documenting this analysis will require the originator to obtain data from each obligor about his monthly housing payments and other amortizing payments, credit card and lease obligations, alimony, child support and other court-ordered payments. Beyond this potentially intrusive investigation, the proposed rules would restrict qualifying auto loans to those with a fixed interest rate, maximum five year term using straight-line monthly amortization, and 20% minimum down payment. Each originator and securitizer will have to make its own determination whether these and other standards in the proposed rule are practical and worthwhile to obtain zero risk retention for any auto ABS issuance.
Because of the high likelihood that a few loans in the securitized pool could fail to meet the agencies’ standards, the proposed rules require the depositor to certify as to “the effectiveness of its internal supervisory controls for ensuring all of the loans backing the ABS are qualified loans” and the sponsor to (a) repurchase nonqualifying loans within 90 days “after the determination that the loans do not satisfy the underwriting standards” and (b) disclose to the ABS investors the loans which are repurchased and the cause for each repurchase. Much of this is customary in auto ABS, but the agencies ominously “seek comment on whether the sponsor should be required to repurchase the entire pool of loans [emphasis added] collateralizing the ABS if the amount or percentage of the loans that are required to be repurchased…reaches a certain threshold.” If adopted, this imposition would be a dramatic departure from industry practice.
The comment period for the proposed rules runs through June 10, 2011.
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Windfall Rewards of Transparency Requirements of Financial Reform
Tuesday, April 05 2011 | 12:50 PM
Ron D'Vari
CEO & Co-Founder,
NEWOAK CAPITAL LLC | While the financial industry lobbyists, political parties, and regulators are still debating the exact form of implementation of Dodd-Frank Reform laws, the financial industry is gradually waking up and comprehending the enormous scope of the infrastructure required for the timely and accurate collection, processing and analysis required to meet the reporting and compliance requirements under the new laws.
For example, just the derivatives and securities lending collateral management would require very large new investments in processes, systems, and personnel. On its face the cost of new systems and processes may appear to put further pressure on profitability on top of the higher capital requirements.
However we would argue that the push for the additional transparency will bring about better internal visibility across business and functional units and better attribution of risk-reward for various business lines and activities.
Long term this should provide a more timely measurement of risks and reward opportunities and lead to a more proactive management that should improve profitability.
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Restarting CMBS Lending
Wednesday, March 30 2011 | 09:53 AM
Malay Bansal
Managing Director,
CAPITALFUSION PARTNERS | The DDR deal, the first CMBS deal after nearly eighteen months, was ten times oversubscribed. The following two deals also saw good demand even though they did not allow for TALF financing. So, clearly, there is good demand for CMBS bonds backed by well underwritten loans. Also, borrowers clearly want loans if they can get a reasonable cost of financing. DDR loan, with about 4.25% all-in cost of financing for the borrower, showed that a low cost of financing is possible even in the current market. Yet, prospects of a conduit style multi-borrower deal seem bleak at the moment. Any CMBS deals that come to market are expected to be single-borrower deals, as in those deals the borrower takes the market risk and not the underwriter doing the deal. Securitization shops do not want to take the spread risk while aggregating the pool because there is no way to hedge that risk, and so are unable to originate loans even though many are eager to restart their lending operation. If they do originate loans without ability to hedge, they would require much wider spread resulting in higher cost of financing than borrowers would find attractive.
Inability to hedge loans while aggregating a pool for securitization is one of the biggest obstacles preventing restarting of conduit lending for commercial real estate properties.
In the past, the conduit originators were able to hedge loans while they were aggregating a pool big enough to securitize. So, they were not exposed to risk from changes in interest rates and bond spreads between loan origination and securitization. The hedging generally involved hedging the interest rate risk by selling interest rate swaps, and hedging the bond spread risk by using Total Return Swaps on Lehman or Bank Of America CMBS indices. These indices allowed loan originators to effectively sell their risk to investors who wanted to gain exposure to CMBS in their investment portfolio. They sold the risk when they originated the loan, and bought it back when they securitized the loans. The hedge worked because spreads on new CMBS deals moved in parallel with the spreads on existing deals.
The problem now is that those indices are no longer appropriate for hedging, especially for new origination loans, because of two problems. One, ratings downgrades have impacted the composition of the indices. Second, and more important, the spreads on new bonds with newly underwritten loans cannot be expected to move in tandem with spreads on old bonds with the old underwriting. This lack of correlation between the two spreads makes the old bonds or indices unusable as a hedge for newly originated better quality loans.
What this means is that to hedge new loans with better underwriting, originators need bonds with better underwritten new loans. In other words, to originate loans, you need bonds with new underwriting, and to create bonds with better underwritten loans, you need the better underwritten loans. That’s the chicken-and-egg type problem of loan aggregation. This is what has prevented loan origination from restarting once the spreads on old bonds widened out.
To solve this chicken-and-egg problem, back in February 2008, I made a suggestion to Markit, which administers the CMBX indices. My suggestion was to create a new CMBX type of index based on future deals that met minimum credit quality. Only deals which met pre-set criteria based on LTV, DSCR, and other credit parameters would be eligible to be included in the new index. Trading of the index would have allowed the market to determine spreads on bonds backed by good newly originated loans, and provided a hedging mechanism for loan originators, solving the chicken-and-egg problem.
Markit discussed the idea in a conference call with the trading desks, but it was thought to require too much work to create, when dealers were busy with the market volatility. Also, the idea was complicated, since it was based on future deals. Additionally, the CMBX is based on CDS (Credit Default Swap), and cash and CDS markets do not always move together, and so the hedge would not have been as good as Total Return Swaps on cash bonds.
Luckily, things have changed since then.
One, Markit has created new indices called TRX, which are based on Total Return Swaps on cash CMBS spreads, which will be a much better hedge for loans than a CMBX or CDS type of hedge. Total Return Swaps are what many originators used in the past to hedge the credit spreads.
Second, new deals with newly underwritten loans have been done and exist now. So, it is not necessary to base the index on future deals, avoiding a lot of complexity. That simplifies things considerably.
One solution to the hedging problem for newly originated loans is to create a new TRX index based on the new deals. It will allow the originators to sell risk, and will allow all the investors (many who did not get any allocations in the over-subscribed deals that have been done recently) to get exposure to new CMBS bonds.
Some may argue that three deals is not enough diversity to create an index. Admittedly, it would be better to have a more diverse pool of deals for the index. However, even with just three deals, the index will allow many originators considering starting origination to solve the chicken-and-egg problem. Also, this by itself will not solve all the problems the CMBS industry is facing. Yet, it will be better to have something, even if it is not perfect, than to have nothing at all.
I urge Markit and the dealers to make available a new index that will be attractive to both loan originators and investors, and just might help solve one of the major roadblocks preventing restarting of CMBS lending.
Note: This article was published on Seeking Alpha.
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Rating Agency Reform: The Real Problem That Has Not Been Recognized
Monday, March 14 2011 | 09:39 AM
Malay Bansal
Managing Director,
CAPITALFUSION PARTNERS | The most important and the most basic issue related to ratings and rating agencies has not been recognized or addressed in reforms announced so far. Here’s a new idea on a practical solution to address this most fundamental issue, which also addresses the conflict of interest issue that has received the most attention so far.
The Reforms
Ratings agencies have been criticized heavily by many for their role in the U.S. financial crisis, in particular over conflicts of interest and their failure to recognize the high risks inherent in complex structured products. They have also been blamed for throwing fuel onto the fire of crises by belatedly and aggressively ratcheting down ratings. Numerous proposals have been put forward to reform the rating process to avoid these issues.
The US Congress, after resolving the differences between the House and Senate versions last week, is on the path to pass a sweeping financial regulatory reform bill aimed at increasing oversight and regulation of the US financial system. Among the issues addressed is reform of credit rating agencies. However, the compromise bill avoids most of the stronger proposals. The bill directs SEC to conduct a two-year study to determine if a board overseen by SEC should be setup to help pick which firms rate asset backed securities (the Senate version of the bill had required such a regulatory board). The bill also adopted a softer version of proposed liability provision than was in the house version of the bill (investors must show a company “knowingly or recklessly” failed to conduct a “reasonable” investigation before issuing a rating). The compromises are better than the extreme versions of proposals even though it means that the proposed regulations may not do much to change how the agencies operate.
Earlier, in mid April, SEC made some changes. In the update of Regulation AB, it eliminated the involvement of rating agencies in the shelf registration process by removing the requirement that the ABS be rated investment grade. This clearly has no impact on the rating process.
SEC also promulgated the Rule 17g-5, which went into effect on June 2, to address perceived conflicts of interest with issuer-paid ratings provided by nationally recognized statistical rating organizations (“NRSROs”). The rule aims to increase the number of ratings and promote unsolicited ratings for structured finance products. To achieve this goal, the rule requires issuers and hired rating agencies to maintain password-protected websites to share rating information with non-hired rating agencies. The concept is good, but if implementation means rating agencies will have to share all information with other agencies, they may have less incentive to dig deeper and find more data.
None of these changes are radical overhauls or even proportionate to the amount of criticism that was leveled at the agencies (Calpers has sued the three major bond rating agencies for $1 billion in losses it said were caused by “wildly inaccurate” risk assessments) or the wide ranging calls for ratings reform. In some ways, it is good that some of the more extreme proposals have not been adopted. But why is it so difficult to reform the rating process?
The Power of the Rating Agencies
One reason that makes it very difficult to make changes to the ratings process is that ratings are heavily embedded in almost every part of the financial systems around the world. They are used in investor’s charters defining what they can buy. They are used for calculation of capital charges for banks, insurance, and other financial companies. They are used in loan covenants and triggers on corporate debt. They are used to calculate haircuts on repo lines, along with many other uses.
Also, despite the recent failings, they serve a very useful purpose. Not everyone has the expertise and resources to analyze every security in detail. Presence of credit rating agencies gives smaller investors a starting point for analysis that they may not otherwise have.
This embedding of ratings in the financial system and reliance by so many participants on the ratings gives the nationally recognized statistical rating organizations or NRSROs tremendous power as ratings changes can have significant impact on companies, and even nations.
There are numerous examples of the impact that ratings changes can have. One recent one was during the onset of the 2010 European Sovereign Debt Crisis. What clearly played a role in triggering and escalating the crisis, even though it was not the cause, was the downgrade of Greece’s credit rating by three steps from investment grade BBB+ to junk rating of BB+. This came minutes after S&P downgraded Portugal by two steps to A- from A+. The announcement came at a sensitive time as the European Union policy makers and the International Monetary Fund were trying to hammer out measures to ease the panic over swelling budget deficits and create a financial rescue package for Greece. S&P followed the next day cutting Spain’s rating by one step to AA, and keeping the outlook as negative, reflecting the chance of further downgrades, with its projection of just 0.7% average real GDP growth annually from 2010 to 2016. Markets reacted violently to the cuts as investors worried about the safety of the debt of these countries, and contagion spread from Greece to other countries. Stock markets tumbled worldwide, and bond and currency markets had big moves and became very volatile.
Another way ratings impact markets is via the feedback loop between the markets and ratings through portfolios tied to indexes mandating certain holdings of particular debt. For example, the Barclays Euro Government Bond Index includes Greek debt as 4% of index, but only if the bonds maintain a certain credit quality based on lower of the rating from S&P and Moody’s. Greece had been 4% of that index but was excluded starting May 1, due to S&P’s downgrade. That in turn likely forced selling from investors tracking that index.
Critics assailed rating firms for fueling woe in Europe and Europeans criticized debt-rating agencies, accusing them of spooking the markets and worsening the plight of financially stretched governments such as Greece, struggling with heavy debt loads.
There are several other examples where a company needing to raise more debt in capital markets finds it cannot do so, or not at a reasonable cost, once it has been downgraded even while it was attempting to raise capital to improve its financial situation. The downgrade increases cost of financing as investors demand more yield reflecting lower rating. The downgrade may also result in existing investors having to sell holdings, further increasing the yields in the market. It can become a vicious circle increasing the likelihood of default. The downgrade reflects rating agency’s opinion of the outcome, but it also becomes a causal factor in determining that outcome. The rating agencies in effect become the judge, jury, and the hangman for the company.
The Real Problem That Has Not Been Recognized
In the current system, the rating agencies’ opinion can become a causal factor in making that opinion become reality. Time and again, in structured products and otherwise, it has been clear that the rating agencies are not infallible in their judgment, and do not have any special powers of predicting future. Their failures in predicting subprime mortgage performance have been appalling. But even if you look at the forecasts of defaults in corporate bonds, the predictions do not match the actual outcome, and the predictions themselves change over time, as they should.
So, if ratings are heavily embedded in the system and are needed, and yet rating agencies are not smarter than everybody else, and if they do not have special predictive powers about the future, how do we avoid giving their subjective opinions so much importance and extraordinary power?
The answer lies in recognizing the real problem – one that has not been addressed in any of the proposals so far. The real problem is that the rating agencies are combining two roles into one. First role is to provide a rating based on statistical analysis and past performance of the assets – remember that SR in NRSROs stands for Statistical Ratings. The second role is that of a research analyst to provide an opinion on what might happen in the future. Currently, rating agencies combine the two. The ratings are a mix of statistical analysis and somewhat subjective opinion on the future. This allows rating agencies to downgrade companies or countries even while they are in the process of attempting to improve their financial condition. At the same time, it leaves rating agencies open to criticism if they do not act and the feared worse outcome becomes reality before their downgrade. This also allows subjectivity and flexibility in ratings process that creates perceived conflicts of interest in issuer paid ratings.
The Solution
The logical solution is to separate the two roles. NRSROs should be doing Statistical Ratings – based on past performance of assets, known facts, events that have already taken place, and statistical models and methods that are well disclosed. They can put bonds on watch for upgrade or downgrade if a financial event is in progress or expected, but cannot downgrade or upgrade till the event actually happens. So they will not be precipitating events, and cannot be blamed for not downgrading sooner. This role will be limited to those approved as NRSROs.
The second role of providing credit ratings in the form of opinion on future performance should be separated from the NRSRO role, and should be open to any research provider, including NRSROs. These credit ratings could be designated as Informational Ratings without any legal or official role impacting investor charters, debt covenants, etc, which will only use the ratings designated as NRSRO Ratings. This will take the non-NRSRO rating agencies back to sort of where rating agencies started – as market researchers, selling assessments of corporate debt to people considering whether to buy that debt.
The information provided to NRSROs should be made available to all NRSROs and other non-NRSRO rating agencies, in a manner similar to password-protected website required under SEC Rule 17g-5. However, to promote competition and improve quality, the other rating agencies should be free to gather more information and not have to share it with others.
The conflict of issuer paid rating could be avoided if issuers were required to pay a fixed fee based on deal type (maybe to a group set up by the SEC or an industry association for that purpose) which would be divided between all NRSRO raters informing issuers of their decision to rate the deal after the issuers post the information on the password-protected website for credit raters. This will avoid ratings-shopping by issuers even though the agencies will be indirectly paid by the issuers. The NRSRO Rating will be provided to investors without any charge. The NRSROs will only provide the current rating, along with disclosing their rating methodology to investors. They will not provide any opinions or qualitative information.
For more qualitative information and opinions, investors will look to the Informational Ratings and more details from research providers (including NRSROs and non-NRSROs). This will be paid for by the investors looking for enhanced information and research. This will be the main source of income for credit raters and will incentivize them to compete with others for investor subscriptions and produce quality results.
Separating the two roles avoids the issues of rating agencies precipitating events if they act or facing criticism if they do not. It avoids the perception of conflict from issuer-paid ratings, by allocating costs between the issuer and the investors. It also preserves the role of rating agencies where its needed, while encouraging the investors to do more work on their own and look for third party unbiased research and opinion.
Note: Versions of this article were published in Structured Credit Investor and Seeking Alpha.
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Dodging a Bullet on the Oregon Trail
Thursday, March 10 2011 | 02:17 PM
Stephen Whelan
Partner,
SNR DENTON US LLP | Readers of this blog were alerted last month to potentially ruinous legislation which had been introduced in the Oregon legislature. Senate Bill 892 would have overridden any contractual “hell or high water” clauses and permitted a lessee or buyer with any “dispute” with the seller or lessor--even if unrelated to the sale or lease contract--to deposit any “payments” (not just periodic installment purchase or rental payments) into an attorney trust account or a statutory escrow trust account, until the dispute had been “resolved”. There was no provision for the seller or lessor to receive interest on any amounts so escrowed.
The legislation also would have applied to lenders and securitization investors, so the Bill threatened to complicate any financing involving Oregon equipment or an Oregon lessee--and probably any Oregon seller, lessor or lender. But this week, face to face discussions by the Equipment Leasing and Finance Association (and member law firm Farleigh Wada Witt) with the sponsor of the Bill were followed by withdrawal of the legislation. Further discussions are expected because of the sponsor’s unsatisfactory experience with processing equipment acquired for use in his business, but it appears that the Senator is aware that legislation as originally introduced could have impeded the flow of capital to Oregon businesses.
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New Regs Suggest Need for Independent Collateral Valuation
Thursday, March 10 2011 | 11:09 AM
Ron D'Vari
CEO & Co-Founder,
NEWOAK CAPITAL LLC | While much attention and scrutiny has been given to the effects of the Dodd-Frank Wall Street Reform and Consumer Protection Act on the financial services industry, other recent regulatory changes will also have profound effects on the way financial institutions do business. One key trend: the need for independent collateral valuation, particularly regarding complex or hard to value collateral, such as many asset-backed securities, whole loans, real estate, pools of receivables and leases.
The motivation behind the new regulations is a perceived need for independent, conflict-free, professional judgment, without influence or pressure that could possibly be exerted by parties having an interest in the transaction. Driving this perception has been the massive federal loss exposure in the aftermath of the subprime financial crisis.
The portfolio valuation requirements of the 2010 Interagency Appraisal and Evaluation Guidelines[1] (which replace the 1994 guidelines) flesh out the new federal expectations; these changes will have application to a wide variety of institutions, including: federally chartered banks and those accepting FDIC insured deposits; fund managers and others who make representations about collateral to public investors; investment bankers; and rating agencies.
Given the regulatory trend, it appears certain to us that the Agencies will follow the lead of the Financial Services Authority in the United Kingdom, which has required financial services firms to engage outside experts to provide independent, conflict-free valuation and risk analysis. This requirement provides an institution with a defendable (i.e., independent) valuation of the portfolio components.
Pursuant to the Guidelines, each financial institution must maintain policies and procedures which establish standards for obtaining current collateral valuation information. The institution may employ a variety of techniques for monitoring the effect of collateral valuation trends on portfolio risk associated with its lending practices.
Changes in market conditions underscore the importance of following sound collateral valuation practices and monitoring when originating or modifying real estate loans and evaluating portfolio risk.
The Agencies implicitly are addressing three major risk exposures that drive the government’s interest in objective third-party collateral validation practices:
1. The FDIC scheme of depository insurance, which depends crucially upon the soundness of bank lending practices.
2. Agency guarantees on mortgage-backed securities provided by Ginnie Mae, Fannie Mae and Freddie Mac.
3. The potential government responsibility to bail out financial institutions deemed “too big to fail.”
The drafting of the Guidelines is a joint effort of the Office of the Comptroller of the Currency, Treasury; Board of Governors of the Federal Reserve System; Federal Deposit Insurance Corporation; Office of Thrift Supervision, Treasury; and National Credit Union Administration (collectively, the “Agencies”). The Agencies have committed to work together to ensure that real estate lending is conducted in a safe and sound manner.
Note: Contributors to this blog post include members of the NewOak Capital team.
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What Do CMBS Spread Forecasts Say About Commercial Real Estate?
Friday, March 04 2011 | 01:15 PM
Malay Bansal
Managing Director,
CAPITALFUSION PARTNERS | Predictions about future bond spreads by market participants provide a window on their thinking about their expectations regarding the performance of the underlying asset class. CMBS industry’s weekly newsletter, Commercial Mortgage Alert published its semi-annual polling of predictions on CMBS spreads six months later last month. One interesting fact in the data was that not a single person asked for their prediction thought that the spreads will be wider six months later! Does this unanimity reflect wisdom of crowds and indicates a steadily improving commercial real estate market, or is this a contrarian signal with respect to where commercial real estate and CMBS spreads are headed? And how does that reconcile with forecasts of the real estate market conditions?
For the commercial real estate property market conditions, The Real Estate Roundtable has just published its 3rd Quarter 2010 Sentiment Index survey of more than 110 senior real estate executives. While the survey found significant concerns and uncertainty about economic & job recovery outlook, government policy, and capital markets, the overall sentiment is that the industry is in for a long slow recovery. The survey reports a Current Conditions Index (reflecting how markets are today vs 12 months ago), a Futures Conditions Index (expectations on how markets will be 12 months from now), and an Overall Sentiment Index, which is the average of the two. For the first time, the survey’s current and future conditions indices merged, scoring an Overall Sentiment Index of 74 (down from 76 in the previous quarter). This score suggests a relatively positive trend and a flat trajectory.
The actual data on commercial real estate is sending conflicting signals and is being read by different people in different ways. Cushman & Wakefield report last month showing US CBD office vacancy dropping to 14.8 % in Q2 from 15% at end of Q1 -first drop since 2007, CMBS statistics showing declining pace of deterioration in delinquencies, etc are seen by many as signs that the CRE market is stabilizing. Others point to declining rents and high unemployment as factors that point to further declines ahead. Both the viewpoints have some validity, which probably implies that the CRE sector might move sideways in near term with some volatility caused by which of the two views is stronger at any given point, till additional market data clarifies the picture more.
Going back to CMBS spreads, the tightening probably just reflects the sentiment expressed in other surveys of an expectation of slowly stabilizing CRE market. For CMBS, as opposed to properties, a consensus that the property price decline has stopped will be enough for bond spreads to tighten. Real estate prices do not necessarily need to go up for CMBS spreads to tighten. What happens if the sentiment on the economy sours impacting the view on the commercial real estate too? Even in that scenario, more and more people are coming to the view that the senior most CMBS bonds will likely not suffer a principal loss, which makes them attractive given the additional yield they provide compared to other similar investments. So, worsening economic conditions may actually cause people to move up in capital stack, creating demand for senior most bonds, and providing support for spreads. No one knows what future will bring, but logically, odds look in favor of the spreads moving in the direction suggested by the unanimous view.
All of the above is fine for trying to understand these markets, but one practical conclusion, and the real point of this article is this: if senior CMBS securities can go up in value even when property markets go sideways, and will have some support if the property markets decline, then logically, senior CMBS bonds have to be better investments at present than commercial real estate properties or loans for those who can invest in any of those.
Note: A version of this article was originally published 8/10/2010 on Seeking Alpha.The views in this article and my spread predictions in the Commercial Mortgage Alert article referenced are solely my own.
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The Biggest Headache For Groupon And Facebook Investors
Friday, March 04 2011 | 10:02 AM
Janet Tavakoli
President,
TAVAKOLI STRUCTURED FINANCE | Groupon makes its money by selling coupons for goods and services. It partners with local merchants. When you buy a coupon for a merchant's discount on Groupon, it reportedly takes a 50% cut in the U.S.
Groupon has had a few embarrassments. On Valentine's Day, FTD's flowers were priced lower than Groupon's "deals" and the online discounter had to apologize to customers. Moreover, merchants often put conditions and restrictions on Groupon discounts that dilute the value of the deal, similar to restrictions on redeeming air miles. Even so Groupon's valuations have ranged from $1.2 billion to $6 billion to $15 billion all in the space of a year. What's it really worth? More on that later.
Facebook is free and "always will be." It makes its money from ads and revenues from games (if users don't block them), albeit phone apps so far do not display ads. Michael Arrington at Techcrunch reported that Facebook is secretly building its own phone to control its own operating system. He noted that Li Ka-Shing is a Facebook investor, and he is an investor in the rumored INQ and Spotify phone project. While Facebook may remain free, it would have to figure out a way to get users to pay their phone bills.
Facebook has tremendous potential to exploit its 500 million users. In fact, one of Facebook's fundraisers is a genius at exploitation. Goldman Sachs, the Great and Powerful Oz of Finance (just don't look behind the curtain), has already opined on Facebook's value. In January 2011, it valued Facebook at $50 billion when it sought to raise $1.5 billion in Facebook financing.
Rich Teitelbaum of Bloomberg News reminded the financial world that Goldman Sachs Asset Management's anemic track record suggests that Goldman may not be the best go-to source for putting a value on an asset. Despite Goldman's public relations hype that it employs the "best and brightest," it trailed the average return of its peer group in every category. Goldman has an incentive to dangle a high valuation on Facebook in front of clients:
Jim Clark of Netscape and Silicon Graphics fame was irritated that Goldman wanted to fee stuff its Facebook offering with a 4 percent placement fee, a half percent expense fee, and a snatch-back of 5 percent of investors' potential profits.
A few months earlier, Clark had invested in Facebook through another financial firm at a lower price, and the other firm wouldn't potentially gouge him with Goldman's 5 percent pleasure-of-your-company tax. "I don't think it's reasonable," Clark told Bloomberg. "It's just another way for [Goldman] to make money from their clients." The question remains whether Clark bought his stake at a reasonable price.
"Blankfein Flunks Asset Management as Clark Vows No More Goldman," by Richard Teitelbaum, Bloomberg News, January 24, 2011
In January 2011, SharesPost Inc. valued Facebook at $82.9 billion on the secondary exchange. Whatever price the market will pay today, one has to be concerned about what it will pay tomorrow. Even if the future value of Facebook is say, $4 billion, Goldman will rake in fees.
Impermanent Value
Both Facebook and Groupon became successes because they are web based networks that required few management skills, minimum capital to start, and there were no barriers to entry. That is also their biggest problem. The ugly truth is that no one can tell you what they are worth as businesses.
Groupon's successful-so-far revenue model is its curse. It's both trying to hold its position in "established" markets, and it's trying to expand. The problem is that web users in other countries have noticed Groupon's success and the fact that Groupon has been paying high premiums for local established discounting web sites just to get at the client distribution lists.
Groupon's competitors are both buying sites for the same reason as Groupon, and local entrepreneurs can easily copy Groupon's business model. It seems all it takes is a good web developer, a two-page merchant agreement, and an accounting firm that can handle the taxes as a site expands internationally. Groupon may have a head start, but it has no long-term competitive advantage. That puts its margins, its market share, and it's ability to expand and hold its position in new markets at risk.
Smart investors look for highly skilled managers in industries with a long-term competitive advantage in a stable industry run by decision makers with a "here-today, here-forever" mentality. Between Groupon and Facebook, it seems Facebook has the better chance of making a case, but it hasn't made one so far.
Facebook seems to be thinking of ways to create a loyal user base by penetrating deep within its user base. It certainly has a shot, but it is unclear whether it can maintain a competitive advantage.
Users are fickle, and young users will gravitate to the next exciting new thing. The rapid success of Catherine Cook's myyearbook.com has to give investors pause. She started the site 6 years ago as a 16-year old high school student with a $250,000 investment from her brother, and the site is valued at $20 million. While it's no threat to Facebook, it has a fresh look, is responsive to users, and offers new spins such as allowing users to buy each other gifts and "lunch money."
Investors may wonder when the next bright young kid will eat Facebook's lunch and make it look like a site for old fogies. Facebook may adapt, but it would do itself favors by disclosing its revenues, and how it plans to face up to potential competitors.
Note: This post originally appeared in the Huffington Post.
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Ending GSE Bailout is A Delicate Balancing Act
Thursday, March 03 2011 | 09:01 AM
Ron D'Vari
CEO & Co-Founder,
NEWOAK CAPITAL LLC | We agree to a well defined and transparent but gradual end to the bail out of GSEs. The process has to be designed with full understanding of the markets and free of political agenda.
On-balance sheet approach is a good aspiration but has its own pitfalls and challenges. The annual budgetary process for allocating on-balance and on-budget has proven to be problematic and has politicized the process as opposed to making it more effective and efficient. GNMA program history is a good case study.
We believe in the end there has to be two fluid markets existing side-by-side:
1) a revised conforming government guaranteed mortgage market,
2) standardized private non-agency market.
The underwriters of conforming mortgages should be more diversified than just the two GSEs. There is need for more of them and should be privately financed with some well defined tail risk protection from government. There should also be a limit on each conforming sponsor’s size to manage systematic risks and moral hazard. With that there would have be a non-risk-taking independent collateral agents to ensure transparency and uniformity. The underwriting guidelines should also be more dynamically adjusted through the economic cycle to minimize and protect against systematic risk. The independent collateral agents should be regulated but not part of direct government administration.
We do believe the securitization of non-agency market is critical but in this case uncertainty in well defined legal frame work and Dodd-Frank rules has severely been the bottleneck.
Significant unsold non-performing loans and REOs stock in the banking system will continue to be a major road block to the non-agency securitization.
We agree to a well defined and transparent but gradual end to bail out of GSEs. The process has to be designed very carefully. On-balance sheet approach is a good aspiration but has its own challenges. The annual budgetary process for allocating on-balance and on-budget has proven problematic and politicize the process as opposed to making it more effective and efficient. GNMA program history is a good case study.
We believe that there has to be two markets:
1) conforming government guarantee mortgage market,
2) non-agency market.
However the underwriters of conforming mortgages should be more diversified than just two agencies and these should be privately financed. Perhaps there should be a limit on each agency size due to systematic risk. With that there would have be a non-risk independent collateral agent party to ensure transparency uniformity. The underwriting guidelines should be more dynamically adjusted through the economic cycle to minimize and protect against systematic risk. The independent collateral agents should be regulated but not part of direct government administration.
We do believe the securitization of non-agency market is critical but in this case uncertainty in legal frame work has contributed to lack of market start.
Significant unsold non-performing loans and REOs continue to keep the non-agency RMBS a non-starter.
Standardized servicing need to also be addressed.
Lastly, lack of well defined rating criteria will be a problem to get the market started.
It is critical for US economy to have a well functioning residential mortgage markets and we believe it should be more of a national priority.
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Ambushed on the Oregon Trail
Monday, February 28 2011 | 11:28 AM
Stephen Whelan
Partner,
SNR DENTON US LLP | Senate Bill 892 was recently introduced in the Oregon legislature. It would affect any equipment sales or lease contract that contains a so-called “hell or high water”, or waiver of defenses clause and, by permitting the lessee or buyer to deposit payments into an attorney trust account or a statutory escrow trust account, would prohibit the lessor/seller or any assignee from enforcing the HHW clause or reporting the nonpayment “as a default or as information that may negatively affect the person’s credit rating…or ability to obtain credit.”
Commentators have identified at least one dozen defects or other problems with this Bill. One of them is that the Bill permits withholding of payments by reason of any “dispute” between the seller/lessor and the counterparty--not just a dispute over operation of the equipment or even a dispute relating to that particular contract. Another is that the Bill applies to any “payments”, so amount payable for maintenance, taxes, indemnities also could be placed in escrow, thereby forcing the lessor to pay property taxes or repair bills or else risk losing title to the equipment.
The Bill applies to assignees of the seller or lessor, so lenders, whole loan purchasers and securitizers would be prohibited from using the HHW clause to enforce payment. There is no provision for the lessor, securitizer or other assignee to receive interest, at the contract overdue rate, on the escrowed amounts.
In short, the proposal would undercut one of the linchpins of lease and securitized finance: the absolute and unconditional obligation of a lessee or purchaser to make payments. If enacted, it could force lenders, syndicators and securitizers to forbid any Oregon contract from being included in contract pools which they finance. Of course, the Bill is silent regarding which contracts would be affected, so the chilling effect on Oregon-related equipment would be even greater.
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Two Points For Investors
Tuesday, February 22 2011 | 02:46 PM
Malay Bansal
Managing Director,
CAPITALFUSION PARTNERS | If a picture is worth thousand words, the graph below is a valuable illustration of two very important points that investors would be better off to remember. This graphic focuses on the returns from various sectors in fixed income market, but the same concept generally applies to equities too.
The creators of the graphic intended to make the case for active management. I am assuming that anyone managing investments for themselves or others already believes in benefit of active management to some extent. The points I want to make go a little further.
The first point is that sector selection is much more important for generating superior returns than individual security selection. You could be very active in selecting securities, but if they are not in the right sector, the returns might suffer, no matter how much effort is put into picking the individual bonds or stocks.
The second point that this graphic makes to me is that, when I am picking funds, it makes sense to pick funds that have broader focus and a manager with expertise in multiple sectors. In other words, funds in which the manager has the expertise and ability to switch between different sectors may be able to do a better job than an investor trying to move between different funds. That thinking leads me to pick funds like PIMCO Total Return (PTTRX), Blackrock Global Allocation (MALOX), Vanguard Wellington Income (VWELX), and others.
Note: A version of this article was originally published on Seeking Alpha.
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Muni Bonds: Matt Taibbi's* Antidote to Meredith Whitney
Tuesday, February 22 2011 | 02:36 PM
Janet Tavakoli
President,
TAVAKOLI STRUCTURED FINANCE | The credit-worthiness of specific muni bonds, particularly non-general obligation project bonds, has become a hot topic since "AAA" bond insurers imploded, partly due to mispriced risk premiums on protection they wrote on value-destroying CDOs for Wall Street banks.
Meredith Whitney provided no research to back up her call on a recent 60 Minutes segment of coming defaults by large municipalities amounting to "hundreds of billions of dollars" (50 to 100 defaults). (Corrected Feb 9). Bloomberg News revealed that her muni report was on the state level and didn't cover large municipalities. That's a problem, since muni credit issues are granular and the severity of the problem -- or non-problem -- depends on the specific situation. Her unsupported claim gives muni-problem-deniers ammunition to claim there is no substance to the argument that there are serious problems with certain muni bonds.
The Columbia Journalism Review made a valid point when it called out 60 Minutes for not making sure Whitney could back up her claims. Max Abelson and Michael McDonald of Bloomberg News debunked her "untarnished" track record and Spaceballs-worthy jabberwocky:
Bloomberg News reported in October that about two-thirds of her stock picks since starting her company in 2009 had fared worse than market indexes. A 2008 Fortune cover story ranked Whitney 1,205th out of 1,919 equity analysts the previous year, based on stock picking.
"A lot of this is, you know it, but can you prove it? There are fifth-derivative dimensions that I don't think I need to spell out to my clients," [Whitney] said.
"Whitney Municipal-Bond Apocalypse Short on Specifics," Bloomberg News, Feb 1, 2011 (excerpted and condensed).
In contrast, Matt Taibbi's Rolling Stone expose of Jefferson County, Alabama's sewer project is a hair-raising account of financial corruption, bribes, cost padding, pay-to-go-away agreements between investment banks, and fee slamming that wildly inflated the cost of a sewer project from $250 million to $3 billion. It saddled Jefferson County's taxpayers with a too-onerous debt burden and broke the financial back of the county. JP Morgan agreed to pay a $25 million fine to the SEC and $50 million to aid Jerrson County's displaced workers for its role in the devastation (updated):
The county, it turned out, was more than $5 billion in debt -- meaning that courthouses, jails and sheriff's precincts had to be closed so that Wall Street banks could be paid...Homes stood empty, businesses were boarded up, and parts of already-blighted Birmingham began to take on the feel of a ghost town.
"Looting Main Street," by Matt Taibbi, Rolling Stone, March 21, 2010
Whitney might back up her claim by walking the media through at least one analysis -- if she has one -- of the specific problems of a large municipal bond issue, since it is beginning to look as if Whitney's claims are a series of PR stunts.
Whitney's claim-to-fame, a bearish bank call on Citi, was over-hyped. Her Citi call was late. Jim Rogers, a world famous investor with a provable track record, appeared with her in early 2007 on Cavuto on Business and explained why he was short (bearish on) Citi. Whitney refuted him and continued to rate Citi sector perform, yet Citi underperformed the sector during this time period. It wasn't until October 31, 2007, that she took Rogers' hint. Likewise her Bear Stearns call was late, and her Lehman call was tardy. I mentioned this in a commentary after either she or her PR people seemed to take credit for an apparently nonexistent early call on AIG. (See: "Reporting v. PR: Meredith Whitney and AIG," TSF, March 23, 2009 .)
Meredith Whitney's PR has more issues than Rolling Stone, but Matt Taibb^i provided evidence that he researched the substance of the problems behind a muni bond issue.
Endnote: (Feb 9, 2011): As I've mentioned in previous posts, there are serious fiscal problems that need to be addressed at state and local levels, but this varies by region and some issues are potentially solvable. For example, Illinois hiked personal income taxes from 3% to 5%. (I'm a resident of Chicago, Illinois.) The Chicago Mayoral race centers partly around steps, including budget cuts, needed to solve Chicago's serious fiscal issues: See also my previous post: "Third World America: 'Fast-Tracking to Anarchy;" HuffPo, August 25, 2010.
Further Reading: "Repairing the Damage of 'Fraud as a Business Model,'" TSF Address to the FHFA's Supervision Summit in Washington D.C., December 8, 2010.
^Feb 11, 2011 addition: Blloomberg News broke this story in September 2005 in an article titled "The Banks that Fleeced Alabama," by Martin Z. Braun, Darrell Preston and Liz Willen
Note: This post originally appeared in the Huffington Post.
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Systemically Significant?
Monday, February 14 2011 | 01:10 PM
Stephen Whelan
Partner,
SNR DENTON US LLP | On February 8, 2011, the Board of Governors of the Federal Reserve (the “Board”) issued a notice of proposed rule making under the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). The proposed rules establish criteria for determining whether a nonbank entity (1) is nonbank company that is “predominantly engaged in financial activities”, and (2) is a “significant nonbank financial company”. Both of these rules are important, because the Dodd-Frank Act gives the Financial Stability Oversight Council (the “FSOC”) the authority to determine whether a nonbank financial company shall be subject to the Board’s supervision, because it could pose a threat to the financial stability of the United States.
One of the necessary criteria for a company to be a “nonbank financial company” is that it be engaged “predominantly in financial activities”. Under the first proposed rule, a company would be “predominantly engaged in financial activities” if in either of its past two fiscal years, eighty-five percent of its consolidated annual gross revenues or consolidated total assets in that year were derived from or related to, respectively, “activities of a financial nature” or the ownership, control, or activities of an insured depository institution or any of subsidiary thereof. Additionally, the Board would have discretion to determine “based on all the facts and circumstances” that at least eighty-five percent of a nonbank company’s consolidated annual gross revenues or consolidated total assets are derived from or related to the aforesaid activities.
One factor, in determining whether a “nonbank financial company” is to be subject to the Board’s supervision, is the degree and nature of its connections with other significant nonbank financial companies and significant bank holding companies. In this regard, the second proposed rule defines a “significant nonbank financial company” as a nonbank financial company that is already supervised by the Board, or that had at least $50 billion of total consolidated assets as of the end of its most recently ended fiscal year. Furthermore, the FSOC may recommend to the Board that nonbank financial companies supervised by the Board report to the FSOC, the Board, and the FDIC on their credit exposure to other significant nonbank financial companies and significant bank holding companies. (A “significant bank holding company” is a bank holding company or foreign bank treated as a bank holding company that had at least $50 billion of total consolidated assets as of the end of its most recently ended fiscal year.)
These proposed rules are important to several companies in the equipment finance arena, because if any of those companies qualify as nonbank financial companies, then they could be subjected to supervision by the Board, similar to that imposed on bank holding companies, and could be required to report on their credit exposure to other significant nonbank financial companies and significant bank holding companies. It is as yet unclear how burdensome the increased regulatory oversight would be.
The deadline for comment is March 30, 2011.
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Tackling the US Unemployment Problem-Infrastructure Investments Without Increasing Taxes or Deficit
Friday, February 11 2011 | 09:44 AM
Malay Bansal
Managing Director,
CAPITALFUSION PARTNERS | High unemployment is one of the most important issues the US economy is facing, and one of the most effective ways to tackle this problem is investments in productive infrastructure. Here is an idea that will encourage private investment in infrastructure without requiring increases in deficit or taxes, along with steps needed to ensure that the program will be effective.
High level of unemployment at 10%, or 17% if you also count the under-employed, is one of the biggest challenges the US economy faces today. Consumers are about 70% of the economy. People without jobs can’t spend as much on goods and services, and can’t buy houses, which does not help housing situation, another significant issue. US companies have managed to increase profits but partly by reducing costs and spending, which also does not help the economy grow. The QE2 program undertaken by the Federal Reserve is meant to help unemployment indirectly by driving interest rates lower, but its effectiveness is far from certain, and is being questioned by many.
Why Infrastructure Investments?
One generally agreed approach to increasing employment is investment in infrastructure projects. The jobs created are local and cannot be exported, and the jobs will be created in sectors like construction that are facing higher unemployment (about 21% of the eight million jobs lost in 2008 & 2009 were in the construction sector, which still has unemployment at 17% level). Also, spending on infrastructure generates demand for products and services from a variety of industries, creating more jobs.1
Another consideration in favor of infrastructure investments is that deteriorating US infrastructure is sorely in need of maintenance. American Society of Civil engineers estimates that US needs $2.2 trillion in infrastructure spending over next five years2. The collapse of the I-35W bridge over Mississippi River in Minneapolis in Aug 2007 was a vivid example of this need. Increased spending also makes sense comparatively - US spends 2% of GDP on infrastructure, while China and Europe spend 9% and 5% respectively.
Also, several factors make this a good time to make investments in infrastructure – raw materials and labor are cheap, as is cost of financing. The maintenance is necessary and overdue. Not doing it now just means that it will have to be done at a later time when it will likely cost more.
Issues in Investing in Infrastructure
The biggest issue is finding funds without increasing deficit or taxes. US National debt for the $14.5 trillion economy has already ballooned to more than $13 Trillion. In Sep 2010, the Obama administration proposed a plan to spend $50 billion on infrastructure investments. However, the congress has not approved the plan, and the increased focus on reducing deficit and spending in the newly elected congress will constrain spending by the federal government. The state and local governments have lower tax revenues due to weaker economy and lower real estate values, and are constrained in their ability to spend.
Need for funds is one problem. Another problem is picking projects that are productive and not just a waste of money. Government may not be the best judge for picking the best projects. Solution to both problems is increased involvement of private sector.
Investment in Infrastructure without Increasing Deficits or Taxes
To get the private sector to invest in infrastructure projects, the government has to provide incentives, but in a way that does not increase deficit or taxes. One possibility for doing this may be by using the estimated $1 trillion of unrepatriated profits US companies hold in foreign subsidiaries. American companies can generally defer paying taxes on foreign profits as long as they keep the money outside US. When they bring the money back to US, they have to pay the top corporate tax rate of 35%. To defer taxes, US companies generally have left large sums of profits in their foreign subsidiaries.
These untaxed profits are part of the reason large multinationals have lower overall tax rates for which they have been criticized at times. Earlier this year, the administration proposed restricting companies from deferring taxes on profits earned oversees (estimated to raise $210 billion in revenues over next 10 years), but faced strong opposition since that would put the US companies at a competitive disadvantage.
On the other end, US companies are arguing that they could bring back the earnings in their foreign operations if the US government offered a tax amnesty and permitted them to repatriate foreign earnings at a low rate of around 5% instead of the 35% federal tax they face at present (see editorial in Wall Street Journal on Oct 20, 2010 by John Chambers, the CEO of Cisco, and Safra Catz, the President of Oracle). They argue that 5% tax could bring $1 trillion back to US for increased economic activity and could generate $50 billion in federal tax revenue.
The tax amnesty does not cause an increase in deficit or taxes, as government is giving up what it is not getting anyway - without it, these funds will not come back into the US economy, and the Treasury will not get the additional tax revenue. However, the funds brought back will not necessarily generate jobs. The companies could use the money for M&A activity, stock buybacks, and paying out dividends. A better idea will be to offer the tax amnesty only to the funds brought back that are invested in infrastructure and clean energy projects in the US. A limited time tax amnesty will encourage US companies to repatriate earnings back to US. A requirement to invest in infrastructure projects for a minimum fixed number of years (say something between 3 to 5 years) will ensure that the funds brought back create jobs. Companies will be allowed to invest in either debt or equity depending on their risk-reward preferences. All investments will be chosen and managed by private fund managers, who will pick projects and investments based on sound economic calculations of cost-benefit and expected returns. The companies will be able to pick any fund manager based on their judgment of manager’s capabilities.
This basic framework could be enhanced in several ways. Companies could be encouraged to invest for a longer period by offering to reduce any taxes on the earnings from the infrastructure investments, if the investments are held for say 7 to 10 years or more. Also, companies could be allowed to use part of funds brought back to build new plants for their own use.
Will Private Investors Invest In Infrastructure?
If the government did allow repatriation at low tax rates for money to be invested in infrastructure, would there be demand for it? Can these projects generate returns that investors will find attractive? The answer to both is affirmative. Prequin reported recently that 28 US Infrastructure debt funds were on the road trying to raise $26.4 billion. Europe, smaller in size, but with better developed Public Private Partnership programs in the sector, had 38 funds trying to raise $29.3 billion. Large investors have expressed willingness to invest in these projects. Zhou Yuan, head of asset allocation at China Investment Corporation (CIC), said in November that CIC would be willing to invest in large projects like high speed links between US cities, and super high-voltage transmission lines that provide a good risk-return profile, and suggested US should invest $1 trillion over next 5 years in form of public and private equity partnerships to create jobs (instead of QE2) and improve competitiveness.
Ensuring the Program is Effective
An editorial in New York Times on Oct 23 opposes the idea of tax holiday for repatriating foreign investments citing the experience of 2004. In 2004, after strong lobbying by the US multinationals, the Congress passed the American Jobs Creation Act in which the Homeland Reinvestment provision gave US companies a one-time break to pay 5.25% rather than 35% in taxes on the repatriated foreign profits, with the intention that the repatriated money would prompt investment in the United States economy and spur job growth. To qualify for the one-time tax break, companies had to promise to use the money to invest in their domestic operations. They could not use it to pay dividends, or compensate executives.
The program was heavily used by large corporations – many in the pharmaceutical and technology industries. For example, Pfizer brought back $37 billion, and Hewlett-Packard repatriated $14.5 billion. The amount of repatriation exceeded expectations. In all, 843 corporations took advantage of the offer, bringing back $362 billion in foreign profits. Of that amount, $312 billion qualified for the tax break, giving those companies total tax deductions of $265 billion claimed from 2004 through 2006.
According to analysis later, of the $299 billion companies brought back from foreign subsidiaries, between 60 and 92 percent of it went to shareholders, through increased share buybacks or increased dividends. Repatriations did not lead to an increase in domestic investment, employment or R&D, even for the firms that lobbied for the tax holiday stating these intentions. For example, Dell, which repatriated $4 billion, spent $100 million on a plant in Winston-Salem, N.C, which they said they would have built anyway, and used $2 billion two months later for a share buyback. Also $100 billion was estimated to go right back to foreign subsidiaries.
The provision requiring domestic investment had wide definitions of the term investment and allowed corporations to use repatriated profits to shore up their domestic finances, pay legal bills and even bankroll advertising. While companies did make investments in their domestic operations, the repatriated money also freed up a corresponding amount of cash to pay out to shareholders or buy back stock.
Money is fungible. It can be easily moved from one bucket to another. Hence, to ensure that the tax break really results in investments that create jobs, that money has to be separated. Hence, for this idea to be effective, the funds brought back must be invested with third-party private fund managers for a minimum number of years to qualify for the tax break.
Longer term, the US needs to develop regulations that clarify and encourage private sector investment and involvement in the infrastructure sector. Public-Private Partnerships and securitization of infrastructure financing can play a very useful role in developing this sector which is essential for the growth and competitiveness of the US economy in the longer term.
1An Oct 2010 report from the Council of Economic Advisors & the US Treasury (An Economic Analysis of Infrastructure Investment) discusses the benefits of infrastructure investments in detail. Also, see Jan 2009 article How Infrastructure Investments Support the U.S. Economy: Employment, Productivity and Growth from PERI & AAM.
2Also see CBO Testimony on Current and Future Investment in Infrastructure.
Note: This idea was originally published at http://marketsandeconomy.wordpress.com/2010/11/23/tackling-the-us-unemployment-problem/
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Blame the Victims and Enrich the Perpetrators
Wednesday, February 09 2011 | 03:28 PM
Janet Tavakoli
President,
TAVAKOLI STRUCTURED FINANCE | It's outrageous the way subprime borrowers swarmed and solicited unsuspecting lenders and camped out in the offices of investment banks to push them to find ways to finance their insatiable need for capital to purchase homes. It's a scandal the way they got in bed with appraisers to get the home values stated at three to five times market value. It's criminal the way they falsified income to push through the mortgage loans. Oh wait... they didn't. [Hat tip to Nomi Prins, author of It Takes a Pillage.]
While there were instances of fraud by borrowers, the key drivers of our housing crisis were fraud perpetrated by mortgage lenders and securities fraud -- by some of our most revered financial institutions -- that provided money to fuel fraudulent mortgage lending.
After the largest bank bailout in world history, we have a national epidemic of foreclosure fraud. In cases where foreclosures are being delayed, banks are walking away from abandoned homes and sticking local taxpayers with the bill to clean up the mess they left behind.
Yet, as Arianna Huffington points out in her latest book, banks continue to find ways to get Americans to subsidize problems that the banks themselves were chiefly responsible for creating. Consumers struggle to keep up with payments as the unemployment rate rises along with food and energy prices, and loan resets kick in:
When they don't, banks, trying to offset losses in other areas, turn around, hike interest rates, and impose all manner of fees and penalties--all of which makes it less likely consumers will be able to pay off mounting debts.
Third World America: How Our Politicians Are Abandoning the Middle Class and Betraying the American Dream Pp. 77 & 78.
GSAMP: Garbage Sold at Mythical Prices
In 2007, the state of Ohio kicked the California-based New Century mortgage lending carpetbaggers out of the state and barred New Century from doing business after despicable practices. A complaint of alleged fraud on the part of Goldman Sachs detailed its close relationships with Countrywide, New Century, and Fremont. The complaint showed Goldman knew of "an accelerating meltdown for subprime lenders such as New Century and Fremont." Despite known serious loan problems, Goldman continued to securitize the loans and sell them in packages of residential mortgage backed securities.
Suspect deals like GSAMP-2006 S3; $494 million of securities bought by institutional investors in April 2006 were created and distributed by Goldman Sachs Alternative Mortgage Products (GSAMP).
Fortune's Allan Sloan and Doris Burke followed the deal as its value slid ever downward as well as the fudgy way the deal's deteriorating value seemed to be overstated by the trustee's report:
More than a third of the loans were on homes in California, then a superhot market, now a frigid one. Defaults and rating downgrades began almost immediately. In July 2008, the last piece of the issue originally rated below AAA defaulted -- it stopped making interest payments. Now every month's report by the issue's trustee, Deutsche Bank, shows that the old AAAs -- now rated D by S&P and Ca by Moody's [junk ratings] -- continue to rot out.
As of Oct. 26, date of the most recent available trustee's report, only $79.6 million of mortgages were left, supporting $159.9 million of bonds...But even worse, those mortgages aren't worth anything like their $79.6 million of face value, according to ABSNet Loan HomeVal...As of Sept. 26 -- a slightly different date from what we're using above -- ABSNet valued the remaining mortgages in our issue at a tad above 20% their face value. Now, watch this math. If the mortgages are worth 20% of their face value and each dollar of mortgages supports more than $2 of bonds, it means that the remaining bonds are worth maybe 10% of face value.
"Junk mortgages: It just gets worse, " by Allan Sloan and Doris Burke, Fortune, December 1, 2009.
"Countrywide Broke the Law"
In above mentioned complaint against Goldman Sachs, allegations of suspect practices from mortgage lenders, including Countrywide, now owned by Bank of America, were revealed. According to a former Countrywide employee:
"approximately 90% of all reduced documentation loans [also known as "liars' loans] sold out of a Chicago office had inflated incomes, and one of Countrywide's [mortgage brokerage arms] routinely doubled the amount of the potential borrower's income...so that borrowers could qualify for loans they could not afford."
When Countrywide's employees received documents verifying income that showed the borrower couldn't afford the mortgage and didn't qualify for a loan, they simply ignored it and "the loan was re-submitted as a stated income loan with an inflated income figure so as to facilitate the approval of the loan." In other words, the former Countrywide employee said that brokers, not borrowers, engaged in massive fraud to push loans through the system and earn commissions.
Illinois Attorney General Lisa Madigan told First Business Morning News: "Countrywide broke the law, homeowners did not."
Pump and Dump
The same banks that supplied money -- and in some cases now own -- suspect mortgage lenders also packaged up and sold those loans to investors. These banks also own or owned "servicers" that are supposed to act as stewards for investors. But if servicers cannot recover foreclosure costs combined with the costs of maintaining and reselling the house, they often abandon the property. After pumping up appraisals and falsifying borrowers' income on applications, banks are walking away. Once again, American taxpayers will foot the bill:
In Chicago, the mortgage servicers and trustees most often associated with the [abandoned] properties are Bank of America, with 314 properties; Wells Fargo (234), U.S. Bank (185), Deutsche Bank (178), and JPMorgan Chase (165).
"More banks walking away from homes, adding to housing crisis," by Mary Ellen Podmolik, Chicago Tribune, January 13, 2011. (Source of data on homes apparently abandoned in the foreclosure process is a new local study by the Woodstock Instititue.)
Despite evidence of widespread interconnected mortgage lending, securitization, and foreclosure wrong-doing and fraud, there are no meaningful felony indictments. Arianna Huffington suggests a solution and a long and difficult road ahead:
The most effective way of fixing the multitude of problems facing America is through the democratic process, but the democratic process itself is badly broken. That is why the first step toward stopping our relentless transformation into Third World America has to be breaking the choke hold that special interest money has on our politicians.
Third World America P. 172
Note: This post originally appeared in the Huffington Post.
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