20 April 2007

The Structural Problems of Structured Finance

Edward Chancellor

When banks discovered how to securitize loans they inadvertently created a sexy alternative investment. Looking for an asset which isn't correlated to the stock market? Then, invest in mezzanine tranches of collateralized debt obligations. Or better still, give your money to a credit hedge fund which promises to produce double digit returns. Rampant demand for structured securities has been a boon to bankers, homeowners and private equity firms. It's also led to the mispricing of credit risk. But participants in this brave new world of finance have little cause to worry about that.

Last year, some $340 billion of collateralized debt obligations were issued in the United States, according to Credit Suisse. That represented a 58% increase over the previous year. The true size of this market is probably much larger when private deals, arranged by investment banks, are included. The securitization of loans has enabled banks to remove credit risk from their balance sheets. It also provides institutional investors with a means of diversifying and creating exposures to new risks, which were previously inaccessible. The first-loss, or equity, tranches of CDOs appeal to sophisticated market participants with a greater risk appetite.

Exponents claim that securitization not only strengthens the financial system by distributing credit risk away from the banking system. It also lowers the cost of borrowing by placing that risk in the hands of those who are most willing and capable of bearing it. If such claims were true, we would expect credit to be more efficiently priced than ever.

That doesn't appear to be the case. Until recently, the US mortgage world, where most loans are securitized, was characterized by an extreme recklessness. Private equity firms are currently able to finance risky buyouts with cheap loans that carry little or no covenant protection. As Carlyle Group co-founder Bill Conway observed in a recent memorandum "there is so much liquidity in the world financial system, that lenders (even ''our'' lenders) are making very risky credit decisions."

Of course, Carlyle's lenders aren't stuck with the consequences of those decisions. Instead, most LBO loans now find their way into structured finance securities, known as collateralized loan obligations. Last year around 60% of US buyout loans were packaged into CLOs, according to Standard & Poor's Leveraged Loan and Commentary. The same dynamic has been at work in the mortgage world. Lower quality loans have been packaged initially as so-called "private label" subprime mortgage-backed securities. The riskier tranches of these MBS, which were traditionally difficult to sell, were subsequently put into CDOs. Around $200bn of mortgage loans went into CDOs in 2005. The bulk of these loans were below investment grade.

Mr. Conway is not alone in believing that the spreads on loans provide insufficient compensation for the risk of loss. David Roche of Independent Strategy, a London-based research firm, has coined the term "New Monetarism" to describe this phenomenon. Roche argues that this new source of liquidity has contributed to low risk premiums and inflated asset prices. But it would be wrong to categorize the lenders as crazy.

As we've seen the banks which make loans don't hang on to them. Nowadays, they earn more than enough in fees from originating, packaging and servicing loans. By freeing up their balance sheets, the banks' returns on capital have soared. The hedge funds, which invest in the equity tranches of these structured securities, also have their reasons. As long as defaults remain low, their risky bets are designed to produce outsize pay-offs. Equity tranches can produce internal rates of return at the high end ranging from 20 per cent to nearly 100%, according to Martin Fridson of Leverage World. Since no US leveraged loans turned sour last year, they've proved a good bet so far.

Furthermore, as these gains have come with little or no volatility hedge funds get to report high risk-adjusted returns (as measured by the Sharpe ratio). Of course, some of these loans may go bad in future. But given the way hedge fund managers are compensated, it doesn't pay for to think too far ahead. After all, their performance fees are distributed annually and aren't refunded even if past gains are subsequently given up. So even if a loan is destined to produce losses over its lifetime, a hedge fund manager can still, in theory, profit from taking an early exposure. For those wary of the endgame, there's always the possibility of selling on the loan before the credit crunch appears.

That's not the end of the story. Institutional investors also pile into the senior tranches of structured securities. Given the complexity of these instruments that might seem strange. Last year, ABN-Amro launched a product known as the Constant Proportion Debt Obligation. The CPDO, as it's called for short, sells default protection through an index of credit default swaps. It is designed to carry maximum leverage of up to 15 times principal. If a couple of names in the index blow up or spreads widen beyond a certain point, then investors in the CPDO could lose most of their capital. A yield of 200 basis points above LIBOR might seem insufficient compensation for these risks.

But not to investors who are attracted by its triple-A rating. Banks and insurance companies like to hold investment-grade debt as it attracts a lower capital charge from regulators. The CPDO appears designed to get the highest possible yield for its rating. Frank Partnoy, a professor at the University of San Diego School of Law, claims that the "ratings agencies have developed methodologies for rating CDOs that result in the combination of tranches being worth more than the underlying assets."* According to this view, structured securities don't create value by distributing risk. Rather, the various tranches are boosted artificially with ratings which don't reflect the underlying risks.

Whether that's true or not depends on the accuracy of the models used by the ratings agencies. These models are not beyond criticism. They use historic data to measure the risk that different names within a CDO will simultaneously default (what's known as "correlation risk"). In the case of the CPDO, they also gauge the likelihood of spreads widening, which is a market risk. For all their mathematical sophistication, the models will only be accurate if the future, more or less, resembles the past.

What's more, the investment banks which issue structured securities shop around for the most favorable rating, says Ed Grebeck, a lecturer in Credit Trading Products at NYU. The ratings agencies earn fat margins from this business, which has been growing rapidly. Around half of Moody's and S&P's earnings now come from structured finance. But if these ratings turn out to be wildly inaccurate won't the credit rating agencies suffer as similar punishment to those investment banks which gave dodgy recommendations on internet stocks a few years back? Possibly not. If everything goes awry, the rating agencies will deny, as they have in the past, any fiduciary responsibility to investors, claiming instead that their comments are made under the right to free speech guaranteed by the First Amendment.

The growth of securitized lending and derivatives has contributed to the extremely easy conditions of the credit markets in recent years. The mispricing of credit appears irrational to many observers. But the structural flaws in the world of structured finance provide market participants with reasons to play this game to its sorry end.

* Frank Partnoy, How and Why Credit Ratings Agencies Are Not Like Other Gatekeepers, in Financial Gatekeepers: Can they protect investors? (Yasuyuki Fuchita and Robert Litan, editors, Brookings 2006)

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