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July 26, 2007
Joshua Rosner646/652-6207
Please refer to important disclosures at the end of this report.
Financial Services Exposures to Subprime, Why we are not ‘Seeing Red’
While the impacts of the dislocations in the mortgage backed securities (MBS) andcollateralized debt markets (CDO) have been of relatively little consequence to reportedearnings this season there are many institutions that have significantly larger embeddedlosses and operational, credit and market risk exposures than they have acknowledged upto this point.
Given the lack of transparency and the fact that recent FASB guidance on Fair ValueMeasurement (FASB “Statement No. 157”) does not become fully effective for allinstitutions until after the institution’s first post November 15 reporting period, manycompanies will continue to avoid recognizing losses as long as they are able.
Barring investor demands for greater disclosures many losses will remain largely hiddenuntil at least the reporting of 2007 annual filings. Even then, we continue to believe thatmany institutions will use the subjective nature of the mark to model valuation methodsfor illiquid securities to defer losses and obscure their true exposures. Beyond avoidingthe negative impact to earnings such improper or aggressive marking of assets obscuresthe usefulness of investor reliance on book value.
Our goal in this report is to provide analysts and portfolio managers with primaryquestions that investors should be asking of managements in an effort to avoid attempts atobfuscation through jargon. Given the relative complexity of structured securities and theconfusion created by the rating agencies ‘one size fits all’ ratings scales, we believe thatinvestors need to understand the unique nature of risk layering and employed leverage ofthese securities.
Although our current focus relates primarily to problems in Residential Mortgage BackedSecurities (RMBS) and related Collateralized Debt Obligations (CDOs), we expect thatthese problems are likely to be a precursor to similar problems in other structuredsecurities, most imminently Commercial Mortgage Backed Securities, CMBS relatedCDOs and CLO’s.
There are many ways to obscure exposures including the moving of exposures, atessentially par, to off-balance sheet vehicles. There are also many types of exposures toconsider including both the internal leverage of the actual structures as well as theoperational risks that may derive from counterparty exposures to leveraged lines of creditto fund managers. Remember, the Long Term Capital Management crisis was largelydriven by the failure of regulated counterparties to properly manage their risk exposures.
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While we will explore many of the above mentioned risks in future reports, this note isintended to lay bare a few of the standard statements used by companies to intentionallyor unintentionally misdirect analysts and portfolio managers. A lack of standardizationcoupled with opaque and liquid markets and a lack of reliable disclosure standards makestraditional income statement and balance sheet analysis of limited use in uncoveringquestionable valuations of risky structured finance exposures.
“Our Exposures are Highly Rated”
When asked directly about their exposures many financial companies have taken to hidebehind the rating agencies assessment of these securities. This is often inappropriategiven the lack of a consistent process for the updating of initial ratings and it also createsmisdirection to investors given the inconsistent meanings of ‘AAA’ from sovereign debtratings to municipal debt ratings, corporate debt ratings, MBS debt ratings and CDOratings. Even within a single CDO there are two tranches of AAA rated securities withvery different risk profiles.
i
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To highlight this point we have shown how few countries, municipalities andcorporations receive ‘AAA’ ratings for their debt issuances. In contrast, the majority ofCDO securities receive such a rating.
Are we to believe that these ‘AAA’ CDO tranches are really as safe as the debt issued bysovereign nations with the ability to tax and to print money or by our most wellcapitalized and respected corporations? Given the market pricing of some CDOexposures it is clear that investors are confident that we could see complete losses toprincipal in some of these still AAA rated exposures.
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(US Municipals are not tax-adjusted)
Remember, due to the internal leverage of the structure, a roughly 4% loss to a RMBScan translate into an almost 40% loss to a CDO. The very large yields paid in thesesecurities highlight the inapplicability of ratings across asset classes. Moreover, theinfrequent and inconsistent approaches to re-rating by the rating agencies highlights thefact that reliance on the yield/rating at origination may have little value for the riskmanagement of secondary market securities including outstanding RMBS purchased innewer vintage CDO structures.
Given that misapplied bond ratings cause MBS and CDO market disruptionsii, investorsshould never again take comfort that a strong rating is a sign of safety. This is especiallytrue in markets without a strong base of empirical data.
Our Process for Marking Exposures is Rigorous
Another common claim that managements make is that they apply rigorous methods formarking exposures to market. Unfortunately, the processes required by accountingstandards regulators, even in the recent FAS 157 guidanceiii, leaves managers with a largeamount of discretion in valuing illiquid securities. In furtherance of these claims many
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US Corporates Sovereigns US Municipals RMBS CDOs
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Yield of AAA-Rated Securities, by Type
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managements routinely state that losses will be shallow and write-downs will not bematerial.
Marking to market:
Banks revalue securities and futures on a daily basis, but loans and other investments aregenerally evaluated and marked down only when there is a change in the creditrelationship. Debt securities and equities that are available for sale are required to be“marked to market” while securities in a “held to maturity” portfolio may be carried attheir original price. When one marks an exposure to market they are assigning a value toa position that reflects the current market price that would be realized in executing an exittransaction of that security. Where a security is not actively traded and there are not clearand current transaction prices for similar securities managements generally rely on a“marked to model” approach to valuation.
Marking to model:
Over the counter instruments are not traded on exchanges and their values are not readilyavailable. In such assets, managements are often forced to rely on a more subjectiveapproach to valuation. This has, in the past, created opportunities for companies to dressup their books with aggressive assumptions in their models. Such was the case of Enronwho clearly took mark to model to a new level that could be described as marking tofantasy.
There are many ways to create the models used to mark securities. Not all of them areequally supportable or equally rigorous. Some firms utilize proprietary models whileothers use ‘independent’ valuation firms and there are no consistent standards.
Investors should not allow managements to avoid disclosure of factual issues of thequantity of exposure. Managements would like investors to accept, at face value, that iftheir models multiply the “exposures” to some estimated depth of loss (which itself mayhave resulted from an inappropriate assumption) and conclude that the loss is immaterialthen they do not have an obligation to disclose the details of the assumptions, assets orpossible or probable levels of loss.
Investors should demand to know the factual elements of these exposures and shouldavoid investing in securities of companies who are unwilling to disclose those. Utilizingindices such as the ABX, TABX or their own knowledge of how similar or identicalassets are trading, investors are fully capable of making their own assessments of therisks posed by an institution’s exposures. Management can hide behind “regulation Fair
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Disclosure” if one or only a few investors are pushing for these disclosures but theycannot really justify that behavior if investors routinely demand such disclosures.
Specifically investors should demand to know:
- If your institution has a formal process for reviewing exposures. How doesinformation come into the organization?
- Do you have a formal and independent process for monitoring andreviewing these risks?
- Please explain the processes you employ.- Does your mark to model approach employ a mark to ratings approach and
if so would you explain the process?- Given the lack of empirical data for either the underlying collateral or the
structures themselves how do you know that the discounts or premiumsapplied for a mark to rating or in valuations will prove to be conservative ina time of market stress?
- How does management process and make adjustments to riskmeasurements?
- In dollar terms, what is the gross (unhedged) notional exposure, by eachvintage year, of your subprime exposure in the form of RMBS, of CDO,and CDO-squared.
- Of your CDO exposure, how much is mezzanine CDO exposure and howmuch is high-grade CDO exposure?
- For each of these exposure numbers, what is the composition of thatexposure by rating?
- By rating and asset category, what has been the impairment resulting fromyour marks relative to par and how are you flowing those through theincomes statement. For example, if you own a super senior tranche of aCDO and are marking that at $.85 while the TABX is quoting a similarvalue at $.40 you may not be fully recognizing the ultimate level ofimpairment.
Investors should demand information such as “we have $5.0 billion of 2006vintage subprime exposure, of which $X billion is RMBS, $Y billion is CDO,and $Z billion is CDO-squared. Of the $Z billion of CDO exposure, half ismezzanine CDO, half is high grade. Of the $X billion RMBS exposure, x% isAAA rated, y% is AA rated, z% is A rated….”
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Investors should also ask about exposures that by their nature will not appear on thebalance sheet such as:
- AAA rated super senior exposures are generally large and structured aslong-dated credit default swaps. Although these may expose the holder tohundreds of millions of dollars of potential losses per transaction they willnot appear on the balance sheet but in “credit derivatives” disclosures.
- Given the large lines of credit many investment banks have extended tohedge funds and other counterparties, investors should ask specificquestions about the practices employed by the investment bank inmonitoring the counterparty’s leverage and in assessing the operational,credit and liquidity risk of those counterparties. This is especially urgentgiven that many of those counterparties will themselves have impairmentsto assets and may, as collateral weakens, be unable to liquidate positions tomeet margin calls or redemptions.
We Have Hedges that Offset our Exposures
Managements frequently state that they have hedges that offset their exposures but rarelydetail, other than by the asset used to hedge, their strategy in a way that would allowinvestors to analyze and make their own determinations about the effectiveness of thehedges. Investors should ask:
- Would you explain the assumed effectiveness of your hedging strategy?- Given that you may have hedged some exposures with correlated indices
and those indices may have already adjusted giving you a positive benefitagainst underlying exposures which have not yet sustained losses, what isyour strategy for maintaining the effectiveness of these hedges goingforward?
- Have you historically hedged “AAA” and “AA” RMBS, CDO and CDO-squared exposures? If not has the increased cost of hedging those exposuresupon downgrades prevented you from doing so? How fully hedged are youto these downgraded exposures?
- What of your hedges, by asset class, are direct hedges and what are indirecthedges?
- What analysis and monitoring procedures do you employ to assesscorrelation risks of indirect hedges used to reduce exposures in periods ofrising volatility? Please detail the instruments used to hedge each assetclass.
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More to Come
The lack of empirical data and the massive structural changes that this economic cyclehas ushered in, both in extension of credit to previously untapped markets and thecreation of and growth of new securities types, will cause these questions to remainrelevant for a long time to come.
As we have made clear since the beginning of the year, the mortgage finance problemsare not isolated to subprime, subprime just had a shorter leash. It is now becoming clearerto others that it is spreading to Alt-A and will ultimately move directly into the primemarket. We expect recent vintage CMBS to show marked deterioration in theperformance of the much of the underlying collateral shortly. Both the CMBS and CLOmarkets will almost certainly see rising liquidity problems.
There is little doubt that beyond large future impairments there are many institutions withsignificant levels of embedded losses that have not yet been recognized as a result ofquestionable valuation. These will come to light as more downgrades occur, fundredemptions rise, margin calls increase and regulators more closely scrutinize portfoliovaluation assumptions for illiquid instruments.
These realities create a demand for investors, especially given the fiduciary nature ofmany of their obligations, to demand greater disclosures of the collateral, valuation andthe structural features of the portfolios of companies they invest in.
Those managements who refuse to see the significance of this tide-change, with powershifting from issuers to buyers, will find reduced access to the capital markets and ahigher cost of capital.
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i Credit Magazineii see: http://hudson.org/files/publications/Hudson_Mortgage_Paper5_3_07.pdfiii see: http://www.fasb.org/st/summary/stsum157.shtml
