Vol 5 (2008) - Issue 3

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The Regulatory Gamble

Déjà vu? Does anyone remember the last downturn in the housing market in the early 1990s? The recent history and current state of the mortgage markets share a close resemblance to the bubble two decades earlier. At that time the US suffered a Savings and Loan Bank crisis. The Resolution Trust Corporation was set up with government backing to take the ‘bad’ credit off the balance sheets of banks that otherwise would have failed – and many did fail. The difference, this time, is the emergence of sophisticated financial instruments allowing the risk to be shared by financial institutions throughout the world.

Has there been enough written about the ‘credit crisis’ that we have been experiencing over the last 8 months? Is there going to be more to the story? When you look at the litany of events, you can not help feeling that something is still missing from the dialogue. Everything from broken structured investment vehicles (SIVs), run on banks, central bank intervention, ratings downgrades, failed investment banks, downgraded credit default insurers, and implications of economic slowdown across the globe are being attributed to the credit crunch. Does anyone hear the chorus of political and governmental action rising into a crescendo of regulation?

The SIV and securitisation of assets through collateralised debt obligations (CDOs) have been driving growth in the financial markets with readily available
financing. The liquidity has allowed consumers to borrow against the increased value of owned real estate assets – which has fuelled overall economic growth
through consumption. When the first signs of softening real estate prices were observed, the securitisation markets came to a stand-still. The cycle turned completely around, and the reverse effects of the cycle of prosperity surfaced in the form of an economic slowdown.

Securitisation has allowed financial intermediaries (banks, investment banks, etc.) to package the assets and move them off their balance sheets. This allowed
the originators the ability to offload the impact of their underwriting decisions through assumed diversification and credit enhanced structures, which turned lower rated assets into AAA-rated assets. These assets are sold to the global investor community – many times through the bank-sponsored vehicle.

We all know well the story behind the residential mortgage backed securities (RMBS) saga. When analysed to the common denominator, the asset backed securities (ABS) market moved away from the five ‘C’s of underwriting by relying upon insufficient investigation of (i) borrower’s character; (ii) borrower’s capacity (cash flow) to service debt; (iii) borrower’s capital (networth); (iv) collateral (aggressive advance rates on value); and (v) conditions of the market. Examples of insufficient underwriting include ‘no doc’ loans and 100%+ loan to value lending.

The sub-prime issues may only be the first act in a tragedy that is being played out in the world financial markets. Could the same factors that created the ‘subprime’ mortgage crisis also be present in the corporate debt held in CDOs and collateralised loan obligations (CLOs) which have also been packaged into many of the same securities that have already suffered downgrades and write-offs? Corporate debt used to be relatively simple. Companies borrowed from the banks or accessed the financial markets for bonds. The banks carried the
senior secured loans on their balance sheets. Investors in subordinated debt evaluated credit risk and looked for appropriate return and legal protection. Corporate debt underwriting is also based upon the five Cs of credit. Corporate debt classified as ‘covenant-lite’ may have violated one or more of the five Cs of credit.

Over the past decade, the rapid growth of outstanding corporate credit, high-yield debt, and leverage dwarfed the sub-prime mortgage market. An economic
downturn, or just a tightening of the credit markets due to credit concerns, is all that is needed to expose the issues in the corporate debt markets. And, it is still early in this act. The concept of covenant-lite transactions eliminates the ‘warning signs’ of a corporate debt obligor’s impending cash flow troubles. Now, the company will ‘hit the wall’ before anyone realises there is a problem – and then it is often too late. Who is responsible to monitor the cash flow travails? High-yield bonds have historically had defaults within 5 years of
issuance in the high 20 percentage point range for those just below investment grade and in the 40+ percentage point range for those bonds with the lowest rating. The pricing on these bonds indicate that investors were not paying attention to the probabilities of loss.