Tuesday, July 24, 2007

Debt Market Update

From Bloomberg:

The Wall Street money-machine known as collateralized debt obligations is grinding to a halt, imperiling $8.6 billion in annual underwriting fees and reducing credit for everyone from buyout king Henry Kravis to homeowners.

Sales of the securities -- used to pool bonds, loans and their derivatives into new debt -- dwindled to $3.7 billion in the U.S. this month from $42 billion in June, analysts at New York-based JPMorgan Chase & Co. said yesterday. The market is ``virtually shut,'' the bank said in a July 13 report.

Investors are shunning CDOs after the near-collapse of two hedge funds run by Bear Stearns Cos. that owned the securities. Standard & Poor's downgraded bonds from 75 CDOs as mortgages to people with poor credit defaulted at record rates. Concern about losses on home loans are rattling investors across the credit spectrum.

This slowdown shouldn't surprise anyone. Bear Stearns announced a hedge fund the invested primarily in CDOs and CLOs was essentially worthless. That's enough to get anyone's attention and force a reevaluation of the market.

And other deals are hitting snags:

Allison Transmission, a highly profitable unit of General Motors Corp. based in Speedway, Ind., has gotten stuck in a traffic jam in the debt-financing market.

Wall Street firms postponed a sale of $3.1 billion in loans that would pay for the leveraged buyout of Allison by private-equity firms, said a person familiar with the matter. While the sale of Allison to Carlyle Group LP and Onex Corp. is highly likely to proceed, the trouble raising debt from investors complicates matters for the company and its bankers.

The snag reflects difficult conditions in the market for risky corporate loans and bonds and raises questions about the prospects of other buyout-related debt financings that need to be completed this summer. That includes a $20 billion loan deal for Chrysler Group. Cerberus Capital Management has agreed to buy a majority stake in the auto maker from DaimlerChrysler AG.

While I don't think this mess will blow over, I do think it is overdone. The basic structure of CDOs -- that is grouping assets into a pool and then dividing the unerlying risk across various bonds -- has been around for about 15-20 years. Here's a brief refresher on how this works.

The basic premise of these investments is simple: pool a group of similar assets to diversity the risk and then parcel out the risk to separate investments carved from the pool. Let's create a simple hypothetical deal to explain this concept. We'll start with a $100,000, 30-year five percent mortgage. After the mortgage closes -- that is, after the borrower and lender have signed all of the paperwork and the borrower is "officially" a borrower -- the lender will usually sell the loan to an investment bank. The investment bank will then pool this mortgage with similar mortgages (same interest rate, maturity etc...) and create one giant pool. This process of pooling asserts can occur with literally anything that has a cash flow -- account receivables, loans, bonds -- you name it, and it can be pooled and carved into separate bonds or cash flows.

Suppose the investment bank creates a pool worth ten million dollars. That means there are now 100 mortgages in the pool. The basic investment concept of diversification tells us that a problem with a few of the loans will not impact the overall performance of the entire pool. Suppose five homeowners in this pool eventually default. There are still 95 mortgages that are making payments on time. This limits the problems created by the five loans that defaulted.

Let's add a complicating factor to this scenario. Suppose there is a problem with a larger percentage of the loans -- say 10 percent or higher. This is when the concept of "structured finance" comes into play. The investment back will create different bonds from the large pool and allocate the pool's payments to these different bonds at different times and at different rates.

Here's an example using the previously mentioned pool. Remember, we have a giant mortgage pool worth ten million dollars, and the pool is made-up of 100 mortgages each worth $100,000 that pay five percent interest. The investment bank will "carve" the ten million dollars into three different "tranches." For all practical purposes, each of these "tranches" is a bond.

Investment banks will usually create three types of bonds from these pools. The riskiest bond is usually called an equity bond, and when there are problems with the underlying pool, most of its loses are allocated to this bond. Using our previous, hypothetical example, suppose 10 percent or 10 of the mortgages in the pool are in default. The equity portion of the bond will absorb all of these losses. As a result, the other two bonds are still receiving their regular payments.

Let's suppose the number of defaults increases to 20 percent, so that 20 mortgages in the $10 million pool aren't making payments. The investment bank will now allocate most of the losses to the equity bond, but will also allocate any spillover losses to the mezzanine bond. This is the next riskiest bond in the structure.

Finally, there are investment grade bonds which are the last bonds to be hit by defaults. Because of the concept of diversification, this bond will usually not experience any problems.

One of the central problems with the CDO market is liquidity. Because there isn't a very active secondary market, there is no market pricing mechanism to determine what each bond is worth. Instead, fund managers use various formulas and methods to determine what the value of a security is. That's where the real problem is coming from. Had there been an active secondary market, market participants would have seen a gradual decline in the value of various bonds. Instead to Bear suddenly announcing two funds were worthless, investors in the market would have seen the funds decline in value over a specific period of time. This would have limited the shock from the Bear collapse.

Back to where we are now. Credit terms have been very lax for the last 2-3 years. What we are seeing now is a backlash against easy credit terms -- in essence, a massive tightening of credit standards. My guess is we will start to see the pendulum start to swing back within the next 12-18 months to a point between easy and tight.