A range of dynamics in the first half of the decade increased the propensity of market participants to lend, borrow, invest and consume, thus injecting more liquidity into an already buoyant market. Solid global growth was underpinned by cheap money and low inflation expectations, and as corporates repaired balance sheets, default rates started declining towards all time lows. Emerging economies swung their current account deficits to very significant surpluses, which helped keep long term US rates low. Bernanke’s “savings glut” was born. Lower rates and risk premia were clearly positive for individual and corporate borrowers, with lenders progressively looking to put capital to more profitable use. These factors crushed credit spreads and created a belief that this environment would last for a long time. In this context, investors looked for products which could leverage these low spreads to create or maintain target returns. Banks also wanted to continue to generate large fees. Structured credit was an emerging area which offered opportunities for all parties. So what went wrong?
It is important to emphasise right up-front that the process that created very high leverage with the vast majority of the capital structure being rated triple-A with attractive spreads was the key contributor to this house of cards. For triple-A structured credit investors, the yield pickup was significant. There were (and remain) less than ten top-rated industrials companies worldwide. Compare the choice of investing in the 7-year credit risk of Berkshire Hathaway (AAA/Aaa) for instance, which in January 2007 paid a spread of 10 bp over Libor, and the junior triple-A piece of an RMBS CDO, with 7 years weighted average life, which paid roughly 45 bp over. Crucially, however, without that structured credit piece carrying a triple-A rating, the investment would not have been as efficient, and the yield pick-up not as comparable, since haircuts and capital charges would be higher and hence leverage and pro-forma returns lower. So how was the triple-A-rating achieved?
Let’s take sub-prime securitisations as an example. The level of granularity in many ABS pools (made up of 2000+ individual mortgage loans) implicitly supported ex ante the idea of diversification, and therefore that the expected return to the pool of assets (and therefore the expected capital loss) was relatively stable, allowing originators and rating agencies to structure transactions in which 75% to 95% of the capital structure was triple-A rated debt. This thinking was reinforced by the secured nature of the collateral, which gave too little emphasis to the potential volatility of asset prices.
The problem, of course, was that the ex post relationship between these various mortgage loans was much greater given the level of downward house price movements. Faced with significant negative equity, US homeowners have incentives to default on their debts whether they are on fixed or floating, interest only or amortising, pre- or post- the discounted teaser rate, or in Florida or California. This, of course, seems obvious now, but faced with the pull of a triple-A rating, investors sought comfort in diversification and security. But granularity in terms of number of borrowers does not necessarily equal diversification in terms of their behaviour and outcomes, and security on a property without much equity beneath you can swiftly be eroded. Once we get to the second order securitisations, CDOs of a number of ABS tranches, this underlying issue was magnified.
Rating agencies get much of the blame for this, but they were acting in co-ordination with banks and within a political environment that supported widening home ownership. Quite simply the capital structure for financing this housing credit boom was over-leveraged, and there was an alignment of interests for this to be the case: structured credit equity investors looked for high embedded leverage to meet target IRR returns, and investment banks looked to distribute as much easy to place triple-A paper as possible, and therefore limit the amount of non-triple-A paper needing to be placed in new deals for which they were to receive fat arrangement fees. The second related issue is the relationship between MTM, ratings and leverage. As we have noted, most of the money that went into structures by definition went into triple-A. Institutions purchasing this paper either leveraged it through use of capital charges (whether on balance sheet through anticipated Basle II guidelines or off-balance sheet through capital charging matrices) or through use of prime brokers. A crucial assumption was that these assets had low price volatility. In simple terms for funds-type investments, structures with 20x leverage assume assets will not fall by more than 5%: for transactions with 5-year duration, spreads need to move 100 bps to absorb the equity buffer. And yet, for example, the benchmark AAA ABX 20071 index went from a spread of under 10 bp on launch in January 2007 to more than 500 bp less than a year later (and as high as 1000 bp over in March 2008). With margin calls unable to be met and structures with market value or NAV triggers getting called, massive write downs and/or forced sales were the natural consequence. In addition, investors who were drawn to highly rated structured credit instruments from a regulatory capital perspective were left with “losses” from rating downgrades that have forced more capital to be allocated to the position, or else the position sold at a significant loss.
Moral hazard, asymmetries of information and misaligned incentives in sub-prime securitisations have been well-publicised explanatory factors. Brokers, banks, rating agencies, managers and investors have all played a part and there is no doubt that improvements in the process of securitisation will be needed. Ultimately there were too many shared interests supporting too much leverage which needed to be applied to support targeted returns. Many market participants knew this in principle, but the stamp of triple-A ratings gave investors an excuse to be complacent and substitute ratings for due diligence.
The primary market will not return in its current form for some of these asset classes. For much of the first wave of securitised structures, first loss equity pieces were the hardest to sell because they were seen to be the riskiest. Now it is the lack of triple-A bidders which means that the primary market is all but dead in many collateral classes: the lack of available leverage and the lack of appetite to jump back into complex structures means some parts of the primary market will not recover for a very long time.
However we are seeing some primary market activity, albeit in lower volumes, in credit cards, student and auto loans, and leveraged loans. Transactions backed by corporate risk, mostly in synthetic form, are also hinting at a comeback, and offer synthetic leverage, which makes funding issues less pertinent.
The loss of confidence in sub-prime has clearly led many market participants to lose faith in a variety of securitisation structures that are far removed from sub-prime, including corporates, leveraged loans and other ABS asset classes. There are proper fears about the spill over between the financial economy and the real economy. We have already started to see that the US consumer, who has supported much of the credit boom, is starting to suffer, with consumer confidence hitting recessionary levels. Many other data points are revealing similar stories. And yet the dynamics of non-sub-prime related securitisations exhibit differentiated underlying asset and liability structures, with the resulting dislocations creating significant opportunities in the secondary market to pick up assets trading at distressed levels, but which have deep value.
If there is one paramount lesson in all this, it is that structured credit investors need to be sophisticated across the capital structure and across collateral classes, and this will be refreshing and rewarding for those with the right resources to analyse complex transactions. Several high-profile institutions are now starting to put money to work in the structured credit space without resorting to the false comforts provided by ratings. This will eventually helpto better price a future primary market. The investor base will evolve and need to work harder to extract value, rating agencies will need to improve and provide better guidance around their processes and methodologies, leverage will need to be lower and capital charges will be higher. This all makes sense and we are already seeing it start to happen.
Robin Edwards is a Director of Eiger Capital where he assists in the marketing of Eiger Capital’s investment products and services. He is also founder and a director of Sabre Fund Management.
Leandros Kalisperas is a Portfolio Manager and Eiger Capital’s Chief Operating Officer.
Eiger Capital is a research-driven investment management firm focused on the full spectrum of the credit markets, including corporate bonds, loans, credit derivatives, asset-backed securities and structured credit. Eiger Capital manages credit exposure primarily through cash and synthetic collateral debt obligations, and is currently setting up a structured credit fund.