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Bankers’ Stew Disguising CDO Scraps as Tasty Morsels: Book Excerpt

by on February 9, 2010

By Mark Gilbert Feb. 9 (Bloomberg) — Since its inception, the derivatives market has echoed the fairground hawkers’ call to “scream if you want to go faster.” Among the new derivatives, collateralized-debt obligations (CDOs) were particularly hot. To make a CDO, bankers bundle together a package of other kinds of securities, such as corporate bonds, asset-backed securities (ABSs) or credit-default swaps (CDSs) that are tied to company creditworthiness or mortgage performance. By carving the resulting collections into slices of differing quality, the creators can make the riskiest portions absorb any losses on the underlying assets first, thereby cushioning the higher-rated slices. No Clear Idea As with almost every other investment vehicle, CDOs were designed to reward investors according to the amount of risk they took. Those who bought lower-risk securities typically earned a smaller rate of return from successful investments than did those who took bigger risks, who received either a larger payoff if the investment performed well or nothing at all if the investment failed. Trouble was, no one had a clear idea of just how risky any given slice was or any sense of how to quantify and value that risk. In the same way that Liverpudlians disguise overripe meat and vegetables by cooking them to mush in a stew called scouse, investment banks, rating companies and plain old market peer pressure turned the investments inside most CDOs from inedible chunks of the financial markets into bite-size morsels palatable to pension fund trustees. No pension fund — and only a few other investors — would buy a structured transaction whose worth depends on what happens to the stock market and company creditworthiness, which way commodity prices go and whether the wind blows on a Sunday. They did, however, happily purchase CDOs that offered strong credit ratings and the promise of top-flight returns. Risk Appetite For the game to work, everyone involved had to turn a blind eye to the less-than-stellar track record assembled by the rating companies that assessed CDOs. And they did — until CDOs’ poor performance became impossible to ignore. Of the CDOs that started with AAA ratings in January 2002, 16 percent had lost that top grade by November 2004. Almost 14 percent of second-tier (AA-rated) securities were cut, and nearly 17 percent of CDOs with third-tier (A- rated) grades were cut. Those early CDOs, which typically contained vanilla corporate bonds, were hurt by a swift deterioration in average creditworthiness, combined with some hefty one-off defaults, including those of Enron Corp. and WorldCom Inc. Demand Soars Memories, though, proved short, and demand for CDOs soared as credit-rating cuts on corporate debt became rarer. (The economy was growing, and most companies had enough cash to cover their debts.) In 2004 in Europe alone, Moody’s rated $56 billion in European collateralized debt backed by default swaps. That was a 20 percent gain over the previous year, according to figures provided by the company at the start of 2005. By 2006, the derivatives printing presses were stamping out $503 billion of collateralized debt for the rating companies to grade, up from $274 billion in the previous year and $144 billion in 2004. In April 2007, Moody’s announced a fourth-quarter profit increase of 20 percent, as revenue from rating structured- finance transactions leaped to $251.5 million, a 44 percent gain over the same period in 2006. Almost half of Moody’s total 2007 sales of $583 million came from its structured-notes business, dwarfing the $115 million it made by analyzing company creditworthiness. Fatally Flawed Risk appetites increased, and CDOs became even more exotic and complicated. Structured-product specialists worked to broaden their appeal by tying CDO values to a broader range of underlying markets, some even creating theoretical bets that were tied to abstract prices. To grade these new financial instruments, rating companies used methodology that was fatally flawed from the start. It was based on induction, the process of inferring a general law or principle from the observation of particular instances. But the particular instances the rating companies chose did not incorporate the lessons of previous housing booms, nor the nonexistent histories of some new, theoretical bets. Instead, rating companies used the brief price history of the derivatives market as a benchmark to assess its likely future price performance. Indigestion The most egregious example of derivative market excess came with the invention of the constant-proportion debt obligation, known as a CPDO. In June 2006, Dutch bank ABN Amro Holding NV issued a 38-page marketing brochure describing a security called Surf: “the first CPDO; a breakthrough in credit investments.” CPDOs were the credit derivatives market’s hottest alchemical method for transforming plumbous yield premiums into the gold of market-beating returns. The marketing literature and associated research reports suggested that the newfangled securities were the holy grail of investing — heads, you win; tails, you don’t lose. CPDOs were an abstract bet on the likelihood of defaults in the corporate bond market. With their values tied to credit- default-swap indexes, the securities promised to deliver as much as 2 percentage points more than money market rates during their 10-year life spans. That was worth about 5.6 percent at the three-month money market rates that prevailed when CPDOs began attracting attention in November 2006. Alphabet Soup At the time, German government debt, deemed the safest fixed-income investments in the European markets, yielded just 3.7 percent annually. No wonder CPDOs looked irresistible. Those remarkable rates of return were made possible by the magic of derivatives, which leveraged the initial bet by a multiplier of 15. The leverage turned average punters into high rollers with the potential for fantastic gains — and losses. When times were good and a CPDO looked set to meet its payment obligations, sponsoring investment banks could reduce their market bets. When times got tougher, banks increased those wagers to boost the security’s net asset value. Credit-rating companies issued CPDOs top ratings for both interest and principal payments. The alphabet soup cooked up by the derivatives chefs — boil some CDOs, toss in a dash of ABSs and a soupcon of CDSs, season with CPDOs and serve with a garnish of overly optimistic ratings — was sufficiently toxic to poison the entire financial system. Just Deserts Capitalism itself ended up looking sickly and anemic. Belatedly, investors discovered the truth of one of billionaire investor Warren Buffett’s aphorisms: Unraveling a derivatives trade, the so-called Oracle of Omaha had said, was like trying to carry “a cat home by its tail.” Wall Street had invented a machine that could recycle just about anything that generated a cash flow. It had a growing, reliable source of supply from the housing market, sufficient to keep the merry-go-round spinning. And shifts in both the investment banking culture and the investing landscape created a willing coalition of buyers and sellers. To contact the writer: Mark Gilbert in London at magilbert@bloomberg.net

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Bankers’ Stew Disguising CDO Scraps as Tasty Morsels: Book Excerpt

China’s Pledge to Cut Greenhouse Emissions Leaves UN Negotiators Guessing

by on September 22, 2009

Bloomberg:

By Jim Efstathiou Jr. and Kim Chipman Sept. 23 (Bloomberg) — China pledged for the first time to reduce its greenhouse-gas emissions in proportion to economic growth in an effort to fight global warming. President Hu Jintao , without giving any numbers, offered to reduce the so-called carbon intensity of factories and power plants in the world’s third-biggest economy yesterday at a United Nations summit on climate change in New York. Hu unveiled the initiative three months before about 190 nations are to gather in Copenhagen for a final round of negotiations on a climate accord. The offer, a step forward in talks over how to rein in industrial emissions, drew criticism for its lack of detail. “Conceptually, it’s an important breakthrough,” said Elliot Diringer , who oversees international strategies at the Pew Center on Global Climate Change in Arlington, Virginia. “But the critical questions are how ambitious a target they will set and whether they’d be willing to commit to it internationally.” China, which before yesterday hadn’t cast efforts on climate change in terms of a carbon-dioxide reduction, will target the amount of emissions produced for every unit of gross domestic product, Hu said. “We will endeavor to cut carbon-dioxide emissions per unit of GDP by a notable margin by 2020 from the 2005 level,” Hu said, without committing to add the policy to a new treaty. Emissions Could Grow Reducing the intensity of emissions from cars, coal-fired power plants and other polluting sources would lower the amount of CO2 used to produce a unit of energy. China’s absolute emissions, though, could grow as it adds factories. Todd Stern , President Barack Obama’s top climate negotiator, withheld judgment on the announcement. The importance of the initiative “all depends on how significant” China’s reduction is, he told reporters. China and the U.S. produce about 40 percent of the emissions blamed for global warming, rising sea levels, more intense storms and declining water resources. China and developing countries such as India say they won’t sign on to binding limits on CO2 that crimp economic growth. Without agreement between the two nations, other countries have less incentive to make commitments by year-end in Copenhagen. Obama, prior to a closed-door meeting with Hu yesterday, said he wants the U.S. relationship with China to be “more dynamic” in dealing with global and regional challenges. No Targets Disclosed Hu’s announcement was disappointing because it did not include a specific target, said Martin Kaiser , coordinator of climate politics for the environmental group Greenpeace. “It seems that Hu Jintao wants to hold the details as a negotiating chip,” Kaiser said in an interview. “He might have listened to President Obama’s speech, which did not include any news.” Obama said yesterday that rich nations must lead on the issue and that fast-growing economies such as China and Brazil have to contribute. China will step up efforts to improve energy efficiency and preserve forests, which help remove CO2 from the atmosphere, Hu said. China previously said it will reduce the amount of energy used in manufacturing and will add power from nuclear reactors and solar panels that produce no CO2 emissions. The name of the game for all countries is “de- carbonization,” Diringer said. “A carbon-intensity goal would set that as an overriding priority around which China would then orient a whole suite of policies.” The goal of international talks is to find a replacement for the 1997 Kyoto Protocol, which expires in 2012. Under the Kyoto accord, industrialized nations have emissions limits while China and other developing nations are exempt. The U.S. rejected Kyoto, never signing the accord, in part because it did not include commitments from China. “In Kyoto you have absolute emissions targets and that should be the primary form of commitment for all developed countries,” Diringer said. “But for a variety of reasons, developing countries should be allowed a broader range of commitments and a carbon-intensity goal can be one of them.” To contact the reporters on this story: Jim Efstathiou Jr . in New York at jefstathiou@bloomberg.net . Kim Chipman in New York at kchipman@bloomberg.net

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China’s Pledge to Cut Greenhouse Emissions Leaves UN Negotiators Guessing

Fed Asset-Backed Loan Plan Gets $2.3 Billion Commercial Mortgage Requests

August 20, 2009

By Jody Shenn Aug. 20 (Bloomberg) — Investors asked the Federal Reserve for $2.3 billion of loans against commercial-mortgage-backed securities created before this year, an expansion from $668.9 million in its financing program’s first round a month earlier. The central bank got no requests for newly issued bonds backed by loans on skyscrapers, shopping malls, apartments or hotels, the New York Fed said today on its Web site . That part of the Term Asset-Backed Securities Loan Facility, or TALF, hasn’t been used since its start three months ago. “I would not call this a blow-out number by any stretch of the imagination, but certainly relative to what we saw in July it was positive and definitely within the range of what people were thinking,” said James Grady , managing director in New York for Deutsche Asset Management, a unit of Deutsche Bank AG that oversees $240 billion of investments. Wall Street profits and the $700 billion CMBS market, which rallied amid the opening of TALF to the debt and start of Treasury Secretary Timothy Geithner ’s Public-Private Investment Program, may depend on the programs’ results. While the average price of top-rated commercial-mortgage securities is up 8 percent since June to almost 90 cents on the dollar, last week values began weakening as buying in anticipation of investor demand tied to the programs eased, according to Merrill Lynch & Co. index data. Looking Ahead “With dealer inventories now fairly bloated across the Street, we will need to see not only a sizable subscription next Thursday, but will also need the Fed to remain accommodative with respect to the bonds it accepts as TALF-eligible collateral,” Alan Todd , a JPMorgan Chase & Co. analyst in New York, wrote in Aug. 14 report. TALF loan requests of less than $1 billion would be a “disappointment” to the market, while requests of more than $2 billion would probably be “well received,” he said in a telephone interview today before the announcement. Investment banks have been recently buying commercial- mortgage securities being offering for sale “pretty aggressively in the expectation that TALF buyers would materialize,” Grady said in a telephone interview. The investors typically will seek to acquire the bonds a few days before, or the same day that, the Fed accepts requests, he said. Fed Chairman Ben S. Bernanke this week extended the TALF for commercial-mortgage bonds into next year as he seeks to stabilize a market where property values have fallen 36 percent from their October 2007 peak, according to Moody’s Investors Service data. Banks and insurers own more than $2 trillion of U.S. commercial real-estate debt not packaged into bonds. Top Rating Required Last month, the Fed refused to accept only one commercial- mortgage bond as TALF collateral, announcing the decision about a week after disclosing the loan requests without saying why it found the debt too risky. At a minimum, the securities must carry top credit ratings, not be under review for downgrades and rank among the senior-most classes of a securitization. The central bank is receiving advice on the decisions from Trepp LLC, a New York-based research firm, and Pacific Investment Management Co., the Newport Beach, California-based firm that manages the world’s largest bond fund. The PPIP, which the government announced July 8 would begin with nine asset managers raising as much as $10 billion and receiving as much as $30 billion in taxpayer capital and loans, accepts a broader range of commercial- and residential-mortgage bonds originally rated AAA. Sales History The Fed is seeking to revive commercial-mortgage bond sales after issuance halted as the cost to sell the debt became too high to originate new real-estate loans. That choked off financing to borrowers including those seeking to refinance $165 billion of debt this year. In 2007, a record $237 billion of commercial-mortgage bonds were sold, before sales fell to $12.2 billion last year and none this year, according to JPMorgan. The Fed extended the commercial-mortgage TALF to June 30, 2010, from Dec. 31. The Aug. 17 announcement followed a letter to Bernanke from 41 House members — including Financial Services Committee Chairman Barney Frank , a Massachusetts Democrat, and Carolyn Maloney , a New York Democrat who heads the Joint Economic Committee — asking for a one-year extension after property owners stepped up lobbying for a later deadline. Spreads Over Benchmarks Yields over benchmark interest-rate swaps on so-called super senior commercial-mortgage securities issued in 2006 that are likely TALF-eligible were about 4 percentage points earlier today, according to JPMorgan data. Spreads on similar bonds that aren’t eligible were 5.5 percentage points. Since Aug. 7, spreads have widened between about 0.50 percentage point and 1 percentage point, with prices for ineligible debt weakening the most, Todd said. In November, the spreads topped out at record highs between about 13 percentage points and 15 percentage points, he said. The average price of top-rated CMBS securities has eased from a high this year of 91.2 cents on the dollar on Aug. 13, after climbing from a 2009 low of 72 cents in February, according to Merrill Lynch index data. To contact the reporter on this story: Jody Shenn in New York at jshenn@bloomberg.net .

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