Securitization: The S Word

NO ONE SAW it coming. And like machine-gun bearing mobsters jumping out of a birthday cake, the liquidity trap in which the securitization market has become embroiled was a very nasty surprise. Indeed, it is hard to overstate the sense of shock that this market is still reeling from. Investment banking is not known as a profession lost for words, but many usually garrulous individuals are still struggling to describe the experience. "It is always the thing that you least expect that trips you up," says one. "Who would have ever thought it would be the SIVs? They sit so high in the capital structure that nobody worried about them – it seems natural that all the risk in the capital structure is at the bottom not the top – so that is where people focused." And by the time it became apparent that there was a serious buyers’ strike in the commercial paper market it was too late. Originators and investors alike faced the unthinkable prospect of the entire ABS market simply shutting down. "When it happened it felt as though maybe the Emperor didn’t have any clothes... maybe there was nothing there after all," says a traumatized investor.

The speed with which all liquidity evaporated was unprecedented in recent years. "I have not seen outright fear and shock like this since 1987," says a veteran. "It has been hard to keep morale going." One originator is more succinct: "There are times when I feel like holding a pistol to my head and other times when I think everything is going to be OK," he says. "But I go home at the weekends hoping for a respite and open up the Sunday papers and every story is about me."

Clearly many are very shaken by what has happened but so far the number of casualties has been contained. That is unlikely to remain the case. "It was very, very scary," says an individual whose fund has been a victim of the liquidity crisis. "The effect on the market was unbelievable. You just sit there seeing it all becoming self-fulfilling: big hit; big markdown; another big hit; another big markdown; another big hit; unwind. The unthinkable becomes reality."

By mid-October there was a sense that the worst was over but that the settling dust would reveal a very different securitization market from the one that everyone had become comfortably used to. And it also brought to light a few home truths that many had probably suspected but chosen to ignore. The most obvious of these is the extent to which investors had simply bought on rating rather than done their own due diligence.

In many ways this is the entire root of the current crisis in securitization. Alan Greenspan’s US "savings glut" meant that there has been a surge of money hunting for yield for the past decade. This money focused on the ABS market and swamped it. Bankers were under enormous pressure to create product to meet this demand; that is why underwriting standards in the mortgage market fell to such lows. Asset originators were driven to relax their criteria just to get product through the door to feed the insatiable demand from the ABS investor base.

"I remember being at a meeting in December 2006 where our ABS guys said that they were expecting $26 billion to clear that month but that it would not be a problem and spreads would still be tighter at the end of the month. I remember walking out at the end and thinking: ‘Oh my God, this market is going to blow; this is whacked,’" says a US banker. The same process (albeit on a far smaller scale) happened in Europe in 2004, when the European market was also swamped with asset allocators searching for yield. This scramble for allocation meant that these buyers were skipping their due diligence and simply buying on rating. This is something that everybody knew was happening, everybody knew was not very smart, but probably no one envisaged would blow up in people’s faces quite as spectacularly as it has.

"The business plan of anyone that has been buying assets on the comfort of a rating is in deep trouble," says a portfolio manager. You would certainly be hard pushed to find a better example of ignorance breeding fear. "The total level of complete withdrawal of every single investor across the ABCP market was unbelievable," recalls an asset manager. "They even stopped buying bank CP. They weren’t buying ABCP where the entirety of the underlying was trade receivables. It was crazy." Another manager of a large ABCP conduit with less than 80 basis points in sub-prime and more than 5% credit enhancement explains how no-one even cared about the structure. His bafflement is shared by another ABCP expert. "ABCP is less likely to incur losses than bank CP!" he says in exasperation. "There was a now infamous Moody’s ABCP conference call shortly after the problems started where it rapidly became very apparent to me that six out of 10 investors on the call had absolutely no idea what the product was all about." And even if they did, their hands were tied by senior management. "If you are told by your boss to get the hell out, what can you do?"

In addition to nobody having understood what they had bought, it became very readily apparent that nobody really knew what it was worth either. As the voracious demand for ABS that had precipitated the crisis disappeared overnight, the process of marking to market bonds that were completely illiquid exposed the flaws in the entire marking concept. "The OTC market has utterly failed," says a head of securitization in New York. "Everyone knew that the marks were crap and marking to market now has no credibility." The arguments against marking debt to market are well rehearsed, but if ever the detractors wanted a graphic illustration of what they have been talking about – this has been it. " Marking to market makes sense in the equity market as the only way you are going to get your money back is to sell to somebody else," says one banker. "In the debt market it is very destructive. It is nuts to suddenly say that a loan on which the credit remains the same and the cash flows remain the same is suddenly worth $20 million less than it was yesterday – or indeed more." A credit hedge fund manager explains patiently, "For mark to market you must have willing buyers and sellers. If you own 50% or 100% of a small mezz tranche of a bespoke CDO there is never a market for that asset. It should not be marked to market. Just sticking assets in a mark-to-market book is nonsense." Many portfolio managers argue – not surprisingly - that the liquidity crunch has demonstrated that the market’s reliance on market-value triggers should now be replaced with a reliance on credit triggers.

As marks headed south, funds were faced not only with the prospect of rapidly deteriorating asset values but also an inability to trade out. "You are in a hostage situation," declares one investor. "You have absolutely no liquidity yourself but have to offer liquidity to your clients. Credit just does not matter – it is pointless. The market is so damaged. I can sit there and talk about overcollateralization levels and triggers but no one is listening. We are just about to put out our September numbers, which aren’t pretty. I am going to have to spend a lot of time on the phone explaining this away but there are going to be redemptions. And there is so much value in ABS now! Look at the carry you are getting!" This is something that has not escaped the notice of some of the issuers, who have taken the opportunity to buy back bonds. "At these levels we would have been quite happy to buy them all day long!" quips one.

What happens now?

As the dust begins to settle, the obvious question is: what happens now? Is the machinery of the market broken? In late October, securitization was still in a hiatus: in Europe only GMAC RFC has braved the primary market, bar a couple of CLOs, while a trickle of deals has emerged in the US. "The first thing that has to happen is that the market has to hoover up the secondary overhang," says an investor. "Dealers’ sheets are bloated with inventory from forced sellers – only when this has been shifted can the primary market come back." The huge bid lists that have been seen in secondary are primarily triple-A (from SIV and ABCP conduit disposals) but there has also been some subordinated paper due to the unwind of the permanent capital mezz funds such as Caliber and Queen’s Walk. "Triple-B mortgage paper is being seen at around 180bp on deals that were done [before the crisis] at about 80bp. That means that the bonds are trading at around 96," according to one investor.

There have been some signs that buyers were starting to return to the market to take advantage of these kinds of levels but the economics of the market have dramatically changed. "If fund buyers can’t get leverage they aren’t interested in triple-A – even if it is paying 100bp," explains one investor. "If they have no leverage they can only make about 7% yield on triple-A so they might as well leave it in cash." Buyers need to put leverage on their assets but leverage is a dirty word in the current climate. An unexpected outcome of this is a surprising demand for assets at the equity and triple-B level – something that should be counter intuitive in a credit crisis. But funds need a lot less leverage to make a decent return on junior assets. And remember, this isn’t a credit crisis – yet. "The credit cycle hasn’t even turned," points out a portfolio manager. "What we need now is a couple of corporate defaults for things to get really interesting," he adds wryly.

But there can be no return to normality without stabilization of the investor base at the top of the capital structure. "What else are triple-A investors going to buy?" asks an exasperated observer. "There are not enough gilts and T-bills in the world for them all! How many triple-A rated corporates are there? Do people really think that banks are safer than triple-A ABS?" he asks incredulously.

A quick fix

The investor base for triple-A ABS cannot recover until the future of the ABCP and SIV markets becomes clearer. "Any business model predicated on buying term assets and funding in the short-term money market is holed below the water line," says an investor. Is that the case? Or can these models be fixed?

For ABCP conduits, the answer depends on liquidity support. "The arbitrage conduits were caught in a perfect storm," says a banker. "The market will recover – but only for vehicles that are bank-backed. Securities arbitrage vehicles and single-seller vehicles are totally screwed."

To put things in context, there is about $899 billion of outstanding ABCP in conduits and about $150 billion of outstanding ABCP in SIVs. (The SIV market was roughly $400 billion in size but a large proportion is funded using MTNs). The proposed $80 billion fund recently announced by Bank of America, JPMorgan and Citi shows how concerned banks are about SIVs. The Master Liquidity Enhancement Conduit (MLEC) seems to be an attempt to stem the flow of forced selling of highly rated MBS assets by these vehicles and its associated impact on spread levels in the market. That is why the banks (and indeed the US Treasury) are so anxious to stop these vehicles dumping assets – there is simply so much paper out there. But while SIVs face substantial challenges because of their lack of liquidity support, it is not the case that the entire ABCP market is poised to collapse. "The ABCP conduit market has always functioned for the right names – some receivables conduits have been funding all the way through this crisis while the arb guys were not getting a bid at all," says a syndicate banker. Yes, the sec arb and single-seller models are probably gone for the time being, but fully bank supported ABCP conduits can survive – however that doesn’t necessarily mean they will.

The most important question is whether this continues to make sense for the bank. Basle II will remove the regulatory capital arbitrage benefits of ABCP conduits but the majority of the vehicles are already treated as on-balance sheet for accounting purposes anyway. Under Basle I the liquidity line provided to the conduit by the bank is 100% risk weighted. However, under Basle II this could be lower as the risk weighting changes to 20% of the relevant assets’ risk weighting. But the crucial question is whether CP rates can return to their sub-Libor levels. "If the cost of ABCP comes back to where it was then it may still be seen as a cost-effective funding source by bank treasurers," says an expert. "It could attract investors that otherwise would not invest in the bank. But treasurers will ask: ‘Do I really want to run the risk of having to fund a, say, $20 billion conduit over 60 days if the market is disrupted?’" Before July it had been assumed that the longest any disruption in the CP market would last was a mere five days.

If bank liquidity lines to a conduit are actually drawn, their risk weighting changes back to 100%. For a vehicle that has to mark to market every day and have those fluctuations running through the P&L the cost benefits will need to be substantial. But for some they will be, and the concept should survive. "The worst-case scenario is that ABCP conduits disappear because sponsors no longer see enough benefit," says a lawyer. "Whether or not this happens depends on where CP rates come back down to. People should remember, however, that no ABCP investor has lost any money; with Cheyne’s SIV declaring insolvency, however, this may not be the case for much longer. The market is like a kayak – it will right itself."

The future is far less clear-cut for SIVs and there is a real perception that this market could simply be wound down and disappear. "The only way that SIVs can survive is for them to be re-formed into investment companies. The fundamental presumptions behind the structure have been blown away," says a banker. "They are a direct victim of the fact that no one has any confidence in mark-to-market values any more." But some in the market maintain that these 20-year stalwarts of structured finance can remain. "SIVs are routine products," claims one. "To say that we are not going to have SIVs any more is like saying that we are not going to have sliced bread any more."

The fund announced on mid-October indicates how seriously the banks are taking the threat of mass liquidations of SIV portfolios. SIV holdings have fallen by $75 billion to $320 billion since July, according to Moody’s. It is no surprise to see Citi among the lead banks of the MLEC proposal – its five SIVs account for more than a quarter of the entire market. But while such a fund can be seen as an elaborate exercise to prop up asset values by creating artificial demand for SIV assets, it could nevertheless prevent uncontrolled dumping of assets into the secondary market, something that everybody wants to avoid. In a glorious irony the fund itself is being financed in the short-term money markets (MTNs and ABCP) but with 100% liquidity backstops from the banks. So while this is being dubbed a "super-SIV", the banks involved are still 100% on the hook. The million-dollar question is to what extent these structures can survive without being seen as completely bank-supported.

Some believe that – with restructuring – they can. "SIVs need robustness," says an expert. "They need provisions that will enable them to batten down the hatches for maybe a year. They don’t want to have to sell assets in markets that are behaving irrationally – they need safety valves. The rating agencies did not realize the market value risk they themselves were creating by having all the SIVs tripping triggers at the same time."

Those SIVs that have entered into wind-down (or defeasance) – those sponsored by IKB and Cheyne – hit those Nav triggers. But it is important to remember that many of the biggest and oldest of the SIVs (such as Beta, Centauri and Gordian Knot) do not have such Nav triggers at all. The looming prospect of the entire SIV industry reaching 80% or so of Nav and being forced to wind down might therefore be being overplayed. But all SIVs have certainly been forced to use asset sales and some term repo to meet liquidity requirements and this is a problem that needs to be fixed.

The obvious suggestion is less leverage and a larger liquidity provision. "SIV sponsors wondering how to respond to this crisis should look at their models," according to one observer. "If your model says that something should only happen once every 1,000 years and it has happened three times so far this week you have probably got a problem." Another suggestion is allowing SIVs to issue extendible CP in order to boost liquidity provision. Several of the ABCP conduits have extended their CP during this crisis, but it is something that the buyers of that CP probably assumed was a very remote possibility when they bought it. "It used to be that if you bought extendible CP you got maybe 2bp extra – now people will be looking for a hell of a lot more than that," says one buyer.

Future flows

If and when the investor base for ABS stabilizes, what will the securitization market of the future look like? Smaller for sure, and the deals themselves will be much smaller as well. "We will be looking at the market of four to five years ago," says a European issuer. "Smaller deal sizes and tighter structures. Then we looked at securitization as a diversity play – and that is what it will now return to."

The multiple mortgage originator bankruptcies in the US together with the demise of securitization stalwart Northern Rock in the UK show what can happen when that "diversification play" becomes such a fundamental part of funding strategy, and will dictate market sentiment for some time to come. "Will we ever see this amount of securitization again?" muses a New York-based banker. "We will certainly never see this much leverage being let into the system again – or at least not until everyone who is involved in the market at the moment is dead."

On the RMBS side, where the buzz word of the past few years has been disintermediation, there will now be reintermediation. "The days of selling the residual have gone," says a securitization head. "RMBS will shrink enormously." The mortgage market needs to go right back to fundamentals. Instead of exploiting the structured credit bid mortgage originators need to rediscover what they should really be charging for a loan. Certainly, as long as there is such great value in the secondary market, any new RMBS origination will have a tough time. In Europe the market has long been anticipating issuance from one of the large UK RMBS master trusts but as the weeks go by there is no sign of any deal. "If, say, Permanent [HBOS’s RMBS master trust] want to come they had better be prepared to pay 55bp to 65bp for triple-A," reckoned one buyer in late September. The market has, however, moved on sharply since then. For an issuer that has become used to paying sub-10bp for triple-A, that is not going to be too compelling a proposition. Investors are certainly in no hurry to chase spreads back in again and while the market needs a high-quality issuer to break the deadlock, most of those are already reasonably well funded or have other funding options.

But some in the market remain upbeat. "Structured finance has a phenomenal ability to reinvent itself," muses a veteran. But that constant innovation is something that got the market into the mess that it is currently in. Nowhere is that more evident than the CDO sector, which can never return to what it was. And nor, some would argue, should it. "The CDO business has changed for ever," says a market expert. "We were the architects of our own demise. The commonly held belief was that the more exposures you have the better it is for marking to market. The whole market was built on the proposition that two non-correlated assets create a better proposition than one correlated asset. But watching how markets behave when something like this happens has been absolutely fascinating," he continues. "Everything goes to a correlation of one – something that all those French mathematicians thought could never happen!"

The arbitrage premise upon which the CDO market was founded has been a casualty of the storm of negative headlines still engulfing the rating agencies. "The arb deals – where you take a bunch of bonds and start arbing the rating agencies to find flaws in their models – are gone," admits one structurer. "If everyone now relies on their own pricing tools then there is no arbitrage left." What will emerge from the ashes will be a far more synthetic-centric and derivative-tooled market. "The knowledge gained over the last few years by using derivative techniques to transfer risk has been immensely useful," says a banker. "There are now so many more risk dimensions than a traditional long-only analyst ever looked at and a much deeper understanding of correlation and hedging tranched products."

Synthetic CDOs have certainly held up better than their cash counterparts in the crisis – largely because they are backed by investment-grade corporates. But the backbone of the cash market in the US – the ABS CDO backed by home equity loans – is gone. There have been a couple of high grade ABS CDOs issued since September, but most of the limited action is in CLOs. "In the CLO space we are about 20bp away from having a fully fledged market," claims a New York-based credit expert. "But the [non-HG] ABS CDO market isn’t even close to reopening." This is not only because of the nature of the underlying, but is also a victim of the liquidity crisis. "Super-senior tranches of ABS CDOs were funded by bank liquidity and wrapped by monolines," says a banker. "That has gone – the liquidity for the senior liabilities has totally gone."

The securitization market faces massive problems – some of them absolutely fundamental to its survival. It has a significant image problem that it will need to address if it is to attract the new investor bases it desperately needs to replace those that have gone or changed for ever. But amnesia has always been a defining characteristic of the capital markets, and this is not a technique to write off lightly. "There are simply too many benefits to pooling assets and tranching liabilities to walk away from securitization," claims a supporter. One issuer (who admits to having adopted the term "The S-word" when discussing the technique with potential investors) nevertheless remains upbeat. "Smart investors know that there is a lot of scare out there," he says.

But it will be a long time before the market feels good about itself again – or even gets moving again. Banks have a lot of indigestion running up to year-end; there is a lot of behind-the-scenes trading of pieces of risk which is purely housekeeping in order to minimize the impact on the balance sheet. It will be a long time before they are in a position to inject any new leverage into the system to get things going again. "The longer this crunch goes on, the higher the risk of a recession," warns an observer. "At the moment we have a reverse multiplier situation where money is being drained from the system. The really shocking thing is how the equity markets have completely misunderstood just how devastating this credit crunch really is."