The StranglersI'm concerned that accountants (and I am one) have played a significant role in the current crisis. Fair value accounting has become the norm in the last few years. The underlying assumption was that market value (mark-to-market or MTM) and fair value are pretty much the same thing.
Maybe in stable markets, but not at the moment. Is the "fair value" of oil $147 or $90? We've seen both in the last 2 months. Do market prices of ABS reflect the amount investors are likely to get back over time? Fitch did an exercise in stress-testing Irish RMBS a couple of months ago. They assumed in their "severe" case 9% defaults and 40% market value declines-but not only did the AAA bonds not default, they were not even downgraded.
Nonetheless, banks holding such assets have to take MTM "losses" through their P+L accounts, which reduces their capital base and destabilises their position in the market, contributing to the current panic. $500bn+ has been written off as losses by banks already. Does this really reflect what is likely to be lost over time, or is it just a function of a febrile market? There's much to be said in favour of old-fashioned historic cost less reserves accounting in times such as these.
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The ECB announced last week a significant increase in haircuts for ABS used as repo collateral to 12% from a minimum 2%. In addition, there is a further 5% haircut (5% of 88% being 4.4%) on ABS created and kept on balance sheet, making a total of 16.4% in such cases.
The amendments were clearly designed to bring the scheme back to its intended purpose, and exclude the likes of Macquarie's Australian car loan deal which some viewed as being exclusively designed to "game the system".
What are the lessons from this?
-Even with a haircut of 16.4%, 83.6% of cheap money is still available;
-Covered bonds attract a much lower haircut, but are still eligible as repo collateral with the ECB
I shall have more to say on the attractions of covered bonds on another occasion.
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Most of us (especially those with school-age kids!) have now had our holidays and are back in the saddle.
There were no big surprises over the summer: most issuance was "structure and hold" either for ECB repo fodder or to speed up future issuance when liquidity returns.
One asset class which has suffered is the SME CLO market, particularly German deals. These have been put together in the past few years as pools of 30-60 loans originated with the express purpose of securitisation. Not particularly "granular", and in many cases subordinated loans, they have suffered from both defaults and more conservative rating approaches this year.
There's another problem on the horizon: these are term loans with several years to run, but there is a significant refinancing risk.
How do we finance SMEs and other companies, then?
I am still positive on trade receivables financing. These are much shorter and more diverse assets which throw off lots of cash. No TR deal has ever been downgraded (except 3 cases due to counterparty downgrade)-unlike many other asset classes!
Many people still associate TRs with commercial paper conduits. This was de facto the case whilst conduits could issue cheap paper, but to say that TRs can only be financed via ABCP is to miss the point by a mile or more. There are many investors who are interested in well-diversified, high-quality paper which generates lots of cash and has the lowest Basel II capital requirements-down as low as 0.56%
And companies who have few alternative sources of funds will pay a good yield.
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I spoke to somebody the other day who is engaged in buying distressed UK properties. Fair enough; I was involved in setting up and running a similar business in the early 90s, and it was successful.
How is he funding this? A thin layer of capital plus "a loan from a major bank at Base+2%".
Blimey. Base+2 is 7%. The same as 3-month Libor plus 1.25%. A great deal for my friend-but you wonder about the bank when it could much more simply invest in AAA mortgage-backed bonds at up to twice the spread, whilst using less capital. Transaction costs, legal costs, the level of due diligence and credit work required, higher Basel II capital charges...what is this bank thinking of?
FOOTNOTE SEP 08
Merrill's research published on 1-9-08 states:"We think the investment case for European structured finance remains strong. With the liquidity premium skyrocketing, the current market presents a good opportunity for buy-and-hold investors to step in and capture the liquidity premium while still being compensated for the credit risk they are taking, in a number of SF sectors, such as the RMBS and CLO."
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An email arrived from Fitch today: "The first half of 2008 has confirmed the Italian market to be one of the most dynamic for structured issuances in Europe. This has been mainly driven by funding from the ECB via repos backed by structured notes and the question is how long it will last".
This doesn't just apply to Italy: banks in many other Eurozone countries are structuring to be repo-ready. This is the case in the UK, too: this month (Aug 08) Lloyds TSB has priced and retained Arkle Master Issuer- Series 08-2, a UK RMBS of £10bn.
The economics for banks are persuasive. As Deutsche puts it "The economic rationale for banks to use their own securitised bonds for central bank short term financing is very compelling, without exception. The ECB does not apply a penal interest rate when financing ABS collateral, and therefore the cost of financing is frequently close to EURIBOR".
Is this a positive development, or are there dangers?
The central banks are fulfilling one of their main roles, which is to ensure that liquidity is provided to the banking sector. Whilst the funding cost is attractive, they do require a haircut (risk piece retained by the bank) of at least 2%. (NB this is based on market value not par value, and the central banks review this daily.) They can also decline to fund assets in some cases, e.g. downgrades.
To address Fitch's question, "how long will it last", it would be perverse for central banks to cease repo facilities at short notice whilst there is still a credit crunch.
Our advice to banks is to get going and structure asset pools to a rated standard:
-If they just stay on the balance sheet, no more risk, capital or funding is required than the "do nothing and hope for the best" option;
-There is the possibility of Central Bank repo funding if the situation dictates;
-The route to capital markets funding proper once the markets recover is much shorter.
Even AAA-rated Rabobank has gone down this route. Bert Bruggnik, Rabo's CFO commented that they had done so "to be absolutely sure that we would not have any liquidity concerns whatsoever, and since
mortgages cannot be pledged to the ECB and RMBS can, we decided to do an internal securitisation and buy back all the notes."
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