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Financial Services Exposures to Subprime, Why we are not ‘Seeing Red’
While the impacts of the dislocations in the mortgage backed securities (MBS) and
collateralized debt markets (CDO) have been of relatively little consequence to reported
earnings this season there are many institutions that have significantly larger embedded
losses and operational, credit and market risk exposures than they have acknowledged up
to this point.
Given the lack of transparency and the fact that recent FASB guidance on Fair Value
Measurement (FASB “Statement No. 157”) does not become fully effective for all
institutions until after the institution’s first post November 15 reporting period, many
companies will continue to avoid recognizing losses as long as they are able.
Barring investor demands for greater disclosures many losses will remain largely hidden
until at least the reporting of 2007 annual filings. Even then, we continue to believe that
many institutions will use the subjective nature of the mark to model valuation methods
for illiquid securities to defer losses and obscure their true exposures. Beyond avoiding
the negative impact to earnings such improper or aggressive marking of assets obscures
the usefulness of investor reliance on book value.
Our goal in this report is to provide analysts and portfolio managers with primary
questions that investors should be asking of managements in an effort to avoid attempts at
obfuscation through jargon. Given the relative complexity of structured securities and the
confusion created by the rating agencies ‘one size fits all’ ratings scales, we believe that
investors need to understand the unique nature of risk layering and employed leverage of
Although our current focus relates primarily to problems in Residential Mortgage Backed
Securities (RMBS) and related Collateralized Debt Obligations (CDOs), we expect that
these problems are likely to be a precursor to similar problems in other structured
securities, most imminently Commercial Mortgage Backed Securities, CMBS related
CDOs and CLO’s.
There are many ways to obscure exposures including the moving of exposures, at
essentially par, to off-balance sheet vehicles. There are also many types of exposures to
consider including both the internal leverage of the actual structures as well as the
operational risks that may derive from counterparty exposures to leveraged lines of credit
to fund managers. Remember, the Long Term Capital Management crisis was largely
driven by the failure of regulated counterparties to properly manage their risk exposures.
Please refer to important disclosures at the end of this report.
While we will explore many of the above mentioned risks in future reports, this note is
intended to lay bare a few of the standard statements used by companies to intentionally
or unintentionally misdirect analysts and portfolio managers. A lack of standardization
coupled with opaque and liquid markets and a lack of reliable disclosure standards makes
traditional income statement and balance sheet analysis of limited use in uncovering
questionable valuations of risky structured finance exposures.
“Our Exposures are Highly Rated”
When asked directly about their exposures many financial companies have taken to hide
behind the rating agencies assessment of these securities. This is often inappropriate
given the lack of a consistent process for the updating of initial ratings and it also creates
misdirection to investors given the inconsistent meanings of ‘AAA’ from sovereign debt
ratings to municipal debt ratings, corporate debt ratings, MBS debt ratings and CDO
ratings. Even within a single CDO there are two tranches of AAA rated securities with
very different risk profiles.
To highlight this point we have shown how few countries, municipalities and
corporations receive ‘AAA’ ratings for their debt issuances. In contrast, the majority of
CDO securities receive such a rating.
Number of AAA-Rated Securities, by Type
Are we to believe that these ‘AAA’ CDO tranches are really as safe as the debt issued by
sovereign nations with the ability to tax and to print money or by our most well
capitalized and respected corporations? Given the market pricing of some CDO
exposures it is clear that investors are confident that we could see complete losses to
principal in some of these still AAA rated exposures.
Yield of AAA-Rated Securities, by Type
(US Municipals are not tax-adjusted)
Remember, due to the internal leverage of the structure, a roughly 4% loss to a RMBS
can translate into an almost 40% loss to a CDO. The very large yields paid in these
securities highlight the inapplicability of ratings across asset classes. Moreover, the
infrequent and inconsistent approaches to re-rating by the rating agencies highlights the
fact that reliance on the yield/rating at origination may have little value for the risk
management of secondary market securities including outstanding RMBS purchased in
newer vintage CDO structures.
Given that misapplied bond ratings cause MBS and CDO market disruptionsii, investors
should never again take comfort that a strong rating is a sign of safety. This is especially
true in markets without a strong base of empirical data.
Our Process for Marking Exposures is Rigorous
Another common claim that managements make is that they apply rigorous methods for
marking exposures to market. Unfortunately, the processes required by accounting
standards regulators, even in the recent FAS 157 guidanceiii, leaves managers with a large
amount of discretion in valuing illiquid securities. In furtherance of these claims many
managements routinely state that losses will be shallow and write-downs will not be
Marking to market:
Banks revalue securities and futures on a daily basis, but loans and other investments are
generally evaluated and marked down only when there is a change in the credit
relationship. Debt securities and equities that are available for sale are required to be
“marked to market” while securities in a “held to maturity” portfolio may be carried at
their original price. When one marks an exposure to market they are assigning a value to
a position that reflects the current market price that would be realized in executing an exit
transaction of that security. Where a security is not actively traded and there are not clear
and current transaction prices for similar securities managements generally rely on a
“marked to model” approach to valuation.
Marking to model:
Over the counter instruments are not traded on exchanges and their values are not readily
available. In such assets, managements are often forced to rely on a more subjective
approach to valuation. This has, in the past, created opportunities for companies to dress
up their books with aggressive assumptions in their models. Such was the case of Enron
who clearly took mark to model to a new level that could be described as marking to
There are many ways to create the models used to mark securities. Not all of them are
equally supportable or equally rigorous. Some firms utilize proprietary models while
others use ‘independent’ valuation firms and there are no consistent standards.
Investors should not allow managements to avoid disclosure of factual issues of the
quantity of exposure. Managements would like investors to accept, at face value, that if
their models multiply the “exposures” to some estimated depth of loss (which itself may
have resulted from an inappropriate assumption) and conclude that the loss is immaterial
then they do not have an obligation to disclose the details of the assumptions, assets or
possible or probable levels of loss.
Investors should demand to know the factual elements of these exposures and should
avoid investing in securities of companies who are unwilling to disclose those. Utilizing
indices such as the ABX, TABX or their own knowledge of how similar or identical
assets are trading, investors are fully capable of making their own assessments of the
risks posed by an institution’s exposures. Management can hide behind “regulation Fair
Disclosure” if one or only a few investors are pushing for these disclosures but they
cannot really justify that behavior if investors routinely demand such disclosures.
Specifically investors should demand to know:
If your institution has a formal process for reviewing exposures. How does
information come into the organization?
Do you have a formal and independent process for monitoring and
reviewing these risks?
Please explain the processes you employ.
Does your mark to model approach employ a mark to ratings approach and
if so would you explain the process?
Given the lack of empirical data for either the underlying collateral or the
structures themselves how do you know that the discounts or premiums
applied for a mark to rating or in valuations will prove to be conservative in
a time of market stress?
How does management process and make adjustments to risk
In dollar terms, what is the gross (unhedged) notional exposure, by each
vintage year, of your subprime exposure in the form of RMBS, of CDO,
Of your CDO exposure, how much is mezzanine CDO exposure and how
much is high-grade CDO exposure?
For each of these exposure numbers, what is the composition of that
exposure by rating?
By rating and asset category, what has been the impairment resulting from
your marks relative to par and how are you flowing those through the
incomes statement. For example, if you own a super senior tranche of a
CDO and are marking that at $.85 while the TABX is quoting a similar
value at $.40 you may not be fully recognizing the ultimate level of
Investors should demand information such as “we have $5.0 billion of 2006
vintage subprime exposure, of which $X billion is RMBS, $Y billion is CDO,
and $Z billion is CDO-squared. Of the $Z billion of CDO exposure, half is
mezzanine CDO, half is high grade. Of the $X billion RMBS exposure, x% is
AAA rated, y% is AA rated, z% is A rated….”
Investors should also ask about exposures that by their nature will not appear on the
balance sheet such as:
AAA rated super senior exposures are generally large and structured as
long-dated credit default swaps. Although these may expose the holder to
hundreds of millions of dollars of potential losses per transaction they will
not appear on the balance sheet but in “credit derivatives” disclosures.
Given the large lines of credit many investment banks have extended to
hedge funds and other counterparties, investors should ask specific
questions about the practices employed by the investment bank in
monitoring the counterparty’s leverage and in assessing the operational,
credit and liquidity risk of those counterparties. This is especially urgent
given that many of those counterparties will themselves have impairments
to assets and may, as collateral weakens, be unable to liquidate positions to
meet margin calls or redemptions.
We Have Hedges that Offset our Exposures
Managements frequently state that they have hedges that offset their exposures but rarely
detail, other than by the asset used to hedge, their strategy in a way that would allow
investors to analyze and make their own determinations about the effectiveness of the
hedges. Investors should ask:
Would you explain the assumed effectiveness of your hedging strategy?
Given that you may have hedged some exposures with correlated indices
and those indices may have already adjusted giving you a positive benefit
against underlying exposures which have not yet sustained losses, what is
your strategy for maintaining the effectiveness of these hedges going
Have you historically hedged “AAA” and “AA” RMBS, CDO and CDOsquared exposures? If not has the increased cost of hedging those exposures
upon downgrades prevented you from doing so? How fully hedged are you
to these downgraded exposures?
What of your hedges, by asset class, are direct hedges and what are indirect
What analysis and monitoring procedures do you employ to assess
correlation risks of indirect hedges used to reduce exposures in periods of
rising volatility? Please detail the instruments used to hedge each asset
More to Come
The lack of empirical data and the massive structural changes that this economic cycle
has ushered in, both in extension of credit to previously untapped markets and the
creation of and growth of new securities types, will cause these questions to remain
relevant for a long time to come.
As we have made clear since the beginning of the year, the mortgage finance problems
are not isolated to subprime, subprime just had a shorter leash. It is now becoming clearer
to others that it is spreading to Alt-A and will ultimately move directly into the prime
market. We expect recent vintage CMBS to show marked deterioration in the
performance of the much of the underlying collateral shortly. Both the CMBS and CLO
markets will almost certainly see rising liquidity problems.
There is little doubt that beyond large future impairments there are many institutions with
significant levels of embedded losses that have not yet been recognized as a result of
questionable valuation. These will come to light as more downgrades occur, fund
redemptions rise, margin calls increase and regulators more closely scrutinize portfolio
valuation assumptions for illiquid instruments.
These realities create a demand for investors, especially given the fiduciary nature of
many of their obligations, to demand greater disclosures of the collateral, valuation and
the structural features of the portfolios of companies they invest in.
Those managements who refuse to see the significance of this tide-change, with power
shifting from issuers to buyers, will find reduced access to the capital markets and a
higher cost of capital.
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