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Rich Carona
HBS Alpha Fund
11/5/2008
Table of Contents
• Originator holds loans for very short periods; quickly sell pools of mortgages to
Securitization investment banks that package mortgages into even larger pools of mortgages
• Investment banks earn heavy fees; and also hold mortgages for only short period
• Banks sell to other banks or issuers of structured finance products (CDOs, CLOs)
Creation of
• RMBS (form of CDO) takes large pool of securitized mortgages and create tranches
RMBS with different risk and return characteristics
• Rating agencies (Moody’s, S&P) rate each tranche. All tranches are investment grade
and range from AAA to BBB; highly lucrative for rating agencies
• Structured finance firms retain residual equity interests, but otherwise sell each
Sale to tranche to investors, earning very high fees
Investors
• RMBS securities are highly opaque; information available may only include yield,
maturities, vintage year, and some statistics about structure of mortgages
• Investors rely heavily (or almost entirely) on ratings
Subprime Mortgage Crisis
Economics of CDO’s
CDO’s divide collateral pools into tranches that have different levels of
risk via loss exposure and corresponding return
Tranche
Key Assumptions: (By Rating) Thickness Support Est. Return
Yield on Collateral
Pool = 6.25% Remaining 20% Libor+50bps
80%
Expected default
rate: 5 to 7%
Recovery: ~75% AAA
A Next 5% 9% Libor+175bps
Low global interest rates, razor-thin spreads cause people to “stretch for
yield”
– Massive demand for highly-rated securities with the yields of low-rated debt
$750 billion of subprime are expected to reset in next five years, with vast majority
from now until late 2008
Subprime Mortgage Crisis
How Large is This Problem?
Leveraged Loans
Commercial Real Estate
(LBO Debt)
More Buyers
Fewer
At Higher
Buyers
Leverage
• New vehicles • Some structures
(LBOs, hedge collapse
funds, CDOs)
• More equity
Easy • Little equity Rising Tightening needed Falling
Credit necessary Asset Prices Credit Asset Prices
• Difficult to
fund-raise
• Tightening • Spreads widen
spreads • Home prices • Focus shifts to risk
• High LTV up 15% per as investors feel
Perception
year “burned” Defaults
• Financial of Low
•Comm RE Cap Rise
“Innovation” Default Risk • Banks are over-
Rates down extended; can’t offer
•Rising prices, from 8% to 3% • Problem credits
new loans
high cash flows can no longer be
and ability to • LBO Multples refinanced
refinance lead from 6x to 9x
• Cash flows
to few defaults •Small caps up deteriorate
20% per year
Unwinding of Credit Bubble
Contagion
The presence of “bad assets” that decline sharply in value can cause declines
in value of “good assets”
Bank Loan • CLOs, CDOs hold subprime mortgages; badly burned in July; demand for
CDOs dries up
Index
• BUT… CLOs are the biggest buyers of LBO debt; banks have $300 bn of Bank Loan
commitments to fund LBO debt in fall months Index Falls
• Anticipating massive new supply, secondary market bank loan index 10% in
(LCDX) trades to 90-92, compounding problem August
• Other fixed income asset classes (e.g., HY, CMBS) must adjust
Unwinding of Credit Bubble
The Myth of Risk Dispersion
A common perception is that structured finance allows risk to be dispersed broadly
to diversified entities, which lowers the probability of financial crises
In previous cycles, banks held all the credit risk. When credit cycled turned, their
solvency was threatened, making it extremely difficult to provide new loans, leading
to multi-year hangovers
In this cycle, banks have been the facilitators of risk-taking rather than
the holders of risk…but in downside scenarios, the risk ultimately
returns to their balance sheets
Banks have enormous exposure to credit derivatives, and lack the infrastructure to
adequately measure those risks
– Examples: $8bn loss at Merrill Lynch only rose to surface one week before announcement
As they have tried to make markets in derivatives, Banks have morphed into
propriety trading vehicles, speculating in equities, fixed income and derivatives
– Thus, they are long the same securities as their clients, making them highly reluctant to call in margin loans
and force hedge funds to mark-to-market their positions
Banks have contracted to be last-resort liquidity providers via back-up credit lines to
SIVs, but aren’t adequately capitalized to do so
– Example: Citigroup may need to raise $30bn in equity capital
Unwinding of Credit Bubble
The Myth of “Excess Liquidity”
“Most explanations of the financial dynamism of the last few years have centered
on…‘excess liquidity’…But where does excess liquidity come from? Not from more
currency. The amount of currency in the world is somewhat fixed, and each person’s
receipt is another person’s expenditure. I think the “L word” that should be
focused on isn’t liquidity, but leverage.”
“A decade or so back, the ability of parties other than the Fed to increase the
leverage in the system was limited. Margin debt for purchases of stock couldn’t
exceed 100% of an investor’s equity, and bank loans likewise were restricted to a
multiple of capital.”
“But in recent years, some new factors have meaningfully changed the picture,
including derivatives, hedge funds and non-bank lending. These have negated
the old limits and made vast amounts of leverage available to investors and
asset buyers.”
“This leveraging up was the greatest single element in the asset surge of
the last few years. In fact, the breadth of the gains tells me we didn’t have an
“asset bubble,” but rather a “leverage bubble.”
Unwinding of Credit Bubble
Range of Possible Outcomes
Excesses curbed from structured finance, hedge Structured finance and hedge fund undermined
funds, and derivatives but “trust” returns as investing vehicles, see capital outflows
Weakening dollar supports economy without Fed rate cuts inefficacious or impractical given
stoking inflation or major decline in currency dollar weakness and inflation
value
International economies / emerging markets
experience slowdowns due to weak demand
from US
– Industrial commodity prices could fall precipitously