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May 1, 2008 5:13 pm
Why have the prices of triple A mortgage-linked securities slumped so dramatically this year? That question has recently caused anguished debate in the banking world.
After all – and as I pointed out in an earlier column – as the credit turmoil enters its ninth month, it has become painfully clear that it is not the behaviour of risky debt, such as BBB-rated securities, which is currently causing the most grief.
Instead, the key problem at banks such as UBS and Merrill Lynch is that the price of triple A rated instruments (such as the so-called “super-senior” tranche of mortgage-linked collateralised debt obligations) has tumbled by up to 30 per cent in recent months – although nobody used to think they would ever fall more than a few basis points.
And as bankers stagger about trying to make sense of these swings, it seems that the Bank of England has now joined this “dazed and confused” club too. In its latest financial stability report, the Bank suggests that the price of some AAA securities only makes sense if you believe that the ultimate loss ratio on securitised subprime mortages will be 38 per cent. However, that loss can only occur if three out of four households defaulted on their loans and house prices tumble dramatically too.
But no one is forecasting defaults on this scale right now. Indeed, virtually no triple A CDO tranche has actually suffered a tangible credit loss yet. Hence the bank concludes – with a sense of pique – that “prices . . . appear to be particularly out of line with credit fundamentals.”
So does this imply that the markets is nuts? Not quite. For the real source of the price swing lies not so much in credit analysis – but a crisis among the investment community.
In the past couple of years, a huge chunk of triple A mortgage securities have been quietly sold to hedge funds, which have leveraged these instruments on an extraordinary scale to produce steady returns. Banks have also been gobbling up this stuff, since the regulatory regime made it easy to hold this on their balance sheet. (As Rick Watson of the European Securitisation Forum points out to me, under the existing Basel II guidelines, the AAA tranche of a high quality granular retail mortgage-backed securities pool would have a capital charge of around 0.56 per cent, theoretically implying it could be leveraged close to 200 to 1.)
However, these days banks are nursing losses, and don’t want to buy more of this stuff; meanwhile, hedge funds can no longer get access to the all-important leverage to make this AAA-linked strategy work.
And while this situation should create an opportunity for new investors – such as pension funds or money market funds – to come in, this is not happening on a large scale. That is partly because the triple A spreads are not high enough to tempt unleveraged pension funds to invest time in understanding these complex deals. However, another crucial problem is that money market funds simply cannot tolerate any mark-to-market volatility – of the type that has just occurred.
So is there anything the authorities can do? One solution would be for central banks to put their money where their risk-analysis mouth is and buy this stuff themselves.
After all, if the prices of triple A did rebound, that would remove some of the balance sheet pressures that are weighing down on the banks – which is exactly what the central banks want to see.
But don’t expect the triple A cavalry to emerge soon. The Bank of England is leery of acquiring US mortgage-linked instruments; meanwhile, the American authorities have no appetite for unveiling more measures to prop up investment banks, in an election year.
So, for now, the implication is clear: yes, the price of triple A securities looks nuts from a fundamental credit point of view; but this reflects the fact that the leverage which has underpinned the structured credit world in recent years has been mad too.
And restoring sanity is likely to take more time – whatever the rational models of bankers (or central bankers) might imply.
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