Wednesday, June 13, 2007

Asset backs, subprime: shades of 1990?

Will the U.S. subprime mortgage lending debacle go down in financial history alongside such notorious washouts as the 1990 junk bond fiasco?

This is the question I asked myself recently while reading through some old articles that detailed the speculative excesses of the high-yield investment markets of the 1980s and early 1990s.

This was a period in which leading investment banks were riding high on the backs of a bull market in stocks, increased activity in the bond markets, a wave of (often junk-financed) LBO deals, and the development of new structured finance instruments, such as the collateralized mortgage obligation (CMO), forerunner to the many forms of collateralized debt obligations (CDOs) that would follow in its wake. It was a time to take risks in the hopes of getting rich.

But the inevitable fallout in the junk bond market came, taking down high profile players such as Drexel Burnham Lambert and leaving institutional investors with what were reported to be enormous losses in the process (however, it has been argued that media reports vastly over attributed the losses suffered by Savings & Loan institutions to their junk bond investments).

Will problems arising out of subprime lending take a similar toll?

Back in March, there was a constant flurry of argument whether or not subprime's problems would spread throughout the financial system. And for good reason: according to data from Standard & Poors, subprime and Alt-A mortage-backed securities accounted for much of the assets backing CDOs issued in 2006.

Here's what the Financial Times said in a March 27 report on the rise of mortgage-backed CDOs:

Structurers of collateralised debt obligations (CDOs) - vehicles used to repackage portfolios of other debt - have been among the biggest buyers of bonds backed by pools of subprime mortgages in recent years, in turn issuing securities with a range of different credit ratings to investors around the world.

The recent woes of the subprime mortgage market have therefore caused ripples of concern beyond traditional mortgage investment circles about where the risks lie. Some estimates put the value wiped off CDOs in this space at up to $23bn. "The question is: 'Who owns all this securitised paper?'," says Douglas Peta, market strategist at J&W Seligman & Co. If these subprime holdings are concentrated among investors such as pension funds or insurers, "another segment of the market will face a problem".

Issuance of cash CDOs grew to $486bn last year, up from $212bn in 2005, according to industry publication Creditflux. The biggest category of deals, at 44 per cent, consisted of CDOs backed by asset-backed securities such as those backed by subprime mortgages.

According to CDO data from rating agency Standard & Poor's, subprime and the slightly less risky Alt-A mortgage-backed securities (MBS) accounted for 55 per cent of the assets underlying these CDOs last year.

So far, we have yet to see the wide-scale catastrophes predicted by many observers, but that doesn't suggest that the subprime bust hasn't claimed more than a few victims. Latest among them are some of the larger U.S. and British financial institutions, including Bear Sterns, Lehman Brothers (who, despite taking a hit from subprime, still managed to report record earnings), and HSBC.

Fresh signs of the continuing turmoil in the US subprime mortgage market emerged yesterday. Woes in the sector dented Lehman Brothers' still record quarterly earnings, while Countrywide Financial - the biggest US mortgage lender - revealed a doubling in foreclosures over the past year.

A spike in late payments and defaults by borrowers with weak credit has triggered the bankruptcy or closure of dozens of subprime lenders following a period of aggressive lending, particularly last year as the housing market slowed.

Subprime problems have also dented results at big institutions including HSBC, the British-based bank, and GMAC, the finance arm of General Motors in which a private equity group led by Cerberus bought a 51 per cent stake last year.

The article goes on to note that, "
subprime problems have also fed through into the markets for securities backed by mortgage loans and derivatives based on them."

And of course, there is the damage done to shares of homebuilders and mortgage lenders affected by the crisis, some of whom have gone bankrupt as a result of their unscrupulous lending practices. In fact it was the insatiable demand for higher-yielding debt instruments backed by home mortgages that helped fuel the tide of undisciplined lending.

This high tolerance for risk in the quest for yield was also evident during the 1980s. As noted in Fortune's 1990 piece on Drexel Burnham Lambert's decline, an increased appetite for deals was driving junk bond king Michael Milken to overreach:

By 1987, however, Milken yielded to the temptation to milk his genius and began underwriting companies that were less creditworthy than earlier ones had been. A source close to Milken admits: ''Quantity became more important than quality. If Drexel couldn't market the security, they bought it for their own accounts rather than not do the deal.''

This appetite for yield, and an increased willingness to structure deals/instruments of progressively lower quality, seem to be the features that most obviously define, and connect, the fallout periods of 1990 and 2007. Will subprime and Alt-A mortgage backed securities be known as the junk bonds of our day?

Postscript: While searching for more articles related to this theme, I came across the following piece by Chet Currier of Bloomberg News. Entitled, "Subprime woes akin to junk bond saga", the article makes a similar analogy regarding shakeouts in the junk bond and subprime mortgage markets, but argues for continued growth in the areas of subprime lending and mortgage securitization. Check it out.