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Commentary

More Subprime – CDO Insurers Downgrade, Bad Doc Trails and The India Impact

I wrote a long while ago about the Subprime problem in the US, and then followed it up with a few posts on the topic.

Let’s see what’s happened since my first post.

After the last crisis, things were kinda ok and recovering, until in late Oct and early November, loss reports started to come in. Countrywide reported a $1.2 billion loss, Merrill Lynch took with a $8 billion write down, and Citi had to match it with a $8-11 billion dollar writedown.

After the losses came a revelation of complexity. (Revelation to me, as you understand I am a newbie at this stuff) Turns out these CDOs, which are essentially securities created out of a lot of loans, are rated as tranches – AAA (huge-ass prime), AA (prime), A (prime but just about losing it), BBB (sub-prime) etc. People buy either all tranches or only some etc.

Now if something is rated BBB, why the heck would anyone buy it? Higher rates of course. But some funds weren’t allowed to buy BBB. So what happened? These CDO creators got in what are called ‘monolines’. These are essentially companies that provide insurance on municipal bonds – idea being if the municipality defaults they pay you instead, and charge you a premium for the exercise. If the municipality does not default they keep their premium. You bought what is called a Credit Default Swap (CDS)on the CDO which is a hi-funda name for “insurance”. Now monolines like Ambac, MBIA etc. are hugely capitalised and have the ability to cover the bonds they insure, so they have always got an AAA rating.

So the CDO creators got the monolines to provide insurance for the CDOs, and the monolines greedily did it for all tranches of the CDO. The premium was exciting, but they didn’t charge too much – heck, who knew the sub prime problem was around the corner?

If you bought insurance from an AAA entity, you could say you have an AAA security, right? So now you can have a BBB tranche of a CDO, paying a fairly kick ass return (you hope) and that is insured by an AAA monoline. Life could not get any better (in terms of three alphabet ownership at least).

Recently someone at the rating agencies woke up and realised that if these Subprime CDOs fail – and as it seems, even the prime CDOs are going down the drain – these insurers will be exposed to an ENORMOUS amount of liability. That may mean that the monolines are not capitalised enough, which is a signal to re-rate them to say AA or something.

This is treacherous. If the monolines get re-rated downwards, some funds will HAVE to sell the CDOs they hold, since they are mandated to hold only AAA paper. Not just CDOs, but also bond-insurance holders who held sub-prime municipality bonds. (yes, municipalities do go bankrupt in the US, unlike India where they are always bankrupt anyway) The muni-bond market is greater a couple trillion, and the monolines are the major insurers, so a de-rate of the monolines is bound to cripple the bond market – the selling will likely be intense.

If the muni-bond market gets hit badly, holdings on the equity side and maybe the corp-bond side may be ruined and the entire financial sector is hit once more. This time it could be worse than the last bash-up in November.

But why aren’t they getting de-rated yet? The rating agencies – firms like Moodys, Fitch and S&P – have a very close relationship with the CDO issuers and insurers. So there will be some under-the-table bailing out (effectively only these guys pay the rating agencies). Now if they do this longer, no one will believe Moodys or Fitch ratings anymore no? Uhm, someone figured that out already – the rating company stocks are down nearly 40% since Jan this year.

Also, there may be capital rescue attempts, like when CIFG’s parent company offered it a $1.5 billion of extra capital to ward off a re-rating. My take on that is – $1.5 billion is nice, but it’s like dropping a grain of salt in water. You can see it drop and in a few seconds it’s gone, and the water doesn’t taste a whole lot different either. We need LOTS of the salt.

What’s also interesting is: some monolines like ACA have threatened to declare bankruptcy if they are de-rated. What does that mean? Bankruptcy = I don’t need to pay my liabilities (or not all of them), so the guys who bought my insurance essentially get less or even zero – meaning, they have no insurance. If that happens, a good part of the CDO portfolio that was assumed to be ‘covered’ by insurance suddenly takes the hit – and I can’t say for sure, but if the equity tranches of the CDOs of these banks have taken multi-billion dollar losses, who knows how much they own that they consider “insured and therefore safe”.

What is also troubling is that in the rush to close loans since the 2005 times, people didn’t quite do the documentation right and now some foreclosures are getting thrown out the door for not having correct paperwork in place. The cost to do that will have to be borne by the banks, and that is another huge-ass loss. And they’ve already paid the bonuses, unfortunately. Those who haven’t, say they will continue to – because they are afraid to lose people. (No, I don’t get it either, but you have to understand that losing most of your staff is a short term nightmare, and no one in this business thinks long term when it comes to bonuses at least) Any Indian company that has outsourced or provided BPO services on such terms is most likely going to get screwed – as the banks are going to say that they messed it up and that the function will have to happen in-house. Why? Because maintaining and managing the doc trail requires a lot of work, training, local contacts and domain knowledge etc. and there are going to be a lot of such professionals in the US who need work (and do it faster as they understand it better)

Let’s get to India now, finally. Why do we care? Global liquidity is one of course, and the fact remains that because we don’t have loan securitisation (or “factoring”) anymore, we don’t have the intensity of the problem internally. But we have something, definitely – US home prices started to decline in 2005 – I have personally seen Bangalore real estate prices coming down in 2007. In two years, we are going to see some shake ups if the trend continues – and what will happen then?

Too much supply, too little demand. The market value of a house can become less than the loan outstanding. This can trigger margin calls (“pay up the difference”). High interest rates, and slowing global economy. In India, we can’t just walk off with a “foreclosure” and the process takes time, and banks can’t securitise and pass off the risks. So the banks will have to take the hit, and perhaps that will drastically reduce their ability to give out more loans, meaning further income losses as well. Where they do foreclose, they will auction and the resulting sales will bring market prices even lower, and there is no organised real estate fund or player to do the buying. (heck, you can’t even short right now)

That could lead to further problems with real estate sales, and in turn with higher discretionary spending (as people struggle to pay off mortgages, they cut down on buying high end cars etc.). The overall market decline will take years to undo as it has to run through the cycle.

Note: I am not predicting this will happen. I’m just saying that the problem could progress in this manner. Yes, we could reduce interest rates dramatically – something our RBI will surely do in a crisis. But it may be too little too late – as the RBI already seems to be complaining about too much bad lending. Sticky wickets.

I’m not buying a house right now, for sure. But then, I can’t afford to anyway, so call it sour grapes :).

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