New Horizons in SF

MARCH 2008 • emii.com

New HorizonsIn Structured

Finance

Business As UsualWith a wary eye on credit spreads, corporate lending remains robust.

Investor Antipathy Sinks MBS A chain reaction of mortgage write-downs and CDO collapses has investors avoiding risk.

FROM THE PUBLISHERS OF:

2008NEW-HOrizons 3/20/08 4:01 PM


New Horizons In Structured Finance

MARCH 2008 NEW HORIZONS IN STRUCTURED FINANCE 3

6 Economic Decoupling Does Little to EaseGlobal Credit Concerns By Gregory MorrisProfessionals overseas are just as concerned as mar-ket players in the U.S. over tight credit, despite thefact that the rest of the world’s economies seem tohave decoupled from a U.S. economy that is flirtingwith recession.

10 Risk Management ShortfallBy Stephen MauzyPoor risk models and market complacency con-tributed to the mortgage meltdown and ensuing creditcrunch. Will regulatory initiatives and improved trans-parency be enough to tame risk the next timearound?

12 Anxiety Begins to Grip ABSBy David LewisSpreads on non-mortgage ABS have widened, butanalysts believe the market should avoid the mort-gage market’s mess.

15 Investor Antipathy Sinks MBS By Stephen MauzyA chain reaction of mortgage write-downs and CDOcollapses has investors avoiding risk and taking await-and-see approach.

18 Credit Derivatives Damaged by Market DoubtsBy David LewisCredit derivatives have become ensnared in a down-ward spiral of doubt and fear, yet insiders insistthere's a silver lining. A reform movement is takinghold of credit derivatives, finding ways to simplify thedevilishly complex products.

20 Business As UsualBy Gregory MorrisThe overall tightening of credit and liquidity actuallymay have helped traditional corporate lending by driving borrowers to simpler forms of financing. Still,terms are tighter and business is far from booming.

Credit Derivatives Damaged by Market Doubts

Table of Contents

18

20BUSINESS

AS USUAL


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Editor’s NoteWelcome to New Horizons in Structured Finance, your window ontowhat lies ahead in the structured finance and credit markets in 2008.

New Horizons in Structured Finance is chockfull of insight and predic-tions from experts in every major sector of the structured finance andcredit markets, beginning with an outlook on the U.S. and globaleconomies. Analysts and market players are split as to whether theU.S. economy will head into a recession, but most agree things arelikely to get worse before they get better. Meanwhile, the rest of theworld keeps chugging ahead, although that’s not to say they aren’talso worried about tight credit markets (see story, page 6).

Next, New Horizons in Structured Finance addresses the roots of thecurrent credit crisis through an analysis of risk management practices.Faulty risk models and market complacency has been fingered as themain culprits, and now the structured finance markets faces a spate ofregulatory initiatives and calls for improvedtransparency. Now the market’s wonderingif this will be another example of too littletoo late (see story, page 10). The supple-ment then goes on to provide an in-depthoutlook at each of the major sectors of thestructured finance and credit markets -including consumer asset-backed securi-ties, mortgage-backed securities, creditderivatives and corporate lending – provid-ing readers with a complete picture ofwhere the markets are now and wherethey are headed.

New Horizons in Structured Finance is the latest in a series of specialsupplements produced by Institutional Investor News exclusively forour newsletter subscribers. It is part of our commitment to bringing ourreaders the freshest news and in-depth analysis on important sectorsand timely topics within the financial markets.

Enjoy,

Erik KolbEditor of Business PublishingInstitutional Investor News


New HorizonsIn Structured

Finance

Business As UsualWith a wary eye on credit spreads, corporate lending remains robust.

Investor Antipathy Sinks MBS A chain reaction of mortgage write-downs and CDO collapses has investors avoiding risk.

FROM THE PUBLISHERS OF:

4 NEW HORIZONS IN STRUCTURED FINANCE MARCH 2008


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A S THE FIRST QUARTER comes to aclose, the U.S. economic outlook for therest of the year is becoming a little clearer.Although economists and money managersare still split as to whether or not there will

be a full-blown recession, there is agreement that the meas-ures taken so far by the Federal Reserve, as well as by banksand major money managers, have helped. However, the con-sensus holds that the economy is likely to get worse before itgets better.

The near-term outlook for the structured finance markets isterrible, but there is surprising optimism for the long run.Financial engineering has become an epithet, and creativity isbecoming associated with irresponsibility. Yet no one is will-ing to write off structured finance permanently. As the smoke

clears, structured finance is being seen for what it is: a usefultool that has been too easy to misuse.

On the international front, there also is consensus that theU.S. and other regions have been decoupled economically.Indeed, professional money managers at U.S. institutionshave been investing in Europe, Asia and developing marketssince the first signs of trouble in the domestic economy lastsummer. Economic decoupling, however, is not the same asfinancial decoupling, and professionals overseas are just asconcerned as asset managers in the U.S. over tight credit.

Recession Ahead?Some market watchers have questioned whether it mattersif the U.S. slips into a formal recession or not. MichaelFeroli, U.S. economist at JPMorganChase, believes that is avalid question. “It does matter, especially for income per-formance,” he said. “We expect the weakness in that metricto continue for several months. Those will be painful

Economic Decoupling Does Littleto Ease Global Credit Concerns Credit markets are expected to remain tight globally despite divergence from a U.S. economy flirting with recession By Gregory Morris



months, even if the worst is alreadypast in the underlying numbers.”

Feroli declined to address specificmeasures that his bank had taken, buthe noted that collectively the steps thebig money-center banks have takenhave been positive when compared tothe same players’ actions in previouseconomic down cycles. “The big bankswere very prompt this time around inraising money,” he said. “That is incontrast to what happened in the cred-it crunch of the early 1990s. Thesesteps may have actually brought ontightness sooner, but it helps ensurethat the current problems will notlinger as they did in previousepisodes.” In effect, the valley will besharper, but shorter.

There is no such optimism for struc-tured finance. “It is tough to see muchrebound in structured products this year,” Feroli said. “Evenif you look out over the longer term, any change in the stand-ing of structured finance depends on what the private sectordoes in advance of regulatory changes. It really depends onhow much transparency and standardization the private sec-tor can put into place.”

“We have heard pointed words even from people on the Fedwho have generally been favorable to financial markets,”Feroli continued. “They are already talking about the nextwave of regulations. Executives and asset managers in theprivate sector should keep that in mind when they are set-ting their own standards. And if job losses continue,Congress will take note.”

Spreading the responsibility even further, Feroli suggestedthat ratings agencies also will be important to the recoveryprocess. “They may want to take this opportunity to fess upto not doing their best work lately,” he added. Feroli did notoffer any specific technical ideas for how to get structuredfinance back on track, but he re-emphasized the fundamentalsof transparency and standardization.

Bringing the discussion full circle, Feroli noted that job loss-es also are key to whether or not there is a recession. “Thatwill be determined in the labor market,” he said. “It could bea mild recession if the declines in the labor market are notvery sharp. But if jobless claims spike higher, we could be infor a tough time. We are definitely keeping our eye on that.”

The other essential indicator Feroli is watching is housingprices. “Those numbers will help determine what happens tothe economy and to credit markets,” he said. “Housing prices

have a strong effect on consumer spendingbecause residential real estate is behindabout one third of all collateralized credit inthe country. If you expand that to all realestate, then you have the backing of almosthalf the credit markets in the U.S. So Iwould really like to see some stabilization inhousing prices.”

So would every other bank in the country,according to Dr. Scott Brown, chief economistfor Raymond James Financial Services. “Moreand more homeowners are finding themselvesunder water,” he said. “They find themselvesfacing adjustable-rate mortgage resets withoutsufficient equity.” The change this year fromlast, he noted, is that lenders are now workingwith homeowners. “Banks do not want thosehouses on their hands,” he added. “They donot want to foreclose.”

Even with the housing outlook negative,Brown does not see that as bad enough to tip

the whole economy over into recession - not even when com-bined with higher prices for food and energy. His logic is thatconsumers are clearly curtailing their spending, but they arenot going to stop buying necessities.

“We don’t really know how bad things will get, but it will bevery slow in the near term,” Brown said. “It takes a while forrate cuts from the Federal Reserve to kick in because there areso many moving parts in the domestic economy, but we seethings picking up in the second half of the year. For all thegloom we hear about home building, that is only 4% of theeconomy. Consumer spending is 70% of the economy. Aslong as we have long-term job growth, then wages will catchup and support consumer spending.”

The bigger worry that has been building for many economistsis that credit conditions are continuing to deteriorate. Brownacknowledged that credit spreads are widening, but he is moretroubled by the problems in the roots of the liquidity mar-kets, such as the bond insurance segment. “The bond insur-ance business used to be so boring, but then they got fancy,”he said. “The new parts of those insurers are in bad shape, butthe old parts are in good shape. The Fed has done its part tosustain liquidity.”

That said, Brown stressed that the economy is not out of thewoods yet. “There are still lots of strain in the markets,” hesaid, citing the broad sell-off in financial stocks. For thebanks with big write-downs or the firms under investigation,that makes sense. “But Raymond James stock is down too,and we don’t hold any subprime paper,” he noted. Not sur-prisingly, he is raising cash and looking for opportunities inoversold financials.

Michael Feroli, U.S. economistat JPMorganChase



Meanwhile, there is not much danger in missing the recovery.Brown does not see a V-shaped downturn, but more of a sce-nario where the markets are bumping along the bottom look-ing for some lift. That could come from exports or frominvestment in emerging markets. “Economic growth in theEuro zone is slowing, but the emerging economies are in rel-atively good shape,” he said. “They have gotten past theirown credit problems, which is good because previous finan-cial shocks have been very damaging to emerging economies.That does not seem to be happening this time, especially inLatin America.”

Inflationary PressureA contrarian note is sounded by Stephen King, group chiefeconomist and global head of economics and asset allocationfor HSBC. In a just-published analysis, he argued thatemerging economies run the very real risk of repeating themistakes that developed countries made in the 1970s. Hecited current inflation rates of 7.1% for China, 9% forSaudi Arabia and 11.9% for Russia. By comparison, henoted that just two years ago inflation in China was only1.5% and was 2.3% in Saudi Arabia.

The fundamental truth, however, is that economies thatare growing quickly experience inherent inflationary ten-dencies, King asserted. In effect, the challenge of inflationis a good problem to have. It means that purchasing powerin international markets is growing, as indeed has beenseen in China and India. Combine that with a desire toboost exports by the U.S. by holding the dollar low, andthe result is inflationary pressure on China, India, Braziland other accelerating economies.

The other result is more ominous in the developed world thanjust sticker shock for Americans in Paris. King explained that thegoods the U.S. has to buy, especially energy, are more and moreexpensive. This, he said, is why inflation fears in the U.S. andEurope have not dissipated despite the credit crisis. King’s ulti-mate concern is that even as investors in the U.S. and Europe seekreturns in the developing markets, the very growth that coulddrive those returns could also stoke inflation.

North American observers are not quite as troubled as King,but inflation concerns persist. In its most recent assessment ofthe North American economy, Royal Bank of Canada notedthat inflation is still a worry for the U.S. Federal Reserve.“While policymakers have had to focus on the downside risks

to the economy as the impact of the housing market recessionsnaked its way through the financial system, inflation ratesremain uncomfortably high,” it stated. “The all-items CPIrate is holding above 4% and the core inflation rate is runningat a 2.5% pace.”

RBC expects that rate to remain elevated in the near-term, whichin turn will keep the Fed concerned about an uptick in inflationexpectations. “Our forecast that the economy will grow at 1.1%on a fourth- over fourth-quarter basis in 2008 bodes well for pricepressures to ease during the course of the year,” RBC stated,“although the core inflation rate is likely to remain slightly abovethe upper end of the Fed’s preferred range.”

The advantage of observing the U.S. economy from as closeas the 49th parallel but outside the jurisdiction is that RBCcan hazard a guess as to when the Fed might change course—a speculation no one in the U.S. cared to make on the record.“U.S. monetary policy will be geared to offsetting the down-side risks to the economic outlook, restoring investor confi-dence and stabilizing financial markets, with the Fed fundsrate expected to fall to 2% by late April,” it stated.

Putting a finer point on the outlook, RBC added that “afteradjusting for inflation, the real policy rate will be at, or justbelow, zero, which historically has been stimulative enough torevive an ailing economy. Our call for a modest recovery inU.S. economic growth in 2009 is consistent with the Fedstarting to reverse recent rate cuts, with a hike of 25 basispoints penciled in for late in the first quarter of 2009.”

Despite the firmness of that prediction, RBC acknowledgedthat uncertainty about the U.S. economic outlook continuesto dominate flows in financial markets, with investors flock-ing to the safety of government bonds while stock marketsand credit products remain under downward pressure. “U.S.Treasuries continue to record solid gains so far in 2008,” itstated. “The growing uncertainty about whether the U.S.economy can emerge from its current state of lethargy ledmarket makers to price in more easing by the Fed.”

Having put a stake in the ground to mark the recovery, RBCwent on to mark the beginning of the recession—a recessionthe bank thinks is starting now. “Our economic forecast callsfor the U.S. economy to stall in the first quarter and contractmodestly in the second,” it noted. However, a fiscally inducedspurt in consumer spending is forecast to jumpstart the econ-

“Even if you look out over the longer term, any change in the standing of structured finance depends on what the private sector does in advance of regulatory changes.”

— Michael Feroli



omy in the third quarter, with realGDP growth of 3.9%.”

Adding a caveat to the recovery inflectionpoint, RBC concluded that the key forthe financial market outlook will bewhether or not the resumption of growthin the third quarter will be sustained inlate 2008 and early 2009. “We are fore-casting that the combination of easymonetary policy and more stable financialmarket conditions, which cut the cost ofcapital for households and businesses, willlead to progressively stronger growth dur-ing the period. If and when the economyreaccelerates as we expect, the Fed will bein a position to start to unwind this year’seasing in interest rates in early 2009.”

Global DecouplingFrom farther outside of the U.S.domestic market, the key question isdecoupling. Few market watchers andmoney managers dispute that it is real,but there is a great range of opinionson the degree to which it has happened. Hugh Simon, chiefexecutive officer and portfolio manager of Hamon InvestmentGroup of Hong Kong, asserted that economic decoupling isreal. More importantly, economic decoupling has created abuffer in which a U.S. recession could take place and even bebeneficial for both the U.S. and global economies.

“Everyone sees what is happening in the U.S.,” Simon said,“but China will grow 9% this year, India will grow 8% and allthe ASEAN nations are still strong - even countries likeTaiwan and Korea, which traditionally have been closely tiedto the U.S. So if there is a recession in the U.S., maybe thatis not such a bad thing. Better financial management of per-sonal accounts is good. So many Americans not having threehouses may not be such a bad thing.”

Simon noted that the Fed is bringing interest rates down towhere people can pay back their loans. “That is not a badthing either,” he added. “The default rate is about 6% now,which is very manageable. The danger level would be around10%.” Along the same lines, he thinks that the big banks havebeen making their write-offs fearing the worst is still ahead.In that, he echoed Feroli, who suggested that the money cen-ters’ early moves augured for a shorter, sharper downturn.

“The bottom will be found,” Simon said, “when we knowthat people will be paying back their mortgages.” But thatmay not be as soon as some have dared hope. “It will taketime,” he added. “It is unrealistic to think that this will all beover in six months. We saw the same thing in Asia exactly 10years ago. People didn’t just borrow too much, they mis-

matched their borrowing. As a result, theyhad huge foreign-exchange losses and had torestructure their balance sheets. That justtook time.”

That brings Simon back to decoupling. Thereis an essential distinction, in that U.S. andinternational markets have not decoupledfinancially, he stressed, noting that liquidityis linked, currencies are linked and so are riskappetites. “What we are experiencing now isa de-rating due to the risk premium,” he said.“Institutional investors had been willing topay 20 times for 25% earnings growth, andnow they are not. Over the last six months,the Hong Kong Index has been trading at 22times 2007 earnings, and now it’s trading at15 times 2008 earnings.”

That puts the Hang Seng into the range of avalue stock. “If you have got fresh capital toinvest, there are values to be found in Asia,”Simon affirmed. “There is a huge middle classstarting to come through China and India whoare eager and increasingly able to buy homes,

cars and appliances. There also are huge needs for governmentspending on infrastructure. They have to do what Japan did atthe end of World War II and put in high-speed rail and otherways of moving people around.”

At the same time, Simon said China wants to slow its racingeconomy, without raising interest rates. “So a slow-down,even a recession, in the U.S. is a good thing,” he added.Another challenge for India and China is how to advance theurban economy without leaving the rural economy behind.“India just waived all bank debts for small landowners,” henoted. “It is electioneering and it is going to cost them $18billion, but it is very good for the rural economy.”

Getting back to the opportunity at hand, Simon noted that somebig investors were leery of Asian regional investment, or morespecifically investing in commodity-related companies. “Prices forcommodities are still strong, but the share prices of companies inthose sectors have been oversold,” he said. “There has been thequestion of how much of commodity prices is real demand, howmuch is the weak dollar, how much is speculation and how muchis hedging. If you track the Baltic Dry Index, it was as high as11,000, then fell to 5,500 and now is back to 8,500. That impliesreal, true demand.”

Simon concluded that there are good long-term plays, but thatthere is no fast money to be made. “These are very attractiveopportunities for global pension fund managers and otherinstitutional investors,” he said. “It is the time for them to addto positions or to start looking into these markets, but not ifthey want to make quick money in a quarter or a year.”i

Dr. Scott Brown, chief economist for Raymond James Financial Services



RISK IS THE NEW FOUR-LETTERword, for the simple reason so many investorsand structured finance sponsors failed to prop-erly measure and manage it. Look no furtherthan the glut of meltdowns and flame-outs

related to mortgage-backed derivatives for an encapsulation ofpoor risk management.

To state the obvious: something has gone wrong, and what hasgone wrong is the inability of many quantitative models to cap-ture ‘fat-tail’ risks – the probability that large losses are likelierthan standard statistical models predict.

“The fact is the tails in the real world are very long,” said BenoitMandelbrot, Sterling Professor Emeritus Math at Yale Universityand author of Misbehavior of the Markets. “The variances are fargreater than many people think.”

Underestimating OutliersComplacency, it's safe to say, was a prominent variable inunderestimating fat-tail risk. In the four years before the sum-mer of 2007, exceptionally benign macroeconomic, financialand monetary conditions combined with financial globaliza-tion contributed to reduced risk aversion and market volatil-ity, thus fostering a search for yield and leverage mentalitythat led to underpricing risk.

The odds of a meltdown and a flame-out following a periodof prolonged prosperity are higher than many market partici-pants expect. The late economist Hyman Minsky found that,in prosperous times, when corporate cash flow rises, a specu-lative euphoria develops. In essence, he hypothesized that sta-bility is inherently destabilizing because stability leads to theextrapolation of stability into infinity. Therefore, the morestability a market exhibits and the longer it lasts, the moreunstable the financial foundation becomes.

Ari Bergmann, principal and head of Penso Capital Market,likened the building instability to an EKG reading before a

heart attack. “The world was complacent because the linekept going higher and higher, and that's where the real risklies,” he said. “The line can only go so high before it gives wayand drops spectacularly.”

Exacerbating matters was the fact that many value-at-risk(VaR) models – models that estimate likely losses during thenormal course of trading – leaned heavily on recent data.Bloomberg reported that Lehman Brothers used four yearsof historical data to calculate VaR, with a higher weightinggiven to more recent time periods, while Morgan Stanleyprovided VaR calculations using both four years and oneyear of market data.

Consider a typical portfolio. A bank might report that itsportfolio has a one-day VaR of $40 million at the 95% confi-dence level based on its analysis of current credit conditions.That implies that, under normal trading conditions, the bankcan be 95% confident that a change in the value of its port-folio won't be more than $40 million during any given day.

However, it's the abnormal trading day that produces the$140 million loss that's the real risk, and one that is invari-ably overlooked when model inputs are based on periods oflow volatility and market-friendly economic conditions.“During times of low volatility, models will show a probabil-ity of a disastrous event occurring being one-in-a-million,when it's really one-in-a-couple of years,” said Mandelbrot.

Banks, structured investment vehicles and hedge funds wereleading perpetrators, but the rating agencies' models alsounderplayed the risk that loans from different lenders andregions could turn sour at the same time. In addition, bondinsurers misjudged the risks lurking in CDOs, underminingthe worth of their guarantees and straining their own creditratings – and hence the financial markets.

Opacity and OperationsThis tendency for quantitative models to fail followingextended bull markets amplifies the need to scrutinize opera-tional risk, especially after many CDO models generated assetprices that were a fantasy at best.

Risk ManagementShortfallFinancial markets and regulators failed to account for risk...againBy Stephen Mauzy

“q



Then again, operational risk has always been a frontline issue. A2005 Standard & Poor's survey on structured finance found that“more than two-thirds of respondents chose operational risk asone of the top three most important areas of risk in the market,surpassing other highly touted forms of exposure such as legal(40%), modeling (39%), interest rate (27%), regulatory (24%)and correlation risk (9%).” Only credit risk received more votes.

A majority of S&P's respondents (78%) identified servicer quali-ty as the most critical element of a transaction’s operational riskprofile, followed by transaction structure. The inherent servicea-bility of a particular receivable was in third place followed closelyby deal administration, which includes the work of the trusteeand the general level of a transaction’s disclosure.

“Operational risk should be evaluated,” said Ed Hida, partner anddirector of risk strategy and analytics at Deloitte & Touche. “Oneobvious concern is the viability of the firm’s internal models.We've seen serious problems with the perceived risk, ratings anddocumentation of the underlying assets.”

A Call for RegulationAnd so have the regulators. The oversight of operational risk relat-ed to fixed-income transactions has moved to the fore and comeson the heels of new Basel II guidelines.

Some of the world's top financial experts have spent the pastdecade designing new rules to help global financial institu-tions avoid trouble. A version of their new guidelines –known as Basel II, for the Swiss city – was about to be phasedin next month in the United States. Basel II's primary tenet:banks should be given more latitude for deciding how muchfinancial risk they should accept, since they are in a betterposition than regulators to make that call.

Under pre-Basel II rules, setting the level of this financial cushionis a relatively straightforward process: banks must hold a specificamount of capital, which is calculated based on the types of assetsthey hold. For example, mortgage-related assets don't requiremuch capital because they have long been considered extremelysafe, so the argument goes.

Critics have charged that Basel II will allow banks to signifi-cantly reduce the amount of capital they need to hold inreserve against their loan. Based on recent experience, it's awell-founded criticism.

Consider Northern Rock, a large British mortgage lender thatoperated under Basel II's tenets. Last year, the lender announced

that it would boost its shareholder dividend by 30%, which proved tobe an injudicious and untimely move. A few months later, Britain suf-fered its first bank run since 1866 when Northern Rock was caughtoff guard as credit markets froze around the world. In January, thelender was nationalized by the British government.

So far, no major U.S. bank has rushed to exploit the greater flex-ibility in risk management allowed by the Basel II accord. Thatsaid, large U.S. banks that operate internationally – such asCitigroup, Bank of America, JPMorgan Chase and Wachovia –are required to switch to the new Basel II standards, but they haveup to 36 months to do so.

Domestic legislative maneuvering is a more immediate concernfor many banks and structured finance sponsors. One bill that haspassed the House of Representatives includes an ‘assignee liabili-ty’ provision that would hold securitizers partly responsible for laxlending by originators. Another bill would allow bankruptcyjudges to alter the terms of struggling borrowers' mortgages. Theindustry argues that this would be an intolerable violation of thesanctity of loan-pooling contracts.

Meanwhile, securitizers face probes by several state attorneys gen-eral, the Internal Revenue Service, the Federal Bureau ofInvestigation, the Securities and Exchange Commission and the

Justice Department, as well as lawsuits from investors and a risingnumber of stricken municipalities.

More TransparencyThe clarion call from all fronts is the need to improve the trans-parency of CDOs and other opaque credit instruments. Whileregulators pay lip service to the concept, they've yet to take anyaction. And why should they? Calls from burned investors forimproving transparency have a closing-the-barn-door-after-the-horse-escapes ring.

“More transparency is fine,” said Bergmann, “but it's up to theinvestor to take a complex instrument and break it down to itslowest common denominator. You have to ask, do I want thisrisk? Am I being compensated for this? Can I hedge this risk? Ifyou can't answer those questions, you probably shouldn't beinvesting in the security.”

Skeptics argue that any new regulation or legislative oversight toincrease transparency will be effete as soon as it's passed, reason-ing that the market will have already moved on to a new wave ofinnovative thinking that will supplant today's already scorchedpastures. Unfortunately, the skeptics have history on their side. i

“You have to ask, do I want this risk? Am I being compensated for this? Can I hedge this risk? If you can't answer those

questions, you probably shouldn't be investing in the security.”— Ari Bergmann


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A NYONE WHO HAS ever looked at anewspaper or watched the news on televisionany time in the past year knows by now thatmortgage-backed securities (MBS) have beenclobbered by the subprime lending crisis and

the ensuing credit crunch. Non-mortgage asset-backed securities(ABS), however, presents a much more complicated picture.

For one thing, non-mortgage ABS consists of numerous creditmarkets, including securities backed by auto loans, credit carddebt and student loans, among many others. For another, non-mortgage ABS has not been attacked directly by credit defaults, ashas MBS. Therefore, calculating the risk of non-mortgage ABS inessence means analyzing a variety of credit markets, as well as pre-dicting the eventual impact of the current economic downturn onpotential defaults on those markets. In short, both micro- andmacro-economic analysis.

“Amid panic and divergence of investors’ views, one thing standsout consistently in any relative risk measure: collapse-type scenar-ios are becoming overbought,” stated a Bear Stearns report. Likemany of its peers continue to do, the now-defunct investmentbank played the ABS market by shorting it.

One consequence of this analysis conundrum is that observersand experts differ widely on the state of the various non-mortgageABS markets, with opinion ranging from “we are in a sellingpanic” to “we are close to a buying opportunity.” Anthony

Sanders, professor of finance at the W. P. Carey School of Businessof Arizona State University, categorized these two forms of analy-sis as the ‘economic effect’ and the ‘contagion effect.’

The economic effect, Sanders explained, stems from our historyof heavily pushing consumer purchasing as the driver of the econ-omy. Indeed, spillover from the mortgage market’s woes exists notonly in the ABS market, but on the consumer level as well.

“We had people not only maxing out on home loans, we hadthem taking a lot of money out of their homes through homeequity loans and home equity lines of credit,” Sanders said. “Wehad people running up their credit cards and leasing cars theyordinarily would never be able to afford because they fell for theillusion of all of this. Finally, the market became saturated and weran out of slack.”

Then there is the contagion effect, which supposes that the inter-national credit markets are scared to death of what is going on inthe United States. “Therefore, in addition to actually havingunderlying economic drivers that are adversely affecting some ofthese asset-backed securities, we're looking at a slowdown in theeconomy,” Sanders explained. “We're talking about loan defaultsin all sectors—housing, credit cards, etcetera.”

Assessing the Markets’ HealthOne way to measure the dislocations of the credit crunch on non-mortgage ABS is to look at spreads and how they have risen.“Non-mortgage ABS spreads have widened, but certainly muchless dramatically than those of MBS,” said Steven Davidson, vicepresident of capital markets research for the Securities Industryand Financial Markets Association (SIFMA). “The two reasons

Anxiety Begins to Grip ABSSpreads widen, but analysts believe non-mortgage ABS should avoid the mortgage market’s messBy David Lewis

“


d. AAA (stable) S&P • Aaa (stable) Moody’s • AAA (stable) Fitch Assuredable) S&P • Aaa (stable) Moody’s • AAA (stable) Fitch Assured Guaranty

&P • Aaa (stable) Moody’s • AAA (stable) Fitch Assured Guaranty Corp.aa (stable) Moody’s • AAA (stable) Fitch Assured Guaranty Corp. AAA

ble) Moody’s • AAA (stable) Fitch Assured Guaranty Corp. AAA (stable)ody’s • AAA (stable) Fitch Assured Guaranty Corp. AAA (stable) S&P •

AAA (stable) Fitch Assured Guaranty Corp. AAA (stable) S&P • Aaa (sta-(stable) Fitch Assured Guaranty Corp. AAA (stable) S&P • Aaa (stable)TABLETABLE

are that people are in a risk-adverse mode and the other part of it- the view that, as the economy slows, what happens to consumercredit is unknown.”

Whether a domino effect will sock non-mortgage ABS is the sub-ject of widely varying debate. “I don't think there has been apanic,” Davidson said. “There are two things going on that weneed to separate and think about: fundamental issues and techni-cal issues. The fundamental issue is the analysis behind the cred-its. Obviously, the market has been very volatile for severalmonths now, and profits undoubtedly will be affected by thesesorts of macro events. Then there are the technical issues, or howmany buyers and sellers are in the market. There is some thoughtthat the market has gotten ahead of the fundamentals and isthinking about at what point it seems oversold, so I don't thinkthere is panic.”

Issuance of new non-mortgage ABS paper has been decent thisyear, particularly on the credit card side, according to JosephAstorina, director in U.S. securitization research at BarclaysCapital. “The auto side, however, has slowed down quite a bitfrom the pace of 2007. We're expecting issuance levels in the $60billion range, but those will be down anywhere from 15% tomaybe 20% from last year.”

Still, investors should not be panicked. “I talk to investors all thetime, and they're fairly comfortable, certainly at the triple-A levelin the credit card space,” Astorina said. “We just don't see creditcard ABS becoming the next subprime MBS meltdown.”

Nevertheless, the market bottom is not yet in sight, and manyinvestors certainly are uneasy. “On the technical side, investors arein a risk-adverse mode” said Davidson. “They are shying away fromall collateralized debt obligations, and it has affected liquidity.”

At the same time, the investor pool has shifted radically. Some seehedge funds and banks remaining in the market, with pensionfunds, asset managers, insurers and others on the sidelines. Othersreport that they have continued business with money managers,

banks and insurancecompanies, whilehedge funds havepulled out of the con-sumer ABS space.

Similar ButDifferentObservers see a gradualfraying of consumerABS. Figuring how fardown the market willdescend is a top-down,macro-economic task.Yet Astorina stressedthat some of theg l o o m - a n d - d o o mregarding non-mort-gage ABS is exaggerat-ed and fails to take keyfactors into account.

Student loans, forexample, have takensomething of a bumrap, resulting in thefailure of recent sales of auction-rate securities (ARS) backed bystudent loans, which make up about one-quarter of the overallARS market. But analyzing student loan-backed securities todayrequires some perspective, Astorina explained, noting that theFFEL student loan program guarantees loans up to 97%.

“Still, we see spreads on FFEL-backed ABS trading in the highdouble-digits, which to us represents an incredible value,”

Astorina said. “We don't see a fundamental reason for thosebonds to be trading that wide. Certainly, there is no credit-basedreason that these things are trading that way. It's safe to say theseare certainly at historically wide spreads. There's definitely a

“In addition to actually having underlying economic drivers that are adversely affecting some of these asset-backed securities,

we're looking at a slowdown in the economy.”— Anthony Sanders

Anthony Sanders, professor offinance at the W. P. Carey

School of Business of ArizonaState University



degree of fear in bringing those spreads thatwide in government-guaranteed paper.”Triple-A rated paper, at that.

Are these sorts of spreads an inducement foradventurous investors? Perhaps.

“We think spreads are attractive at these lev-els,” said Astorina. “The risk obviously is thatspreads continue to widen on fear in the mar-ket, but there is not really a good fundamen-tal argument for spreads being so wide.”

No one is trying to call the market bottom,and there are solid technical reasons whyspreads are so wide. Factors include sellingpressure from structured investment vehiclesand well-publicized unwinds of higher-qual-ity consumer ABS paper.

“When investors’ mortgage holdings wentdown the drain, they had to raise cash,” saidAstorina. “The most liquid and most valuablething they could sell was probably some oftheir consumer ABS. So that contributed to alittle bit of this spread widening that we'veseen. That is not really a fundamental reason - the credit perform-ance of those deals is still pretty strong - but it is a technical reason.”

The fear factor also is playing an important role in other non-mortgage ABS markets. But then, the fundamentals of the othermajor ABS markets are not 97% guaranteed.

Credit card ABS, however, tend to have borrowers with muchhigher FICO scores. “It is not, in our view, the next shoe to dropin ABS land,” said Astorina. “We will see higher losses and high-er charge-offs in credit card land, and that could have an impacton banks having to take higher provisions. But investors in cred-it card ABS should be in reasonably good shape.”

Somewhat like student loan ABS, government intervention has tobe taken into account when considering credit card ABS.Historically, charge-off levels hovered around 6.5-7%. Then, inOctober 2005, bankruptcy reform changed the ABS landscape.

“That really cleared the decks of weak credit card performers,”Astorina said. “We had a rush of people come in to file for bank-

ruptcy, and it caused a surge in charge-offs. Charge-offs fell to abnormally lowlevels right after the bankruptcy reformwent into effect, but since that timecharge-offs on credit card portfolios havebeen increasing at a moderate pace. Thatis something that we have been expecting;we always expected charge-offs to returncloser to their historical levels.”

Today, credit card charge-offs have roughlyreached the 4.5% level, so there is still signif-icant room to move up before getting back tohistorical levels. “There is an ample cushion,in terms of where we are currently to wherewe have been historically, before we really seethings get ugly,” Astorina added.

Lastly, there is the third major leg of the con-sumer ABS space, securities backed by autoloans. In February, Barclays reported thatprime retail auto ABS spreads rose to 35-45basis points for triple-A securities, while sub-ordinate spreads reached 50 basis points overfor single-A ratings and 100 basis points overfor triple-Bs.

Of greatest concern is the auto equivalent of a subprime loan,namely the extension of auto loan terms. “We recommendinvestors look at deals that don't have a sizable concentration ofloans with greater than 60 months to maturity,” Astorina said.“Typically, standard auto loans had been anywhere from three to

five years. Now we're starting to see six- and seven-year loanscreep into these securitization pools on an increasing basis.There's no real documentable adverse effect, but the obvious issueis whether you are squeezing someone into a loan for the longerterm just to get them to be able to qualify for that lower month-ly payments. That could be an issue going forward.”

Deterioration is a major theme among ABS analysts. “Our econ-omist’s view is that the first half of the year is going to be prettytough and the second half should see a bounce-back,” Davidsonsaid. “If the bounce-back occurs and the economy doesn't dra-matically deteriorate, our view is that there may be opportunitiesfor a real pickup, particularly since the Fed has injected liquidityinto the short-term markets.” i

Joseph Astorina, director in U.S. securitization research at

Barclays Capital

“When investors’ mortgage holdings went down the drain, they had to raise cash. The most liquid and most valuable thing

they could sell was probably some of their consumer ABS.”— Joseph Astorina



T HE AMERICAN DIALECT SOCIETY(ADS) recently named ‘subprime’ the wordof the year for 2007– an appropriate, if notblindingly obvious, accolade given that sub-prime is as ubiquitous in the adult lexicon as

‘dude’ is in the adolescent one.

Subprime took to everyone's lips in force last August, whenthe housing market’s weaknesses – loan-quality problems,uncertainty about inventories and interest rate resets –became so readily apparent. These weaknesses led to a dra-matic thinning in trading for subprime structured instru-ments, many of which were synthetically priced on impliedvalue instead of posted market prices.

‘Liquidity’ was likely the ADS's penultimate word, asinvestors' desire for it applied enormous pressure onovernight interest rates last August, sparking a sharp upwardrepricing of risk premiums. To mitigate a stampeding liquid-ity run, the European Central Bank injected 94.8 billioneuros into its financial system. On this side of the Atlantic,the Federal Reserve injected $38 billion through repurchaseagreements backed by triple-A rated mortgage-backed securi-ties - a huge intervention, on a par with measures taken fol-lowing September 11th.

SIV SmackdownThe sudden desiccation of liquidity was particularly pro-nounced in structured investment vehicles (SIVs) - off-bal-ance sheet conduits typically constructed of three financinglayers: an ‘equity’ tranche, often as small as 1% of the capitalstructure; a mezzanine tranche, a single- or double-A rateddebt instrument; and senior debt, a pari passu combination ofmedium-term notes and commercial paper.

An SIV is essentially a highly leveraged bank, and its ‘deposi-tors’ are the buyers of its commercial paper. In good times,the spread between commercial paper and subprime assetswas as high as four percentage points and leveraged in multi-ples of 10-15. Life was good, so banks decided to get in onthe action and began sponsoring their own SIVs.

Of course, leverage is a two-edged sword and, if an SIVexperiences a ‘run,’ the good times quickly end, as SIV

sponsors are painful-ly aware. “Many ofthese SIVs have cer-tain ratios they haveto adhere to,” saidSean Davy, managingdirector of MBS andsecuritized productsat the SecuritiesIndustry andFinancial MarketsAssociation. “If theassets are falling inprice, they have tode-leverage and thenthe losses reallybegin to multiply.”

Many banks previ-ously listed SIVs offtheir balance sheets,so their exposurewas initially unclear.However, with thedisappearance of the SIVs' funding sources - notably asset-backed commercial paper - banks had to bring more than$136 billion back onto their books. That comes on top ofmore than $160 billion, so far, of subprime-related write-downs. More recently, Carlyle Capital roiled financial mar-kets when it said it failed to meet margin calls on its $21.7billion MBS-laden portfolio.

MBS MorassIn financial circles, subprime mortgages are tethered to themortgage-backed securities – the most mature, ubiquitousand complex of consumer structured finance products,according to Mark Zandi, chief economist at Moody'sFinancial Services’ Economy.com. The architects of the newfinancing structure found that bundling hundreds of dis-parate mortgages of varying credit quality from across thecountry into a big MBS bond wasn’t enough. If the WallStreet MBS underwriters were to sell their new MBS bondsto the well-endowed pension funds of the world, they need-ed some extra juice. That's were guarantors like Ambac andMBIA come in, giving their triple-A imprimatur to manysenior tranches.

Investor AntipathySinks MBSA chain reaction of mortgage write-downs and CDO collapses has investors avoiding riskBy Stephen Mauzy

Mark Zandi, chief economist atMoody's Financial Services’

Economy.com

g



Complexity was further enhanced when numerous MBSwere securitized into collateralized debt obligations.Whereas MBS is supported by static pools of underlyingassets, CDO pools are managed; hence, the composition ofthe asset portfolio can change dramatically throughout thelife of the CDO. What's more, CDOs are heterogeneous;some may contain as little as 20 underlying assets, whileothers may contain several hundred.

To further obfuscate matters, CDO tranches were diced,sliced and julienned to create CDO-squared, and even CDO-cubed instruments. At each stage, the risk was magnified,while the hazards became harder to understand or to manage.“These MBS products and their derivatives are very com-plex,” said Zandi. “There are many moving parts, and fewpeople focused on all the parts.” In some instances, theseinstruments were sold as the product of a putative form offinancial alchemy that was believed to turn triple-B andlower-rated credits into triple-A product.

However, the growing process of mortgage defaults left gap-ing holes in the underlying cash payment stream intended toback up the newly issued MBS and CDOs. Because the entiresystem was opaque, no one - least of all the banks holding thispaper - knew with certainty which securities were good and

which were bad. The end result has been a cascade of bankwrite-downs and hedge fund margins calls, which has every-one retreating from credit risk.

To wit, government-chartered Freddie Mac and Fannie Maeaccounted for 45% of the $11.5 trillion home loan marketlast year. This year, mortgage-related issuance will be $1.7trillion, down about 12.8% from 2007 volume of $1.95 tril-lion, according to SIFMA. As a result, Freddie and Fannie'smarket share of the MBS market will surely expand.

“Since the second half of August of last year, the non-agencymarket has dried up completely,” said Guy Cecala, publisherof Inside Mortgage Finance. “It's nearly impossible to issuesubprime securities, and it's likely to become even more diffi-cult to issue Alt-A securities and jumbo securities.”

SIFMA data supports Cecala's contention, reporting thatnon-agency, residential mortgage-backed securities (RMBS)issuance decreased last year to $440.8 billion, down 25.4%.Fourth quarter issuance fell to $30.4 billion, from $89.6 bil-lion in the third quarter, and was lower than the $142.4 bil-lion issued in the fourth quarter of 2006, reflecting the pric-ing differential and credit-quality weakness.

New agency edicts could further desiccate the MBS market.“Freddie Mac announced that it would charge extra in terms ofan additional delivery fee for any loan that didn't have a mini-mum 740 FICO score and 20% down payment,” Cecala noted.“With those kinds of requirements, you are going to choke off alot of business. That's how risk adverse people are.”

Opaque OutlookThe credit system today could be likened to a baby's mess.Literally trillions of dollars worth of securities, previously val-ued in the marketplace based on confidence in the underlyingfinancial guarantees, have been transformed into a noxiousmush. Many players throughout the credit market are nowseverely impaired and have lost the capacity to hedge to mit-igate further losses.

“While everyone is taking write-downs on securities and talk-ing about their exposure, relatively little of these problemsecurities have been sold off.” Cecala said. “The banks mightbe taking billions of dollars in write-offs in subprime securi-ties, but they haven't sold off any of the subprime securities.I think you'll find more people unloading and willing to takethe losses just to clear them off the books”

Indeed, the initial resets of adjustable-rate mortgages (ARMs) aredue to peak this year and in 2009, increasing mortgage marketrisk exposure and borrower stress, which has lead to demands forthe Fed to continue to drop interest rates to stimulate liquidity.“The best thing to help the liquidity crunch is for the Fed to keeplowering interest rates, so just about any enterprise can raise com-mercial paper at 5%,” Cecala said.

“fi

Back to Basics The Security Industry and Financial MarketsAssociation's research report from February2008 shows the financial world is embracingsimplicity. SIFMA reported that funded CDOvolume declined to $485.7 billion for full-year2007, down 12% from 2006, while fourth-quarter volume declined by 67.3% on alinked-quarter basis to $29.9 billion.

Among the subcategories, cash-flow andhybrid CDO volume was $347.4 billion in2007, down 16.2% from 2006, and declinedto $21.9 billion in the fourth quarter, down59.9% on a linked-quarter basis. SyntheticCDO volume was $51.5 billion in full-year2007, compared to $89 billion in 2006, andaccounted for $3.9 billion in fourth-quarter2007, compared to $25.3 billion in the fourthquarter of 2006. Lastly, market-value CDOissuance was $4.1 billion in the fourth quar-ter, compared to $23.3 billion during thesame period in 2006.



Others, though, remain skeptical of the Fed rate cuts’ but-tressing powers. “The Fed at this juncture is pushing on astring,” said Elisa Parisi-Capone, lead analyst for finance andbanking at RGE Monitor. “You have such an oversupply ofassets that no one wants. You can't inflate the asset prices anymore. The quantity of assets available, and not the price, isthe issue. The spreads are as high, or even higher, than beforethe Fed started cutting rates.”

So maybe rate cuts aren't the answer. In fact, JeffreyGundlach, chief investment officer at The TCW Group,believes the Fed should be raising, not lowering, rates. “It'sblatantly obvious that Fed rate cuts are making prices godown,” Gundlach said. “When the Fed cuts rates, the couponrate goes down because many of these coupons have a floatingrate. But when people have a perception of credit risk rising,yields must go up.”

The tepid response to interest rate cuts has prompted theFed to propose that lenders write down the value of troubledloans. This has led to widely publicized loan modification

initiatives that would have lenders accepting less than par.It's a tough sell; the last thing lenders want is to becomeensnared in an uncontrollable, morally hazardous spiral ofdebt forgiveness.

If loan workouts or Fed funds rate cuts won't jumpstart themarket, what about bottom fishing? There are bargains to behad, to be sure, if you can buy mortgage securities for $0.50on the dollar. Indeed, hedge funds and private equity firmshave raised funds to buy distressed assets, meaning some willlikely start fishing soon. But will it make a difference?

“Forget it,” Gundlach said. “You hear about firms raising $5,$10 or $20 billion to go bottom fishing, but you’re looking ata market that is $2-3 trillion in size. Twenty billion dollarsisn't going to do anything.”

Bottom-fishing investors also cannot overlook the prospect ofbeing sliced by the proverbial falling knife. “The ABX marketpoints to $300 billion in subprime-related losses, and you seeonly about $150 billion being written down so far,” notedParisi-Capone. “People who get back in too soon will getburned, and then you will see another change in liquidity andrisk perception.”

Speaking of write-downs, many large financial firms have

adopted a bad-news, good-news strategy: the bad news is theyare posting multi-billion dollar write-downs, the good news isthat the write-downs are paper and not realized losses.

That said, many firms heavily exposed to subprime are underpressure from auditors to take even bigger write-downs.Banks and other financials have marked down more than$150 billion in assets since the subprime debacle unfolded,but auditors may want even more, depending on how aggres-sively they apply post-Enron accounting rules. They couldforce companies to value investments using market-basedmeasures rather than their own, sometimes too rosy, esti-mates. Auditors also might challenge the guesswork that goesinto companies' pricing models.

A Matter of TimeAt this point, SIFMA's Davy believes mortgage markets arein wait-and-see mode. “There is no good handle on what thedefault rate in mortgage defaults will be; it's so rare to havethis kind of housing depreciation,” he said. “It ultimatelyhas seized up a lot of the mortgage market, because there is

such a wide parameter of assumptions about what peoplewere holding. That's why you have such big bid/ask spreads;lack of a reasonable consensus is stopping activity in themortgage market.”

Gundlach believes the key to jumpstarting the mortgage andMBS markets is home prices reversing course and movinghigher. “Until housing prices start rising, you're not going tosee any increased appetite for risk,” he said. But don't expectimpending government initiates to provide much inspirationon that front. He believes that any federal legislation willprove anachronistic and effete at best.

In economics, the money stock is the liquidity of the market,which creates the concept of liquidity as a pool of money. Acontrarian opinion forwarded by Paul McCulley of PIMCObelieves that liquidity is the result of investors' appetite tounderwrite risk and savers' appetite to provide leverage toinvestors who want to underwrite risk. The greater the riskappetite, the greater the liquidity and vice versa.

Fortunately, changes in appetite risk are often measured inmonths, not years, which is one reason Gundlach seesimprovement in both the MBS and housing market by year'send and why ‘risk’ could be the American Dialect Society'sword of the year for 2008. i

“You hear about firms raising $5, $10 or $20 billion to go bottomfishing, but you’re looking at a market that is $2-3 trillion in size.

Twenty billion dollars isn't going to do anything.”— Jeffrey Gundlach



T HE UNCERTAINTY THAT HAS grippeddebt markets since last summer has notexcepted credit derivatives and its cousin,credit derivative swaps. Credit derivatives,like virtually every credit product, have

become ensnared in a downward spiral of doubt, fear andeven, some say, panic.

Yet insiders insisted there's a silver lining to the chaos anduncertainty. The upside to all this downside is that a reformmovement is taking hold of credit derivatives, finding ways tosimplify the devilishly complex products.

Credit derivatives find themselves in close to the same boat asmortgage-backed securities (MBS) —being virtually shunnedby the same investors and issuers who made the productsamong the most popular of the past decade. “It is the samestory,” said Steven Davidson, vice president of capital marketsresearch for the Securities Industry and Financial MarketsAssociation (SIFMA). “People were very willing to investwhen they were looking to pick up yields. In considering thepositive credit environment that we saw, there was a great dealof willingness to sell risk through derivatives. The environ-ment has changed for those investors; now there is more of afocus on buying protection. People want protection againstrisk, and there are few people that want to sell the risk. Thatis part of what has changed in derivative spreads.”

These concerns are nothing new. Back in 2002, then-FederalReserve Bank chairman Alan Greenspan prophetically said,“Derivatives, by construction, are highly leveraged, a condi-tion that is both a large benefit and an Achilles' heel. Thebenefits of risk dispersion are accomplished without holdingmassive positions in the underlying financial instruments.Yet, too often in our financially checkered past, the access tosuch leverage has induced speculative excesses that have led tofinancial grief. We are scarcely likely to reform the underlyinghuman traits that lead to excess, but we do need to buttressour risk management capabilities as best we can to delimitsuch detours from the path of balanced growth.”

Indeed, credit derivative spreads have mushroomed, while theunderlying market appears to have withered. Credit defaultswap activity is down about 90% year-to-year.

In January, spreads rose to more than 100 basis points aboveLIBOR for the first time. There was a brief settling-downperiod before spreads began to rocket upward again inFebruary, from about 110 basis points above LIBOR to about160. At the end of February, spread widening started torecede to about 140 basis points, but then they shot up againin March to about 180 basis points above LIBOR. Accordingto Markit Group, which tracks indices of credit derivativesand other credit products, spreads in mid-March settled downagain to ranges from 87 to 102 basis points.

“We are in a period of increasing volatility and uncertainty inspreads, where we have spread widening and spread volatility,” saidAlberto Gallo, managing director and head of the credit derivativesstrategy team at the now-defunct Bear Stearns. “In the last few

Credit Derivatives Damagedby Market DoubtsThe silver lining could be a renewed focus on reforming, simplifying complex instrumentsBy David Lewis

“dea



weeks, investors are starting to worry more and more about otherissues - counterparty risk, recovery rate risk and default risk.”

Gallo predicted that, just as investor attention has shifted fromyields to risk, their focus now is going to move from volatility todefaults and recovery rates, especially in the United States. “Theshock wave that started from subprime and financials is spreadingout to the rest of the economy,” he added.

Even the sheer size of the credit derivatives and related prod-ucts market will cause problems, analysts said. The notionalvalue - the value of a derivative's underlying assets at the spotprice - of the synthetic credit derivatives market alone is esti-mated to be about $40 trillion. “A huge amount of productshave been issued, and now they are marked down and beingunwound,” Gallo explained. “Some investors have pointed tothis as a potential source of problems because the derivativesdon't have enough underlying to be settled.”

In the event of default, there are going to be challenges in

risk management and counterparty risk. “So far, we havesomething like 2,500 reference entities in credit defaultswaps and only six or seven have defaulted,” Gallo said.“We've only tested the settlement process in a very limitedway. Going forward, there's going to be more work on thatside of operations, and counterparty risk potentially couldbe a major issue.”

Frenzy vs. Real RiskJust as extremely low spreads probably did not reflect the underlyingcredit risk of credit default swaps, today's extremely high spreadsreflect a selling frenzy rather than real risk. “We went through a peri-od that was very favorable for credit, with very low default rates,” saidByron Douglass, senior research analyst at Credit Derivatives Researchin Walnut Creek, Calif. “A lot of structured product issuance wasbased on these synthetic contracts, and they really drove credit spreadsdown, pushing them tighter and tighter. What we've seen now is thatwe've broken free of this positive credit environment, and we're nowin the opposite mode - more of a panic - because a lot of these struc-tured products are being unwound. That means the credit spreads aregoing the opposite way without true regard for the fundamentaldefault risk of these companies, so the spreads just keep going up.”

One major problem, expert observers agreed, was an over-relianceon ratings by investors. “Think about it: equity derivatives aren'trated and neither are interest-rate derivatives. Yet, credit deriva-tives have a rating, and it's proved to be not very reliable,” Gallo

said. “Traders and investors in the past didn't consider the com-plexity of the products; they just looked at ratings. Now they arediscovering that there are many other aspects to consider. Thisdoesn't mean that the products are dangerous or negative; itmeans they require more understanding.”

The good news, such as it is, is that the woeful state of the creditdefault swaps market could provide impetus to improve credit deriva-tives and related products. Close observers said such efforts, spear-headed by the International Swaps and Derivatives Association,appear to be intensifying in the wake of the credit crunch.

The problem, said Brad Bailey, director in business devel-opment at Knight Capital Group, is that credit derivativesare a great idea, but in reality not such a great vehicle.“Fundamentally, the problem is that the credit derivative isa great product but it has a lot of problems because of thenature of how it's traded - a lot of settlement issues and alot of complexity around the processing. As much as therehave been moves toward trying to streamline the processing

of these products and the settlement, there's still a greatways to go.”

Some of the problems are merely hard; some are extremelyhard. “It's a difficult topic because simplifying swaps makesthem easier to trade,” noted Douglass. “In more liquid times,it increases liquidity and increases the volume of transactions.However, these products deal with a company defaulting,which is itself complex in its legal nature, and simplificationcan cause problems at that point. The question becomes:When does a company actually default? What actually trig-gers these traded default swaps?”

In the real world, argued Gallo, the prospects of defaults rockingthe credit derivatives market are rather remote. “Before, every-body thought that the probability of default would be in the firstfew defaults,” he said. “Now, investors think that there's a lot ofprobability of having more than 3% defaults, more than even 7-10% defaults. If you buy protection on senior and super-seniortranches, these kinds of hedges are not realistic. They are like endof the world scenarios.”

Meanwhile, the markets appear gripped by fear, many saypanic. “You can say that these extreme defaults scenarios are apanic that will probably not be realized,” Gallo said.“Nevertheless, investors are assigning these scenarios a lot ofspread in percentage to the total risk.”i

“In considering the positive credit environment that we saw, there was a great

deal of willingness to sell risk through derivatives. The environment has changed

for those investors; now there is more of a focus on buying protection.”— Steven Davidson



B EWARE THE IDES OF MARCH.One week in advance of that ominousdate, the Federal Reserve announced twoinitiatives to address heightened liquiditypressures in term funding markets. The

Fed said laconically that it is “in close consultation with for-eign central bank counterparts concerning liquidity condi-tions in markets.” But the international note did not disguisethe domestic focus, specifically the efforts to prevent the sub-prime meltdown from spreading to healthier bank businesses,such as corporate lending.

The Fed’s first action was pointed directly at stimulatinglending. The amounts outstanding in the Term AuctionFacility (TAF) were increased to a total of $100 billion. Theauctions on March 10 and March 24 each were increased to$50 billion, an increase of $20 billion from the amounts thatwere announced for those auctions on February 29.

The Fed also said it would increase the auction sizes further ifconditions warrant. To provide increased certainty to marketparticipants, the Fed reaffirmed that it will “continue to con-duct TAF auctions for at least the next six months unlessevolving market conditions clearly indicate that such auctionsare no longer necessary.”

In conjunction, the Fed began a series of term repurchasetransactions that are expected to total $100 billion. Thosetransactions will be conducted as 28-day term repurchaseagreements “in which primary dealers may elect to deliver ascollateral any of the types of securities—Treasury, agency debtor agency mortgage-backed securities—that are eligible as col-lateral in conventional open market operations.” As with theTAF sizes, the Fed said it will increase the sizes of these termrepo operations if conditions warrant.

Those measures, in addition to lower interest rates and othersteps, make it clear that top financial officials fear a reces-sion far more than they fear inflation. Few dispute that basicphilosophy, but not everyone in the banking business isquite so fretful.

A Boon to Business?Carlos Evans, wholesale bank executive for Wachovia, is dubi-ous of the dire predictions of recession. “If we are going intoa recession, it is the most unusual recession I have ever seen,”he said. “And after 35 years in banking, I have seen several.”He noted that corporate lending to companies in the $3 mil-lion to $1 billion range has been business as usual.

Wachovia is the second largest lender in its bracket and is thelargest lender to the automotive sector in its footprint. Thatoperational region for Evans’ business is a U-shaped footprintdown the Atlantic Seaboard, across the South and West andup the Pacific Coast. He differentiates his territory from thatof Wachovia’s securities and investment advisory unit, which

Business As UsualWith a wary eye on credit spreads, corporate lending remains robustBy Gregory Morris

prt



is nationwide and includes broker-dealer A.G. Edwards – a firm particularly strong inthe Midwest.

“In previous recessions, we have seenmuch more widely spread problemsthrough the economy at this point,” Evanssaid. “In the current situation, things arepretty good, except of course for residen-tial housing and the sectors of the econo-my that are directly related to that, such asconstruction and consumer durables. Butbeyond those, things are business as usual.Really, we are out there doing businessevery day. We are keeping an eye on capi-tal markets, but so far they have notaffected our ability to lend.”

In one small irony, Evans noted that, tosome degree, the overall tightening of cred-it and liquidity has actually helped tradi-tional lending. “At the top end of our busi-ness, our largest clients have seen theirability to get leverage from other forms, such as bonds andhigh-yield securities, curtailed. That development has drivensome of them back to traditional borrowing, absolutely.”

To be sure, business as usual does not necessarily mean that businessis booming. Evans acknowledged that times are tougher for mostclients; he just differentiates a rough patch from a crisis. “Are we in arecession? Are we going well into a recession? That is debatable,”Evans said. “What is not debatable is that we are into a significanteconomic slow-down. When consumer spending slows, everyonefeels that, from the big companies to the mom-and-pop shops.”

That said, Evans reiterated, “We have not seen the magnitude ofpain as we would expect with a full-blown recession. It could bethat some of that slack is being taken up by exports, consideringhow weak the dollar is. Export-oriented businesses have done bet-ter recently than some others.”

Prudence, Not For Prudes AnymoreThe other revelation from the credit crunch recapitulates the old adagethat, when the tide goes out, it becomes apparent who has been swim-ming naked. “We in the financial sector all collectively created this bub-ble in housing,” Evans said. “We will just have to work through it.”

Having cast broad responsibility for the current crisis, Evansis quick to detail how Wachovia has stuck to due diligence

and prudent lending. He said the bankdid not have to take any emergency meas-ures to protect its corporate lending port-folio because it was careful all along. “Wefirmly believe in good banking practices,”he added. “We have a very diverse portfo-lio with a high degree of variability acrossborrower sizes and between manufactur-ing and services.”

That prudence may have seemed morelike prudery in the go-go years just past,and Evans accepted that as the price forbetter performance over the long haul.“We are never going to be as aggressive assome in the good times, but that helps usand our customers in the tough times,”Evans said. “That does not mean we areavoiding risk; a range of risk in the port-folio is fine, as long as you are gettingpaid for the risks you are taking and youunderstand the scope of those risks.”

The main problem in swinging for the fences, both forlenders and for borrowers, is the inconsistency. “Clients hateinconsistency,” Evans stated flatly. “Many of our best clients

are not investment-grade companies. They cannot readily goto the capital markets, so they rely on us for access to capital.We have got to be a consistent provider for them, or theywon’t be there for us as a customer base.”

Specifically, that means not running hot and cold, pushingclients to borrow one day and severely restricting credit thenext. “The places where we are seeing the most pain today arethe places where the easiest money was made,” Evans said. Incontrast to that, Wachovia is being very consistent. “We arestanding by our customers, stepping up to lend when andwhere we can,” he added.

Reflecting on the complex financial engineering that in manyways led to the problems in residential lending and in thebroader markets, Evans continues to see a use for such exoticsin the future. “There will be a place for financial engineering,but I don’t think it will ever get back to the level where it wasbefore,” he said. “It will be slimmer and definitely more trans-parent.” Choosing his words carefully, he added, “I don’tthink, at least I hope, that lending markets will ever let thingsget so …effervescent.”

“In previous recessions, we have seen much more widely spread problems through the economy at this point. In the current situation,

things are pretty good, except of course for residential housing.”— Carlos Evans

Carlos Evans, wholesale bankexecutive for Wachovia



Easy Money?Barry James, president and portfolio managerfor James Advantage Funds, concurred withEvans’ assertion that corporate lending is themain access to capital for most businesses.“The commercial side of lending is thelifeblood of business,” he said. He added animportant caveat, however, noting that lend-ing has perhaps become too ready a source offunds, even for larger firms with direct accessto capital markets. “Cheap debt became soeasy that companies did not even think aboutissuing stock or other ways of raising money,”he pointed out.

By way of illustration, James noted that, if acompany could turn a 12-15% profit, a 4-5%cost of capital was easy to accept. “Corporatelending is still an essential operating tool forcompanies, but credit requirements have def-initely gotten tighter, especially at the mar-gins,” he said. “Companies now need torethink how they use that tool in relation to others. In manycases, banks have been hesitant to lend because their non-bor-rowed reserves are miniscule. In contrast, the terms on short-termpaper are still not that onerous.”

In that light, James suggested the answer to the question whetheror not there is a recession - even whether or not there is a creditcrunch - is heavily dependent on revenue. “If a commercial lenderhas an international bent or some exposure to borrowers inexport, that lender has multiple advantages,” he said. Thoseinclude steady, even-growing demand and customers payinginvoices in cheap dollars using stronger currencies.

“Industrial sectors also could hold up better,” James added. “It isthe consumer products - the non-cyclicals, like groceries, thatgenerally do better in a recession - that have not responded so far.”

The big fear is that many banks, and even some borrowers, have manythings that are not on their books that could come back onto thebooks. “They just don’t know what they have,” James said. He sees atriple threat, with those unknown exposures combining with the lackof liquidity and an overall worsening economy. “Unit labor costs arerising, and the price of goods is rising,” he added.

James sees another unusual aspect to the current credit crunch. “Pastrecessions have been producer recessions or consumer recessions,” he

noted. “They started in other sectors of the econ-omy, and the banks were hit later. This is a finan-cial recession, which means the banks were hitfirst and now the effects are rippling around therest of the economy. Unfortunately, that alsomeans that an echo will ripple back to the banks.”

That reality may lead to a counter-intuitive out-come. James said his portfolios underweight allfinancials at the moment, but he feels that thelocal banks do not have the same exposures asthe multi-national money center banks.Specifically, the local and regional banks aremore reliant on traditional deposits and lending,especially commercial lending, and less exposedto financial engineering. “In contrast, the bigguys have a lot more pain to go through. That isa very big concern,” he said.

Look to AsiaFor a model of going through the pain,players in the U.S. can look to Asia, where

an entire continental economy was on the ropes for more thanhalf a decade. “We saw all this starting in 1997 with the Asianfinancial crisis and struggling through to a bottom in 2003with the SARS epidemic,” said Hugh Simon, chief executive

officer of the Hamon Investment Group. “We saw negativeequity and people having to rebuild their balance sheets, justas the U.S. is seeing today.”

That recent history has prompted corporate lenders in Asiato lend prudently, and borrowers to borrow prudently,Simon said. It also has prompted central banks to hold thereins tightly. “The Chinese central bank has raised lendingrequirements 13 times so far,” he noted.

Like Fiorello LaGuardia, mayor of New York during theDepression, Simon advised patience and fortitude in thecurrent U.S. corporate lending situation. “It will take timeto rebuild balance sheets,” he said. “But the money beingpumped into the system now will come back out.”

Simon also noted that corporate lending retains an impor-tant advantage over real estate and other forms of lending.“Banks know their clients better, and banks are not lendingvolume for basis-point returns,” he said. “They want adecent margin.”i

Barry James, president andportfolio manager for James

Advantage Funds

“Corporate lending is still an essential operating tool forcompanies, but credit requirements have definitely gotten

tighter, especially at the margins.”— Barry James


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