The Aftermath
Carnage in a subset of the mortgage market catches Wall Street, regulators and the Fed off guard, and a year later the markets are still reeling. Now the hard part: planting the seeds to foster growth of fees and revenue.
By Aleksandrs Rozens August 18, 2008
By May 2007, faultlines in the subprime market were becoming apparent. New Century had filed for bankruptcy and other mortgage lenders had been tripped up by problem loans—but the Fed chief, Ben Bernanke, told a banking conference in Chicago the financial markets are “better than regulators at allocating credit.”
Days after the first meeting of New Century creditors, Bernanke said there was little chance problems in a subset of the multi-trillion dollar mortgage market would spill over into the broader financial system or the broader economy.
Weeks after that mid-May address, Bernanke’s thoughts on credit conditions were echoed by Fed Governor Randall Kroszner. Speaking to an association of large financial institutions in Athens, Kroszner said that issues in the subprime market should remain contained relative to the broader housing market.
What a difference a year makes.
“So far the events are moderate, in an economic sense. In a financial sense the events that have materialized are quite extraordinary,” says Henry Kaufman, former Fed economist. “The Federal Reserve and other supervisors were not aware of the magnitude of the problem.”
Says Marcia Myerberg, former treasurer at Freddie Mac and a former Salomon Brothers executive who was involved in the development of some of Wall Street’s earliest structured mortgage bond products: “This is the worst I have ever seen. It is worse than the S&L [crisis].”
The problems in subprime mortgages led to a series of downgrades of bonds pooling these loans. Securities pooling debt to less-creditworthy borrowers were used by investors who created collateralized debt obligations. These CDOs were popular because investors could buy lower-rated bonds or loans and pool them into another security that attained a higher credit rating. Downgrades of subprime mortgage bonds brought about downgrades of many CDOs, gumming up Wall Street’s CDO machine.
The fallout within CDOs permeated other businesses at banks and brokerages that had little to do with subprime mortgage lending. Massive mergers and acquisitions were financed with debt and this debt was routinely scooped up by investors creating CDOs. Suddenly, there was less money around for the behemoth acquisitions.
Now, a year later, Wall Street is still reeling from the credit storm. Tens of thousands of jobs have been lost and two firms once prominent on Wall Street—Bear Stearns and Countrywide Financial—are out of circulation. The Fed and US Treasury stepped in to shore up banks and brokerages and the US central bank has teamed up with other central banks to keep open the credit tap. Borrowing rates for banks have been lowered and a wider range of collateral is now acceptable.
The credit problems, though, have seeped into almost every aspect of bank and brokerage balance sheets. The result is that tighter credit standards promise to have a profound effect on the US economy. As Fed policymakers who have studied previous economic downturns know well, a sudden cutoff in credit has implications for the broader US economy’s growth.
Corporate bankruptcies have become increasingly frequent and the cost of money for corporations has risen, as is evident in a recent Federal Reserve survey.
“Banks that had tightened credit standards on consumer loans increased notably relative to the April survey. On net, considerable fractions of foreign institutions also had tightened their credit standards and terms on loans to businesses over the past three months,” according to the Fed survey of bank loan officers published last week.
Not only is credit harder to come by, it is also more expensive.
Just last week, Standard & Poor’s noted that its investment grade composite credit spread is 84% wider than a five-year moving average and 36% wider from the beginning of the year. The rating agency’s speculative grade composite credit spread is 34% wider from the beginning of the year and 82% wider than the five-year moving average.
In August 2007, S&P’s speculative grade composite spread was at 415 basis points, and last week it was at 774 basis points. S&P’s investment grade composite spread in August 2007 was at 156 basis points, but last week it was at 278 basis points.
“You have seen less and less money around to finance. People are very reluctant to continue to lend. The market is an overnight market,” says Bob Hawley, head of fixed income for the Americas at BNP Paribas.
The credit tightening has had a two-pronged impact on corporations. Consumers have seen their home values decline sharply and expenses for routine items such as gas for a car have risen dramatically. Few consumers can readily get additional credit using a home equity line and confidence about the economy has faltered, bringing about a decline in spending on goods and services. At the same time, corporations face a rise in borrowing costs or they are in danger of violating loan agreements, many of which stipulate how much cash a business has to have on hand and the earnings it should generate.
A year that rocked the world
But the downturn on Wall Street has had its greatest impact on securitization, which has had an impact on home sales and prices. A drop in demand for mortgage bonds has made it tougher to resell less credit-worthy home loans and Alt-A mortgages. These days, the only mortgage debt that can be readily resold as a bond has a guarantee from Freddie Mac, Fannie Mae and Ginnie Mae. These mortgage bonds from the agencies, though, have seen a marginal increase in borrowing costs because spreads for agency mortgage bonds have widened dramatically. While they are not at their historic wides last seen in March, spreads of conforming mortgage securities are wider than they were a year ago and this means borrowers face higher borrowing costs.
The drop in demand for securitized products has slowed down issuance of other types of loans, notably commercial mortgage-backed securities. Moody’s recently announced that issuance in the first six months of this year is off 91% from the first six months of 2007 and dropped to levels not seen since 1996, when the market was just beginning to take off. While problem loans have not rocketed in the CMBS market as they have in the subprime arena or Alt-A home loans, commercial mortgage loans have seen a rise in problems—notably within multifamily home loans.
The drop in the creation of bonds backed by regular payments of principle and interest has resulted in massive job cuts not only at investment banks. Rating agencies once busy evaluating new issues have cut staff as have law firms that once advised on the legal aspects of the securitizations. This year, $137.5 billion worth of mortgage bonds was completed in the US, down from $622 billion, according to data compiled by Thomson Reuters.
To get around the drop in demand for securitizations, US Treasury and the Fed have encouraged commercial banks to consider a new financing vehicle, covered bonds, that could lure investors because they would be backed by better-quality home loans. Also, poorly-performing loans backing a covered bond can be tossed out and replaced with performing mortgages, something that would be welcome by investors who have seen AAA-rated classes of debt—once viewed as impervious to credit issues—downgraded by rating agencies.
But securitization probably won’t go away. As Myerberg sees it, “the right kind of securitization will always be viable for capital markets. It starts with the collateral. If the collateral is not good, the securities won’t be good.”
A fast drop in various business lines
Securitization, of course, isn’t the only business line on Wall Street to be impacted by the credit issues on Wall Street. IPO issuance, for example, has plummeted. In the first half of 2008, 24 companies were taken public by Wall Street investment banks, netting proceeds of $25 billion. Take out the Visa IPO and that is just under $6 billion worth of proceeds. Last year, investment banks completed 103 initial public offerings worth $24 billion, according to Thomson Reuters.
On the M&A front, 103 transactions with a deal value of $500 million to $1 billion were announced for a total $72 billion worth of deals in the January-to-June period. In the first six months of 2007, 161 deals worth $112.5 billion, were completed.
In addition to a massive drop in fees related to mergers and acquisitions, underwriting bonds and stocks, Wall Street banks and brokers face rising costs related to problem loans. Delinquencies and foreclosures of mortgage debt have spiked to historic levels and there are expectations that corporate debt defaults will climb in coming quarters. Martin Fridson, a longtime credit market observer, believes corporate debt problems will not peak until the first half of 2010.
The lockup in credit markets has prompted some banks to sell off massive pools of loans, often at cut rates, and there are expectations that banks and brokers will abandon certain business lines, either by selling a business unit or by laying off professionals.
In January, for example, when Citigroup announced its fourth-quarter earnings its chief executive, Vikram Pandit, vowed that Citigroup would continue its divesting of non-core assets and businesses. In the fourth quarter of 2007 Citigroup had just over $40 billion worth of leverage debt on its books. Some of that has been sold this year to investors such as private equity financiers Apollo Management, Blackstone Group and TPG.
Merrill Lynch, too, is in the process of selling debt. In a deal with private equity firm Lone Star, Merrill sold nearly $31 billion of collateralized debt obligations at 22 cents on the dollar. A year ago Merrill’s CDO folio had $53 billion worth of securities. With the sale to Lone Star that total of CDO holdings is just under $9 billion.
The changes on Wall Street also show up in daily trading activity. Dealer firms are not as readily making markets. If an investor wants to sell a security, a dealer firm will only take it on its balance sheet briefly and likely will have lined up a buyer for the bond.
“Dealer appetite to warehouse risk has dropped dramatically,” says Mark Howard, head of credit analysis at Barclays Capital. In the years leading to the credit bubble’s burst, many dealer firms would take on securities and allow their inventories to balloon.
“It has gotten increasingly worse. There are more and more lists, but fewer and fewer securities actually get traded,” says Carol Bunevich, managing director and partner at Fieldstone Capital. “Everything has changed. It started a year ago. Money has gotten tighter and tighter. People can’t buy AAAs and lever them up anymore. Desks can’t take securities down and hold them. It’s a very different market.”
A year ago, says Howard, “people had unwittingly gotten into the storage business. Today, nobody is keen on being in the storage business.”
BNP’s Hawley says the seeds for the latest credit crisis were sown between June 2005 and June 2007. Fed funds were low and banks were encouraged to buy assets and finance them. But, “as very good assets tightened versus the cost of money people started taking lesser quality assets with higher yields and spreads. The balance sheets of investment banks and commercial banks were bigger than ever before,” he recalls.
Compounding the problems, says Kaufman, was the fact that “senior managers were not fully aware of the magnitude of their companies’ risk.”
Barclays’ Howard believes the latest credit bubble actually has its roots in the final days of the dotcom bubble. The lending binge leading to the latest credit bubble “came as a legacy of the dotcom bubble bursting. People wanted equity-like returns, but didn’t want to stay in the equity markets,” says Howard. “It goes to a structural shift in the capital markets. There was a very significant need for high returns.”
So, when do things on Wall Street get better? Hawley believes “there will still be a concern about who you lend to.” Referring to the Fed’s move to shore up credit markets, Hawley says “the liquidity moves helped a lot.”
Kaufman predicts that the tighter credit conditions will continue for some time. “Credit will not be as readily available in the next three or four years. We are in a period of slow and modest growth,” he says.
Howard says investors are assigning more value to the probability of a return as opposed to the possibility of a return. Leverage is in the process of coming down, but it’s not going away.
“People will come back,” he says. “Memories are short. The bigger question is how the market reinvents itself.”
(c) 2008 Investment Dealers' Digest and SourceMedia, Inc. All Rights Reserved.
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Robert Hawley
Martin Fridson
Vikram Pandit
