April 2007 onwards

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ASF's subprime relief plan

The much awaited relief plan that seeks to save subprime mortgages from getting into inevitable foreclosure was unveiled by American Secuiritization Forum, having been endorsed by the Bush Administration.

The plan applies to mortgages that are ARMs, are subprime, were originated between Jan 1, 2005 to 31st July 2007, and have interest rate forthcoming between Jan 1 2008 to 31st July 2010.

Essentially, the plan classifies mortgages into 3 segments – (1) those that may qualify for refinancing under available mortgage lending plans, (2) those that are current, that is, not delinquent, and (3) those that are not current. In the first case, the servicer should educate the borrower and advise him to have the mortgage refinanced.

The second case is one of loan modification. Here, if on the reset date, the mortgage instalments would go up by 10% or more, and the borrower meets the FICO score test, the loan will be eligible for a fast track modification, under which the existing interest rate will be kept frozen over the next 5 years.

The third case is one where the loan is already delinquent. Here, the approach is one of loss mitigation. The servicer should take measures that would maximise the present value of the loan recovery. These include loan modification, forbearance, short sale, short payoff and foreclosure.

The complete ASF document is here.

Old habits of securitization world come to question 

Public charities, SPV ownership structures, etc. raise curious concerns

These may be absolutely normal for any securitization practitioner – so normal that one would not even have ever pondered for a second as to how unrealistic the whole setting of facts is, and these practices are now coming into sharp scrutiny.

In a typical securitization transaction, the almost-universal practice is to have a special purpose vehicle owned by a public charity. The legal domicile of the SPV is a tax haven, typically Cayman Islands. The public charity owns the nominal equity of the SPV – typically something like 1 dollar or 10 dollars. So, with a few dollars of capital, the SPV acquires assets of millions, and intends to do the good of mankind with the residual returns on equity that it would never get, since there is a residual income class that sweeps the entire profits of the SPV left after payment of coupons to the noteholders.

The superstition in the legal world is that with legal ownership of the SPV in the hands of a so-called public charity, that has done no charity ever, the SPV would be legally an orphan, that is, would not have any clear owner at all. While accounting standards have demolished this myth and are now looking at residual interest for consolidation purposes (Fin 46R and SIC 12), but for consolidation for bankruptcy purposes, it is still believed that the legal ownership in the hands of a charitable trust would be respected.

Guardian started a wave of investigations in Northern Rock's granite securitisation program. It carried an article titled A twisty trail: from Northern Rock to Jersey to a tiny charity. The article also says that the Charity Commission has started an investigation against Northern Rock.

While Guardian might have led to enthused investigations against Northern Rock, within the securitisation world, it is common knowledge that this structure is used by just everyone.

Bad news galore as securitization markets almost liquidate

Bad news continued to pour in during the week, with JP Morgan, Bank of America etc continued to post gloomy pictures of their Q3 losses and impending Q4 problems. Wall Street Journal is giving a quick summary of Q3 financials.

CDO rating downgrades continued. In almost a rare example, State Street Capital-managed CDO called Carina CDO Ltd fell from the roof and was downgraded from AAA to CCC. S&P justified the stern rating action on the ground that the senior investors had decided to liquidate the collateral at a time when the market was already bad, and therefore, the collateral might realise more losses than otherwise.

New issuance activity has come to a grinding halt. As per data on, the new issuance in the whole of October was just about $ 34 billion whereas the same period last year saw a new issuance of $ 130 billion. The liquidity in the ABCP market is also completely dried up as the curve of outstanding ABCP continues to slide down steeply.

The barometer of credit default swaps on asset backed securities, ABX.HE, gives gloomiest picture ever. The AAA tranche of ABX.HE has reached a new low of 69.93, and in just a week's time, has fallen from 80.17. The poorer siblings – BBB and BBB- tranches, seem to be falling from a cliff, with prices of 20.79 and 19.36 respectively.

In a bad time such as this, the pains of the banking community are exacerbated by FAS 157 which becomes applicable from Nov 15, 2007 and would therefore apply to the next quarter. Under this standard, for computing fair value of assets, an entity must distinguish between assets where it applies market values (Level 1), model values based on observable facts (Level 2) and best estimates (Level 3). The new standard requires valuations to consider all risks in case of Level 3 assets.

UNCTAD paper takes stock of securitization risks

While there is no dearth of recent articles and write ups fuming and fretting against securitization, the UNCTAD recently put together a note on the risks facing the global financial economy, and spent a good part on the subprime crisis, and the risks inherent in securitization in general.

On the larger global economy risks, UNCTAD, like IMF and several others, paints a rather gloomy picture of the US economy and predicts three different scenarios – a benchmark scenario, benign scenario and a crisis scenario. In the benchmark case, a bleeding US economy will eventually cause losses to the emerging markets too.

As for securitization risks, the UNCTAD note takes the same line as BIS and FSA recently took – that the originate-and-distribute model on which banks work currently undermines credit underwriting discipline and hence affects the quality of assets. As one of the recommendations, UNCTAD even recommends a legislation that would require banks to keep some part of the assets they originate.

Rating agencies have a substantial role in the CDO market, and rating agencies' rebuttal that their ratings should not be used as the basis of investment decisions is completely unacceptable. The UN trade body recommends a relook at this scenario, including may be an oversight authority on the rating agencies.

The article, containing a complete dossier on the important events in the subprime crisis, also provides a quick view of important risks facing the financial system. The text of the article is here.

Securitisation: Article in The Economist sees it as a turning point

There is absolutely no dearth of harsh words and harsher voices against securitisation these days – you don't even have to dig the surface as it is all up there, all over the financial and general press. There are people who have called it a swindling game, conning game, outsmarting device, etc.However, The Economist has built its own gravity over the years of its readership.

The 20th Sept issue of The Economist carries an article titled When it goes wrong. It says a complete generation has prospered from the wholesale transfer of risk by way of securitisation. Now, it is paying the price.

See the text of the article here.

In the meantime, hearings before lawmakers are taking place on both sides of the Atlantic. The Senate Banking Subcommittee is continuing its hearings in Washington. In London too, the Financial Services Authority is continuing its investigations.

Special purpose vehicles to be put to acid test

As securitization is passing through the worst time over the 30 years or so of its practical history, the ubiquitous tool that enables securitizations – special purpose entities – will be passing through an acid test. If in the coming few months, courts or lawmakers do not make things extremely adverse for SPEs, they would be a part of the business world's toolbox for all time to come.

Special purpose vehicles are special in many ways – they have a legal existence but a substative void, There are no assets, risks or liabiliteis other than those involved in the given transaction. They have a management that is supposed to be independent, but they have nothing really to manage. They are independent, while the only reason why they exist is to enable a particular transaction. The most curious part of SPVs is their ownership by public charities which is virtually a shame on the grand name of charity. The device has been used to simply hive off an asset, transaction or relation and give it an incorporeal status.

The current crisis will put SPEs under very sharp eyes – public, legislative, judicial. The public is already outcrying and investigating the ownership structure of entities like Northern Rock's Granite securitizations.

However, here comes another very curious test – as hedge funds are filing for bankruptcy protection, the enigma is – should they file for protection under Chapter 15 of the US bankruptcy code as a case for cross border insolvency, or Chapter 9 or 11 as a case of US insolvency. In preliminary proceedings relating to Bear Stearns' hedge funds, a Manhattan bankruptcy court seems to have taken the view that while the hedge funds are registered in the Cayman, the Cayman office is nothing but a "letter box". As almost all the liquid assets of the hedge funds are in the US, they must come under Chapter 9 or 11 as US entities,

If this view prevails, the registered office of the hedge funds will be taken as irrelevant. The ruling may form the basis of tax, and on exttension, even regulation. Similar views were taken by the UK Court of Appeal in the case of Indofoods last year.

Links For more on SPVs, see our page here.

Moody's talks of new securitization risks

While lot of heat is turned on the rating agencies themselves, as to how is it that they are getting all this wisdom only now, here is some brilliant piece of wisdom from Moody's – it says it is for the first time since LTCM that the disintermediated financial markets have got their first stress test.

The originate-to-distribute model became particularly very strong over the last few years when banks stepped their originations that would not stay on their balance sheet – something that every underwriter in the bank would know.

Moody's wisdom is that the present crisis teaches us the same lessons that LTCM did – "The lessons to be learned are for a good part lessons to be learned again. Most of the deficiencies exposed by the current episode were identified in the aftermath of the Long-Term Capital Management (LTCM) crisis in 1998: the modern financial system over-relies on the presumption of li quidity; risk is increasingly difficult to localize; asset correlations increase in times of stress; and leverage changes the scale of market dynamics, on 
the upside as well as on the downside", says the article titled Stress-testing the Modern Financial System.

Moody's also blames the mark-to-market accounting system – "The world would be a much safer place if all securi ties were held by ?real money? buy-and-hold inves tors who did not have to mark to market, and who therefore did not have to make forced sales into panicked markets. Unfortunately, literally trillions of dollars of securities are now held by leveraged mark-to-market institutions relying on other peo ple?s money to finance sometimes opaque, complex and risky investments."

The article talks about several securitization risks that the current crisis has thrown up:

  • "Securitization relies upon historical relationships (e.g., subprime default and loss levels) that can change unexpectedly and by orders of magnitude. The proliferation of non-standard products has impeded the development of a liquid secondary market for many types of securitizations. As we are observing, there is no observable market price for a unique security.
  • Securitization creates an agency problem by separating the originator from the ultimate holder. While this is one of securitization's car dinal virtues, it is also a problem in that origina tors may be incentivized to maximize origina tion volume, instead of quality. And, as we see in subprime, some originators may be tempted to misrepresent the quality of loans being sold or, less sinisterly, originators are not motivated to care about the quality of loans because they 
    aren't owners of the assets for very long.
  • The opacity and/or complexity of some securiti zation products have led some investors to over-rely upon third-party credit analysis (i.e., ratings) without fully understanding what they are buying (and now what they own). And many 
    market participants have over-relied on ratings in determining appropriate price levels for such securities.
  • Some companies' business models were built on the presumption of securitization as a viable funding source. When certain asset classes fall out of favor, these actors may find themselves out of business.
  • Idiosyncratic risk is different for structured se curities than for corporate instruments. Idiosyn cratic risk in RMBS appears most visibly at the originator and vintage levels. Originator risk may be analogous to individual company risk, 
    but vintage risk is an overlay that has no corpo rate analog. And even with twin forms of idio syncratic risk, structured securities may exhibit fewer significant idiosyncratic attributes – causing more herd-like changes in creditworthiness –
    due to more limited operating characteristics and more homogenous assets.

Northern Rock's Granite RMBS still safe: rating agencies

While Northern Rock's ship is rocking, its RMBS transactions are not affected, say the rating agencies. While that may be good news for the securitisation investors as opposed to the depositors in the troubled UK mortgage originator, there are questions on the servicing risk, liquidity risk, etc which might affect the securitisation transactions as well.

Northern Rock, 4th largest UK mortgage originator, has been one of the leaders in UK RMBS supply. Under its Granite template, Northern Rock has some GBP 40 billion odd funding by way of RMBS. It has several covered bonds issuances too.

S&P issued a press release on 19th Sept affirming the ratings on the securitisation transactions despite the rating downgrade of Northern Rock. There are sufficient credit enhancements in the securitisation pools, and the pool is a prime RMBS pool. However, the as the originator faces severe liquidity problems, its servicing capabilities are unlikely to remain unaffected. In addition, people ha ve already started probing into the SPVs that have funded the securitisation transactions. In the present environment where SPVs are only again looking suspect, there might be probes into Northern Rock that might bring up some fundamental questions on securitisation structures.

If at all there is a servicer change, this might be one of few instances of servicer migration in the UK.

Today (20th Sept), BoE's Governor equated the current crisis in UK banking as the worst since 1973.


The bird in the Bush will now come out –
Prez to announce measures on subprime crisis

Today morning, US time, President Bush is expected to announce measures to contain the subprime crisis that actually continued to build like a toxic tank right under the nose of the Federal regulators ever since 2005, and finally burst and spread all over the World.

US press said Bush plans to announce a variety of measures in the Rose Garden on Friday morning that are designed to help struggling homeowners with subprime mortgages avoid foreclosure and will declare that lending practices need to be tightened. Presumably, bankers were all this while waiting for the Prez to ask them to tighten their lending practices.

The measures might include some tax relief to troubled borrowers to rework their loans. The measures are also affected to deal, at least in part, with securitization transactions, and perhaps will have some impact on the servicing industry and the rights of the servicers to modify terms of loans before they are in default.

While the Prez may not go into finer details at this time, gain-on-sale accounting practice may also come for question. The FASB is already considering proposals to replace the present accounting practice by one based on "linked presentation" that UK FRS 5 had several years ago.

Keep watching this site – we will bring further updates.

Bad news pours in – ABCP, student loans, aircraft leases 
– all seem to be going wrong at the same time

Suddenly, all seems to be going wrong. The institutions of structured finance that we nurtured over all these years, on which Wall Street investment bankers bagged fat bonuses every year, all seem to be looking suspicious. In India, they say – having burnt your lips with hot milk, you would even blow into buttermilk before taking a sip.

The supply in the asset backed commercial paper (ABCP) market is seemingly badly affected. ABCP conduits issue short term paper and were originally created to acquire trade receivables of their clinets, but over years, they have grown into mini off-balance sheet banks and acquire variety of credit assets including RMBS,CMBS, CDOs, trade paper, etc. The size of the ABCP market is nearly USD 1.2 trillion. While most of the paper that ABCP conduits buy has already been credit-enhanced to AAA levels, the issue of commercial paper is done expecting a roll-over funding. The sponsoring banks provide a stand-by liquidity support. As the investors have broadly retreated, liquidity lines of the conduits have been drawn up in some cases, and this has created another source of jitters in the market. Rating agency Fitch held a conference call last week highlighting the liquidity concerns, and resulting capital consequences and mark-to-market pressures.

Increasing consumer bankruptcy fears have also put questions on credit card ABS, one of the very safe collateral classes. According to Moody's Investors service, the bankruptcy filings this year are 30% higher than a comparable number last year.

Liquidity has dried up for student loan ABS also.Even as diverse an asset class as aircraft leases has been affected.

Needless to say, CDO issuance is almost completed dried up. The volumes for August 2007 reported on add up to $ 7.8 billion whereas usual issuance in this month would have been nearly 5 times. The total US ABS issuance for August shows as a mere $ 4.5 billion, as opposed to $ 70 billion in the same month last year.

Will the Fed interfere to bail out mortgage markets?

Historically, when financial markets hit rocks, the US government has deployed the Federal agencies to bail them out. This happened in the case of LTCM, and Savings and Loans crisis. As the mortgage market troubles continue to jolt the global financial system, a key question is – will the Fed interfere? If so, will it be a day too late, or just in time?

Noises are doing rounds that the GSEs may be called upon to buy junked loans. If that is to happen, it must happen before it is too late, because it is clear that it would take days, not weeks or months, before the financial system would be in a deep mess.

The portents of the impending crisis are all but unclear. Lots and lots of funds world over are invested in the US mortgage market. Liquidity in the securitization market has dropped down drastically, even for asset classes traditionally regarded very very safe. The cost of borrowing via asset backed commercial paper has gone up by something like 50 bps. As investment funds face liquidity crisis, many of them have already blocked redemptions – the latest to do so was BNP.

The impact of the US meltdown is seemingly spoiling the party of global growth. The financial press is using words like "US exports poison" (BBC News), "Ugly American hits Europe" (BusinessWeek), etc.

Australian mortgage markets also catch cold: 
mortgage insurance claims rise 329%

The frenzied pace at which mortgages were created by banks was not limited to the US banks. Australia is another very well developed mortgage securitization market, and Australian banks were going high on mortgage origination too. Hence, it is not surprising that the spectre of increasing mortgage defaults has affected the Australian market too.

Australian Prudential Regulation Authority (APRA) reported that claims on mortgage insurance companies in 2006 were 329% higher, that is, more than 4 times the claims in 2005. It is a common practice among mortgage originators in Australia to buy pool mortgage insurance covers, and if the defaults happen on a pool, the insurance company faces claims.

The reports also indicated that the rate of increase on account of mortgage defaults was higher than any other insurance sector claims..

Australian stocks have been badly affected by the mortgage crisis, both local and global. Most of Australian banks have exposure in US markets too. Australian banks both originate and invest in CDOs. In fact, CDOs have even been sold to retail investors in Australia. Macquarie's mutual fund is supposed to have lost nearly 25% due to the mortgage meltdown.

Wall Street is now firing:
Securitisation and credit derivatives jobs are being cut

After several years of high-pay and high-stress jobs, investment bankers are now in a mood to fire. Wall Street is facing a lot of fire here, there and everywhere anyway.

Troubled Bear Stearns' president resigned; reports indicated that he was responsible for mortgage-related investments in the investment bank. Bear Stearns has said that it is facing the worst financial crisis over the past 20 years.

Nomura Securities' structured finance research team has been reduced substantially. Notable securitization expert Mark Adelson has left the firm, along with several of his team members.

In the mortgage sector, some 50000 jobs have been laid off in all, as per data on

Every year, leading investment banks hire finance, quant and trading experts from business schools world over. Investment banks are typically manned by young blood, who believe more in passion than in caution. This year, it seems recruitments in derivatives, investment banking and structured finance desks, particularly hedge funds and private equity, will be substantially reduced.

Crisis raises basic questions on securitisation; many funding plans disrupted
BAA's whole business securitisation may not fly

As is quite common behaviour, the subprime crisis has put some very basic questions on securitisation. In some of the blog sites [for example,’s blog site], people are arguing about securitisation per se. As investors get securitisation-scary, funding plans of many are being disrupted.

Global issuance data on shows a world-wide decline in the month of July – a rare occurrence after several years. As the after-effects begin to jell, there might be sharper decline in the current month. Spreads on ABS are also showing at 52 weeks' highest, with AAA home equity quoting at a whopping 170bps.

In the USA, alt-A mortgage securitization has completely stopped, says a report at

Reuters came out with a big listof hedge funds who are reportedly or admittedly in trouble. Here is the list:

  • Bear Stearns Two Bear Stearns funds have filed for bankruptcy already. A third one has stopped redemptions.
  • Absolute Capital (Australia) – Half-owned by ABN AMRO. Temporarily closes two funds in late July with a combined A$200 million in assets amid problems with collateralized debt obligations.
  • Macquarie Bank (Australia) – The bank warns in early August that retail investors in two of its debt funds face losses of up to 25 percent. Note that this is a mutual fund and not a hedge fund.
  • Basis Capital (Australia) – Suspends redemptions on two of its funds in July. Presently conducting a fire sale of assets.
  • Oddo Asset Management (France) – in late July closes its Oddo Cash Titrisation, Oddo Cash Arbitrages and Oddo Court Terme Dynamique funds, which manage total assets of around 1 billion euros.
  • Sowood Capital Management (United States) – The hedge fund which managed money for Harvard University tells investors on July 30 that it will wind down after suffering losses of more than 50 percent which wiped roughly $1.5 billion in capital.

Among the casualities are the huge whole business securitisation announced by BAA earlier this year [see news on our site here]. Reports indicate that BAA may not be able to refinance its properties by arising GBP 4.5 billion, as proposed earlier, as liquidity in the market is quite tight and leveraged finance may drop down sharply.

Lot of fire, and lot of smoke all over: crisis spreads wider and deeper

The inevitable crisis in the subprime mortgage securitization segment is now spreading like wild fire. And it is difficult to say if the fire is more or the smoke, as crisis alarms have gone off everywhere.

Geographically, the crisis has already affected some European banks; some Australian hedge funds have also suspended redemptions, though they claim to be unaffected by the subprime crisis. Some more US hedge funds closed redemptions.

A third Bear Stearns hedge fund, Asset-backed Securities Fund, was reported by Wall Street Journal to be in trouble; has stopped redemptions. C-BASS, a mortgage investor, seems to have heavily lost money, and consequentially, MGIC and Radian have suffered losses of impairment. There are other subprime lenders who have suffered huge casualties, as reports indicated that subprime mortgage losses were not stopping. Mortgage insurers might have substantial liabilities.

Australian bank Macquarie's Fortress Funds might lose value upto 25%, though it is not reportedly connected with subprime losses.

German bank IKB was also reported to have suffered huge losses out of US mortgage market – its rating has already been downgraded by Fitch. In Paris too, Oddo and Cie, a fund manager, is reportedly shutting down two of its funds.

In the midst of the heightening worries in the subprime market, trades in credit derivatives on subprime securitizations found that the subordinated tranche of the ABX.HE index still meant some value – BBB- tranche of ABX.HE's 2007-2 run went up in value from its lowest point of 39.97 on 27th July to 41.22 on 31st. However, the senior-most tranche still lies at 94.5, its lowest since inception.

Updated August 2, 2007: The impact of the US securitization crisis is widening. Equity markets world-over reacted sharply with most indices taking a beating. Losses in market cap add up to billions of dollars. In the meantime, Bear Stearns hedge funds filed for bankruptcy, and investors have joined together to file litigation. Reports keep pouring about several European banks that would lose heavily in the subprime market.

Notably, the Macquarie Ban's fund reported to have lost nearly 1/4th of its capitalisation is a retail mutual fund.

Most other hedge funds have got margin calls from their banks, bringing liquidity to an all time low.

It is not a ripple effect; it is web effect

It would be wrong to call it a ripple effect: ripples get lighter as they spread. This one is a web effect, as the world of finance today is a complex web of one instrument heavily depending on the other. The crisis that originated in the subprime mortgage market brought CDOs to a complete halt (see report below and updates in this item). At the same time, hedge funds were hit as they continue to face losses either as purchasers of the ABX indices or as equity holders in CDOs. The CDO/CLO market was a big supplier of liquidity to the leveraged loan market – so, with the CDO machine halting, there is a sudden crisis of liquidity in the leveraged loans market. And it would continue to spread – to conduits, to private equity lenders, even to seemingly unconnected participants as insurance and reinsurance companies.

Market is abuzz with news of failed syndicated loan deals – be it refinancing of Cerberus' purchase of Chrysler,or Kolberg Kravis Roberts & Co.'s purchase of Alliance Boots.

Lots of investors have started doubting the veracity of the ratings – AAA ratings have fallen by several notches in the recent weeks, and the downgrades are not stopping. Investors are questioning as to whether the rating agencies could not have seen this when they rated the transactions in 2006 – credit enhancements levels were much lesser in those deals than the transactions structured in 2001 and 2002.

In the meantime, a new roll of ABX.HE, 2007-2, continues to slide. The safest tranche fell from 99.3 to 95.39 in matter of days, a decline of nearly 5%. The BBB- piece fell to as low as 40.39 from its inception price of over 50.

On the other side of the Atlantic, the iTraxx crossover index, an index of credit default swaps on entities that crossed over recently from investment-grade to below, has been crashing, taking along the confidence of the community that saw credit derivatives as a hedge against volatility. Today's Financial Times quotes Jim Reid of Deutsche Bank as saying this: "We should now be in little doubt over the power and influence of leverage, derivatives and structured products. They are not volatility dampeners, but volatility magnifiers".

CDS spreads on most of the leading Wall Street investment banks have risen sharply, which means their cost of capital will increase. As mortgage delinquencies continue to raise, and housing sales have been dropping, the portents are surely not good.

Links See Vinod Kothari's piece on two old risks of structured finance here.

CDO market comes to a grinding halt, says report

If, as 2006 volume statistics clearly show, 70% of CDO issuance was what is called structured finance CDOs, it is hardly surprising that with never-before concerns about the structured finance market, CDO issuance should have halted. International Herald Tribunequoted a JP Morgan report that the volume in July had come down to a mere $3.7 billion from $42 billion in June. The global CDO issuance data on bears this out – the number for June 2007 is shown as USD 50.1 billion, whereas that for July to date (as seen on 24th July) is merely USD 1.9 billion.

CDO structurers were going gung-ho on structured finance transactions. A CDO would pick up BBB to BBB- pieces of asset backed transactions, mostly subprime and the likes. That is where the arbitrage lay. Till 2005, CDO structurers were making merry on CDO^2, which became unpopular thereafter.

The sqeeze of liquidity in the CDO market is also likely to be accompanied by similar shortage of funds in the private equity market.

On the other side, a new 2007-02 run of the ABX.HE index was launched. The BBB- tranche that started with a price of 50.33 slided to 47.86 in a matter of days. Even the AAA tranche fell from 99.33 to 98.03.

India's securities regulator puts up draft regulations on securitised instruments public offer and trading

There may not be much of securitisation happening in India these days, but that has not stopped regulators from coming up with elaborate rules, complete with licensing, eligibility conditions, rejection of application for registration, appeals, and so on.

The Parliament recently amended the law that deals with trades in securities – Securities Contracts Regulation Act – and made "securities" inclusive of securitised instruments. This was made out to be a boon for securitisation as it would permit public offers and exchange trading for securitised instruments. It was noone's case that lack of such listing or public trading was hindering the market in any substantial way.

That amendment having been through, the Securities Exchange Board of India [SEBI] which was empowered to write regulations for public offers and listing has now come up with draft regulations that have been put up on its site today.

Instead of falling in line with similar public offer rules for asset backed securities in other countries, for example, Regulation AB, SEBI has drawn heavily on its own template in context of mutual funds and similar market intermediaries. Thus, for a securitised instrument to be offered to public, there has to be a special puropse distinct entity (read SPV). While the normal concept of SPVs is a discrete body for each transaction, SEBI's idea seems to be some kind of a continuing umbrella entity that would serve several transactions in a sequence. Hence, there is a need for registration of such entity, and such registration must be maintained on a continuous basis. A single SPV can come up with several transactions of securitisation, called "schemes", again in line with mutual fund parlance. Hence, the SPV becomes a kind of protected cell or multi-segmented entity, though the law in India currently does not have any cell protection rules.

Once the SPV is registered, it can, over time, bring public offers by having an offer document which would also need to be registered with SEBI. There are scanty disclosure requirements in the offer document, which obviously indicates that SEBI did not have the benefit of similar disclosure requirements either from SEC USA or from industry bodies.

The draft rules are placed for public comments on SEBI site.

Subprime sorrows deepen with downgrades, 
defaults and hedge fund collapse

Financial press is full of stories about the sorrows of subprime lending. The news is coming from different quarters, and is constantly causing loss of nerve in the CDOs, ABX trades and the financial services industry in general. The news of the mounting delinquency rates in the US mortgage market (see news immediately below) was quickly followed by Moody's releasing its latest reseach report on the "challenged" market. Moody's downgraded 131 securities of the 2006 vintage and placed a good 136 on rating watch negative. While most of the downgraded securities had a rating of A or lesser, a small percentage had a Aa and Aaa rating also.

In the meantime, the market got further disturbing news about a 10-month old Bear Stearns hedge fund High-Grade Structured Credit Strategies Enhanced Leverage Fund was nearing collapse as investors were breaking gates for redemptions and the fund did not have liquidity to do so. The fund was focused on subprime market. The highly geared fund had a capital of about USD 640 mil, but borrowings of about USD 6 billion. There were reports about a bail out effort with additional capitalization from Bear Stearns or others.

In the meantime, the ABX.HE index continued to slide down. The BBB- piece reached an alltime low of 60.39 and the slide does not appear to have stopped.

The liquidation of the subprime MBS portfolio held by the BS hedge fund and others might soon exacerbate into a liquidity crisis in the market as most of the players are driven by mark to market practices and will have to report losses. The reported losses may reach deleverage triggers. In fact, most of the leveraged investment vehicles in the market has deleverage triggers that are ruthless and automatic. They require the fund to liquidate its assets when the times are bad, which sounds like counterintuitive.

While subprime servicers are exploring ways to resolve foreclosures by restructuring loans, one of the technical issues that have comes up is – does FAS 140 laying down conditions for QSPEs allow that discretion? Some democrats seems to have sought SEC clarification on this.

Updated 21st June 2007

Merrill Lynch, a lender to two of the Bear Stearns hedge funds that are nearing collapse, has reported seized USD 850 million of the assets of the hedge funds held as collateral by the former. Merrill has begun selling these assets, most comprised of CDOs and CDO^2.

In the meantime, ABX.HE fell below the 60 mark and the last quote went to 59.79. The expectations are that there will be further decline before the trading closes for the week.

In the meantime, SEC and FASB are meeting today to discuss whether a servicer can have the right to alter the features of a mortgage before it goes into a default. The critical question comes in context of the 2/28 ARMs that would start posting increased instalments from the end of the second year, fast approaching in case of mortgages written in 2005 and 2006. In the already weakened market, the increase of mortgage payments would be a hard blow

We will continue to provide more coverage on this very serious crisis facing the securitization market.

Mortgage woes hurt leading originators; 
foreclosure rates highest in last 50 years; ABX.HE starts sinking again

Several related things happened this week to hurt the sore spot of US banking – the mortgage market. Piggybacking on historically low interest rates, most US originators marketed mortgages aggressively enough, mostly with features that would look attractive enough upfront, but would be painful in the long run.

The US mortgage bankers body Mortgage Bankers Association of America reported that foreclosure rates in the 1st quarter of 2007 reached 1.28 percent of all loans outstanding at the end of the first quarter, an increase of nine basis points from the fourth quarter of 2006 and 30 basis points from one year ago. The Washington Post added that this was the highest in last 50 years.

The rate of foreclosures started on subprime ARMs jumped from 2.7 percent to 3.23 percent. The states mainly responsible for that increase were California, Florida, Nevada and Arizona. The reasons cited for the increase were decline in home prices and increase in unemployment rates.

In the meantime, the Goldman Sachs reported performance for the last quarter and its shares dropped 3%. Bear Stearns' earnings at Bear Stearns in the second quarter fell 10 per cent to $486m, with lower mortgage lending and securitisation volumes offsetting strong growth in other businesses, particularly investment banking, prime brokerage and wealth management.

The index of representative subprime securitization transactions, ABX.HE has started sliding again. The BBB- tranche fell to a price of 61.91, lower than the previous low reached in the 1st week of Feb this year.

More reports There are more related stories below.

UK FSA report exposes securitisation risks, loud and clear

There is a saying in rural India – If there is a theft at the village launderer's shop, everyone loses, except the launderer. Present day banking system relies heavily on the originate-and-distribute model for credit assets. The assets are distribute either by cash securitisation, or synthetically by structured credit trading. In either cases, the risks are dispersed in the capital market, with the banks merely making their originator profits. To Alan Greenspan, this was responsible for holding the entire banking system in good stead, but the UK FSA clearly warns that the systems has far thrived in benign credit markets; it has not faced the test of stressful times.

A phenomenal part of the latest Financial Stability Report of the the UK Financial Services Authority is dedicated to the risks of securitisation and credit derivatives market.

Taking a leaf from the troubled UK subprime mortgage market, the FSA argues that similar risks might be growing underneath the calm of the UK financial system too. It makes what seems like a very bold critique of the securitisation system:

  • Strong investor demand for securitised assets, combined with benign market conditions, has sustained a heavy
    issuance of both RMBS and CMBS. In turn, this seems to have led to an easing in underwriting standards, such as increasing ‘covenant-lite’ deals in the leveraged lending arena and weaker documentation requirements for CRE lending.
  • Given that risk is transferred to other market participants, there are concerns that the originate and distribute’ model might dilute incentives for the effective screening and monitoring of loans in the corporate market, as appears to have occurred in the sub-prime market.
  • Since lower tranches of securitisations are mostly taken to CDOs, the embedded leverage in CDOs is common across sub-prime, CRE and corporate credit markets and could magnify the market response if there was a particularly sharp deterioration in the performance of underlying assets.
  • The separation of the origination of risk from its ultimate incidence may mean that less information on underlying credit quality is available to the bearers of risk. In US sub-prime markets, end investors appeared not to be able to determine the credit quality of lending being securitised very accurately. Originators with incentives to sustain lending volumes originated poorer quality lending. While market mechanisms
    exist to maintain credit quality by ensuring that originators remained exposed to some of the potential credit loss, the high levels of arrears in recent vintages of US sub-prime mortgage lending raise questions about the effectiveness of those mechanisms.
  • Where risk transfer leads to a greater dispersion of individual credit risks across investors, the fixed costs of monitoring credit risk may mean that the standards of individual investors’ own credit risk assessments are lowered as they hold smaller exposures. In such circumstances, credit risk assessment is often partly delegated to third parties, including rating agencies, lead arrangers and managers of structured credit vehicles, such as CDOs. But there are risks that investors could become overly reliant on the assessment of others.
  • Recent events have also highlighted risks from excessive reliance on, or confidence in, historical credit-risk scoring models for credit assessment. Models can break down when the attitudes of borrowers towards default are shifting, as may have been the case recently in the UK unsecured lending market. And modelling risks will be heightened when these models are applied to new forms of lending

Links For full text of the FSR, see here.

Subprime debacle hardly surprising, says paper

Nomura Fixed Income Research's Mark Adelson and team came out with a very timely paper on the subprime debacle. As may be common intuiation, the subprime lending spree of 2005 and 2006 ignored some very basic principles of money lending and therefore, foreclosures were bound to rise with house values declining. The brilliant is just brilliant, and we bring below the key conclusions of the paper:

There is no sub-prime surprise. High delinquencies and defaults are an inevitable result of the kinds of loans made in 2005 and 2006. Ignoring the Three C's of lending could produce no other result. Moreover, the warnings were loud and clear. The warnings also were numerous and frequent. And they came from many diverse sources, including the general media.

The current flurry of activity to "do something" about the sub-prime mortgage situation is a day late and a dollar short. Policymakers and market participants who don't like the current situation should 
have acted sooner by taking obvious preventive measures. Both policymakers and market participants share responsibility for the current situation by having ignored the warnings and having failed to act sooner.

Unfortunately, some policymakers are trying to exploit the current situation by pandering to defaulted
borrowers. That conduct is counter-productive. Policymakers and market participants need to come to grips with reality. There likely will be an uncomfortably high level of foreclosures. Despite the best of intentions, rescue attempts on many loans probably will fail. And, lastly and most importantly, policymakers should refrain from taking drastic, ill-conceived actions that ultimately do more harm
than good by unduly reducing the availability of mortgage credit to American families.


Trade bodies release draft of self-regulatory non-mandatory guidelines
for retail structured products

While US congressmen continue to examine if things had indeed gone wrong in the way subprime mortgages were packaged and sold, trade bodies got into the act and released draft of self-regulatory non-mandatory guidelines for retail structured products.

The guidelines were released jointly by the Securities Industry and Financial Markets Association, European Securitisation Forum (ESF), the International Capital Market Association (ICMA), the International Swaps and Derivatives Association (ISDA), and the London Investment Bankers Association (LIBA).

The guidelines are applicable when structured products are delivered to retail investors. Retail structured products should always be distributed through distributors. The distributor should understand what he/she is distributing and should take responsibility for the contents of the term sheets. Product providers should likewise understand who the distributors are. Even the distributors should know who the product providers are. The essence is the same as in case of the general "know your counterparty" principles such that people do not hide behind their ignorance about the counterparty.

The guidelines are very general and do not say much that is not sheer commonsense. Like industry codes, they are perhaps overpowered by the desire not to restrictive at all. Like most self regulatory codes, they remain like holy principles of benign conduct which but for the code would be found in religious texts.

Links Full text of the guidelines in draft is here.

Home equity down surely, 
but ABS volumes are almost unfazed in Q1, 2007

With all the turbulence in the home equity market and the resulting impact on several CDOs, the volumes of ABS issued in 1st quarter 2007 is not much lower than the same quarter last year. Data on, which compiles global data, shows that the volume for the 1st quarter was Usd 267.6 billion , compared to last year's 281.8 billion, roughly a decline of 5%. Given the fact that last year was an exceptionally good year, this decline is not very dampening. On the contrary, if one looks at the volume of CDO issuance for the 1st 3 months of 2007, it is USD 132.1 billion, as against only 69.9 billion last year.

A report on Bloomberg citing a Citibank source said the volume of home equity securitization was down sharply -with a decline of over 37%. This is clearly understandable, since, home was at no 1 position in asset backed segment last year, and this year seems to be the year of CDOs.

New Century files for bankruptcy

Even as New Century, one of the one-time leading lenders in the subprime mortgage market filed for bankruptcy protection, the key question in everyone's mind is – is that the worst? While S&P ran a comparison between subprime deals of 2000 and 2006 vintage, and estimated expected losses of about 7.5%, the worry is if with the lowering house prices, will the defaults increase beyond that level?

New Century, which has been in the news below for almost 2 months now, finally succumbed and filed for Chapter 11. It has set up a new site where it intends to put further information on the restructuring plan. The company's press release says it has entered into an agreement to sell its servicing assets and servicing platform to Carrington Capital Management, LLC and its affiliate, subject to the approval of the Bankruptcy Court. The purchase price for the assets is approximately $139 million. In addition, New Century has agreed to sell to Greenwich Capital Financial Products, Inc. certain loans originated by the company, as well as residual interests in certain securitization trusts owned by the company, for an aggregate price of $50 million.

The subprime market has seen several sad spots over the last couple of months or so – see our comments below.

In the meantime, the subprime credit derivatives index ABX.HE BBB- was quoting at 66.59. It is not the least that it has recorded – there was a bit of revival from the trough of 62.25 quoted earlier.

See more of our notes and coverage below.