NO ONE SAW it coming. And like machine-gun bearing mobsters jumping out of a birthday cake, the liquidity trap in which the securitization market has become embroiled was a very nasty surprise. Indeed, it is hard to overstate the sense of shock that this market is still reeling from. Investment banking is not known as a profession lost for words, but many usually garrulous individuals are still struggling to describe the experience. "It is always the thing that you least expect that trips you up," says one. "Who would have ever thought it would be the SIVs? They sit so high in the capital structure that nobody worried about them – it seems natural that all the risk in the capital structure is at the bottom not the top – so that is where people focused."
And by the time it became apparent that there was a serious buyers’ strike in the commercial paper market it was too late. Originators and investors alike faced the unthinkable prospect of the entire ABS market simply shutting down. "When it happened it felt as though maybe the Emperor didn’t have any clothes... maybe there was nothing there after all," says a traumatized investor.
The speed with which all liquidity evaporated was unprecedented in recent years. "I have not seen outright fear and shock like this since 1987," says a veteran. "It has been hard to keep morale going." One originator is more succinct: "There are times when I feel like holding a pistol to my head and other times when I think everything is going to be OK," he says. "But I go home at the weekends hoping for a respite and open up the Sunday papers and every story is about me."
Clearly many are very shaken by what has happened but so far the number of casualties has been contained. That is unlikely to remain the case. "It was very, very scary," says an individual whose fund has been a victim of the liquidity crisis. "The effect on the market was unbelievable. You just sit there seeing it all becoming self-fulfilling: big hit; big markdown; another big hit; another big markdown; another big hit; unwind. The unthinkable becomes reality."
By mid-October there was a sense that the worst was over but that the settling dust would reveal a very different securitization market from the one that everyone had become comfortably used to. And it also brought to light a few home truths that many had probably suspected but chosen to ignore. The most obvious of these is the extent to which investors had simply bought on rating rather than done their own due diligence.
In many ways this is the entire root of the current crisis in securitization. Alan Greenspan’s US "savings glut" meant that there has been a surge of money hunting for yield for the past decade. This money focused on the ABS market and swamped it. Bankers were under enormous pressure to create product to meet this demand; that is why underwriting standards in the mortgage market fell to such lows. Asset originators were driven to relax their criteria just to get product through the door to feed the insatiable demand from the ABS investor base.
"I remember being at a meeting in December 2006 where our ABS guys said that they were expecting $26 billion to clear that month but that it would not be a problem and spreads would still be tighter at the end of the month. I remember walking out at the end and thinking: ‘Oh my God, this market is going to blow; this is whacked,’" says a US banker. The same process (albeit on a far smaller scale) happened in Europe in 2004, when the European market was also swamped with asset allocators searching for yield. This scramble for allocation meant that these buyers were skipping their due diligence and simply buying on rating. This is something that everybody knew was happening, everybody knew was not very smart, but probably no one envisaged would blow up in people’s faces quite as spectacularly as it has.
"The business plan of anyone that has been buying assets on the comfort of a rating is in deep trouble," says a portfolio manager. You would certainly be hard pushed to find a better example of ignorance breeding fear. "The total level of complete withdrawal of every single investor across the ABCP market was unbelievable," recalls an asset manager. "They even stopped buying bank CP. They weren’t buying ABCP where the entirety of the underlying was trade receivables. It was crazy." Another manager of a large ABCP conduit with less than 80 basis points in sub-prime and more than 5% credit enhancement explains how no-one even cared about the structure. His bafflement is shared by another ABCP expert. "ABCP is less likely to incur losses than bank CP!" he says in exasperation. "There was a now infamous Moody’s ABCP conference call shortly after the problems started where it rapidly became very apparent to me that six out of 10 investors on the call had absolutely no idea what the product was all about." And even if they did, their hands were tied by senior management. "If you are told by your boss to get the hell out, what can you do?"
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Where will rates settle? |
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Overnight to 90 ABCP rates in the US |
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Source: Federal Reserve |
In addition to nobody having understood what they had bought, it became very readily apparent that nobody really knew what it was worth either. As the voracious demand for ABS that had precipitated the crisis disappeared overnight, the process of marking to market bonds that were completely illiquid exposed the flaws in the entire marking concept. "The OTC market has utterly failed," says a head of securitization in New York. "Everyone knew that the marks were crap and marking to market now has no credibility." The arguments against marking debt to market are well rehearsed, but if ever the detractors wanted a graphic illustration of what they have been talking about – this has been it. " Marking to market makes sense in the equity market as the only way you are going to get your money back is to sell to somebody else," says one banker. "In the debt market it is very destructive. It is nuts to suddenly say that a loan on which the credit remains the same and the cash flows remain the same is suddenly worth $20 million less than it was yesterday – or indeed more."
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