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Two Views of the Current Structured Finance Market

Recent problems at two Bear Stearns hedge funds have started a discussion in the financial press and financial blogs about possible problems in the collateralized loan obligation markets (CLO) and the collateralized debt obligation (CDO) market. Below are two views of the possible shake-out from this situation. I will present a more optimistic view and Barry Ritholtz of the Big Picture blog will take the less optimistic view. Neither of us knows what will actually happen. However, I hope the views expressed will shed some light on the pros and cons of the current situation.

The more optimistic scenario:

CDOs and CLOs are two of the newest developments in the structured finance markets. While there are understandable concerns about these new structures, structured financial products have already demonstrated their effectiveness over the last 25 years. There is no reason to think they will behave differently now.

First, let's explain a few of the basic ideas behind these products.

The basic premise of these investments is simple: pool a group of similar assets to diversity the risk and then parcel out the risk to separate investments carved from the pool. Let's create a simple hypothetical deal to explain this concept. We'll start with a $100,000, 30-year five percent mortgage. After the mortgage closes -- that is, after the borrower and lender have signed all of the paperwork and the borrower is "officially" a borrower -- the lender will usually sell the loan to an investment bank. The investment bank will then pool this mortgage with similar mortgages (same interest rate, maturity etc...) and create one giant pool. This process of pooling asserts can occur with literally anything that has a cash flow -- account receivables, loans, bonds -- you name it, and it can be pooled and carved into separate bonds or cash flows.

Suppose the investment bank creates a pool worth ten million dollars. That means there are now 100 mortgages in the pool. The basic investment concept of diversification tells us that a problem with a few of the loans will not impact the overall performance of the entire pool. Suppose five homeowners in this pool eventually default. There are still 95 mortgages that are making payments on time. This limits the problems created by the five loans that defaulted.

Let's add a complicating factor to this scenario. Suppose there is a problem with a larger percentage of the loans -- say 10 percent or higher. This is when the concept of "structured finance" comes into play. The investment back will create different bonds from the large pool and allocate the pool's payments to these different bonds at different times and at different rates.

Here's an example using the previously mentioned pool. Remember, we have a giant mortgage pool worth ten million dollars, and the pool is made-up of 100 mortgages each worth $100,000 that pay five percent interest. The investment bank will "carve" the ten million dollars into three different "tranches." For all practical purposes, each of these "tranches" is a bond.

Investment banks will usually create three types of bonds from these pools. The riskiest bond is usually called an equity bond, and when there are problems with the underlying pool, most of its loses are allocated to this bond. Using our previous, hypothetical example, suppose 10 percent or 10 of the mortgages in the pool are in default. The equity portion of the bond will absorb all of these losses. As a result, the other two bonds are still receiving their regular payments.

Let's suppose the number of defaults increases to 20 percent, so that 20 mortgages in the $10 million pool aren't making payments. The investment bank will now allocate most of the losses to the equity bond, but will also allocate any spillover losses to the mezzanine bond. This is the next riskiest bond in the structure.

Finally, there are investment grade bonds which are the last bonds to be hit by defaults. Because of the concept of diversification, this bond will usually not experience any problems.

So to sum up so far, we have two separate ways the risk from the underlying loans is diversified. The first is by pooling a group of assets into a larger, single pool. This limits the impact when a percentage of the underlying loans experiences problems. The second is by allocating the risk of defaults to specifically designed bonds that absorb the losses, protecting the senior, higher rated bonds.

Most of the problems with synthetic investments have occurred when a money manger made really stupid decisions. The recent Bear Stearns situation is a classic example. There the manager was highly leveraged; for every dollar invested he borrowed nine dollars. Simply put, that's about one of the dumbest ideas I've ever heard. If the market goes up you're a genius. If the market goes down, you've lost everything.

The Bear situation illustrates why I think the CDO and CLO situation will not have an extremely adverse impact on the markets or the economy. Most money managers take their fiduciary obligation seriously; they don't make wild bets on the market. They will allocate a small portion of their portfolio to riskier assets. If these assets drop in value, the small allocation percentage insulates the rest of the portfolio from extreme downside risk.

That is not to say there won't be problems. I would expect there to be a few more really stupid managers out there is a position similar to the Bear situation. These managers' funds will take big hits and the funds may have to liquidate. However, as a recent WSJ article notes, these events will probably not be fatal:

Part of the answer lies in the strength of the financial system's shock absorbers, which have improved since 1987, the 1997 Asian financial crisis, the 1998 Long-Term Capital mess and Sept. 11 attacks. Hedge fund Amaranth Advisors collapsed without many side effects. It looks like the same may go for the two Bear Stearns funds, whatever their fate.

Recent history is encouraging. The 1987 stock-market crash, as frightening as it was, didn't tank the U.S. economy. Neither did the horror of the Sept. 11 attacks. The economy gulped and then rebounded. That isn't any guarantee that the next crash or crisis, and there will be one someday, will have similarly passing effects on the impressively resilient U.S. economy. But it is encouraging.

Here is the less optimistic viewpoint. It comes from Barry Ritholtz at the Big Picture blog. Barry is pretty-much every economic blog's Godfather. As always, Barry makes some extremely astute observations that should be seriously considered in any analysis.

Last night's discussion of the Bear Stearn's hedge fund melt down was remarkably sanguine.

I guess to those who look at the blow up of a small hedge fund -- it was only $684 million in equity, albeit leveraged up 10-to-1 to $6.8 billion. Hey, sometimes, losses happen.

And Wall Street has been terrific about managing risk, haven't they? I mean, they did a great job with the dot coms, and they are doing a terrific job with housing, right? There may be 49 trillion dollars worth of derivatives -- that's trillion with a "T" -- so what if one or two percent goes belly up? It's well contained.

Um, not exactly.

There are several issues here that deserve closer scrutiny. Here's how I connect the dots:

1. Side Pockets: A way to move toxic holdings "Off Balance Sheet," to a netherland, hidden from investors and perhaps regulators. This lack of transparency does not exactly comply with truth-in-reporting to your investors or FASB accounting standards.

Sound familiar? It should: Its remarkably similar to Enron Off Balance Sheet Special Partnerships. The WSJ's Scott Patterson went into the details last week:

Even if Bear's pain spreads through the market, other hedge-fund investors might not feel it, at least right away. Sometimes, hedge funds move big pieces of their holdings into separate accounts known as side pockets to keep declining assets from hurting a main fund's performance record -- and managers' wallets. They can also block investors from cashing out.

2. Mark-to-Model: The similarities to Kenny boy's outfit don't end there: What do we do with illiquid holdings where the fund is both the buyer and seller, and the parent company is the buyer of last resort? Unlike most mutual and hedge fund, who mark-to-market based upon the closing price pof their assets, holders of these CDOs get to indulge their "creative" side. Instead of writing the great American novel, they derive a model that optimistically prices these illiquid assets.

Why optimistic? Because the theoretical returns to investors and actual fees to management are based on the pricing of these (non-priced) assets! Keep those Enron parallels coming!

Indeed, the reason Bear was originally willing to pony up $3.2 billion dollars was what would happen if there was an actual public auction price: The entire complex would have to reprice all oft heir holdings. Buy bye investor returns, buy bye fees!

3. Crimping Copious Consumer Lending: What does all this esoteric derivatives and murky hedge fund operations have to do with me, the ordinary investor?

First off are lending standards: They have tightened -- in some instances, dramatically. That means any debt fueled consumer purchases -- most especially, homes -- have a reduced pool of buyers. That will pressure prices further, reduce MEW, leading to decreasing consumer spending. The spigot that has been open wide for so long is now reducing its flow.

4. Crimping Copious Corporate Liquidity: Mr. Market has enjoyed a delightful wind at his back, funded by corporate buybacks, Leveraged buyouts, M&A activity. The issue rates front page coverage in this morning's WSJ: Market's Jitters Stir Some Fears For Buyout Boom.

Remember, this is all courtesy of lots of Fed induced liquidity, and a willingness of lenders to provide lots of cash to high risk borrowers at low rates with easy terms. In Tuesday's FT, Lombard Street Research's chief economist, Charles Dumas noted what could happen as this dries up:

"With this mortgage-backed crisis we could simultaneously see market-price liquidity implode just as banks are forced to shrink their books by capital losses."

"Banks' capital is about to be slashed, and with it excess liquidity in the global system...Suppose the CDOs held by banks were valued at "market" rather than "model" levels (a fancy new euphemism for illusionary historic book values). Their capital would turn out to be lower. Preservation of capital ratios against loans would require fewer loans: liquidity would have imploded... better to let the Bear flounder than reveal just what a low value the Street puts on even the A-rated paper. A bunch of hedge funds may have problems, but that is the tip of the iceberg for "Titanic" Wall Street."

Mr.Duma may be overstating the case somewhat -- he's more Bearish than I -- but he raises very significant issues that have very real risks -- the same risks most of the bullish crowd seems to be overlooking.

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How might this play out? Well, mortgages at banks with past due payments are at the highest level since 1994, according to first-quarter data compiled by the Federal Deposit Insurance Corp. Mortgage defaults are accelerating, not getting better.

Oh, and a whole slew of Sub-prime ARM Mortgage Resets are scheduled to hit in the 2nd half of 2007.

To say the least, this is going to get increasingly interesting...

So there you have it - the optimistic and the not so optimistic viewpoints on the current I wanted to thank Barry of the Big Picture for allowing be to use his article on this very important and timely topic.

For economic commentary and analysis, please go to the Bonddad Blog.

Here is a link to the Big Picture Blog.