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It is impossible to open the financial press without reading references to toxic debt, overborrowed financial institutions, short sales and related issues. Brian Malone provides some insight into these topics and their contribution to the credit crisis.

Collateralised Loan Obligations and Toxic Debt If anything has come to characterise the current financial crisis it is Collateralised Loan Obligations (CLOs) and related Asset-Backed Products. Google ‘toxic debt’ and most hits include a reference to CLOs. Getting this toxic debt out of the banking system so that it can start to operate effectively again is the main focus of the US Federal Reserve’s rescue package. While it is easy to mention CLOs and Toxic Debt in the same breath, Asset-Backed Securities come in many shapes and forms, not all of which are toxic.

In the airline industry they represent loans backed by identified aircraft and related spare part inventories; at the other end of the scale they represent loans backed by real estate mortgages or credit card debt backed by no realisable security. The evolution and operation of the asset-backed security market is worth exploring and, since it is topical, the subprime mortgage market will be used as an example. Retail banks in the US issued mortgages to individuals; these mortgages were grouped together and sold in bulk to investment banks that consolidated them into Special Purpose Vehicles or similar entities. Interests in the complex capital structure of these entities were sold to investors under the general CLO label. Cash flows from the better quality loans funded the preferred capital and the cash flow from the high-risk subprime mortgages supported the equity return. Each level in the capital structure represented a different risk profile and produced a different cash flow, e.g. some tranches contained interest only mortgages, others carried the pre-payment risk of early redemptions or the default risk on the first 5% of mortgages to fail. Spreading the risk across multiple borrowers was supposed to reduce the overall risk profile.

The principle behind Collateralised Loans is simple enough and the market started in the late 1980s. Soon the complexity and permutations of the resulting products became mind boggling as firms offering CLOs struggled to keep up with the demand for highly rated fixed income products. CLOs were further packaged into other more complex products and an active secondary market developed so that investors could quickly enter and exit the market at short notice. However, two serious flaws developed as a result of bad market practice. Additionally, the existence of Freddie Mac and Fannie Mae, as mortgage lenders of last resort in the US, managed to keep a leaky ship afloat long after it was unseaworthy. The first flaw was that lending standards at banks originating loans deteriorated significantly. There are stories about lending in excess of 120% of the asset value and one bank briefly offered a 60-year interest only loan. An entire vocabulary of acronyms developed to describe some of these loans, e.g. NINA (no income no assets). In the US, regulatory safeguards exist to prevent this reckless lending but were not enforced. The banks’ ability to offload these mortgages and associated risks contributed to the deterioration in standards and freed up capital so that they could make more such loans as part of a temporarily self-sustaining process. The second fault was that to appeal to hedge funds and institutional investors the CDOs needed a favourable credit rating. This was provided by rating agencies such as Moodys and Standard & Poors. These agencies gave the special purpose vehicles a rating that bore no relationship to the risk profile of the underlying assets. To quote Barack Obama: “You can put lipstick on a pig but it’s still a pig.” Since the rating agencies were paid by the institutions that packaged CDOs, they had a serious conflict of interest.

Leverage Leverage is the attempt to increase investment returns by using borrowed funds. For example, if equities can generate 8% and cash can be borrowed at 5%, an investor can have an excess return of 3% by borrowing and investing the proceeds in equities. The use of leverage by institutional investors is widespread but there are no free lunches in the investment business. Loans come with strict conditions and lenders can demand a return of funds if any of the conditions are breached. Typically terms require the investor to use some of its own cash and maintain an agreed loan to asset value. There is a serious dislocation in the time horizon of the borrower and lender which oftenunravels an otherwise sound investment strategy. Investments purchased by borrowed funds are typically medium or long term; loans are short term, often overnight, and can be recalled at any time. Borrowers rely on being able to constantly roll over loans at favourable rates. When markets are liquid investors can usually obtain funds, but when they are over-stretched they often have to sell into a falling market to cover their loan obligations. Leverage itself is neither inherently good nor bad. The use of leverage in a properly risk-managed environment allows investors to increase their potential returns. However, the over-use of leverage and the failure of levered investors to have sufficient cash reserves has resulted in many spectacular failures, the most notable of which almost brought down the US financial system, i.e. Long Term Capital Management (LTCM) in late 1998. Following the collapse of LTCM the President’s Working Group on Financial Markets stated: “The central public policy issue raised by the LTCM episode is how to constrain excessive leverage more effectively.” Since then there have been a number of equally spectacular failures indicating that the problem has not gone away. It is not just hedge funds that have highly levered business models. Goldman Sachs and Morgan Stanley were reported to have highly levered businesses before this backfired and forced them to change their corporate status in order to survive.

Short Selling Short selling is a practice whereby an investor sells an investment he doesn’t own in the hope that its value will fall by the time he has to deliver it to the buyer, thereby profiting from the fall in price. Although most of the media coverage concerns short sales of equities, it is possible to short many financial instruments including bonds, treasuries and most derivatives. In the majority of developed markets, an investor wishing to short sell must borrow the investment prior to making the short trade. Since many large pension funds, brokerage houses and index trackers hold stock that is infrequently traded, they are often the best source for stock borrows. The mechanics of short selling are similar to leverage in that the borrower must provide the lender with adequate collateral and is charged a borrowing fee. The harder it is to borrow a stock the higher the borrowing costs. Rates can be changed often with little notice and the stock can be called back at any time forcing the borrower to either buy back the share or find another lender at short notice. Shorting carries other risks; if it becomes obvious that certain shares are the target of short sellers, the market can create what is called a ‘short squeeze’ by bidding up these prices and forcing the short sellers to cover their positions, frequently at a loss. Therefore the decision to short is more complex than the simple identification of an overvalued investment; it is necessary to factor in the requirement to borrow the share and the cost of doing so over the investment time horizon coupled with the risks of a short squeeze or a recall by the lender. The twin requirements of cost and the need to find a lender have encouraged the practice of naked shorting where investors sell shares without first finding a lender but rely on their ability to buy the shares back before settlement date. Naked short selling is illegal in most developed markets but a recent SEC focus would suggest that it is alive and well in the US and probably elsewhere. Short selling of financial shares has recently been banned in many markets, including Ireland, the UK and the US, the practice having been condemned as market manipulation by many, including the Church of England. This view is common but not universal and The Economist noted that once short sales of UK financial services companies were banned the market became less efficient. Short selling has put weak banks under further strain but there is little evidence that short selling had any role in precipitating the current crisis.

Conclusion While the history of financial services is littered with shady practices, conflicts of interest, bad products, regulatory failures and outright fraud, seldom before have these issues had a global impact. Even the collapse of Long Term Capital Management barely impacted Main Street and in any case was over before most people knew it had happened. It is tempting to think of CLOs in this light and ask how a single product could bring about a global credit crunch. The answer lies in the sheer size of the problem (the cost of the rescue is estimated at 8% of US GDP and almost 17% of UK GDP) and its global nature – toxic debt was held by almost every nation. The biggest 3 holders are the US, the Euro zone and Japan with a combined 62% of an estimated $145 trillion in toxic debt. Once the housing market started to turn down, the cash flows backing the CLOs stopped and the secondary market dried up. With no one buying CLOs, banks originating mortgage loans were left with them on their own books. This meant that banks were less prepared to provide funding to the housing market and other sectors of the economy that rely on easy credit. The downward spiral began as the economy retracted and more loans defaulted, cutting into retail bank reserves and further limiting lending. Since the capital base of many major investment banks has been eroded by their toxic debt write-downs, their ability and willingness to lend to each other in the overnight market has largely evaporated and the credit crisis will continue until a way is found to encourage banks to start lending again. The overzealous use of leverage by individuals and financial institutions contributed to the ultimate size of the problem and the speed at which the credit market seized up once the inevitable slowdown in the housing market started.

Finally, history is unlikely to treat kindly those whose task it was to regulate lending practices and failed to do so.

Brian Malone, FCA, is Chief Financial Officer with Kellport Capital Management, a private investment firm based in Boston. USA specialising in credit-focused hedge funds and fixed income products. Prior to moving to the US he worked in a variety of financial services roles in London and Guernsey.

This is an incredible insight to our current economical situation and describes in detail the how and why of our credit crunch