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Friday, November 23, 2007

Not Just Subprime, And Not Just American

While it's true that the Fannie/Freddie guaranty losses are causing digestive problems for investors everywhere, other RE companies in Europe are having similar problems. This week French banks had to bail out CIFG Guaranty, a firm owned by French banks. These bailouts will continue. Another UK property fund (mostly commercial) is limiting redemptions:
The change in policy at M&Gā€™s offshore UK property fund ā€“ which affects only institutional investors ā€“ is the latest sign of a growing crisis gripping the real estate sector.

Mark Dampier, of financial adviser Hargreaves Lansdown, warned last night that the move could herald a more widespread panic. With listed property shares in freefall, many investors have been withdrawing money from unlisted vehicles.
Most of the figures given for losses at banks involve direct losses from subprime residential mortgages, but ignore the knock-on effects of guarantees, swaps, insurance and the inevitable rollover to prime or Alt-A. For the largest financials, there is additional exposure in the form of directly owned investments in residential and commercial mortgage-related companies, as well as in the various types of insurers.

Because many of the same companies wrote insurance for municipal bonds, there is a further ripple effect. Many investors are now seeking insurance from another company, which is causing the derivative market as a whole to grow very rapidly.
The market for derivatives grew at the fastest pace in at least nine years to $516 trillion in the first half of 2007, the Bank for International Settlements said.

Credit-default swaps, contracts designed to protect investors against default and used to speculate on credit quality, led the increase, expanding 49 percent to cover a notional $43 trillion of debt in the six months ended June 30, the BIS said in a report published late yesterday.
516 trillion dollars. For comparison, US GDP is under 14 trillion. Minor problems in just the credit swaps portion of this market are capable of inflicting unimaginable financial losses.

Europe has problems with its own real estate bubbles in quite a few countries, but investors in Europe have also gone hog-wild on junk corporate bonds and speculative trading in credit default swaps. Some Euro companies were doing very well with infrastructure and capital investments in various EM (which include the escapees from the Soviet bloc) countries. However, the bulk of the financing for the investment in those countries came externally, from financial companies and investment funds in Europe, the US and elsewhere. And much of that financing was sold off to investors with the theoretical underpinning of dubious guarantees.

It's very doubtful whether many of these EM countries have reached the self-sustaining point that would allow payments on these debts to be funded from their own internally-generated profits. Instead, these countries are dependent on a continued flow of external investment capital.

The breakdown of many of the currency carry trades, as well as the problems with risky debt, are a huge threat to these continued flows of capital. The plight of EADS (Airbus) is just one example of the problem.

That is the global story.

The problems with the credit system in the US evolved from combining insurance with banking and poor credit-granting practices. The repeal of Glass-Steagal in the 1990s allowed banks to get into these lines of business and produced a level of correlated risk not present in the banking system since the Great Depression. But it's critical for everyone to understand that the same thing was being done by financial companies globally, and has created the same risks.

To bring the story back to the shores of the US, let us use Goldman Sachs as an example. Goldman, like other companies in the securitization business, has direct investments in companies involved in the business. There was an incestuous nature to the development of widespread prime and no/low doc Alt-A that is going to cause major losses in the underlying companies, which will eventually show up in the balance sheets of the holding companies.
Go to Edgar's full text search. Choose the advanced option. Enter GSAMP in the text block, and select FWP as form type. You will get a list of FWPs for Goldman's trusts (under Goldman Sachs Mortgage Company). Only by reading these things can you get an accurate understanding of the risks and correlations. Let's look at the FWP dated 1/26/2007 for GSAMP 2007-NC1.

At S-42 we see that the loans came from New Century (a new breed of blue chip, now bankrupt). After an episode of hearty laughter generated by reading New Century's underwriting guidelines on S-44 and S-45, we proceed onward reading information about servicing, which is handled by New Century and Avelo:
Avelo, a Delaware limited liability company, is a wholly-owned subsidiary of
Archon Group, L.P., which is a subsidiary of The Goldman Sachs Group, Inc., a
publicly traded Delaware Corporation (NYSE: GS). Avelo is an affiliate of the
depositor, the sponsor, the swap provider under the interest rate swap agreement
and the cap provider under the interest rate cap agreement. Avelo began mortgage
loan servicing operations by boarding loans in December 2005, and activated its
first mortgage loans in January 2006.
The FWP filed 2/08/2007 will give you more information about Avelo, and I think anyone who knows anything about mortgage servicing will get another hearty laugh out of stuff like this:

Transferred servicing of seasoned high delinquency rate assets from             GMAC Mortgage to Avelo              o     797 assets transferred in June                   ------------------------------                    GWAC                       10.22                   Avg. UPB                 $47,244                   Age                           89                   LTV                           81                   FICO                         580                   % v = 30 days delinq       23.50%              18 in foreclosures and 34 bankruptcy assets
It turns out that Avelo seems to have started its operations by buying junk mortgages cheap and trying to make money off of them. More on Archon here.

Going back to our original FWP, in case you are wondering about the identities of the swap and cap provider, on page S-55 you discover:
The interest rate cap agreement and the swap agreement will be provided by Goldman Sachs Mitsui Marine Derivative Products, L.P., a Delaware limited partnership ("GSMMDP," the "Swap Provider" or the "Cap Provider"). GSMMDP is primarily engaged in the business of dealing in derivative instruments. GSMMDP has a counterparty rating of "Aaa" from Moody's Investors Service, Inc. and a credit rating of "AAA" from Standard & Poor's Ratings Services, a division of The McGraw-Hill Companies, Inc. GSMMDP is an affiliate of the sponsor, the depositor and the underwriter.
In other words, GS Mitsui Marine is also a subsidiary of Goldman Sachs. They aren't insuring the credit here, though, so they aren't going to take a big loss.

Deutsche Bank (S-54) is the custodian of the mortgages. Recently there has been much wild yammering about a case in which DB tried to foreclose on some mortgages without actually having taken assignment of the underlying mortgages at the time it filed the action. (See Tanta.)But DB is a pretty good outfit and it will correct that and refile. The custodian is the party that has the actual mortgages physically in its possession. We certainly hope that DB's custodian operation is strong, because let's face it:
This concludes today's rendition of stupid things you can do with credit. Remember, it's not the fall that hurts, but the landing.

Comments:
Hello, nice post.

Banking losses are irrelevant. The same criminals who are running the banking system now will be running it ten years from now. There will be no high profile prosecutions, because they are meaningless anyway. We have neither a democracy nor free markets.
 
I remember reading a quote from an American economist named Morris Sachs on Bloomberg years ago. He said "It's not a crash till it hits something"

Just read on C.R. The first CPDO has blown. We discussed these in a risk meeting several months ago, and it was at that moment I knew the world had gone mad.

Drove in to Soho from Greenwich in 45 minutes. Don't care what the stats show for retail today. Nobodys here.
 
Heh, heh, I wonder what that Morris Sachs guy would say now?

I thought everyone knew those CPDO's were like icecubes dumped on a lawn in summer - they just couldn't stand sunlight. Bundled credit swaps, what a glorious investment.

Edgar - no, we have a democracy and a free market to some extent. What's going on now is what was happening in the 1920s. This is what the lack of meaningful regulation causes!
 
Hi MOM,

If everything is above board then the system will crash. I don't think they even count the money anymore. The SEC is a joke, the fed and the gubbermint will prop up banks and let the criminals continue to run things. I respectfully disagree, the only people who will suffer are those who didn't get their millions from criminal enterprises on Wall Street. I will wait and see, but nothing bad will happen, it never does, they just change the, er, (chuckles), rules. heh, heh.
 
I believe that Mitsui Marine & Fire Insurance is a wholly owned subsidiary of Mitsui Sumitomo Insurance Co. Ltd.

I hope that your research on the GS Mitsui entity doesn't mean that the Mitsui or Sumitomo keiretsu's are the ultimate bag-holders for that mess.
 
I'd have to check. The point I wanted to make here is that it is extremely hard to figure out who really will be affected by losses.
 
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