CDOs in Australian council portfolios

I wrote this email in August 2005 to Janet Tavakoli, the supposed CDO guru, because I was concerned that Australian councils were buying CDOs and had no idea why. If only she'd shown a little more encouragement....

> From: Janet Tavakoli [mailto:jt@tavakolistructuredfinance.com]
> To: 'Jonathan Shapiro' [mailto:jshapiro@insto.com.au]
> Sent: Wed, 31 Aug 2005 21:32:07 +1000
> Subject: RE: CDOs in Australian council portfolios
>
> As a matter of policy, I do not provide information - other than what is
> available on my web site - to non-clients. Good luck with your research.
>
> Janet Tavakoli
> President
> Tavakoli Structured Finance, Inc.
> 360 E. Randolph St., Suite 3007
> Chicago, Illinois 60601 USA
> (312) 540-0243
> e-mail: jt@tavakolistructuredfinance.com
> web site: www.tavakolistructuredfinance.com
>
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> -----Original Message-----
> From: Jonathan Shapiro [mailto:jshapiro@insto.com.au]
> Sent: Wednesday, August 31, 2005 1:24 AM
> To: jt@tavakolistructuredfinance.com
> Subject: CDOs in Australian council portfolios
>
>
> Hi Janet,
>
> I am e-mailing you from Sydney in Australia. For the past two months, I have
> been researching CDOs and structured credit products as we are hosting a
> conference on High Yield investments and are planning to host a training
> course on synthetic CDOs. I have made extensive use of your website and have
> come across a number of articles in which you have been used as a key
> source, so as far as I am concerned- you are my CDO guru !
>
> For the past few days, I have been ringing up middle market investors from
> the local councils. Most of the councils have investment portfolios of 30
> million Australian dollars (approx 22.5 million US). The councils adhere to
> local government guidelines which advise what they should invest in. As far
> as I understand it recommends that the councils should not invest in assets
> that are rated lower than A-.
>
> I have come across a number of councils that have a large portion of their
> portfolios invested in CDOs. One council said that they had 90% of their
> portfolio in CDOs, while others had 30-40%. Many did not invest in CDOs.
> Technically, they are allowed to invest in CDOs as their ratings fall within
> the guidelines.
>
> I asked why they invested in CDOs and many said they could not find the
> returns they wanted in other investments in those credit rating categories.
> I al I also asked who advises them and a name that came up quite often was
> the name of a local investment bank that structures CDOs, and other
> investment advisers that 'actively encouraged' investment in CDOs .
>
> My questions are: Does the rating agencies accurately reflect the risk ?If
> they don't, this is of great concern. What are the basic risks of CDOs? ie
> what can really go wrong ? are they correlated ? Is it prudent to hold such
> a high proportion of CDOs in a portfolio, especially a portfolio of public
> money. Have the risk models of the rating agencies changed since Enron?
>
> Also are US councils large investors in CDOs ?, do they have to adhere to
> mandates and do US council finance managers possess strong financial
> knowledge?
>
> I am also sceptical of the financial knowledge of these council finance
> managers and the conduct of investment banks in promoting CDOs and acting as
> advisors. Perhaps I am overstating the risks of CDOs and understating the
> abilities of the rating agencies.
>
> Although we are a financial services publication, whose strength is in
> capital markets, following up on these issues are not really in our
> interest. We have a close relationship with many of the banks who are
> involved in our events and for the most part we service them by providing
> them with information on fixed income markets. However I would be interested
> to understand the role of CDOs in public portfolios and would be very
> interested to hear your opinions on this matter, if you have an opportunity.
>
>
> Kind regards,
>
> Jonathan
>
> ================================
> Jonathan Shapiro
> Research Associate
> insto
> Level 6, 67 Albert Avenue
> Chatswood NSW 2067 Australia
> t +61 2 9004 8613
> f +61 2 9004 8699
> m +61 401 605 640
> e jshapiro@insto.com.au
> w www.insto.com.au
> ================================
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Watching financial markets armageddon

My weekly credit update on September 19, 2008, the most infamous 7 days in the history of finance. We sat on the trading floor in amazement as everything seemed to implode. 

Some moments I'll remember during that week: seeing the bright red text flash up on my Bloomberg terminal 'LEHMAN BROTHERS FILES FOR CHAPTER 11 BANKRUPTCY' and pondering the chaos those words would unleash;and watching the HBOS stock price with the traders late one night, I ducked off to the toilet. In those two minutes, the bank lost half of its GBP12b market value, and got it all back when news of a bailout from Lloyds emerged - the world had gone mad ! 

I got really afraid when the trading floor received an email telling us, in essence, to hold off on doing any business with Macquarie Bank. Could the bank down the road really be on the brink of collapse ? What the hell was going on!! The embargo was brief, if at all, and Macquarie is battling on but in that environment of sheer panic, no one knew who to trust. 

Weekly credit update from the Syndicate desk as follows…in case you missed it!! 

Sheer terror gripped financial markets this week as some global financial heavyweights met their end.  The drama began after midnight on Monday when the Fed declined to step in and save Lehman Brothers, forcing the 158yr old firm into bankruptcy. As Lehman’s fate was sealed, Bank of America snapped up a nervous Merrill Lynch. 

Insurance giant AIG, with its global web of interests was deemed too big to fail. It was saved from collapse at the last minute by a US$85b Fed package. In the UK regulators hastily arranged a £12b tie-up between HBOS and Lloyds, following the collapse of HBOS’s stock.

Markets went mad with massive movements in anything tradeable. Swap spreads and short term lending rates spiked as banks hoarded cash, forcing Central banksto inject funds. CDS spreads gapped as traders frantically reacted to headlines. Globally, investors shunned risk seeking refuge in Govt Bonds and gold.  Australian markets felt the pain, with banking stocks heavily sold off. Macquarie Bank’s senior CDS traded at unpresedented wides (+1000) as its stock price plummeted.

With financial markets in chaos, shortsellers were relentless; targeting ailing names such as WaMu and the brokers Morgan Stanley and Goldman Sachs.   Despite their apparent liquidity, firms such as Morgan Stanley realised that their fate is not in their hands, but in those of their counterparties.

Once the dust settles, attention will turn to the disposal of assets, and dealing with the headaches created as the intricate web of structured credit exposures are unwound. All eyes will be on policymakers, who will be instrumental in coordinating short term fixes and setting long term guidelines as global banking enters a highly regulated future.

The future of credit markets

My career as an Investment Banker was short-lived but long enough. Here is an internal note I sent out on my final day at ANZ, on how I saw credit markets shaping up in 2009.

Global outlook




The year 2008 was characterised by unprecedented involvement in financial markets by governments. Given the extent of their action this year, their involvement in insuring markets are able to function will increase in time and scale in 2009.




As fiscal stimulus packages and rate cuts work through the system some element of confidence should be restored. Demand for commodities may rebound as state sponsored infrastructure projects get underway, but it may not be as early as 2009.




Credit markets will remain challenged until the US housing market recovers, the US consumer starts spending again and market volatility is reduced. More importantly, the banks have to face up to their losses, both in their books and in their mentality, before a true recovery can begin.  

  
Offshore primary markets will be dominated by government guaranteed bank issuance, with a flood of supply anticipated as banks refinance debt. The key dynamic will be the interaction of GGBs and sovereign debt as governments ramp up their borrowing programmes to fund deficits.




The pros and cons of various sovereign guarantees will become clearer and the French system will emerge as a clear winner. By issuing bonds from a single entity the French government is able to issue larger volumes (and liquidity for investors) at tighter spread. The same outcome, which is to provide banks with access to funds, is achieved at a lower cost. The Government is also better able to coordinate the process and phase it out when banks are able to raise their own debt, and banks have scope to raise funds independently through the existing un-guaranteed market. 




While other steps taken in 2008 were implemented to reduce systemic risk, there will be some adverse consequences, Do government balance sheets have sufficient capacity to underwrite bank losses and guaranteeing bank debt? Are governments able to assume an increasing role in overseeing financial systems? Will they find the middle ground between over-regulation impeding private sector growth and under-regulation encouraging excessive risk taking? The strain placed on governments to guarantee banks and the effects its creation has had on semi-governments and agencies means that for the time being, there will be no such thing as risk free security.




Significant supply from true corporates looking to refinance is also expected to keep the cost of debt wider. The market will remain closed for many, forcing them to raise funds through either equity issues or reduced dividends. This is fundamentally positive for investment grade credits. Refinancing however will prove too onerous for many debt laden high yield issuers and we will see more defaults.




In the banking sector, hasty mergers have now created institutions that are too big too fail, and as time passes they may be tempted to take on more risks. If governments are to ensure their bailout is effective and long standing, they will have to carefully manage the behaviours of banks to ensure they are acting in the long term interests of all stakeholders, including ‘passive’ tax payers.




‘Mega banks’ credit policies will also decrease the efficiency of capital allocation. Regional lenders have historically proven to be far more effective in determining credit worthiness but larger banks will systemise credit processes potentially limiting access to capital for worthy borrowers.

  



The dark horse is geopolitics. China’s economic downturn is causing increasing social unrest. India and Pakistan remains a hotspot, fluctuating oil prices is resulting in meddling and Russia continues its brinkmanship towards the West. While threats are not immediate, rising tensions could impede global capital flows. A more likely outcome will be trade tariffs as governments seek to protect key industries and source access to vital inputs.




Domestic outlook




Credit markets will remain volatile and illiquid. Cash markets will continue to suffer as the pool of ‘investable’ fixed income has been substantially reduced by redemptions and rebalancing into equities.

Real money investors will continue to exhibit caution, favouring cash and more liquid assets to avoid distress selling. 'Cash Plus’ funds faced heavy redemptions and we do not expect them to return as buyers in the near future. The flight to safety will manifest itself in an increase in deposits rather than a reallocation from equities to fixed income.




Whilst corporate bonds have and probably never will offer such attractive risk adjusted returns, only a handful of funds will be in a position to capitalise on wide spreads. This will keep the cost of borrowing high and prohibitive, forcing those in need of funding to turn to equity markets. 




Credit is yielding equity like returns and one solution to the current misallocation of deployable capital in credit markets is to entice equity funds to examine the opportunities in credit markets.  The returns are as attractive, and investors are being rewarded for holding the assets.




Bank balance sheet investors will remain the most active investors, underpinning demand for repo-eligible securities. These investors are likely to drive primary markets supply. Their participation in credit markets however resembles nothing more than an elaborate paper shuffle as banks swap paper that allows them access to RBA cash. Internal securitisations too, which has transformed billions of dollars of mortgage loans into securities that are in a format palatable for the RBA have no true economic rationale. Until such time that external funds enter the system, credit markets here will remain challenged.  




Ironically the fate of regional banks lies in the hands of bank balance sheets. If the premium regionals can afford to pay to issue guaranteed (and un-guaranteed) bonds is attractive enough for bank balance sheet and real money investors, they will be able to be able to access capital markets. If not, we may see some consolidation. Early signs are encouraging as Suncorp and Macquarie were able to issue guaranteed debt, albeit at high spreads. The danger is that their desperation for funding at any price, will push up the cost of funds for the major banks.




The key to the survival of smaller regionals is deposits and with most of their holdings being less than A$1m, they can offer free insurance to their customers. Old fashioned banking and servicing customers may ensure they survive by funding through deposits, shored up by the government guarantee.




The major banks will experience some losses in their corporate and mortgage portfolios, and face higher cost of funds, but will be compensated through decreased competition. Capital raisings are likely as the Tier I bar is raised, benefiting credit investors at the hands of shareholders.




The advent of the Government guarantee will create ‘the new semi’. Australian debt markets have made room for semi Government bonds ie a quasi government risk with a yield pick up. The issuance of bank debt with a government guarantee will create a new curve sitting above its more liquid semi cousin. Unfortunately semi governments are now in effect subsidising the banks as their funding costs have spiked at a time when they need to up their fund raising, due to the competition from the guaranteed sector. Unless modifications to the wholesale guarantee are made (adaptation of the French issuance model could be one) banks will capture funding from semi governments. Political factors may impede aid to the semi governments as the Federal government may not want to be perceived to jumping to the aid of Labor states.




So what is the future of credit markets in Australia? Not very bright given pressures on both supply and demand. The true corporate bond market has hardly existed since well before the credit crunch, lack of liquidity in the RMBS market is keeping investors hesistant, and wide secondary spreads are pricing primary bonds out of the market. Structured credit had only received support from middle market investors, who have been badly burnt and both insto and retail investors have found out that hybrids are equity dressed up as debt. Added to that are the losses, redemptions and reweightings that have  impaired our bond funds. It might be some time before our credit markets have regenerated, and are once again vibrant and thriving.