The Unwinding of the Credit Bubble

Understanding the Problem and its Implications

Rich Carona
HBS Alpha Fund
11/5/2008
 Table of Contents

„ Subprime Mortgage Crisis

– Underlying Causes
– Magnitude of the Crisis

„ Broader Credit Bubble

– Other Assets that Mirror Subprime
– Nature of Credit Cycle
– Contagion
– Risk Dispersion Myth
– Excess Liquidity Myth

„ Possible Outcomes (Just Musings)

 Subprime Mortgage Crisis
The Roots of the Crisis
„ Subprime mortgages were originated, securitized and packaged in a complex,
“innovative” process that had inherent conflicts of interest at every stage
• Mortgage originators (e.g., Countrywide) compensated on (a) size of mortgage and
(b) level of complexity. They have high incentives to make transactions happen
Origination
• These incentives led to many dubious financial “innovations”, including interest-only
loans, two-year ARMS, teaser rates, no-doc loans, 100% loan-to-value
• Sales practices ranged from highly deceptive to outright fraud

• Originator holds loans for very short periods; quickly sell pools of mortgages to
Securitization investment banks that package mortgages into even larger pools of mortgages
• Investment banks earn heavy fees; and also hold mortgages for only short period

• Banks sell to other banks or issuers of structured finance products (CDOs, CLOs)
Creation of
• RMBS (form of CDO) takes large pool of securitized mortgages and create tranches
RMBS with different risk and return characteristics
• Rating agencies (Moody’s, S&P) rate each tranche. All tranches are investment grade
and range from AAA to BBB; highly lucrative for rating agencies

• Structured finance firms retain residual equity interests, but otherwise sell each
Sale to tranche to investors, earning very high fees
Investors
• RMBS securities are highly opaque; information available may only include yield,
maturities, vintage year, and some statistics about structure of mortgages
• Investors rely heavily (or almost entirely) on ratings
 Subprime Mortgage Crisis
Economics of CDO’s
„ CDO’s divide collateral pools into tranches that have different levels of
risk via loss exposure and corresponding return
Tranche
Key Assumptions: (By Rating) Thickness Support Est. Return
Yield on Collateral
Pool = 6.25% Remaining 20% Libor+50bps
80%
Expected default
rate: 5 to 7%
Recovery: ~75% AAA

AA Next 6% 14% Libor+125bps

A Next 5% 9% Libor+175bps

BBB Next 5% 4% Libor+250bps

Equity First 4% 0% Approx 15%

 Subprime Mortgage Crisis
Key Causal Factors
„ Rising home prices create false sense of security on part of homebuyers
and mortgage investors
– Assumption that house could be sold for higher price, mortgage refinanced
– Implies that value of collateral mitigates any borrower-specific credit risk

„ Low global interest rates, razor-thin spreads cause people to “stretch for
yield”
– Massive demand for highly-rated securities with the yields of low-rated debt

„ Ratings agencies play central role in the mispricing of CDOs

– Conflict of interest: immense profits from structured finance boom
– Flawed methodology: dogmatic reliance on historical default data as predictor of risk

„ Robust credit analysis on collateral pools is challenging, so many investors

decided not to do it
– Highly opaque collateral pools – what do I actually own?
– Unsophisticated investors decided to rely primarily on credit ratings for risk assessment
– Structured finance new, complex, untested in down cycle

„ Every link in value chain compensated by transaction fees or management

fees – huge incentives for size and speed, no incentives for quality
 Subprime Mortgage Crisis
The Catalyst for Default
„ Many mortgages were sold with two-year “teaser rates” that then adjust to market
rates, which now are 10% to 12%, making them unaffordable for borrowers

„ $750 billion of subprime are expected to reset in next five years, with vast majority
from now until late 2008
 Subprime Mortgage Crisis
How Large is This Problem?

„ $3.2 trillion of subprime mortgages „ $500bn purchased by CDOs since 2004

originated in last ten years
„ Credit Derivatives issued against CDOs are
„ $1.0 trillion issued in 2006 and early estimated to be between 10x and 100x
2007 – most challenged credits underlying securities
 Subprime Mortgage Crisis
Subprime RMBS Trading Prices
„ 2006 and 2007 vintage pools are experiencing massive defaults (~15%), with low
recoveries (<50% per unit)

„ Junior RMBS tranches trading at 20 cents on dollar

 Subprime Mortgage Crisis
Subprime RMBS Trading Prices
„ Remarkably, AAA pools, previously thought impenetrable, are trading at
80 cents

„ This is almost unprecedented and causing major disruptions to the

banking system
 Unwinding of Credit Bubble
This problem is not “contained” to Subprime
Leveraged Loans and Commercial Real Estate
have similar dynamics

Leveraged Loans
Commercial Real Estate
(LBO Debt)

„ Massive demand from CLOs: „ Aggressive bid from CMBS and

$300bn of CLO issuance since CDOs
2004
„ Transactions being priced at
„ $550bn of leveraged loan >100% Loan to Value
issuance in 2007, up 60% from
2006 „ Cash flows unable to finance debt
service (borrow to pay interest)
„ Covenant Lite / PIK Toggle
„ Massive appreciation in
„ Massive dividend recaps commercial real estate values =>
Yield on U.S. Real Estate Index
„ Overly optimistic credit for “pro fell from 8% in 2002 to low of
forma” cost savings 2.7% in early 2007
„ LBO purchase price multiple
expansion: Avg EBITDA Mult. Of
6.1x to 9.0x in five years

„ Avg Debt / EBITDA mult. from

4.6x to 7.5x in five years
Source: Pershing Square presentation “Who’s Holding the Bag?” May 2007
 Unwinding of Credit Bubble
The Credit Cycle and Its Impact on Asset Prices

Virtuous Circle (2002-2007) Vicious Cycle (2007 - ?)

More Buyers
Fewer
At Higher
Buyers
Leverage
• New vehicles • Some structures
(LBOs, hedge collapse
funds, CDOs)
• More equity
Easy • Little equity Rising Tightening needed Falling
Credit necessary Asset Prices Credit Asset Prices
• Difficult to
fund-raise
• Tightening • Spreads widen
spreads • Home prices • Focus shifts to risk
• High LTV up 15% per as investors feel
Perception
year “burned” Defaults
• Financial of Low
•Comm RE Cap Rise
“Innovation” Default Risk • Banks are over-
Rates down extended; can’t offer
•Rising prices, from 8% to 3% • Problem credits
new loans
high cash flows can no longer be
and ability to • LBO Multples refinanced
refinance lead from 6x to 9x
• Cash flows
to few defaults •Small caps up deteriorate
20% per year
 Unwinding of Credit Bubble
Contagion
„ The presence of “bad assets” that decline sharply in value can cause declines
in value of “good assets”

„ Contagion is caused by three factors:

– Levered vehicles or vehicles facing redemptions sell what they can sell, not what they want to.
“In times of crisis, all correlations go to one”
– Market psychology shifts from greed to fear
– As prices fall in Asset Class A (leading to higher expected returns), Asset Class B must adjust to
be competitive

• Hedge fund exposed to sharp decline in subprime needs to raise

Quant money to meet margin calls. Sells relatively liquid equities that are Goldman
Unwind held by quant funds, covers shorts positions also held by quants. Hedge Funds
• Quant fund models do not anticipate this. Suddenly, undervalued down 30%
equities fall, overvalued equities rise. Early quant funds see this, in first week
close positions. Other quant funds (levered 6x) must move to all in August
cash to avoid insolvency

Bank Loan • CLOs, CDOs hold subprime mortgages; badly burned in July; demand for
CDOs dries up
Index
• BUT… CLOs are the biggest buyers of LBO debt; banks have $300 bn of Bank Loan
commitments to fund LBO debt in fall months Index Falls
• Anticipating massive new supply, secondary market bank loan index 10% in
(LCDX) trades to 90-92, compounding problem August
• Other fixed income asset classes (e.g., HY, CMBS) must adjust
 Unwinding of Credit Bubble
The Myth of Risk Dispersion
„ A common perception is that structured finance allows risk to be dispersed broadly
to diversified entities, which lowers the probability of financial crises
„ In previous cycles, banks held all the credit risk. When credit cycled turned, their
solvency was threatened, making it extremely difficult to provide new loans, leading
to multi-year hangovers

In this cycle, banks have been the facilitators of risk-taking rather than
the holders of risk…but in downside scenarios, the risk ultimately
returns to their balance sheets

„ Banks have large exposure to the senior tranches of CDOs, CLOs

„ Banks extend massive amounts of credit to hedge funds
– Three banks make up 60% prime brokerage market
– Example: Merrill Lynch seizing assets from Bear Stearns hedge fund

„ Banks have enormous exposure to credit derivatives, and lack the infrastructure to
adequately measure those risks
– Examples: $8bn loss at Merrill Lynch only rose to surface one week before announcement

„ As they have tried to make markets in derivatives, Banks have morphed into
propriety trading vehicles, speculating in equities, fixed income and derivatives
– Thus, they are long the same securities as their clients, making them highly reluctant to call in margin loans
and force hedge funds to mark-to-market their positions

„ Banks have contracted to be last-resort liquidity providers via back-up credit lines to
SIVs, but aren’t adequately capitalized to do so
– Example: Citigroup may need to raise $30bn in equity capital
 Unwinding of Credit Bubble
The Myth of “Excess Liquidity”

From Howard Marks (Chairman of Oaktree), “It’s All Good…Really?”

„ “Most explanations of the financial dynamism of the last few years have centered
on…‘excess liquidity’…But where does excess liquidity come from? Not from more
currency. The amount of currency in the world is somewhat fixed, and each person’s
receipt is another person’s expenditure. I think the “L word” that should be
focused on isn’t liquidity, but leverage.”

„ “A decade or so back, the ability of parties other than the Fed to increase the
leverage in the system was limited. Margin debt for purchases of stock couldn’t
exceed 100% of an investor’s equity, and bank loans likewise were restricted to a
multiple of capital.”

„ “But in recent years, some new factors have meaningfully changed the picture,
including derivatives, hedge funds and non-bank lending. These have negated
the old limits and made vast amounts of leverage available to investors and
asset buyers.”

„ “This leveraging up was the greatest single element in the asset surge of
the last few years. In fact, the breadth of the gains tells me we didn’t have an
“asset bubble,” but rather a “leverage bubble.”
 Unwinding of Credit Bubble
Range of Possible Outcomes
Soft Landing
„ Housing market continues to weaken, but prices
decline only modestly or remain flat
„ Fed continues to cut rates to soften housing
market
„ International economies / emerging markets
have truly “decoupled” from US, leading to
strong demand for US exports
– Softening US consumer does not impact export-
dependent Asian economies
„ International capital continues to flow into US,
keeping spreads tight and underlying bid for
troubled assets
– e.g., South Americans and Europeans buy Miami
condos
„ Excesses curbed from structured finance, hedge
funds, and derivatives but “trust” returns
„ Weakening dollar supports economy without
stoking inflation or major decline in currency
value
Hard Landing
„ Massive oversupply and tightening credit lead to
sharp multi-year downturn in home prices
– 2 to 4 million Americans lose their homes in Subprime
crisis, prompting regulatory response
„ Severe credit tightening leads to rapid decline in
asset values
– Real estate, financials, consumer/retail, small cap
equities most vulnerable
„ Softening economy weakens employment,
hurting consumer demand
„ Corporate default rates rise; numerous
bankruptcies in financial sector; need for equity
infusions in large banks; several large cap PE
deals see distress
„ Structured finance and hedge fund undermined
as investing vehicles, see capital outflows
„ Fed rate cuts inefficacious or impractical given
dollar weakness and inflation
„ International economies / emerging markets
experience slowdowns due to weak demand
from US
– Industrial commodity prices could fall precipitously