Unintended Consequences

Have you wondered why many overseas banks and insurance companies seem to continually write down the value of their assets on one hand, and then line up for a governmental bail outs on the other? We will try and put it into perspective in an oversimplified story.

In the beginning there were ratings agencies, and they rated corporate bonds from the very highest of credit quality (AAA) down to junk (CCC).  A  AAA rating means that the chances of losing money are very, very low.  With each level of increased incremental risk, comes a lower rating.  If a corporate bond was at risk for losing just one dollar, it was rated all the way down to junk. 

Investment bankers then had the bright idea of getting ratings agencies such as Standard and Poor’s to rate a large group of home mortgages in a pool known as a Residential Mortgage Backed Security (RMBS).  The investment bank then divides the pool (the RMBS) into various tranches.  The highest-rated tranche would be given a rating of AAA.  That AAA tranche may have comprised 92% of the loan pool. 

Simplistically, the AAA tranche would receive the first 92% of all monies coming into the pool before the other investors were paid.  That means that the pool could have 16% of the home loans default and lose 50% of their value before the AAA tranche would lose even one dollar.  It sounds like a pretty good deal, and it provided highly rated securities to sell to retail banks such as Citibank, Bank of America and the myriad of other banks.

Unfortunately some of those AAA rated tranches are in fact going to lose money.  Rating agencies are now writing down the ratings on the former AAA tranches all the way down to junk.  This leads to some very bad unintended consequences.

If a bank had a loan portfolio of 1,000 individual mortgages valued at an average $200,000, for a total portfolio value of $200 million.  Say 16% of the homes went into foreclosure (mortgagee sale) and lost an average of 50%.  That means 160 homes went into foreclosure and that the bank lost an average of $100,000 per home, or $16 million overall.  But what if the bank invested $200 million in a RMBS that was rated AAA and 16% of the loans in the security went bad? The loss to the RMBS is 8% of capital yet the losses to the AAA tranche are only 1%.  This is hardly a catastrophe, and if it was normal lending by the bank the $2 million loss would be easily provisioned for in the banks accounts.

It is not so simple with the new financial accounting standards.  Investments have to be valued at “market”.  The RMBS is now rated as junk by the ratings agency because of the minor loss of capital.  The junk bond might now only be valued at 20% of face value, meaning that the bank must provision for $160 million of losses, rather than the $2 million it would have if it had been lending instead of investing.  The net result is that the bank requires more capital to cover the write down. This is a vicious circle and has lead to the need to prop up a number of banks throughout the world. The reality is that “at market” is nonsense for many of these loans. Fortunately here in New Zealand our financial institutions have been relatively immune from these problems, largely because they have been borrowers rather than investors.

“Vulture Fund” investors of course can see the great opportunity that this presents.  They know that they can buy the $200 million worth of residential loans for around $40 million.  They can then renegotiate the interest rate with the borrowers to make the property affordable for them.  It is only a matter of time before they will make a lot of money.