Subrime 2.0 – Is 2008 is back? | Hacker Noon

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CIA Supervisor:

Jesus F***ing Christ. What did we learn, Palmer?

Palmer:

I don’t know sir.

CIA Supervisor:

I don’t f***ing know either. I guess we learned not to do it again. I’m f***ed if I know what we did.

Palmer:

Yes sir, it’s hard to say.

Many people erroneously believe that the 2008 crisis was about people getting home mortgages and not paying them back. That is true, but it is only part of the truth. In reality, the consequences wouldn’t be so dramatic if it wasn’t for financers that thought it would be a great idea to repackage hundreds of billions of dollars in mortgages into something called collateralized debt obligations (CDOs). As Mark Baum said in The Big Short: “mortgage bonds are dog shit. CDOs are dog shit wrapped in cat shit.”

Theoretically, CDOs were supposed to shift risk from banks. Unfortunately, banks are not charities and they exist to make money. Thus, it shouldn’t be a surprise that banks that issued home loans also bet on CDOs. Major rating agencies, on the other hand, were very slow in revising the rating of Collateralized Debt Obligations (CDOs). The reasoning was also explained in The Big Short: 

Two hedge fund managers visit a Standard & Poor’s executive in her office in Manhattan. One asks the exec to name a time in the past year when the company didn’t give a bank the AAA rating it was seeking. She demurs. “If we don’t work with them,” she says, “they will go to our competitors. It’s not our fault. It’s simply the way the world works.”

As a result, when the bubble burst, those banks were doubly punched. Lehman Brothers went bankrupt, meanwhile, Merrill Lynch, AIG, Freddie Mac, Fannie Mae, HBOS, Royal Bank of Scotland, Bradford & Bingley, Fortis, Hypo, and Alliance & Leicester had to be rescued.

The “funny” part of that is that these banks were supposed to be backed up by teams of math whizzes and computer geniuses, even though they managed to lose billions of dollars. As a result, the crisis of confidence has infected the world, driving the dollar to record lows – and helping send the prices of commodities, especially oil, soaring to historic highs. Curiously, we do observe a fall in the dollar now but the prices of commodities also suffered. 

It is worth mentioning that with the Subprime crisis, Wall Street banks couldn’t even calculate how much risky securities on their books were really worth. In conference calls and press releases, they have been changing their estimates of the value of these assets. 

Merrill Lynch, for example, expected a $4.5 billion subprime loss for the third quarter, but three weeks later, its analysts announced that its real deficit was $7.9 billion. Probably, it wasn’t the best idea to become a huge investor in the funds it assisted. But, as the saying goes, big chances are never small stakes.

Howbeit, investors couldn’t trust management’s estimates of future losses anymore. Today, we see that time cures everything, which is why Wirecard AG was able to operate without being objected to by the auditors for such a long time…

This brings us to the idea that when Wall Street is bringing its attention to mysterious products and complex trades, the game is on and so is a risk. The only question is when it will hit the market.

But did we learn something? It has been recently announced that the first ETF Tracking the $700 Billion CLO-Market begins trading on the New York Stock Exchange. According to Alternative Access Funds co-founder Peter Copp, the fund will track the highest-rated CLOs. “These particular bonds have maintained their AAA rating through a variety of market selloffs, and we think that’s a testimony to it being a good product and reasonable for retail investors to have access,” Coppa said. It is important to highlight that ETF could make CLOs more accessible to retail investors and this can be dangerous in case something goes wrong, again.

Some are scared that if the economy continues to suffer from COVID-19, corporate loan defaults could rise, leading to a wave of CLO write-downs and default—as it happened with CDOs in 2008. It should be mentioned that the structure of CLOs to CDOs from the economic perspective. Each pools multiple loans to create synthetic, bond-like investments. Investors buy a slice (or tranche) of the underlying interest and principal cash flows of the portfolio. A defined order of which investors get repaid first and which bear the most losses allocates risk differentially.

According to SPGlobal, Japan’s top CLO investor, Norinchukin Bank, told in May that it would refrain from investing in more CLOs. Despite the fact that the default risk of CLOs appears low for now, rising risk aversion among investors had led to an unrealized loss of about ¥400 billion of its CLO portfolio in the March-end quarter.

On the positive side, CLOs have greater protection in comparison with CDOs, as repackage corporate loans, primarily leveraged loans, as well as consumer credit such as automobile loans. Besides that, higher levels of losses are required before they lose money. Even though they are still pretty risky. Probably, it would be rational for investors to check the credit quality of the leveraged loans, which underlie the bulk of CLOs before anything. 

Disclosure: The information set forth herein has been obtained or derived from sources believed by the author to be reliable. However, the author does not make any representation or warranty, express or implied, as to the information’s accuracy or completeness. Nor does the author recommend that the attached information serve as the basis of any investment decision and it has been provided to you solely for informational purposes only and does not constitute an offer or solicitation of an offer, or any advice or recommendation, to purchase any securities or other financial instruments, and may not be construed as such. 

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