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Insights on the Continuing Credit Crunch

By: Wellington Management Company

Not long ago, even some seasoned investors had never heard of SIVs or ABCP. Now those terms are part of the common parlance in the ongoing coverage of the credit crisis that was triggered last summer by problems in the subprime mortgage market. Since then, we've seen US mortgage foreclosures hit record highs and bank writedowns run rampant. We've also seen the public and private sector response, including infusions of capital into the markets by central banks. Most notably though, we've watched a true contagion take hold, with the credit crunch spreading well beyond the subprime market, driving increased volatility and risk aversion and pushing uncertainty about the broader economy to new heights.

So the question many are asking is what happened? The story is complex and still evolving, but here's a quick guide to the basic developments that brought us to this point.

Anatomy of a Credit Crunch

Today's problems center on asset-backed securities (ABS), specifically those backed by subprime mortgages. The casualties have been numerous, from downgrades in ABS collateralized debt obligations (CDOs) that held subprime assets to a freeze on withdrawals from a Florida state cash-management fund after investors learned about its subprime-related holdings. More recently, some commercial mortgage-backed securities (CMBS) have been swept up in the credit crunch.

In recent years, ABS and other securitized assets have been increasingly repackaged into structured products, such as CDOs. A CDO is a trust that holds rated assets and issues debt against them. It can hold ABS, leveraged loans, or credit default swaps. The common characteristic is that the CDOs are leveraged, so any changes in valuations are amplified relative to the underlying securities. The problems we're experiencing today are concentrated in ABS CDOs, which represent about 20% of the outstanding CDO market.

How does a subprime mortgage find its way into an ABS CDO? It's a long path that begins with a consumer with poor credit history taking a mortgage from a mortgage originator who then sells pools of these mortgages to an investment bank. The originator can use the proceeds to originate more of these mortgages. The investment bank securitizes these mortgage pools into subprime mortgage-backed securities (subprime MBS) in the form of bonds with different credit ratings, ranging from AAA to BBB, and sells them to institutional investors. Most of the AAA-rated debt is sold to investment managers, banks, insurance companies, and pension funds. Prior to the credit crunch, the rest (AA, A, BBB) generally ended up in ABS CDOs, which were also issued as bonds in multiple rating categories and sold to institutional investors around the world; this segment of the market has effectively shut down since the credit crunch, however.

Banks were most heavily involved in the senior classes of ABS CDOs. International banking standards issued under Basel II encouraged them to hold AAA-rated assets due to risk-based capital requirements. The big underwriters of ABS CDOs - mostly broker/dealers - have been exposed to the super senior AAA tranches, where they earned fees but may now face counterparty risk as a result of potential downgrades of the financial guarantors (companies that insure municipal bonds and some structured products).

From Crunch to Contagion

Since late last summer, the problems in mortgage-related assets have spilled over into other asset classes and, by degrees, the larger economy. Downgrades in subprime MBS translated into downgrades in ABS CDOs, which, due to their embedded leverage, became more sensitive to falling home prices. High-grade (AA, A) and mezzanine (BBB) ABS CDOs outstanding total approximately US$300 billion, and that is where the bulk of writedowns have taken place. Some of the downgrades have been severe - for instance, US$1.5 billion of AAA-rated ABS CDOs were downgraded to CCC or below last year as of December 15.

From there, subprime problems fed into fears about the leveraged loan markets, where the loans are used to back collateralized loan obligations (CLOs). Leveraged loans have dominated the high yield market. Cheap financing enticed private equity firms to keep the LBO craze going, confident that CLO demand would continue, which created an enormous forward calendar of loans. When fears spread, demand for CLOs dried up, which reduced demand for leveraged loans and popped the private equity balloon.

Asset-backed commercial paper (ABCP) programs were the next victims. An asset-backed commercial paper (ABCP) program or conduit is a special purpose finance company that buys and holds receivables or securitized financial assets (auto loans, credit card receivables, commercial loans, equipment leases, CDOs, and subprime MBS) and finances the purchase of assets through the issuance of asset-backed commercial paper. ABCP represents over half of all outstanding US dollar-denominated commercial paper and provides cost-effective funding to a sponsoring bank's customers. The ABCP market allows receivable sellers that otherwise cannot directly access the commercial paper market to finance their receivables at favorable rates.

The problems started with SIVs, a type of ABCP conduit that buys highly-rated securitized assets and finances the purchase of those assets through the issuance of ABCP. SIVs differ from other ABCP programs in two important ways. First, they are leveraged investment companies. And second, unlike other ABCP programs that require liquidity backstops from a large bank to ensure that funds will be available to repay investors at maturity, SIVs do not have backstop liquidity agreements with banks. Instead, SIVs need to mark to market their assets and meet a series of capital and liquidity tests. Failure of these tests can result in SIVs being deleveraged and unwound.

A combination of mark-to-market losses on the assets, the lack of a liquidity backstop, and the leveraged nature of these conduits panicked ABCP investors in late summer and early fall. Investors balked at buying the commercial paper issued by these vehicles, leaving many SIVs unable to roll over their existing commercial paper and forcing their liquidation.

Several banks, including HSBC, Citigroup, Societe Generale, and Rabobank, have brought billions of dollars of their own subsidiaries' SIV assets back on their balance sheets. As SIVs and ABCP work their way back onto balance sheets, it will put more pressure on capital ratios and further reduce lending. In addition, interbank lending has sputtered due to the lack of transparency regarding subprime exposure. That is precisely how financials and the broader economy have become caught up in the credit crunch.

Sizeable Damage

Financial institutions have taken approximately $150 billion in writedowns due to their exposure to the subprime mortgage sector so far. These include writedowns related to subprime mortgage-backed securities, direct mortgage lending, ABS CDOs, and bank loan exposure. Further writedowns are expected.

Meanwhile, mounting balance sheet pressures and growing losses have made banks hesitant to lend. This can be seen in a number of markets. Swap spreads around the world, for example, are at elevated levels, and swap curves are inverted, reflecting more near-term concern.

Looking Ahead

There are mixed signals about the near- and longer-term outlook. The potential positives include monetary policy and government support. The Federal Reserve has cut the federal funds rate and the discount rate, and introduced several non-traditional lending facilities to support the financial system. For its part, Europe has served up a huge volume of reserves to mitigate stresses in the banking system.

The lingering problems, on the other hand, include the continued deterioration of housing, signs that the consumer may be pulling back, and tighter lending conditions.

The credit crunch story is still being written. The situation is very fluid with new developments coming out every day that need to be understood and evaluated. Recent months serve as a stark reminder that credit ratings are but one factor to consider when evaluating the multi-faceted risks inherent in today's complex financial instruments. In this environment, independent credit research and in-depth structured finance expertise are of paramount importance.


About Wellington Management Company
Wellington Management Company, llp is an independently-owned, SEC-registered Investment Adviser which, along with its subsidiaries and affiliates (collectively, Wellington Management) provides investment management and investment advisory services to institutions around the world. Located in Boston, Massachusetts, Wellington Management also has offices in: Atlanta, Georgia; Chicago, Illinois; Radnor, Pennsylvania; San Francisco, California; Beijing; Hong Kong; London; Singapore; Sydney; and Tokyo.

This material is prepared for, and authorized for internal use by, designated institutional and professional investors and their consultants or for such other use as may be authorized by Wellington Management Company, llp or its affiliates. This material and/or its contents are current at the time of writing and may not be reproduced or distributed in whole or in part, for any purpose, without the express written consent of Wellington Management. This material is not intended to constitute investment advice or an offer to sell, or the solicitation of an offer to purchase shares or other securities. Investors should always obtain and read an up-to-date investment services description or prospectus before deciding whether to appoint an investment manager or to invest in a fund. Any views expressed herein are those of the author(s), are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may make different investment decisions for different clients.