Structured Products ( incl Minibonds, High & Pinnacle Notes)

[kennynah]

ultimately, it is the buyer who must assess the risk of their own investments....that comes from information given in good trust. misrepresentation by sellers warps those information on risks and hence investors really have grounds for restitution.

[LenaHuat]

I'm inclined to think that there was a conspiracy to this saga. These notes were apparently not sold in Japan or Australia. Why did these US banks, the originators/arrangers of the notes targetted the HK and Singapore markets??

In fact, I had been tracking the US banks for a long while. I'm inclined to think that they did not wake up one day to sell these notes. I think they realized very early on that their balance sheets had gotten risky and hence decided to offload their risks.......and cleverly bounced on these mortgages off their balance sheets in the form of CDOs/CDS. By doing so, they also made a bundle along the way.

The notes sold in HK and Singapore are SGD-denominated subordinate notes.
Who bought the USD-denominated notes?? These tier 1 holders would be adequately protected compared to the poor HK and Singapore investors.

Furthermore, the pressure is obviously on DBS but DBS did not sell as much of these notes compated to Maybank. Is there political pressure not to squeeze Maybank???

[sidney]

For those who are interested in financial weapons of mass destuction....

Minibonds and highnotes are a form of mortage/asset-backed secruities.

Banks' deposit is a liability and mortages is their assets.

Basically banks will match investors' fixed deposit against mortage loans, traditionally. However, drawback is banks faced shorter term liquidity constrains against longer term mortage ~ therefore there is a mismatch of durations of assets against liabilities. Besides, ppl tend to refinance when interests rates is low (assuming bypass lock-in period) or ppl simply pay up principal in full or part faster to reduce interest payment amortisation. Banks faces prepayment risk. Therefore "mortage backed secruities" are engineered to "pass the risks" to investors. Mortages are pooled into a trust, which in turn issued securities/bonds to investors to buy the bonds backed by the cashflows from the trust. They might be classified in tranches etc. A, B, C, Z.

Banks will undertake as middleman to leech the spreads and earn underwriting cost. Pretty risk free... In addition, once the mortages are freed, banks will have money again to lend to more mortage holders and the whole process will restart again. Banks will retain AA, AAA clean balance sheet health status bcos the toxic loans is no longer their problem. They passed the buck through a trust.... Therefore it is someone's somebodies' somefriends' some investors' problemsss. Now globally across financial markets, investments bank with global footprints can simply buy loans, repackage, underwrite, sell to businessman, uncle, aunties or sell to your local banks.

How mortgage-backed secruities works

The underlying logic is tranch A will tank the prepayment risk first when mortage holders refinance/ pay in full or part faster / default on mortages, therefore Tranch A will get the highest yield followed by B, C. Tranch C is considered the safest investment grades as they are shielded by A and B tranch. Yield is obtained though mortage payments, partially is amortised as interest payments, partially goes towards principal repayment. When someone prepays ahead of mortage schedules, Tranch A will be hit first as the future interest cash flows will be reduced.

In the event, all mortages are paid, Z class will recieved all those excess cashflows. Due to extreme cash flow uncertainity, they are usually brought by hedge funds, who seeks excessive risk for high returns. How come Minibonds will go bust is "i think in the coventant, it is stated Lehman is the trust holder... or something like tat." This one need to verify, but concept is similar. Someone must go bust, then investors will pay for it.

There are many reasons/ theories behind the financial bomb. A few logical explanations are

1) low interest rates environment during US constuction boom. This leads to excessive borrowings by credit unworthy.
2) Imprudent lending pratices by financial institutions
3) Greed over logic, increased speculations as cost of borrowing is low
4) Repeats of repackaging mortages to freed up captial by banks to even lend more mortage loans
5) Using Swaps complicates. Banks insures against default. Counter parties if took wrong bet will end up cooked.
6) Swap is unregulated. Therefore there is no control. Furthermore, no "true assets" is needed to backed against the claims
7) Depth and breadth of financial corrosion is unknown. Counter parties unable to determind extend amount of risk they undertook
8) Swaps gaurantees can be sweeped under the carpet by keeping it off-balance sheets by just mentioning in footnotes
9) velocity of risk compounds everytime a new mortage is repackaged. Think of it how banks increases the velocity of lendings by simply having lower CAR ratios ~ This is my theory. Lol

[kennynah]

actually, it is very simple why these banks are all facing mortgage assets writedown..

a) lenders are defaulting on their mortgage loans.... this means bad debts to the banks who loaned out these mortgage loans
b) as the housing value deteriorates, the houses pledged as collaterals against the loans made by the banks, become less valuable. to the extend that the value of these houses depreciate, the banks assets will also dwindle

now to the CDOs which contain mainly mortgage assets... these CDOs, an asset class by itself, will also become less valuable. pension funds, hedge funds, investment banks, high net worth individuals, who all bought these CDOs then are screwed left, right, centre, front and back. those with very heavy exposure to these CDOs have bellied up.

those investment banks, you've heard about counter party risks term, trade among themselves using CDS ... in a gist, a CDS is simply a financial transaction where 2 or more parties enter into some form of asset swapping...it could be mortgage asset papers swapping for cash or other forms of assets... now, supposing you are an investment bank and i think you have too much toxic waste assets in your closets, i wont trade with you and many even demand that we terminate all of our earlier swaps... if you cannot fulfill your end of the bargain, i have a problem.... and i may choose to force you to pay up your losses to me...failing which i can sue you... and this in a nutshell is what happened to LEH...

in the end, the source of the problem is the value of the houses, which are the collaterals against the trillions of $$ of loans given out... as long as these collaterals are worthless, the banks cannot possibly regain their loans and have to eventually write them off as bad debts.

the US treasury will assist home owners as much as they can thru fiscal policy, just so americans will have more disposable income but truly, this cannot solve the housing problem in its entirety...

the employment rate must go up...now we are looking at ~6% unemployment and when banks fail, many companies will fail too...this has a negative spiral impact on the financial health of americans...and that will again lead to housing lean defaulting. u see, when the home prices drop, no one in the right mind will want to pay a loan sum that is astronomically higher than the valuation of that property....better they either declare bankrupt, or simply walk away... they could just buy a RV and live in it...they have plenty of land and they can just park they RV just about anywhere they want...no wilson parking to worry about.

the US dollar against majors.... it would be very silly of US teasury to insist on a strong dollar now...a strong dollar will negatively impact the trade deficit account. they cant sell as much exports as they want to... see how the dollar has become so strong in 2 months against euro... this will be a bane to their exporting economy...

the consumers...back to employment...got jobs got money to spend...no jobs, eat themselves...

fed injecting liquidity into the banking sector is just to ensure that they maintain their tier 1 liquidity ratio....it does not mean banks will lend to each other or businesses, if the risk of lending is deem very high now... hope for mortgage rates to lower...tan ku ku... it wont happen now...just ask yourself, if you are a mortgage loan lender...will you lend at a low borrowing rate now? no way hosay... you will likely ask for an arm and leg for every $$ you dish out to compensate for the risk of default... will fed's action of lending money to banks at low IR help to push mortgage rates down? maybe somewhat...but i dont think it will drastically cause mortgage rates to lower substantially...


so then what can the US govt do to solve the problem at the roots ? .... i dun know...and i think, nothing much except to calm the edgy sentiments... i am afraid those house price will not recover to their pre2007 prices again in the near term...banks therefore have to suffer for the consequences of their over lending/leveraging against their capital....

thus...more banks should fail and their assets sold at joke $1 price to the acquirer and then maybe the situation will recover slowly... in short....banks loaned too much of what they did not have in the first place...these were phoney money....and so, expect next to nothing to be recovered...wipe the sleight clean and start all over again....

[financecaptain]

Below is quite a long article. But it gives a good illustration on how credit rating works in America. This system of relying on professional rating agency and research analysts have become a total joke. Why ? Many of these analysts do not use common sense; they rely on compurter models and Company's provided information and sitting confortably in the office; instead of hardwork understanding business fundamentals/domains and market intelligence. Secondly, they have commerical interest to make cerain recommendations. They are not burnt when making the wrong call, investors are. Head or tail they still win. And investors are still relying on them ? FerroChina case is a classic case. Why do we need analysts if all information needs to be provided by Company ?

In rating structured finance products, why a certain tranche of cash flow be able to be rated triple A and the other trache non-investment garde if all the cash flows come from a common source; and default outcome is binary : 0 and 1, no such thing as 20% or 50% default ? When an airplane dives into the sea, everything goes, regardless of wether you are first class, business class or economy passengers. Use your common sense.

Is this structured finance episode not equivalent to the recent food poisioning incidents in China ? Wall Street is more developed than China's farming villages, so you have toxic financial products; In China you have toxic food products. Motivation is the same, more monies to the producers of the goods and let the final consumer takes all the shit until the whole thing blow up.

Published: FT, October 17 2008

In the summer of 2002, John Diaz, a managing director at Moody’s Investors Service, was called before a US Senate subcommittee investigating the collapse of Enron. The senators wanted to understand why Moody’s had said that the energy trader’s debt was investment-grade in late October of that year ? only to see the company default on its bonds four weeks later as it declared bankruptcy.

Diaz described his company as an information provider. Moody’s researched and analysed companies’ financial health, then offered investors its views, to help them decide where to put their money. “Ratings,” he told the
subcommittee, “are a simple symbol system to express relative creditworthiness ... Moody’s ratings are designed to provide a relative measure of risk, with the likelihood of default increasing with lower ratings.”

Diaz expressed regret that he and his colleagues had not “discovered the information that would have allowed us to serve the market more efficiently in this instance”. If Enron had not misled the analysts, he said, the
ratings would have been lower. In his concluding remarks, when suggesting areas in which the ratings process could improve, he called for more financial disclosure from companies, closer attention to liquidity risks by Moody’s, and a focus on companies’ “corporate governance and how aggressive or conservative are accounting practices”.

As it turned out, the accountants, not the rating agencies, came to shoulder much of the blame for Enron’s collapse and the economic downturn it wrought. The bookkeepers had shed their dull reputation, their ledgers
and calculators, for life in the fast lane, advising companies and helping them design Byzantine financial structures ripe for breakdown. And they paid the price: Enron’s accountants, Andersen, closed down in 2002,
shedding 85,000 jobs, and most of the other big firms split their accounting and consultancy practices.

Moody’s fared better. Despite being the subject of an Enron-related competition probe by the US Justice Department (which was dropped but led to a separate felony indictment for the shredding of subpoenaed documents), the company, which only listed in 2000, continued to grow and reported the highest profit margins of any company in the S&P 500 index, the creme de la creme of big US companies. It held that position for five years running; its shares rose 500 per cent in their first four years of trading ? at a time when the rest of the market was down; and Moody’s earnings rose by 900 per cent in a decade.

Then, on August 16 last year, after an internal revision of its ratings practices, Moody’s made an announcement that heralded the beginning of the credit crunch.

. . .

Moody’s was the second investor-services project of John Moody. The son of a New England ice salesman, Moody moved to New York at the turn of the 20th century. The city was gripped by a banking boom and Wall Street was awash with railroad bonds, issued to finance the taming of the Wild West. Moody was a muckraking journalist, a sometime Wall Street analyst and a Catholic proselyte. In 1900, he had what he called his “eureka moment” and left his clerking job to begin publishing a regular manual evaluating the quality of stocks and bonds. It became enormously popular, but the venture went under in the 1907 stock market crash. In 1913, Moody began publishing a new manual, which analysed the creditworthiness of the US railroad companies themselves. Soon, he had broadened the mandate, writing about a wider range of industries, and a year later, the company was incorporated.

Moody modelled his ratings on credit-reporting systems established in the last decades of the 19th century. If a company’s bond was given a triple-A rating, it meant Moody believed that you could lend to the group with a very high chance of getting your money back, plus interest. The worse the chance, the lower the rating ? from Triple A to Double A to Single A, then down to Baa. Ratings below that were considered junk ? or high risk.

It soon became essential that any financial product carry a rating, and by the 1920s, Moody’s rated almost the entire American bond market. In those years, the service was paid for by investors, through subscriptions. It was a system that made sense: in property sales, for example, surveyors are
paid by the buyers, not the sellers. This wasn’t so different. But by the 1970s, the growing complexity of financial products and the sheer size of the debt market demanded staffing levels at Moody’s that a subscription model couldn’t sustain.

There was a further rationale for changing the model and charging the bodies that wanted to issue bonds to obtain a rating: the ratings had become essential to any deal. As debt markets grew, investors became more
discriminating. Most bond investors required two ratings, in fact. Moody’s provided one and Standard & Poor’s, a more recent arrival on the scene, the other. It was a happy duopoly ? and the lack of competitive pressure meant independence for the agencies. On the other side of the deal table, however, it led to frustration. Companies complained that agencies were aloof, opaque, secretive ? the svengalis of debt. Analysts didn’t answer their phones. And when they did, the bond issuers complained, they weren’t helpful. By the 1990s, Moody’s was known for its bookish, academic atmosphere, which grated on many bankers, according to an industry survey.

Several factors began to change this culture. First, was the rise of Fitch, a third big ratings agency. Fitch had been recognised, along with Moody’s and S&P, as a “nationally recognised statistical rating organisation”
(NRSRO) by the Securities and Exchange Commission (SEC) ? Wall Street’s regulator ? as early as 1975, but it wasn’t until the 1990s that it became a serious contender for ratings jobs. A third agency meant that banks could now “ratings shop” ? and avoid Moody’s, which was known for giving lower ratings than its competitors.

A second factor for change was Brian Clarkson. Clarkson was born in Detroit and went to law school at the University of North Carolina, Chapel Hill, before joining Moody’s in 1991 at age 35. He started as a mid-ranking
analyst in what was at the time an experimental backwater at the company: structured finance.

Rating a corporate bond, the bread and butter of the Moody’s business, is relatively straightforward. It essentially involves rating a company, and companies have assets, business models, balance sheets, managements and, most importantly, history. A rating is based on a qualitative and quantitative assessment. Rating a structured-finance instrument is different. Rather than having a whole, living corporation standing behind them, structured bonds are backed by pools of debts which are collected and sold on by banks. Most structured bonds are collections of mortgage loans.

The first mortgage-backed bonds were created in the late 1980s, well before Clarkson’s time, by a trader called “Lewie” Ranieri. Ranieri, the head of the mortgage trading desk at the former investment bank Salomon Brothers, was famous for the huge sums of money he netted for his employer and for the quantity of cheeseburgers he ate. What he struck upon in structured finance was a process of pure alchemy: a way of turning myriad messy mortgage loans into standardised, regimented and easy-to-assess bonds.

Ranieri knew that the magic of structuring was in the packaging. Packaged in the right way, mortgages could come to create a huge, new tradable bond market. And this is where the rating agencies came in. Structured bonds, like any other bond, needed ratings in order to be sold. But with a structured bond, the pools of debt could be built or modified in order to attain a particular rating. This wasn’t a matter of disguising the risk,
rather a way of reapportioning it and allowing investors with different risk appetites to buy the right product for them. “The rating is what gives birth to the structure in the first place,” explains Sylvain Raynes, a financial modelling expert who was with Moody’s in the 1990s, when Clarkson joined. In some cases, the ratings are known before the bonds have even been inked. “You start with a rating and build a deal around a rating,” Clarkson told an investment magazine last year.

From the start, Clarkson was involved in the part of the structured finance world Ranieri created: mortgage-backed bonds. By 1997, Clarkson was in charge of the whole mortgage bond division. What he understood was that the success of the structured finance business didn’t only depend on the complicated models and analysis it used. As with any other deal-making process on Wall Street, it was about people. If Moody’s wanted to reassert itself as the world’s top rating agency, it had to reform itself, and structured finance showed how: rating wasn’t something done from an ivory tower, rating was done as a service for clients, and, in the case of structured finance, as a service for banks.

“We’re in the service business,” Clarkson said in an interview last year. “I don’t apologise for that.”

. . .

If Clarkson set the course for the personality shift in structured finance, the listing of Moody’s spurred it on. The agency was floated as a public company in 2000 ? spun out of the financial publisher Dun & Bradstreet. As
one former Moody’s staffer recalls: “The change was just precipitous. There was suddenly a concentration on profits. Management got stock options. It’s true there was a big personality shift in the company ? lots of cozying up to clients went on.”

“We were lily white,” says Ann Rutledge of her time working in the Moody’s structured finance division in the mid-1990s. “But then the centre of gravity in Moody’s shifted. Moody’s went public.”

Soon there were stories of analysts going skydiving with clients; of structured finance experts and bankers on weekend getaways together; of golf outings and karaoke nights (Clarkson was known as a fan of the latter). Analysts at Moody’s now picked up their phones.

Alongside the new-found service culture came other, more fundamental, changes. “In the late ’90s, research and development at Moody’s slowed right down,” says Rutledge. “The banks caught up. And then they came to be the ones in the lead.” As the structured finance arms race accelerated, Moody’s and its peers became more passive participants. Where the firm had once been at the cutting edge of statistic analysis (analysing facts) and stochastic analysis (analysing probabilities), soon it found itself trying to keep pace with the latest engineering packages devised by the banks.

“Over time, disagreements with analysts were just smoothed out. And it was no longer the rating agency which always won,” says Raynes, who left Moody’s to set up his own credit analysis consultancy. “The banks won. Now the modelling is done by the street.”

The agencies were inundated with a huge volume of new structured finance deals that they were being asked to rate. At Moody’s, the flipside to the huge revenue growth was a high-pressure work environment. One analyst recalls rating a $1bn structured deal in 90 minutes. “People at the rating agencies used to say things like, ‘I can’t believe we got comfortable with that deal,’” says Raynes. “People talk about moral hazard at the banks, but the moral hazard for the rating agencies is extreme.”

Moody’s rejects the suggestion that it subordinated the integrity of its ratings to chasing a larger share of the market. It told the FT in May: “Moody’s has published extensively on our position that each possible
business model brings with it potential conflicts. The real issue is how credit rating agencies manage them.

“The quality of our ratings opinions, commentary and analysis has been and continues to be our primary concern and commercial considerations are never a factor in the rating assigned to an issuer or transaction. Our ratings and research are our only products, and our reputation is our only capital.” Moody’s was invited to comment in detail on the specific points raised within this article, but declined.

Clarkson, according to several people at Moody’s, made clear to his analysts that accuracy was fundamental. There was no policy of subordinating ratings to market share. But, say some, there was a significant institutional fear of losing business. Though analysts weren’t strictly paid according to the amount of work they brought in, employees ? who were often rewarded with stock options ? had reason to see the company
do well. Clarkson could not be reached for comment.

. . .

In the early days of the millennium, it was almost impossible for one of these bundles of bonds ? known as CDOs or “collateralised debt obligations” ? to get a triple-A rating from Moody’s if the collateral was entirely
mortgages. The rating agency had a long-standing “diversity score”, which prevented securities with homogenous collateral pools from winning the highest rating. S&P didn’t have such a score and neither did Fitch. The result, even with service-oriented Clarkson at the head of the structured finance department, was a steadily dwindling number of mortgage CDOs rated at Moody’s.

As the mortgage CDO market continued to grow, Moody’s couldn’t continue as it had. In 2004, the diversity score was abolished ? a decision approved by the Moody’s credit committee. The number of mortgage CDOs rated by Moody’s rocketed.

Meanwhile, by 2006, Clarkson’s team, spread all over the globe, was delivering 40 per cent of annual income for Moody’s, eclipsing all the other parts of the business. Clarkson wasn’t involved in the day-to-day running of the structured finance unit ? that was left to a network of deputies. Frederic Drevon was Clarkson’s prelate in Europe, working in cathedral-like offices in the City of London, and it was under his watch
that Moody’s first came across the CPDO ? a “constant proportion debt obligation”. The product had been designed by a crack team of credit experts at the Dutch bank ABN Amro and was called the “Holy Grail of
structured finance” by analysts at Bear Stearns. It had been built with a view to achieving triple-A ratings, but also promised to pay investors a substantial return ? more than 10 times what comparable triple-A
instruments were offering. CPDOs were not mortgage-backed, but rather collections of bets on the creditworthiness of hundreds of European and US corporations.

Moody’s rated the first of the CPDOs in August 2006, after an unusually long analysis period. The rating it came up with was triple A ? the closest thing you can get to risk-free. S&P also gave it a triple-A rating. About two weeks after those first ratings came out, Fitch, which was not hired to rate any CPDOs, said it couldn’t understand how they had been achieved: its own models had put CPDO bonds barely above junk grade. Fitch’s doubts ? echoed by a few other researchers ? did not steal ABN Amro’s thunder. It was the new bestseller, and received this plaudit from Citi’s research team: “Jokingly, we have started calling the product a Hydra. Almost every time we tried to kill it by subjecting it to severe stress, it seemed somehow to be able to recover par by maturity.”

At Moody’s, Drevon and his team had reason to be pleased. The CPDO was a new product in a new area of finance. By winning the first rating mandate, they had effectively guaranteed a big future income stream. As other banks rushed to bring their own versions of the CPDO to market, they naturally went to Moody’s and S&P for the ratings. CPDOs were reported to be the most lucrative individual instrument Moody’s had ever handled. “We’re working night and day to rate CPDOs,” said one Moody’s managing director to a conference in September that year.

Rating a new transaction, as an analyst, is a relatively simple procedure ? but it can be time-consuming. From an ordinary desktop computer, you start the Moody’s rating software. A window opens in which you set the basic assumptions: duration of bond, payment, collateral details ... and then ? click ? the simulation is set running. Not once, but a million times, each time with a different outcome. It’s the average outcome from all those simulations that gives you a rating. “You’d run the program ... one million simulations at your desk... you might leave it going overnight, sometimes just come back the next morning,” explains an analyst.

Still, by the Christmas holidays, the rating team was burnt out. Most had gone home to their families. But one analyst kept working over the holidays, and on January 2 2007 sent the team an e-mail message: “Hi Guys!
Happy New Year! I’ve spotted another bug in the CPDO code.” This in itself was nothing serious. Bugs in ratings are not uncommon; the Moody’s internal error-log lists numerous glitches and hiccups in the many codes the agency develops. Most of them are minor.

With CPDOs, however, there were quite a few more bugs than usual ? which Moody’s attributed to the fact that it was a new product. What’s more, it wasn’t uncommon for the company’s client banks to be the ones spotting the errors. One bank recalls how it ? and others ? often phoned Moody’s to register problems: things that didn’t seem to stack up on their machines; tweaks or adjustments they wanted to insert. For the most part, they were just creases which needed ironing out.

The bug spotted over the Christmas holiday didn’t have a big impact on CPDO ratings. But another bug, spotted soon after, did. A single small error in the computer coding that Moody’s used to run its CPDO performance simulation had thrown the results way off. When the error was corrected, the likelihood of CPDO default increased significantly. CPDOs, it turned out, weren’t triple-A products at all. Preliminary results suggested the error could have increased the rating by as many as four notches.

A meeting of the rating committee was hastily arranged, involving some of the most senior managing directors in the company’s European structured finance division. Drevon, Clarkson’s deputy, was informed. The committee, however, did not disclose the error to investors or clients. The bug was corrected and the same model was then used to rate new CPDOs. But the new CPDOs still achieved triple-A ratings. The reason was that the committee made other changes to its code. A senior analyst proposed three alterations to the basic rating methodology. Two of them were adopted. The third was ditched because, as one document stated, “it did not help the rating”.

The FT revealed the CPDO rating error at Moody’s in May. The agency commissioned an external investigation, led by law firm Sullivan & Cromwell. In July, the findings were released. Staff had “engaged in
conduct contrary to Moody’s Code of Professional Conduct”, said the agency. "Specifically, some committee members considered factors inappropriate toV the rating process when reviewing CPDO ratings following the discovery of the model error.” Moody’s instigated a company-wide review of methodology and modelling as a result, and began disciplinary proceedings against staff.

Around the same time that Drevon’s Paris team discovered the rating error in CPDOs, another Moody’s team ? a dozen or so junior analysts and directors in the US ? spotted a different potential problem in the systems at Moody’s. This problem wasn’t a coding bug.

From January 2007, the Moody’s US residential mortgage bond team began tracking a disturbing rise in the number of subprime mortgages going delinquent. The delinquency rate is the first of three key measures that
rating agencies use to assess the soundness of a mortgage-backed bond. The second key measure shows the number of people delinquent for more than 90 days and the third shows the number of foreclosures. The trio form the danger-alert system on any mortgage bond: if homeowners miss a payment, they make it into the first category. If they miss three payments in a row, they fall into the ignominy of the second. After that, they lose their home; the mortgage loan defaults. Green, amber, red.

What shocked the Moody’s analysts about the delinquency rate they werewatching ? the green lights ? was that it had moved up very fast. And it was happening not just in isolated regions but all over the US. More
worrying still: in some cases, mortgage loans were jumping the lights and moving straight from green into red. This was not in their models ? nor anyone else’s.

The agency’s chief economist, Mark Zandi, had been warning of a US housing downturn for some time. In May 2006, he wrote that the housing environment “feels increasingly ripe for some type of financial event”. But Moody’s triple-A rated bonds were thought safe ? as were those highly rated by other agencies. According to a report in March 2007, the risks of the defaults in subprime mortgage bond pools climbing further up the structured finance chain were “mild to moderate”. Nothing needed be done unless the second warning ? the amber lights ? lit up.

Pretty soon they did. The same people who missed one mortgage payment had now missed three. Outwardly, the rating agencies were sanguine. “Over the past several years, Moody’s rating changes in the second half of the year have greatly outnumbered actions in the first half,” said Moody’s, trying to explain the large number of downgrades it seemed to be making.

But behind the scenes, Moody’s was already taking steps which would drastically revise its outlook.

At the end of July, the company decided it needed to update its rating methodology. The review was publicly announced on August 2. Five days later, Clarkson was appointed chief executive of the company, replacing Raymond McDaniel. Meanwhile, the new delinquency assumptions were calibrated, and the analysts typed the revised data into their machines. When they came back to their desks, they realised, one bond at a time, the
severity of the mortgage crisis. On August 16, on a mild, rainy day in New York, Moody’s released the results of its revised methodology. In one fell swoop, it downgraded 691 mortgage bonds. The two biggest other rating agencies ? Fitch and S&P ? were issuing unprecedented downgrade notices too.

The action was the first in a series of surprises for the credit markets. In each of the succeeding weeks, it seemed, Moody’s and the other rating agencies had more bonds to downgrade. And each set of downgrades was a convulsive shock. In the final few months of 2007, Moody’s downgraded more bonds than it had over the previous 19 years combined. Panic gripped trading floors. Titanic structured vehicles, created by banks to warehouse their “riskless” mortgage bonds, became untouchable for short-term investors. As a result, two big German banks revealed that they were within a whisker of collapse, and virtually overnight all the world’s banks stopped lending to one another.

. . .

“We were preparing for a rainstorm and it was a tsunami,” said Clarkson earlier this year. Moody’s insists there was no way it could have foreseen the onset of the credit crisis. But were any of the agencies looking? Moody’s hadn’t updated its basic statistical assumptions about the US mortgage market since 2002.

Some analysts believe Moody’s and the other rating agencies could have acted sooner. There were debates in 2006 among the firm’s mortgage-security rating teams about the quality of the collateral they were allowing to be rated. Too many American mortgages seemed prone to fraud; the risk of a house-price collapse was looming; subprime lending was exploding across the US. E-mails which the SEC recovered from the rating agencies ? S&P, Moody’s and Fitch ? paint a grim picture. One senior director at an unnamed rating agency wrote to a colleague: “I have been thinking about this for much of the night. We do not have the resources to support what we are doing now ... we need staff to keep up with what is going on in subprime and mortgage performance in general NOW.” Another wrote: “Doing a complete inventory of our criteria and documenting all of the areas where it is out of date or inaccurate would appear to be a huge job.”

In the case of the multibillion-dollar CDO market, Moody’s denies that it was aware of serious problems with its methodology. “[We] change methodologies on a regular basis to enhance them and to reflect recent
events and our best estimates of the future,” says the firm. In the end, as long as the banks were churning out CDO deals ? and in early 2007, they seemed to step up a gear ? the rating agencies continued to rate them. In the words of one senior executive at the firm, it was “like a suction pump”. A highly placed figure from Clarkson’s former team says: “If you speak to anyone individually at the rating agencies then of course they’ll say they’re not to blame for the crisis. I don’t think any individuals are losing sleep over it.”

Moody’s is not a rated company. If it was, its outlook might be bleak. In its latest results, filed in August, revenues at the company were reported to have halved from the same quarter a year earlier. US lawmakers are already exploring the role the rating agencies played in the lead-up to the credit crisis. Influential senators have called for fines to be imposed in the event that any wrongdoing is proved. In a July report, the SEC demanded far greater transparency from the rating agencies, requiring them to disclose much more information to the market about the securities they rate. Staff were to be prohibited from receiving gifts from their banking clients with a value greater than $25. In Europe, Charlie McCreevy, the European Union’s internal markets commissioner, said it was “time to end the rot at the heart of the structured finance rating process” and called for “mandatory, well-targeted and robust internal governance reforms”.

The rating agencies say they are co-operating fully with the authorities. But then there are the civil cases. Only last month, the Abu Dhabi Commercial Bank filed a lawsuit against a number of Wall Street banks as well as Moody’s and S&P, alleging that they inaccurately rated securities that the bank had been unfairly sold. The bank’s management say they expect some of the biggest sovereign wealth funds in the Middle East to join them in the lawsuit.

Moody’s used to be headquartered at Church Street in Manhattan, on a prime piece of downtown real estate a block south of Ground Zero. Looming above the entrance to the squat building was a bas-relief of polished bronze that John Moody had installed when the office opened in 1951. In hammered-out letters a foot high each, the inscription read: “Credit: Man’s Confidence in Man”. Below that was a quotation from the antebellum-era US senator Daniel Webster: “Credit is the vital air of the system of modern commerce. It has done more ? a thousand times more ? to enrich nations than all the mines in the world.”

The frieze has now been melted down. Shortly before Clarkson was appointed chief executive, the firm moved to more glamorous headquarters in the reconstructed World Trade Center Tower 7. In the place of the old Moody’s HQ, a monument to the property market will stand: America’s tallest residential tower.

In the meantime, with trust eroded on Wall Street and in financial centres around the world, governments are bailing out the banks that bought toxic assets that had been given the A-OK by the ratings agencies. It’s unclear, as yet, what the ramifications for ratings will be. Stricter oversight will be enforced. Moody’s will have to distance itself from its clients. Clarkson has already resigned. He has been replaced by Michel Madelain ? formerly the head of corporate and sovereign rating, a core part of the Moody’s of old. But lawmakers may not have the appetite to go after the rating agencies. The world’s financial markets have credit rating hard-wired into them.

There is perhaps a middle ground. Egan-Jones is a small, newly registered agency which, unlike Moody’s, S&P and Fitch, earns its income from bond investors, not issuers. Ratings are paid for by subscription, and not by
fees from the companies and banks trying to sell the deals in the first place. But going to an investor-pays model is probably too big a change to ask for more broadly. American and European market regulators seem happier to push for a much-reformed status quo.

The agencies, meanwhile, need to start earning back trust. “Rating is a religious process,” says Sylvain Raynes. “Once you’ve lost the confidence of investors, it’s gone. You can’t get that faith back. The rating agencies have lost their influence, just like the Church did 500 years ago. People don’t have faith in ratings any more and the scale of this crisis is such that I’m not sure they ever will again.”

[b]Sam Jones is a reporter for FT Alphaville
Copyright The Financial Times Limited 2008

[OE2008]

actually, it is very simple why these banks are all facing mortgage assets writedown..

a) lenders are defaulting on their mortgage loans.... this means bad debts to the banks who loaned out these mortgage loans
b) as the housing value deteriorates, the houses pledged as collaterals against the loans made by the banks, become less valuable. to the extend that the value of these houses depreciate, the banks assets will also dwindle

now to the CDOs which contain mainly mortgage assets... these CDOs, an asset class by itself, will also become less valuable. pension funds, hedge funds, investment banks, high net worth individuals, who all bought these CDOs then are screwed left, right, centre, front and back. those with very heavy exposure to these CDOs have bellied up.

those investment banks, you've heard about counter party risks term, trade among themselves using CDS ... in a gist, a CDS is simply a financial transaction where 2 or more parties enter into some form of asset swapping...it could be mortgage asset papers swapping for cash or other forms of assets... now, supposing you are an investment bank and i think you have too much toxic waste assets in your closets, i wont trade with you and many even demand that we terminate all of our earlier swaps... if you cannot fulfill your end of the bargain, i have a problem.... and i may choose to force you to pay up your losses to me...failing which i can sue you... and this in a nutshell is what happened to LEH...

in the end, the source of the problem is the value of the houses, which are the collaterals against the trillions of $$ of loans given out... as long as these collaterals are worthless, the banks cannot possibly regain their loans and have to eventually write them off as bad debts.

the US treasury will assist home owners as much as they can thru fiscal policy, just so americans will have more disposable income but truly, this cannot solve the housing problem in its entirety...

the employment rate must go up...now we are looking at ~6% unemployment and when banks fail, many companies will fail too...this has a negative spiral impact on the financial health of americans...and that will again lead to housing lean defaulting. u see, when the home prices drop, no one in the right mind will want to pay a loan sum that is astronomically higher than the valuation of that property....better they either declare bankrupt, or simply walk away... they could just buy a RV and live in it...they have plenty of land and they can just park they RV just about anywhere they want...no wilson parking to worry about.

the US dollar against majors.... it would be very silly of US teasury to insist on a strong dollar now...a strong dollar will negatively impact the trade deficit account. they cant sell as much exports as they want to... see how the dollar has become so strong in 2 months against euro... this will be a bane to their exporting economy...

the consumers...back to employment...got jobs got money to spend...no jobs, eat themselves...

fed injecting liquidity into the banking sector is just to ensure that they maintain their tier 1 liquidity ratio....it does not mean banks will lend to each other or businesses, if the risk of lending is deem very high now... hope for mortgage rates to lower...tan ku ku... it wont happen now...just ask yourself, if you are a mortgage loan lender...will you lend at a low borrowing rate now? no way hosay... you will likely ask for an arm and leg for every $$ you dish out to compensate for the risk of default... will fed's action of lending money to banks at low IR help to push mortgage rates down? maybe somewhat...but i dont think it will drastically cause mortgage rates to lower substantially...


so then what can the US govt do to solve the problem at the roots ? .... i dun know...and i think, nothing much except to calm the edgy sentiments... i am afraid those house price will not recover to their pre2007 prices again in the near term...banks therefore have to suffer for the consequences of their over lending/leveraging against their capital....

thus...more banks should fail and their assets sold at joke $1 price to the acquirer and then maybe the situation will recover slowly... in short....banks loaned too much of what they did not have in the first place...these were phoney money....and so, expect next to nothing to be recovered...wipe the sleight clean and start all over again....

K,

Great summary made easy to read and understand.

"what can the US govt do to solve the problem at the roots?" Market has to do the nasty job of cleaning up the mess.

A simplistic explanation, IMO is that Bush Admin together with FED under the Chairmanship of Alan Greenspan have much to blame when they tried to solve the problem (US market crash-dot com bust followed by the tragic 911) by using home ownership to pump prime the faltering economy. Home mortgages of sub prime, etc, refinancing of home mortgages at ever higher level were generating the "wealth" for more profligate spending.

A slew of measures are now introduced by Treasury, FED and major Central Banks. We will know the full impact 3-5 years down the road. Asset deflation, super high inflation or stagflation?

[kennynah]

....
A slew of measures are now introduced by Treasury, FED and major Central Banks. We will know the full impact 3-5 years down the road. Asset deflation, super high inflation or stagflation?

hi oe2008, good to hear from u again...

my guess for the USD is that it will be weakened against the euro in the next 2-3 years...my reasoning...too much printed money is entering the US economy artificially...the eurozone may be suffering some form of depressed economic activity but this is more related to the spill over effect of their investments in US ... but otherwise, they have been trying to build up a strong eurozone powerhouse of their own.... their unemployment is manageable at this stage, some of their stronger economies are still enjoying healthy trade account surplus, the strong euro while Crude was at its height, mitigated their inflationary pressures, and thus, imo, the eurozone is not in as bad a shape as the US. also, trichet has been very adamant about not lowering interest rates against common sense... common men do common things in the face of pressure...uncommon men, and sometimes wisely so, do quite the opposite even under insurmountable pressure to conform... we will know if trichet will enter history as the best ECB chief of all time...

focusing on the US....over the next 2-3 years...they will obviously suffer the consequence of printing fiat money to the tune of $1trillion... some consequences will be inflation, a sustained lower employment rate leading to lower consumerism and thus a depressed GDP growth rate,....now this is bordering on "stagflation" possibility....

on the other hand, china with its huge amount of foreign reserves, will want to continue to grow and keep ahead of the rest of the world...they should no doubt become one of the largest consumer market for international goods in the next 5-10 years... as they become wealthier, so will their ability to spend...china goods is far from acceptable international branding standards...so, they buy guccis, LVs, hugos, ferraris, porsche, whirlpool,ie foreign goods.. they become a noticeable importer to power the world's economy... china RMB should strengthen against the USD to <6 by then.

singapore..... hmmm.....too small...dont waste time thinking about where she is going... not that it can really influence her own destiny anyways...

[LenaHuat]

Now we know those poor investors are holding out at the mezzanine level - between equity and the senior debt holders. Is Zircon Finance a Bahamas Jersey Isle Isle of Man incorporated SPV

Good luck to these chaps. I hope they will persevere in their fight.

[millionairemind]

Good news for those retirees..

Most likely alot of arm twisting behind the scenes...

October 28, 2008, 6.56 pm (Singapore time)

Brokers to buy back Minibonds from 'vulnerable investors'

By WONG WEI KONG

Six broking houses said they are prepared to buy over troubled structured investments from investors deemed 'vulnerable' at up to cost, less coupons already paid, with no admission of liability.

This followed a meeting to consider the plight of investors exposed to the Lehman Brothers Minibonds issue and the Merrill Lynch Jubilee Series 3.

The six brokers are CIMB-GK, DMG & Partners, Kim Eng, OCBC Securities, Phillip Securities and UOB Kay Hian.

'The brokers are sympathetic to the plight of the vulnerable. However, the brokers are of the view that investors should be prepared to bear some personal responsibility for their investment decisions,' said a statement issued by the Securities Association of Singapore.

Brokers have, by and large, been involved in executing orders from stock-trading clients who initiated the trades after having learnt about the investment products from advertisements or from fellow investors, it said.

'Nonetheless, the brokers, in a collective effort to help the situation, are prepared to buy over the investments at up to cost (less coupons already paid) from investors deemed vulnerable, with no admission of liability.'

Those eligible would include, among others, investors who are above 62 years of age, less educated, and have little investment experience. These points would be determined in an interview process.

For investors who do not fall under the category of 'vulnerable investors', the brokers said they will investigate and carry out a fair review of any formal complaints of mis-selling on a case-by-case basis.

[financecaptain]

Got the following from Straits Times dated 29 October 2008. Investors are being taken on a ride on the so-called High Note 5.

The structured note is as good as getting the investors to write a 5 year Credit Default Swap (CDS) on any 5 banks includuing Lehman. The premium is 5% per annum (only) for 5 years and settlement price is 100% of principal, which you need to provide the 100% collateral upfront (screwd again).

A lousy deal even for any CDS traders because any if any one of the 5 bank defaults, you have to make 100% payout on the CDS. Typical contract is only 1 insured party and now your risk has been increased 5X for 5% per annum premium ! And you need to provide the 100% collateral upfront. In the CDS market, collateral value is not likely to be 100% or else traders would not be motivated to trade as there is no leverage !

Although the instrument is 5 years, typical CDS trader can exit the principal risk by selling away its position at a marked-to-market lost (e.g. may be 7% annual premium payout with another party now against the 5% that you agreed to receive previously). For the High Note 5, investors were locked in completely and they could not reverse their position at a loss to prevent loss of principal. And this liquidity risk, I believe is not even priced into in the product (screwed again). Just before Lehman went bankrupt, its 5-year CDS was trading at 7.90% or 790 basis points, about 3% above the 5% on the High Note.

Finally on the default settlement, the High Notes guys are settling with 100% loss as DBS is declaring that they are worthless now. But on the CDS market the settlement price for Lehman CDS has been set 91.38% as the existing Lehman bonds have recovery rate of 8.625% (screwed again).

CDS is like a binary option (outcome is zero or 1) on the credit risk of a company (the High Notes is on any 5 companies) . Getting the investor to write a CDS or credit-linked binary option is risky for any traders or corporates never mind the potenial return. And you are selling it to the retail market for a miserable 5% return ?

Straits Times, 29 October 2008

INVESTORS in DBS High Notes 5 finally got the news they have been dreading for weeks: Their investments are officially worthless.

DBS said on its website yesterday that the redemption value of the notes has been calculated to be zero, so nothing will be paid out. Letters are going out to investors notifying them of the valuation.

WORST-CASE SCENARIO
'Unfortunately the worst-case scenario has materialised and the majority of High Notes 5 investors will not be receiving anything back.' - A DBS spokesman

Brokerages act to help 'vulnerable' investors
SIX stock brokerages last night unveiled compensation plans for 'vulnerable' investors burnt by toxic products linked to the collapsed United States investment bank Lehman Brothers.

The six are: CIMB-GK Securities, DMG & Partners, Kim Eng, OCBC Securities, Phillip Securities and UOB Kay Hian.
... more
Sias to produce guidebook to help investors
A GUIDE to help people make investments, especially in complex products, is being launched by the Securities Investors Association of Singapore (Sias).

Sias president and chief executive David Gerald said the handbook will reach out to a broader base of investors.
... more
About 10,000 retail investors bought more than $500 million worth of structured products linked to now-bankrupt Lehman Brothers, with about 1,400 of them pumping $103 million into DBS High Notes 5.

Some investors of this product received late-night phone calls on Sept 16 from DBS relationship managers warning them that their entire stake may be wiped out.

High Notes 5 was offered to better-off DBS customers last year with a promised annual return of about 5 per cent.

An investor who did not want to be named said yesterday's zero calculation was inevitable.

'Guess that was the message the bank had prepared us for, so now we'll just have to wait for the forum on Thursday,' said the 52-year-old man who invested $50,000 in the product and will be attending a dialogue with bank officials tomorrow.

A DBS spokesman told The Straits Times: 'Unfortunately the worst-case scenario has materialised and the majority of High Notes 5 investors will not be receiving anything back.'

When the bank distributed the structured notes last year, the likelihood of Lehman filing for bankruptcy was extremely remote, she said.

But she added that in cases where DBS' standards were not met when the notes were sold, the bank will take responsibility and 'investors will be compensated accordingly'.

The bank has estimated that it will pay compensation of about $70 million to $80 million in Singapore and Hong Kong, where it sold a similar Constellation Series of notes.

In Hong Kong, there are 3,300 investors who invested about $257 million in the notes.

The payout will go to people such as retirees who the bank feels were mis-sold the risky product.

On DBS' part, it does not profit from the unwinding of these notes.

While yesterday's zero valuation was expected, questions have been raised over how the figure was arrived at.

Lawyer Siraj Omar, from Premier Law LLC, combed through the High Notes 5 pricing statement and told The Straits Times that it contains four different formulas for calculating what is called the credit event redemption amount.

A credit event is triggered when one of the entities linked to the notes defaults.

Two formulas are absolute calculations while the other two are percentage calculations.

'DBS has now given its calculation of the credit event redemption amount based on just one of the four formulas. The question is whether there is any justification for selecting this particular formula over the other three,' said Mr Siraj.

'If there is no justification based on the terms and conditions, the question arises whether the notes should be considered void from their inception.'

A DBS spokesman said that three of the various formulas are 'consistent with each other and mathematically the same' while one has a 'typo error'.

Lawyer Raymond Lye, from Pacific Law Corporation, said the credit event redemption amount 'appears to be described in several different ways'. But he cautioned that bank contracts usually contain clauses that protect the bank in the event of ambiguity.