Pathology of Debt

Henry C.K. Liu

Part I: Commercial Paper Market Seizure turns Banks into their own Vulture Investors
Part II: The Commercial Paper Market and Special Investment Vehicles

Part III: The Credit Guns of August heard around the world

This article appeared in AToL on November 29, 2007

Evidence of global contagion surfaced as a string of Germany banks ran into trouble with their leveraged bets on collateralized debt obligation (CDO) instruments and the even more toxic “synthetic” CDO derivatives: securities that contain top-rated tranches of US unbundled  subprime mortgage pools. A series of emergency actions by the European Central Bank (ECB) injecting a further $85bn in liquidity through various mechanisms in the third week of August highlighted the seriousness of the crisis.


A Dusseldorf-based bank that focuses on small and medium-sized companies, IKB Deutsche Industriebank AG, invested in structured credit portfolios was the first German bank to crumble early in August, requiring an €8.1bn state-rescue just days after it denied any significant exposure to sub-prime debt.  Fallout from the subprime mortgage rout was roiling markets around the world as rising risk premiums caused companies to face higher interest on their borrowings.

Contracts on 10 million euros of debt included in the iTraxx Crossover Series 7 Index of 50 European companies increased as much as 60,000 euros to 504,000 euros. Investor confidence in high-risk, high-yield loans fell to the lowest in nine months as the iTraxx LevX Index of credit-default swaps on loans to 35 European companies dropped 0.25 to 94.50. Credit-default swap contracts based on 10 million euros of IKB debt, which traded at 15,000 euros in early July were at 120,000 euros on July 27.

The state-owned bank SachsenLB in former East Germany, founded in 1992 after the fall of the Berlin Wall, reportedly accumulated $80 billion of exposure to risky assets through a set of Irish funds kept off balance sheet. SachsenLB was rescued in August in a state orchestrated bail-out by a consortium of banks agreed to provide a €17.3 billion credit lifeline, but only on the understanding that it agreed to be sold to a stronger player. The regional government of Saxony then agreed to sell the state-owned bank - the biggest victim up to that time in the worldwide credit rout - for a token €300 million to the Landesbank Baden-Württemberg in Stuttgart (LBBW), ending a three-week saga that revealed the extent of German involvement in treacherous US subprime debt. LBBW has the right to cancel the sale if further significant exposures to subprime risk are found at SachsenLB or any of its off-balance-sheet units.

Süddeutsche Zeitung reported that Irish “conduits” (off-balance sheet vehicles) were used by SachsenLB to fund 65 billion euros for investing in CDOs and other high-risk structured investment vehicles (SIVs) which involve using short-term credit to buy longer-term assets, creating mismatches in maturities that were highly vulnerable in a volatile market.

Rhinebridge Plc, a fund managed by Dusseldorf-based IKB Deutsche Industriebank, sold $176 million of assets after it couldn't find buyers for its short-term debt.


News of the unwinding of Dublin-based Cheyne Finance flashed around the globe in late August.  Cheyne Finance, a SIV managed by hedge fund Cheyne Capital, was forced to begin selling its $6.6 billion portfolio after a downgrade by Standard & Poor’s, the ratings agency.

Cheyne Finance, the SIV managed by British hedge fund Cheyne Capital Management, went into receivership (known as bankruptcy in the US) in September after exhausting bank liquidity credit lines to help repay maturing debt. The receivers had to arrange with the Royal Bank of Scotland (RBS) to restructure the finances of Cheyne Finance after the SIV stopped making payments on its debt in early October.  Ratings agency Standard & Poor’s said the Cheyne Finance portfolio was made up of 56% of residential mortgage-backed securities (RMBS), 6% of collateralized debt obligations of asset-backed securities (CDOs of ABS, consumer credit) and 38% of other debt, such as corporate CDOs and commercial mortgage-backed securities. Some 52% of the portfolio was rated AAA before S&P cut the ratings on Cheyne Finance to D, or default, after it stopped payments.

Cheyne Capital Management Ltd., whose Queen’s Walk mortgage bond fund reported losses in June, was forced to sell assets backing a $6 billion commercial paper program after a global credit market rout. The Cheyne Finance LLC fund had been selling assets and had enough cash to repay commercial paper due through November. But Standard & Poor’s cut Cheyne Finance ratings citing the deteriorating market value of its assets. S&P lowered the credit rating on the commercial paper issued by Cheyne Finance by two levels to A-2 from the highest level of A-1+. The rating on senior debt was cut six levels to A- from AAA.  The average yield on the highest rated asset-backed commercial paper with one-day maturity has risen 0.71 percentage point to 6.04 percent as investors have fled funding linked to subprime mortgages. Cheyne Finance had drawn on all three of its emergency funding facilities and would continue to sell assets to meet its liabilities. Cheyne is working on recapitalizing or restructuring the company and extending its debt maturities.

Cheyne also runs Queen's Walk Investment Ltd., a fund that invested in mortgages and reported in June a loss of 67.7 million euros ($92 million) in the year ended March 31.

Funds like Cheyne Finance, so-called structured investment vehicles, typically sell commercial paper and use the proceeds to purchase bonds with longer maturities.

HBOS Plc, the largest mortgage lender in the UK, repaid about $35 billion of commercial paper owed by its Grampian Funding LLC unit as contagion from the subprime slump drove up the cost of borrowing.

RBS agreed to set up a new investment vehicle that will buy Cheyne’s failed SIV’s $7 billion portfolio, financed by new and existing investors.  The new company set up by RBS would attempt to liquidate the portfolio in an orderly manner over time, with the existing senior creditors buying the senior part and new investors for the junior part. The bulk of the risk is taken by the junior investors with compensatory returns. Mezzanine investors could get back some of their investment in the event of a sale above a certain level. Similar to the Goldman Sachs rescue, it is a strategy to maximize the post-restructured value of the senior tranches at the expense of the junior tranches, by creating a new level of investors with increased risk appetite. It is essentially a vulture solution.

Barclays has been left with an exposure of hundreds of million of dollars to failed debt vehicles created by its investment banking arm amid growing scrutiny over its links to Sachsen LB, the failed German public sector bank. The UK bank provided back-up financing to one of four structured investment vehicles set up by its asset management unit, Barclays Capital, leaving it with a credit exposure. Ironically, news of Barclays’ exposure eased concerns among investors about potential losses arising from the vehicles, known as SIV-lites.

However, the bank’s relationship with Sachsen faced scrutiny after it emerged that Barclays had set up a SIV-lite on the German bank’s behalf less than three months before it collapsed. The recent liquidity crunch and turmoil in the credit markets has highlighted some of the risky structures set up by Barclays and other investment banks in an effort to capitalize on investor demands for highly-rated assets that offered an attractive yield.

Sachsen ran into trouble this month when Ormond Quay, an off-balance sheet funding vehicle, was no longer able to issue short-term financing in the commercial paper market.

Sachsen was sold to LBBW, the rival German public sector bank.  In May, Barclays set up a SIV-lite on Sachsen’s behalf. The vehicle, Sachsen Funding 1, had assets of $3 billion, backed by prime and subprime US mortgages. Standard & Poor’s, the credit rating agency, placed Sachsen Funding 1 on review for a possible downgrade, warning that it might have to wind down if it could not access sufficient liquidity. At the same time, S&P also slashed credit ratings for two other SIV-lites created by Barclays and placed a third on review for downgrade. Edward Cahill, the Barclays banker who was responsible for setting up the SIV-lite structure, and a junior colleague resigned, prompting widespread speculation about potential losses at the bank.

Other non-US banks were also hit by the US subprime market collapse, particularly British HSBC, the world’s third-largest bank, which saw its bad-debt provisions soar to $10.8 billion in 2006 as defaults in its subprime portfolio prompted the first profit warning in the bank’s recent history. In explaining adverse results, the bank disclosed that its own risk projections had failed to predict how many borrowers would fall behind on mortgages as interest rates climbed and saddled them with higher monthly payments.

HSBC Holdings, the bank’s parent and one of the most aggressive players in the US market for low-quality mortgage, sent a pall through the financial world with news that its bad-debt charges will be 20% higher than forecast. It was the largest lender to date, though not the first nor would it be the last, to warn on credit problems. Higher adjustable interest rates in 2007 were starting to hurt borrowers, especially those with poor credit, who bought homes using mortgages with low introductory rates during the liquidity-driven real-estate boom in the US. The ability of these borrowers to meet their mortgage payments depended on rising value of home prices to enable them to refinance their mortgages a year or two after purchase into low fixed-rate loans before rates climbed. By mid 2007, US home prices began to fall as home financing became more difficult and more expensive to obtain, causing a downward spiral. HSBC announced a strong second quarter dividend payout, and claimed that the subprime problem was largely contained. The market was not convinced as other distressing news surfaced.


Union Bank of Switzerland (UBS) announced in May that it was shutting its Dillon Read Capital Management hedge fund unit after subprime mortgage related losses dragged the bank's first-quarter profit down 7% to 3.28 billion Swiss francs ($2.71 billion) from 3.5 billion francs. Dillon Read suffered only a 150 million franc loss from trading in the collapsed US subprime mortgage market, but the effect of the credit deterioration was devastating. UBS share prices fell 4.5% in Swiss trading and matched that decline shortly after the opening of US trading on the day after the news. The Dillon Read unit was launched in 2006 and had benefited from significant investment with about 250 employees, more than half of whom were transferred from UBS's investment-banking unit when Dillon Read was launched.

Through the third quarter of 2007, UBS wrote down $4.4 billion in mortgage related products and $400 million in leveraged loans to private equity firms. Market analysts expect UBS to write down a total of $7 billion before the crisis subsides.


Caisse d’Epargne and Banque Populaire, two French mutual banks, pledged on November 21 to inject $1.5bn into CIFG, a bond insurer, to enable it to weather the collapse of the subprime mortgage debt market. It was the most striking subprime-related episode so far seen in France, which had previously been spared the dramas taking place on the other side of the Rhine in Germany, where IKB and Sachsen LB had to be rescued after they failed to handle exposure to volatile credit markets.

The Financail Times reported that credit ratings agencies had warned that CIFG was at risk of losing its vital AAA ratings if it did not increase its capital cushion because of the worsening outlook for subprime debt losses. CIFG is owned by Natixis, the French investment bank that is in turn controlled by Caisse d’Epargne and Banque Populaire. The two mutual banks announced that they would buy CIFG from Natixis and directly inject funds into the unit to maintain its all-important AAA rating. The announcement sparked a partial rally in Natixis’s share price, which had fallen steeply because of subprime fears. In late morning trading, Natixis shares were trading 18 per cent higher at €13.37. However, this was still 37 per cent less than their value at the start of 2007. Following the news of the capital injection, Fitch Ratings reaffirmed CIFG’s AAA rating.


In Canada, Coventree Inc., Canada's biggest issuer of non-bank asset-backed commercial paper with assets of almost C$40 billion, has been unable to renew about C$5.12 billion ($4.86 billion) of asset-backed commercial paper after some investors shunned the debt and technical problems prevented others from buying. Coventree and other non-bank owned funds failed to roll over most of their asset-backed commercial paper last week as mounting losses on US subprime mortgages led investors to avoid all but the safest government debt. The company's refinancing troubles have been exacerbated by technical glitches that made it difficult for some investors to roll over securities, according to a spokesman for a group of bank and pension funds that agreed on a rescue plan last week for some commercial-paper trusts.

A group of international financial institutions that included ABN Amro, Deutsche Bank and HSBC, Merrill Lynch, UBS, Caisse de Depot et Placement du Quebec agreed to a plan to end a liquidity crisis in the Canadian commercial paper market, staving off immediate problems but throwing fresh focus onto short-term funding troubles in other markets. It involves the conversion of outstanding ABCP, which normally mature in one to three months, into five-year floating-rate notes. This will remove the immediate uncertainty about lenders’ ability to renew these debts. Investors had also agreed to remove triggers that forced the underlying assets to be sold when they fell below a certain price. This mechanism is thought to have helped drive down prices, even though the creditworthiness of the underlying assets has not changed. The agreement, which covers about two-thirds of Canada's outstanding asset-backed commercial paper (ABCP), removes some of the immediate concerns about liquidity in the Canadian market but did not resolve the long-term problem.

The agreement is seen by some participants as a possible template for resolving blockages in other ABCP markets around the world. There is concern in Europe that banks may have to absorb tens of billions of dollars of ABCP on to their balance sheets. This would eat into their capital reserves and could trigger a broader credit crunch.


Three leading Japanese banks became the latest victims of the US subprime woes, which are proving more trouble to the country’s financial sector than initially expected. Mitsubishi UFJ Financial Group (MUFG) took a writedown on its subprime exposure of up to six times its initial forecast of ¥5 billion ($43.6 million) to ¥30 billion as of the end of September.

Sumitomo Trust, a large trust bank, revised its net profits forecast down by 31% as a result of additional provisions against its exposure to non-banks and losses related to the US subprime mortgage sector. Sumitomo Trust scaled down first-half net profits to ¥38 billion from ¥55 billion, on higher revenues of ¥520bn. Full-year 2007 net profits are now expected to be 25% below an earlier forecast, at ¥90 billion, rather than ¥120 billion.

Sumitomo Trust said its loss relating to the subprime mortgage sector would be ¥9 billion and, combined with ¥30 billion in additional provisions against its exposure to non-banks, credit costs in the full year would double to ¥50 billion from a previously forecast ¥25 billion. Sumitomo Trust is the largest lender to Aiful, the consumer finance company.

Sumitomo Trust’s consumer finance woes followed profit revision by Shinsei Bank which lowered its interim net profits forecast from ¥38 billion to ¥31 billion and its full-year net profits forecast from ¥72 billion to ¥62 billion, largely because of losses and writedowns related to two consumer finance affiliates and to the US mortgage market.

In a surprise move, the bank, in which the government owns 10% in common shares, passed its interim dividend. Shinsei will pay an interim dividend on the government’s preferred shares, which face mandatory conversion next April, raising the government’s stake to 25%.


Bank of China Ltd., the nation’s second-largest bank, announced it holds almost $9.7 billion of securities backed by US subprime loans, the most of any Asian entity. The collapse in securities backed by US subprime mortgages has caused losses at lenders from Japan to Australia, helping send Asian banking stocks lower in September. Bank of China, which accounts for more than two-fifths of foreign currency advances by Chinese banks, was also weighed down by 1.2 billion yuan in foreign-exchange losses in the period.

Credit-default swaps tied to Bank of China's bonds widened by about 15 basis points to 68 basis points. Swap prices rise when investors perceive higher risk of default.

Mitsubishi UFJ Financial Group Inc., Japan's biggest bank, said in September it has about 300 billion yen ($2.6 billion) of investments that incorporate subprime loans. Sixteen Taiwanese banks reportedly held a total $1.2 billion in securities linked to US home loans.

Next: Lessons Unlearned