In Echo of Runup to Crisis, Bond Investors Reaching for Yield

An article in the Financial Times by Tracy Alloway gives yet another sighting that bond investors are getting a bit frantic in their hunt for yield. The piece has the eyepopping title, Yield-hungry investors snap up US homeless bond. It uses recent deals in the CMBS (commercial mortgage backed securities) market as a proxy for bond investors’ QE-driven hunt for more return.

And the homeless part isn’t an exaggeration:

One of the more eye-catching examples is a bond sold by Citigroup which is backed by 137 commercial mortgages. The bond includes a loan to 127 West 25th Street, a homeless shelter whose location in the fashionable Chelsea neighbourhood of Manhattan has raised the ire of some of the area’s residents. The bond was sold last year but has not previously been reported.

Now as sensational as this sounds, this data point is hardly damning in isolation. Who is the lessor? New York City or a private body? If New York City, and the lease is long enough and has decent price escalations built in, this could actually a good if unconventional credit. And having 5-10% of a deal in unusual leases isn’t imprudent if the leases have stable enough tenants and/or compensating factors (like the yield on them really does compensate for the risk). But this is still a big departure from the usual constituent elements of CMBS deals, whose staples are conventional commercial properties, like high quality office buildings and malls. And the homeless shelter is far from the only exotic asset included in these transactions. One which is clearly high risk is the Kalahari Resort and Convention Center, “a chain of African-themed waterparks.”

And the article makes clear that there are broader signs of frothiness:

Pro forma underwriting, where originators estimate the future cash flows of a property on optimistic projections rather than current rates, has crept back into the market, according to some commercial mortgage brokers who connect property developers with lenders.

“Different folks have different perspectives on what they believe ‘pro forma’ is,” said Eric Thompson, senior managing director at Kroll. “There is a clear line though – and if originators are giving credit to rental revenue that is not in place and/or above market rates it is pro forma, and we have seen some of that.”

Interest-only loans, another hallmark of pre-crisis lending practices, have also returned.

Another indicator is a close-to-cheerleading article a few days ago in the Economist about the return of securitization. Never mind that securitization was used to eliminate the need for banks to hold equity against loans, and over time, lending decisions based on local market knowledge and character assessment were replaced by model-based processes. The latter did not perform very well. Yet the article blandly parrots official PR that the problems with securitization have been remedied:

Why are regulators so keen on the very product that nearly blew up the global economy just five years ago? In a nutshell, policymakers want to get more credit flowing to the economy, and are happy to rehabilitate once-suspect financial practices to get there. Some plausibly argue it was the stuff that was put into the vehicles (ie, dodgy mortgages) that was toxic, not securitisation itself. This revisionist strand of financial history emphasises that packaged bundles of debt which steered clear of American housing performed well, particularly in Europe….

This is in large part because regulators want banks to be less risky, by increasing the ratio of equity to loans. As banks are reluctant to raise capital, they need to shed assets. This is where securitisation helps: by bundling up the loans on their books (which form part of their assets) and selling them to outside investors, such as asset managers or insurance firms, banks can both slim their balance-sheet and improve capital ratios.


One improvement is that those involved in creating securitised products will have to retain some of the risk linked to the original loan, thus keeping “skin in the game”. The idea is to nip in the bud any temptation to adopt the slapdash underwriting practices that became a feature of America’s mortgage market in the run-up to the financial crisis. Another tightening of the rules makes “re-securitisations”, where income from securitised products was itself securitised, more difficult to pull off.

Let’s consider how this really works. Banks have been repeatedly required by investors to rescue securitizations they’d sponsored. In other words, they really didn’t transfer the risk to investors. For instance, consider the history in credit card conduits. As we wrote in ECONNED:

Screen shot 2014-01-14 at 5.51.25 AM

And readers who followed the press in the early phases of the crisis will also recall how banks were on the hook for the supposedly off balance sheet structured investment vehicles (recall Citigroup board member Bob Rubin claiming he was unaware of the fact that they contained a “liquidity put”.)

Nor should anyone put much faith in “skin in the game”. The amounts are too small in economic terms to have much impact, and any losses are down the road and hurt the institution, rather than the responsible individuals. Clawbacks of compensation for the teams who worked on these deals would be far more effective. The article also claims that investors are wiser about CDOs. History shows that memories fade with remarkable speed. The 1990s subprime market, like its successor in the 2000s, depended on CDOs to sell the riskiest tranches of subprime bonds. That market blew up at the turn of the century. CDOs made a comeback in a small way in 2003, and had roared back to life by 2005, because supposedly new better structures and asset selection had fixed the problems with the old CDOs. Regulators should have prohibited resecuritizations entirely (this was part of a very well-thought out FDIC proposal that the sell-side fought hard). The fact that they’ve left an opening will allow the industry to push it wider.

And an aside early in the piece seriously undermines the author’s credibility:

Excluding residential mortgages, where the American market is skewed by the participation of federal agencies, the amount of bundled-up securities globally is showing a steady rise (see chart).

The reason the Federal agencies are so deeply involved in the US mortgage market is that US mortgage investors see securitization reforms as inadequate and are not getting back in the pool. The Federal agencies are filing a huge gap, not pushing private capital out, as the Economist incorrectly implies. And part of the failure of securitization in the US is the inability of investors (when they could not, as with credit cards, make a stink and force the banks to deal with unexpectedly high default levels) to get recourse in court for a whole raft of abuses: misrepresentation of the quality of the deal, the trustees’ failure to replace servicers who refused to put back bad loans to originators, and numerous types of servicing abuses, which hurt borrowers as well as investors. The failures here are legion, yet the Economist brushes by them.

Finally, a comment on the FT article by one “William J. Harrington (Former Moody’s SVP & Derivatives Analyst)” highlights another not-widely-recognized risk, that of defaults on the swaps in these deals (and the swaps are senior in these structures):

Commenters are correct that taxpayers are on the hook. Most CMBS, indeed most U.S. ABS, are exposed to counterparty risk, in addition to asset pool risk. Issues of CMBS and other ABS hold zero reserves against failure of a counterparty to an interest rate swap, instead relying on unenforceable “flip clauses” to pretend that an insolvent counterparty cannot claim funds earmarked for investors. Similarly, all rating agencies, including those quoted above, assign zero probability to the risk that CMBS investors will lose if a counterparty becomes insolvent.

Bank bail-outs stemmed CMBS and ABS losses in 2008 by preventing a major counterparty from becoming insolvent (Lehman provided few interest rate swaps to ABS issuers.) Only future bail-outs will validate issuers in betting that zero reserves will be more than ample to protect CMBS investors against counterparty exposure.

In fairness, the fact that investors are feeling their oats more than looks prudent does not mean a crash is nigh. Gillian Tett started expressing muted concerns about CDOs in 2005, for instance, just as the toxic phase was starting, years before the ugly denouement. But the hunger for risk-taking and the regulators’ confidence that meager reforms were adequate are not the sort of thing that one wants to see so soon after a global blow-up.

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  1. vlade

    A few points.
    Securitization is here to stay unless the whole economy changes dramatically – the banks would never be able to suppor the amount of credit currently needed for the economy on their balance sheets. Note that I’m not saying that the economy should not change to avoid that, I’m saying that in the current situation it’s close to impossible to live w/o some securitization (and F&F securitize).

    The world, excluding the US has been happily securitizing even in the last few years. There wasn’t much UK issues last year, but that was down to funding-for-lending scheme pushing the price of credit so low that it just didn’t make sense to securitize (well, in the sense as to get it to an external investor as opposed to lodge with BoE as collateral to FLS) anymore. For the record, no AAA rated RMBS in the UK lost its investors any money on credit events (and that includes Northern Rock’s Granite vehicle).

    Re the swaps. Not all swaps are supersenior. In particular, only asset swaps (swapping mortgge interest to LIBOR+x) are supersenior. Liability swaps (say XCY BGSes that swap libor flows from the asset swap to whatever the investor gets) rank pari-passu with investor.
    Theoretically, there are ways to deal with the insolvency of the cpty, but to my knowledge they have never been truly tested. That is, ALL of the swaps require downgrade clause. That is, the moment the cpty is downgraded below a certain rating (differs by agencies), they are required to post collateral to the SPV. The collateral is MTM of the swap + what’s called volatility cushion (VC), which is usually quite a large chunk of the notional. VC is there to deal with the illiquidity (and thus potential problems with getting a replacement) of the swap – the more exotic/illiquid/volatile/longer the swap (as deemed by the agency), the higher the VC.
    That is the “first rating” trigger. Second rating trigger usually requires that the swap provider replaces itself.
    Most of the banks in the world are now either at the first rating trigger (for AAA rated securities) or one notch away, the exception being a handfull of Aussie and Canadian AA- rated banks. LCR B3 requirements actually require that the banks hold the collateral they would have to post within three notches downgrade as part of their daily liquidity – so say all UK banks are required to do that (and have been for a while). US banks successfully lobied to get it postponed, and I believe some of the Europeans also want to postpone the LCR rule (which would otherwise come in effect Jan 2015).

    So we’re currently in the world where almost all banks are pretty close to posting the collateral, or are already posting. If rating agencies up the criteria just by a bit, they will cover just about all banks in the world, so – for AAA rated – securities the cpty criteria seems to go away. Fitch has already done that to an extent. The usual first rating trigger was BBB+, but Fitch now has for some time first rating trigger at A-.

    Of course, the problem is, if you have everyone rated close the second (replacement trigger), or even first (post collateral trigger), it’s hard to impossible to find a replacement cpty. So the real risk is less of a cpty default than the ability to get a replacement swap (for the amount of money that the SPV is able to spend on it).

    If you want more details on that Yves, you know where I live :)

    1. Yves Smith Post author

      Fixed-floating swaps in CDOs were senior, and also in a lot of MBS. I’m not familiar with CMBS structures, so I can’t speak either way.

      Agreed re securitization not going away, but IMHO you’ve still got the construction a bit backwards. The fact that we can’t wind the clock back does not make this situation desirable. No one is willing to acknowledge the hidden but large costs of securitization:

      1. Way too much loss of information critical to making sound credit judgments. This means you need MORE risk bearing capacity somewhere. You may have some parties who have cheaper risk bearing capacity than banks, but collectively everyone is kidding themselves to think it approaches the lending capacity of banks pre securitization. Look, the Eurobanks are simply way too big asset size wise relative to their economies. Tell me how you find enough capacity to take up lending that was a multiple of GDP of various advanced economies.

      2. Too much herd behavior. It’s bad enough with banking, and securitization makes it worse. You’ve got too many people who use the same models (driven by investor laziness and rating agencies, and to some degree, regulators).

      Who got to Andrew Haldane? He was loud not long ago in saying that too little diversity of institutions was a cause of systemic risk. I’m sure you saw his FT comment and Bank of England speeches on this. For other readers, a non-paywalled overview:

      Combine this with the observations of Amar Bhide (you can get a lot of the gist from the teaser at the HBR; more detail at the second link), that securitization has forced standardization of mortgage processes, such as the agreements themselves:

      Thus you have a highly homegenized industry, which per Haldane’s prior argument, increases systemic risk.

      We are in the fix I describe in ECONNED:

      Let’s use a different metaphor to illustrate the problem. Say a biotech firm creates a wonder crop, the most amazing creation in the history of agriculture. It yields far more calories per acre than anything else, is nutritionally extremely complete, and can be planted and harvested with far less machinery and equipment than any other plant. It is tasty and can be prepared in a wide variety of ways. It is sweet too, so it can be used in place of sugar and high fructose corn syrup at lower cost. We’ll call this XCrop.

      XCrop is added as a new element in the food pyramid and endorsed by nutritionists and public health officials all over the globe. It turns out that XCrop also is an aphrodisiac and a stimulant (hmm, wonder how they engineered that in) and between enhanced libido and more abundant food supplies, the world population rises at a faster rate.

      Sales of XCrop boom, displacing a lot of traditional agriculture. A large amount of farmland is turned over from growing other types of produce to XCrop. XCrop is so efficient that agricultural land is taken out of production and turned to other uses, such as housing, malls, and parks. While some old-fashioned farms still exist, they are on a much smaller scale and a lot of the providers of equipment to traditional farms have gone out of business.

      Twenty years into the widespread use of XCrop, doctors discover that diabetes and some peculiar new hormonal ailments are growing at an explosive rate. It turns out they are highly correlated with the level of XCrop consumption in an individual’s diet. Long-term consumption of high levels of XCrop interferes with the pituitary gland, which controls almost all the other endocrine glands in the body, and the pancreas.

      The public faces a health crisis and no way back. It would be very difficult and costly to put the repurposed farmland back into production. Some of the types of equipment needed for old-fashioned farming are no longer made. And with the population so much larger than before, you’d need even more farmland than before. The world population has become dependent on the calories produced by XCrop, so going off it quickly means starvation for some. But staying on it is toxic too. And expecting users simply to restrain themselves will likely prove difficult. The aphrodisiac and stimulant effects of XCrop make it addictive.

      Advanced economies have become addicted to debt technology, which, like XCrop, is addictive and hard to wean oneself off of due to its lower cost and the fact that other approaches have fallen into partial disuse (for instance, use of FICO-based credit scoring has displaced evaluations that include an assessment of the borrower’s character and knowledge of the community, such as stability of his employer). In fact, the current debt technology results in information loss, via disincentives to do a thorough job of borrower due diligence (why bother if you are reselling the paper?) and monitoring the credit over the life of the loan. And the proposed fixes are not workable. The Obama proposal, of having the originator retain 5% of the deal and take correspondingly lower fees, is not high enough to change behavior. And a level that would be high enough to make the originator feel the impact of a bad decision would undercut the cost efficiencies that made securitization popular in the first place. You’d have better decisions, but less lending, and more costly. That’s a desirable outcome, but as in the XCrop situation, no one seems prepared to accept that a move to healthier practices will result in much more costly and less readily available debt. The authorities want to believe they can somehow have their cake and eat it too.

      1. vlade

        I agree with both Haldane and Bhide (and with what you wrote in EC – which I’ll happily admit to owning).

        What I wrote was (but will put some emphasis/clarification) “Note that I’m not saying that the economy should not change to avoid that (and by implication be able to avoid securitization), I’m saying that in the current situation it’s close to impossible to live w/o some securitization (as it would be w/o your XCrop)(and F&F securitize).”.

        The current economic model is too dependent on plentiful credit. By credit I mean capital that seems to be “safe”, I’d be perfectly happy with world where everyone fully accepts securitization and understands the (meta)risks (as in that they can’t understand the correlation risks, ever, so it’s really a punt, but then, how is it different from owning equity in any sufficiently complicated company?) and behaves accordingly. I doubt we’re ever going to get that, as default human behaviour is to seek security and eliminate risks (and in the process of doing that accept the pretense of elimination of risks as good-enough substitute). My thinking is very close to Bide on public companies and debt vs. equity, so I’m really glad someone much more famous than I talks about it.

        Re the technical details on swaps. If you have a single-series SPV issued in the currency of the underlying assets, all you need is an asset swap (which would be supersenior). I don’t know much about how the actual CDO SPVs looked like legally, but I assume it was pretty close (in theory) to a standalone MBS SPV.

        If you’re issuing more than one series from the SPV (say UK Master Trust structure), you need both liability and asset swaps. Asset swaps will be super-senior, liability swaps pari-passu.

        Still, to be rated, both asset swaps and liability swaps will have the rating triggers to give the SPV some cpty safety, but as I wrote, they have their own problems (and to my knowledge are not truly tested in a distressed market when no cpty may be willing/able to take them). There are some real problems coming up around that, and more and more people are starting to monitor and worry this “replacement value adjustment” (Risk magazine second half of the last year) – and in general try to avoid the triggers where possible. Which brings its own problems.

  2. Dino Reno

    Subhead for cited article in the Economist: Since the whole world is now backstopped, snarky little journalists can safely crawl out of their free market holes and proclaim the world is being once again saved by financial innovation.

    1. OpenThePodBayDoorsHAL

      Ah yes, backstopped indeed. Wouldn’t it be nice if there was some money good collateral back there somewhere, not just “full faith & credit” and endlessly rehypothecated guys pointing at each other? China is the best example of full retard backstopping, in the West we have much more complicated schemes per this article, but the issue is the same. When you pull back the curtain on the Great OZ, or when Buffet’s tide goes out again, what’s left? Uh-huh…the chump taxpayer, yet again. He gets to pay through financial repression, through loss of services, through loss of purchasing power. As Travis Bickle said “someday a REAL rain is gonna come…”

    2. Ben Johannson

      Well, yes. The whole point is to lure institutional investors and the little guy back in after being so badly burned in 2007-2009. But no one trusts the bond peddlers any more so Uncle Sam is now standing behind them, smiling, his arms wide in a come to Jesus moment.

      It’s as transparent as it is crooked, which is a big part of Yves’ point.

  3. Chauncey Gardiner

    Thank you for your enlightening observations and commentary on recent developments in the debt markets. I concluded in the wake of the banking industry’s lobbyists successful efforts to neuter meaningful regulatory reform, the failure of the DoJ to prosecute the crooks responsible for the Great Financial Collapse and subsequent racketeteering (think LIBOR), the actions of government at all levels to aggressively repress those protesting corruption rather than focusing on the corruptors and corruptees, government officials moving through the revolving door to lucrative “private sector” appointments and other payoffs after their “public service”, the failure to rein in derivatives speculation and related activities, and the financial repression of QE-ZIRP for the benefit of the corruptors, that we will at some point be revisiting the same issues that confronted us in Autumn 2008.

    The developments mentioned in this article would seem to support this hypothesis. IMO we will not see meaningful change until Citizens United is overturned, either by a change in the composition of the Supreme Court or a grass roots Constitutional amendment.

    1. Vedicculture

      What a dumb post. QE doesn’t “repress” crap. The fact you think it actually means something is embarrasing. You will always revisit the same as August 2008 because Capitalism will always revisit crisis.

      Your post represents the ills of modern day politics. Inability to understand capital flows and how they interact with society.

      1. Chauncey Gardiner


        I feel badly for you in the position in which it is likely you find yourself.

        QE-ZIRP is a wonderful policy IF your interest is inflating financial asset prices and transferring wealth to a small segment of society from the general population. You can google a number of articles about how QE-ZIRP is deflationary for the real economy, but here’s just one article for you that pertains to the financial repression aspects of this policy:

        I encourage you to consider that Japan has been running QE-ZIRP policies for 20 years now to what effect?

        I will defer comment on the relatively short term positive effects of QE-ZIRP on the net interest margins of financial intermediaries, as fuel for speculative trading gains, or its longer term implications for the US dollar as the global reserve currency.

      2. h_rostam

        “capital flows interact with society”

        I THINK, far from defending QE & ZIRP, that you’re some sort of Marxist making a vague (and completely out of place) point about the dialectics of base/superstructure… I THINK you’re trying to say that blaming QE/ZIRP is an ideological way of ignoring deeper structural problems inherent to capitalism… I think that’s what you mean by it “doesn’t repress crap”… I also think that you smugly assume no one gets your “higher understanding”… I think your comment is extremely annoying, strange, and makes me hope to God that you’re in reality like 16 or something…

  4. Sufferin'Succotash

    An “African-themed waterpark” named after the Kalahari Desert?
    I’m suspicious already.

  5. Murky

    Blazingly intelligent debate on Naked Capitalism is sometimes punctuated by exceptionally stupid comment. The most moronic posts are usually of the ad hominem variety. No quality of argument. No careful parsing of facts. No attempt at persuasion. Just sheer and brutal aggression. I’m right, your wrong. End of discussion. Thank you, Vedicculture, for sharing.

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