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Financial

Hurricanes and the housing bubble 2.0

Was Hurricane Katrina a one-time blow for the financial industry? Now, 12 years later, it looks like the answer may be "no."

In April 2008, I wrote that of the many metaphors that commentators had applied to the then economic crisis — turmoil and turbulence being particular favorites — one,by Susan Walker of Elliot Wave International, was heavy with irony: “The world is awash in bad news about the sub-prime mortgage meltdown, just the same way that New Orleans was awash in floodwaters from Hurricane Katrina two summers ago.”

This was because at least one-third of the 360,000 housing mortgages that Hurricane Katrina had affected were sub-prime and many of those had been taken out by poor homeowners who were uninsured. Thus, the hurricane was the final straw that tipped the precariously balanced mountain of U.S. sub-prime securitized debt into the same abyss into which prime residential, commercial real estate and the consumer credit market debt were falling.

The summer of 2017

The summer of 2017 has been rife with portentous predictions about the imminent bursting of the putative housing bubble 2.0 ─ predictions that may be about to come true sooner than envisaged by their authors as the housing mortgage market buckles under the onslaught of hurricanes Harvey and Irma.

The Data & Analytics division of Black Knight Financial Services, Inc. recently released an updated assessment of the potential mortgage-related impact from Hurricane Harvey, indicating that the total mortgaged properties in Hurricane Katrina-related FEMA disaster areas had been 456,000 compared to 1,180,000 in the case of Hurricane Harvey and the total unpaid mortgage balances in the Katrina-related FEMA disaster areas had been USD $46 billion, the figure for Harvey (so far) is USD$179 billion.

The commercial mortgage market

In terms of other markets which proved vulnerable in the wake of Katrina,Fitch ratings have indicated the risk with regard to commercial property centers not only on properties that may be uninsured against flood damage, but also on those that  flooding may have left undamaged but which have been abandoned because people cannot reach them. Other risks include that of failing to have in place business interruption insurance. The Mortgage Brokers Association reported Morningstar Credit Ratings, New York had indicated that Harvey-related flooding would create uncertainty for 1,529 Texas properties with a USD$19.4 billion property balance backing commercial mortgage backed securities. Moody’s has reported close to two-thirds of Moody’s-rated commercial mortgage-backed securities (CMBS) transactions, and 5.7 percent of rated CMBS collateral, have exposure to Hurricane Irma-affected regions and that for individual transactions, deal-level exposure can be as high as 100 percent. Furthermore, nearly half of Moody’s-rated CRE collateralized loan obligation (CLO) transactions have exposure to regions hit by Hurricane Irma, as does 4.9 percent of Commercial real estate (CRE) CLO collateral. For individual transactions, deal-level exposure can reach 22.6 percent.

Consumer credit markets

In terms of the consumer credit markets, Bank of England Governor Mark Carney announced in July that unsecured consumer credit had risen to £200 billion for the first time since 2008, the height of the last financial crash. The Prudential Regulatory Authority issued a statement on consumer credit which warned that the resilience of consumer credit portfolios was reducing, due to the combination of continued growth, lower pricing, falling average risk-weights (for firms using internal-ratings based models2), and some increased lending into higher-risk segment. Concern about these markets was also evidenced by the publication of a consultation on consumer credit by the Financial Conduct Authority (FCA).

Low interest rate environment

Back in 2008, then-Federal Reserve Board chairman Alan Greenspan was on the defensive with regard to his record in response to those who had suggested that his low-rate regime had created, or at least helped to blow up, the then-asset price bubble. Such a low interest rate environment has remained for the last decade thanks to the instigation and maintenance of quantitative easing schemes of asset purchases by central bankers.

Relaxing the eligible collateral rules

In 2008, central bankers were stepping up to the plate by offering to relax the normal eligible collateral rules to enable them to shoulder some of the risk burden of the toxic assets weighing down the banks’ balance sheets. In 2008, Greenspan had enjoyed the advantage of having the example of a similar exercise engaged in by the Bank of England in the case of Northern Rock in 2007 to inform his monetary policy decisions.

Mervyn King, then-Governor of the Bank of England, warned, however, that such policies undermined the efficient pricing of risk by providing ex-post insurance for risky behaviour which encouraged excessive risk-taking, and sowed the seeds of a future financial crisis.

Nevertheless, he concluded that the economic costs of failing to introduce liquidity outweighed the potential future costs of the concomitant moral hazard.

Toxic waste

Alistair Darling, then-UK Chancellor of the Exchequer, was reported to have favored a coordinated intergovernmental plan to relieve commercial banks of mortgage-backed securities and move them on to the central banks’ balance sheets. The uncomfortable fact remained in 2008 that the nettle of finding out how much toxic waste there was and then figuring out where to put it had to be grasped.

Capital relief trades

There are indications that one of the consequences of the more stringent prudential regime which followed the financial crisis of 2008 and the prospect of further restrictions on the use of the internal ratings-based approach to credit risk under a CRD IV is an increase in the use of capital relief trades (CRTs).

These are typically defined as synthetic securitizations through which banks transfer the risk of a reference pool of credit exposures to nonbank investors. The transfer can occur though a credit default swap or a financial guarantee with a special purpose vehicle, or it can be embedded in a credit-linked note that the bank issues. As Paul Mason of Barclays Bank recently noted “there’s been a meeting of minds, between investors looking for yield, and banks looking for capital relief.”

The Bank of England characterized such trades as capital trades, which seek to transfer the risk related to portfolios of assets from a bank to a third party, such as a hedge fund. If the structure of these transactions is not fully effective in transferring the risk, the bank may be under-capitalized as a result.

Even if the risk is completely transferred, transactions of this type increase interconnectedness and reduce transparency about where risk sits in the financial system and how much capital is held against it.

CDO magic

Bayview Financial was reported to be  in a deal described in terms of a hedge fund using  “CDO magic to transform Fannie Mae junk debt,” whereby it had packaged junk-rated securities issued by the two government-backed companies into USD $118 million of new bonds graded A- by Fitch ratings. The sale also allowed the hedge fund to borrow against its investments in the mortgage debt, giving it fresh funds to buy more assets to boost its returns.

The allusion to the notion of a “magic” transformation is eerily redolent of the characterisations of the CDO market prior to the financial crisis, where one guide published by  S&P Global Ratings’ Credit Research was titled  Distressed Debt CDOs: Spinning Straw Into Gold.

The debt that Bayview bundled into bonds was among USD $36 billion of credit-risk transfer notes that Fannie Mae and Freddie Mac have issued since 2013 such as the Structured Agency Credit Risk (“STACR”) Debt Notes.

The transfer of risk in the courts

A recent decision in the Commercial Court concerned a capital relief trade. The litigation featured a dispute concerning the interpretation of the terms of a credit protection guarantee.

It is interesting to note that Hon. Mr Justice Popplewell indicated in his judgement that “One of the reasons for structuring the deals in a way which did not expose Barclays to any real credit risk on the first loss tranche of the portfolio, which was the risk notionally being protected by the guarantees, was that Barclays would not have been prepared to take such a risk, at any price, in the current turbulent market conditions. Nevertheless the structure of the transaction was apparently such as to persuade the regulators that there had been an “effective transfer of risk” on this tranche so as to qualify for the full risk weighted relief in respect of it.”

The negotiations prior to the entry into these agreements had begun on 16th September 2008. On September 15, 2008, Lehman Brothers had filed for bankruptcy.

Supervisors are unlikely to have been so accommodating in the post-Lehmann era.

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