So how does one explain the contagion to corporate credit from the subprime market given the disparity in fundamentals between these two sectors?
Although the answer is complex, one factor stands out: There has been a loss of confidence among investors in their ability to assess the value of and risks associated with structured products, which has led to a sharp drop in demand for such products.
The loss of confidence stems from many sources, including the opacity of such products; the infrequency of trades, which makes it more difficult to judge appropriate valuation; the difficulty in forecasting losses and the correlation of losses in the underlying collateral; the sensitivity of returns to the loss rate and the degree of correlation; and the problem that the credit rating focuses mainly on one risk—that of loss from default.Please note that it is the opacity of structured finance markets that makes them impossible for market participants to assess their value and risk.
When investors cannot assess the value and risk of an investment due to a lack of transparency, they stop buying or selling said securities. They stop because they have no way of independently determining the value of the securities and comparing this independent valuation to the prices shown by Wall Street to make a buy, hold or sell decision.
More than five years after this FOMC meeting, the question is: what has changed about structured finance securities to make them transparent?
The answer is nothing.
These securities will not be transparent until such time as they provide observable event based reporting and all activities like payments and delinquencies on the underlying collateral are reported before the beginning of the next business day.
Without observable event based reporting, buyers or sellers of these securities are simply blindly betting on the contents of brown paper bags.
The CLO and CDO markets have facilitated the transformation of low-rated paper—for which there is a limited investor appetite—into a high proportion of high-grade-rated debt.
For example, in a typical CLO structure, the underlying loan quality averages a rating of about B. Yet through the magic of structured finance and the corporate rating agencies, the resulting CLO tranches are rated predominately investment grade.
Exhibit 8 shows the structure for a representative CLO: More than two-thirds is AAA-rated debt, and 87 percent is investment grade.
The loss of confidence among investors in the ability to assess the value and risks associated with this structured product has led to a sharp drop in CDO and CLO issuance.
As shown in exhibit 9, CLO and CDO issuance plummeted in July.
This is very important because the CLO and CDO markets represent the bulk of the demand for non-investment-grade debt. With this demand falling away at a time when the forward supply of high-yield corporate loans and debt exceeds $300 billion by some measures, a huge mismatch between demand and supply has developed.
The underlying problem is that the depth of the market for non-investment-grade rated loans and debt—excluding CDO and CLO demand—is far shallower than the market for investment-grade products.The only way to restore depth to the market is to provide transparency. Until this is done, the buyers will remain on strike.
Please note that based on the minutes of the FOMC this simple fact was known prior to the beginning of the financial crisis on August 9, 2007.
Yes, in all of the Fed's responses to the financial crisis, the Fed has never addressed making structured finance securities and bank balance sheets transparent.
From the August 10, 2007 Fed conference call, Ben Bernanke speaking:
President Fisher, our goal is to provide liquidity not to support asset prices per se in any way.
My understanding of the market’s problem is that price discovery has been inhibited by the illiquidity of the subprime-related assets that are not trading, and nobody knows what they’re worth, and so there’s a general freeze-up.
The market is not operating in a normal way. The idea of providing liquidity is essentially to give the market some ability to do the appropriate repricing it needs to do and to begin to operate more normally.
So it’s a question of market functioning, not a question of bailing anybody out. That’s really where we are right now.Please re-read the highlighted text as within a span of 3 days following the FOMC meeting that said that opacity was making it impossible for market participants to value structured finance securities, Mr. Bernanke has completely forgotten the problem needs to be addressed.
Note that he asserts that the goal is to provide liquidity until the market's problem with price discovery is fixed.
And lo and behold, the Fed has been adding liquidity through programs like quantitative easing ever since. Of course there is no end in sight for these liquidity programs because no one is working to make these securities transparent!!!
Governor Mishkin on August 16, 2007 conference call discussing letting banks pledge structured finance securities at the discount window as a mechanism for unfreezing the frozen subprime mortgage market caused by the buyers' strike,
The issue is that there’s an information problem in the markets, but the banks’ knowing that there’s a backstop and that we’re doing something in terms of the discount window could actually unfreeze the system so that we could have players come into these mortgage markets to replace the players that are now not in the mortgage markets.An information problem that can only be solved by bringing transparency to both structured finance securities and bank balance sheets.