Creditflux Newsletter

This is a traditional financial crisis, complete with wavering and incompetent politicians, balance of payment problems and currency speculators. And it’s not our fault: CDOs played no part in stoking lending to the eurozone periphery. Even the rating agencies are, for once, blameless.

As a result, a good number of structured credit specialists are cheering the euro crisis: not just because it draws attention away from subprime loans,
but because it might be good for business.

The market for distressed structured finance assets has become hopelessly one-sided in recent months. Hedge funds that have ridden up one of the most spectacular recoveries in financial history are desperate to buy more discounted CLOs and other fundamentally strong securitised bonds. But no-one wants to sell.

The waves of forced selling – by liquidating SIVs and failing banks – came early in the crisis. Today, even when vehicles such as CDOs of ABS are being liquidated, the controlling investors are in many cases buying back the assets from the auction, preferring to hold them cleanly on their own balance sheets than indirectly through a frozen vehicle.

A large proportion – no-one can say quite how much – of all outstanding CLOs is held by bank and insurance legacy books and bad banks, and
these institutions are also determined
to hold their assets.

As one structured credit official points out, legacy books are no longer something to be ashamed of. Instead, they are a source of profits. Many banks marked these assets down aggressively in 2008 and 2009. So all they need do to book a profit is monitor their value in the secondary market and adjust them accordingly. This is not even an expensive business to run. Structured credit specialists come cheap these days. Banks can hire experienced professionals with deep product knowledge and good contacts for sums they used to consider pocket money. And plenty of asset management firms and brokers will provide free valuations in the hope of securing some crumbs of business in future.

So those who run distressed hedge funds are hoping that a rise in systemic risk will put the wind up some bank investors and prompt them to sell.

This might happen. Some of the best buying opportunities in the last three years have arisen when some distant layer of management or some board of directors have panicked and sent out the order to “get rid of all this stuff”.

But even amid a full blown euro collapse, banks might choose to hang on to their structured credit legacy books. Partly, this is because they have had time to figure out which of their investments really are likely to pay back at par. Partly, it is because there will be more pressing issues to deal with amid a new crisis. And partly, it is for more human reasons.

The people running legacy books are not usually incentivised to make quick sales. Few are promised a whopping bonus if they wind the book up quickly. Rather, they are marking time, and hoping to return to the business of selling products when some kind of new issue market re-emerges. If they sell quickly, they will put themselves out of a job.

There is also one important reason that the euro crisis might turn out to be bad news for credit investors. It is due to the fact that, if several big institutions off-load their structured finance positions, distressed buyers may get more than they bargain for. After all, the buyer base is still small compared to the total value of legacy assets, and it would not take much to tip this one-sided market into big falls.