OH CDOs, CDOs, WHEREFORE ART THOU CDOs?

As the quarterly earnings season rolls forward, we are finally getting our first concrete statements as to exactly who lost what as a result of this summer’s financial turmoil. So far, financial institutions have booked losses of around $30 billion, with the grand total likely to come in at about double this amount when all is said and done. While not an insignificant sum, if spread evenly across investors worldwide, this would equate to just a nickel loss for every $100 invested in global bond and stock markets.

A large amount of the losses was concentrated in asset-backed securities (ABS), and even more acutely in mortgage-backed securities (MBS). These are financial instruments in which a bond or note is backed by an asset or stream of revenue tied to that asset. Many of these instruments were spliced into complex financial instruments known as collateralized debt obligations (CDOs) that continue to be at the heart of financial market disruptions.(1)

The cone of silence that descended on many financial institutions this summer when it came to discussing exposures has made resolving market disruptions slower than it might have otherwise been. But the lack of transparency runs much deeper. Nearly two-thirds of U.S. originated MBS’s held abroad went through offshore and intermediary financial centres which limit our ability to track their ultimate holder. In the aftermath of a crisis of confidence in global financial markets stemming from a lack of understanding and trust, this is not helpful to say the least. Nevertheless, in spite of selling off U.S. financial assets in August in record amounts, there appears to be an ongoing appetite for American financial products.

The current paper explores the rapid growth of asset-backed products in the United States, the extent to which these products found themselves distributed around the world, and how this has compared with demand for other U.S.-originated financial products. We differentiate U.S. assets by type and separate out major global players, including Offshore and Intermediary Financial Centres (OIFC), Sovereign Wealth Funds (SWF), and the other major emerging markets of Brazil, India, and Russia.

Go forth and multiply

Not all asset-backed securities are created equal or have been equally disruptive to financial markets. The main culprit has been MBS issued by the corporate sector. Outside of this, there are MBS products which are guaranteed by the U.S. government agencies Freddie Mac and Fannie Mae (together with non-MBS products, these are labeled Agencies). This latter group, as well as products backed by other assets – credit card receivables, auto loans, etc. – do not carry the same costs of potential default. They did not succumb to the same deterioration in lending standards seen in the U.S. mortgage market and have therefore recovered more quickly.

TD Economics estimates that the stock, as of June 2007, of U.S.-originated, long-term, asset-backed debt held outside the United States was about one-half of the size of U.S. equities held abroad and about one-third of the size of other U.S. debt held abroad. Its growth over the last several years, however, has been quite striking. In the four years from June 2003 to June 2007, the foreign holdings of U.S. asset-backed securities grew by an average of 46% each year, over three times the rate of growth of foreign holdings of other U.S. debt or equities. This came from extremely low levels, however. In fact, while about 17% of U.S. corporate MBS and 13% of other ABS products were held abroad as of June 2006, this compares with nearly 21% of other non-ABS U.S. corporate debt and 43% of other U.S. government debt. So, global portfolios were eating these products up, but not in undue amounts relative to the shares of other U.S. debt products.

With U.S. Treasury yields being depressed at low levels – as have been long-term interest rates world-wide – there was a global demand for new fixed-income products.(2) MBS and ABS products offered the desired high yield, and, prior to this past summer, this extra yield was thought by many to be relatively risk-free. So while demand for U.S. fixed income products as a whole has grown at a fairly constant rate since 1999, waning demand for U.S. Treasuries since 2004 was replaced with increasing net foreign purchases of corporate bonds (which include MBS and ABS) and Agency debt.

Peek-a-boo, I see you

But where were all these financial products going? The pie chart on this page shows that with regards to the stock of total foreign holdings of U.S. securities, the G7 and OIFC each hold about one-third, while the SWF and Other categories evenly split the last third (the MEM’s hold just a negligible share). Looking at the table on page 8 for a breakdown of the stock of holdings as of June 2006 (the most recent detailed breakdown) and the series of charts on page 7 for the changes in stocks since then, we see that the G-7 nations continued to be the principal purchasers of U.S. securities, adding about $700bn in new U.S. securities – more than 25% of their existing holdings – from July 2006-August 2007. In fact, the only category where the G-7 have not been the biggest player over the last year has been in agency debt, where SWFs – especially China – have been adding to their holdings of these higher yielding products. Driven by these strong purchases, SWF nations appear to have been ramping up their purchases of overall U.S. debt at a faster rate than non-G-7 groups while OIFC – which held roughly the same amount of debt as G-7 nations in the summer of 2006 – added very little to their holdings over the last year.

When it comes to purchasing corporate MBS, however, it looks as if investors were a bit shy about their holdings well before this summer’s financial disruptions. Fifty-eight per cent of all U.S.-originated corporate MBS were bought through OIFC that tend to maintain investor anonymity. If we add to this amount just half of the MBS that flowed through the United Kingdom, as a guess as to the foreign investors using London as their financial intermediary, we have no way of tracking down the ultimate holders of roughly two-thirds of all of the risky corporate MBS which flowed outside the United States. Again looking at the charts on page 7 to see how holdings may have changed over the last year, all regions added to their holdings of corporate debt (in the monthly data there is no way to separate the ABS vs. non-ABS debt), although OIFC started to pare back their holdings in June 2007. Looking at MBS debt held by each nation as a share of their holdings of all U.S. debt, four out of every ten dollars held in the Channel Islands was a U.S. corporate MBS. Across all OIFC, nearly 10% of all U.S. securities held were corporate MBS and 20% were an ABS product of some kind. Both of these shares is roughly twice their average share within the U.S. dollar national portfolios of the other major regions and is a higher concentration than even the share of ABS debt held by U.S. residents.

The concerns in Europe over the subprime crisis also make more sense once we see that outside of the U.S., four of the top five holders of U.S.-originated corporate MBS are European countries. Moreover, outside of the OIFC, the largest concentration of corporate MBS as a share of total U.S. holdings was in Germany, where it accounted for 12% of their national portfolio of U.S. holdings as of June 2006. Looking at the monthly changes since then, the initial reaction might be to think this exposure was lessened. From July 2006 through July 2007, German investors sold off about $14bn in U.S. corporate debt (again which would include the ABS and MBS holdings) and added about $14bn in U.S. non-corporate debt. There is a peculiar spike in the sale by German investors of U.S. corporate bonds in the fourth quarter of 2006; however, and an equally peculiar spike of nearly the same magnitude in net purchases of U.S. corporate bonds in the same quarter in – where else – the Cayman Islands.

This could be a mere coincidence in the data or it could be German companies selling to different off-shore investors or it could be German companies moving their assets to their own off-shore accounts or structured investment vehicles (SIVs). These SIVs became warehouses for subprime-backed debt largely by buying ABS debt and issuing commercial paper at a lower interest rate to finance these purchases. Because of the high amount of debt relative to equity, these vehicles were susceptible to sudden market disruptions for commercial paper, as we’ve now seen, but more broadly, they appear to be part of a broad reorganization in global financial markets away from transparency and towards opaqueness. Some of this can be tied to the public accounting reforms put into place in the U.S. in 2002 – the Sarbanes-Oxley Act (SOX) – in response to various corporate accounting scandals. But creative accounting need not happen within national borders. The widespread perception that SOX regulations are unnecessarily onerous for U.S.-based firms to comply with has driven companies to more closely scrutinize precisely where they report their profits, losses, assets, and liabilities in order to skirt the good intentions of SOX with more creativity. This kind of tax- or regulatory-arbitrage is nothing new, but in the aftermath of a crisis of confidence in global financial markets stemming from a lack of understanding and trust, a lack of transparency is a hindrance, not a help. This does not necessarily mean it will lead to changes in the way financial markets operate, especially if looking at day-to-day volatility, but it certainly makes it harder to prepare for the next financial crisis because we may not be able to see it coming.

Buckle up for safety

In August 2007, foreigners sold U.S. securities to the tune of $35 billion net, the largest monthly decline on record with 30 years of data. There has been a concern that the onerous regulatory environment, unfavourable investment climate, and now the subprime financial crisis will lead investors to blindly sell their holdings of U.S. assets. U.S. Treasury demand is often cited as one such product that will see flagging demand, especially given the stated desire of nations with large international reserves and/or SWFs to seek higher yielding assets. In fact, over the last year, only OIFC pared back their holdings of U.S. Treasuries, while SWF holdings were flat – at first accumulating Treasury wealth through the end of 2006 before selling off most of these gains by August 2007. The remaining regions’ purchases still outweighed the sales, so foreign holdings of U.S. Treasuries have grown each year since 2002.

Even the argument that a weakening dollar implies a weakening of U.S. economic might and is likely to drive investors out of the U.S. financial markets appears to be flimsy. In fact, the relationship over the last decade has been in the opposite direction – a strengthening U.S. dollar tends to accompany net foreign sales of U.S. Treasuries while a weakening U.S. dollar tends to see net foreign purchases of U.S. Treasuries. The weakening dollar can signal global economic financial risks and the U.S. remains investor’s preferred location when fleeing to safety. Also, a weakening dollar means increased purchasing power by those not holding U.S. dollars so perhaps this has been the dominant effect. The magnitude of these shifts – as well as the domestic U.S. economic events underpinning them – do seem to cause an echo in the spreads associated with U.S. Treasuries so rising bond prices play a role, as well. Regardless, it does appear that demand for U.S. assets remains.

There are certainly many lessons still to be learned from this summer’s tumult. Financial markets are still rethinking the new business models developed in recent years which employed rapid securitization and distribution of risk. The economic impact from these losses, though, still appears to be fairly contained, especially relative to the worst case scenarios imagined in July and August. Unfortunately, periods of rapid financial innovation tend to be followed only later by understanding. Additionally, there has been an unfortunate relationship – those investors with the least transparency are increasingly buying the riskiest financial products. In the weeks and months to come, there will be more financial institutions around the world reporting more losses as a result of the summer’s turbulence. These admissions are cathartic for financial markets. More progress needs to be made, however, to improve transparency, especially when it comes to the seemingly simple question of who is buying what? Our increasingly advanced and globalized financial markets have the tools they need to address current and future dislocations, but you can’t fight what you can’t see.

Richard Kelly, Senior Economist
416-982-2559

(1) For more on these issues, see TD Economics report entitled The Grey Anatomy of the Current Credit Crunch here: http://www.td.com/economics/special/rk0807_grey.pdf.

(2) For more on the factors keeping yields low, see TD Economics report The Shape of Yields to Come here: http://www.td.com/economics/special/ca0607_rates.pdf.