Drying up down under

Liquidity in Australia's nascent structured credit market has suffered as a result of the subprime squeeze, leading to an inevitable bout of finger-pointing. Marion Williams reports

Australian investors have so far been hit hard three times by the US subprime loans debacle and the ensuing liquidity crisis for leveraged credit structures. Just one of Australia's publicly known incidents involves a collateralised debt obligation with exposure to US subprime loans. The other two relate to investment through structured credit investment manager Absolute Capital and hedge fund Basis Capital, both Sydney-based firms. On the whole, the countries' institutions seem to have fared better than those in Europe and the US, but financial executives are still very cautious on the subject, which suggests the issue is not resolved quite yet.

No CDOs rated by Standard & Poor's in Australia have defaulted; but, as elsewhere, valuations on these and other leveraged-credit securities have been slashed, despite them having no exposure to US subprime loans. For example, the A$220 million ($193 million) Macquarie Fortress Funds, which invest in a diversified, actively managed, leveraged portfolio of US senior loans, had a net asset value per unit of A$0.785 cents as of October 31, up from A$0.686 cents on August 31, but still down from A$1.019 on June 29. Fortress Funds are unrated managed 'alternative' investments open to retail investors.

A Lehman Brothers structure, marketed as Federation around May, is the only CDO widely distributed in Australia with known exposure to US subprime loans. The distributor was Grange Securities, a small investment bank with a client base comprising high-net-worth individuals, government departments, not-for-profit organisations, local councils, charities and emerging corporates. Grange is among Australia's leading CDO distributors and one of the earliest market entrants. Over the years, it has sourced product from several investment banks. Lehman Brothers acquired Grange in March.

Grange marketed the A$65 million Federation CDO to clients and institutional investors. A Lehman spokesperson says take-up was similar to that of other CDOs Grange has distributed over the years, with investors attracted to the diversification the product offered. It was unique in Australia in being linked to the US ABX index of single-A rated securities backed by home loans. "Federation was manufactured to investor demand, which came from across the client spectrum," says the spokesperson. "It was not underwritten to a certain size and then sold."

As with other CDOs, Grange placed some of the Federation CDO in the discretionary funds it runs for local councils, knowing that highly rated CDOs are eligible investments for councils under their governing laws. Hence several councils in New South Wales made headlines when their investments in the then AAA rated Federation CDO became known.

The spokesperson says Grange has cancelled the Federation trade with a limited number of its clients and that most issues have been resolved. Federation's senior tranche is now rated AA and the tranche originally rated A is now rated BBB+.

Basis Capital's leverage led it to place its Alpha Yield Fund in provisional liquidation in August. In July, US research house Morningstar said the fund had net assets of A$320 million. Investments included equity tranches or first-loss pieces of CDOs. Basis Capital did not invest directly in US subprime mortgages or mortgage bonds, but indirectly via CDOs created and managed by BlackRock, Credit Suisse Alternatives and Trust Company of the West.

In a late September client newsletter, Basis Capital says its problems began when risk was repriced globally and investors wanted to exit structured credit products such as CDOs regardless of whether they contained subprime loans. Banks responded by dramatically marking down prices, including to customers that they were funding, triggering an unprecedented wave of margin calls. Citigroup, Goldman Sachs, JPMorgan, Lehman Brothers, Merrill Lynch and Morgan Stanley all issued default notices to the hedge fund. In its January quarterly update, Basis valued the fund at two cents in the Australian dollar.

Basis Capital says the investment banks that created the CDO market "became in effect, judge, jury and executioner ... marking, bidding and pricing securities for lending purposes where they deemed fit and devaluing the same assets that they had created only weeks and months earlier". Several dealers had taken short positions over the market and may have arguably exploited their position, adds the fund, and also started hoarding capital.

Unlike Basis Capital, Absolute Capital has direct exposure to subprime mortgages, albeit less than 5% of its Yield Strategies Fund portfolio. It was not leveraged when its difficulties began, nor does it invest in CDO equity tranches. On July 25, the firm announced the temporary closure of its Absolute Capital Yield Strategies Fund (Classes A and C) and the Absolute Capital Yield Strategies Fund NZD that together have around A$200 million in assets. It said the closure was to ensure equity for, and to protect, investors amid the current lack of liquidity in global structured credit markets.

Keep it simple, stupid

Arguably, these events are not representative of Australia's otherwise conservative A$10 billion-plus CDO market. Mei Lee Da Silva, director of structured finance at S&P in Melbourne, says the types of CDOs that her agency has rated in Australia show that the country is behind the European and US markets. "In Australia, they try to keep them as simple as possible and all of them are synthetic," she says. That is, they reference the underlying loans, unlike with cashflow CDOs where arrangers buy the assets.

By volume, 70% of the synthetic CDOs S&P rated in Australia and New Zealand from 2006 to end-October 2007 are classified as balance sheet transactions. Banks including National Australia Bank and ANZ sold securities referenced to loans on their books to reduce their risk-weighted assets. Yet the banks retain the first-loss piece and continue to manage the risk of the loan portfolios.

Other than these balance sheet trades that are better categorised as collateralised loan obligations, institutional investors have only more recently begun investing in leveraged credit such as CDOs, says Nick Fyffe, head of high-yield investments at ANZ in Sydney. They initially regarded CDOs as a knowledge arbitrage between themselves and banks with sophisticated risk systems. Having upgraded their systems, some fund managers are buying CDOs at the fringe, for high-yield and enhanced cash funds or as a learning experience.

Pierre Katerdjian, head of portfolio trading and structured credit at Westpac Institutional Bank in Sydney, says Australian fund managers tend to avoid CDOs in the primary market. He says those managers prefer well-seasoned CDOs, where they can see the names of the underlying credits, analyse the default performance and assess the likelihood of default over the remaining two or so years to maturity.

CDO-shy

The bulk of managed funds in Australia are superannuation funds - a type of pension fund. Asset consultants such as Russell Investment Group advise the trustees who govern these funds. Andrew Lill, director of investment consulting at Russell, says none of the firm's institutional clients have direct exposure to CDOs. Some may have indirectly, through extensions of their bond managers' and cash managers' mandates, he says, but it is a very small percentage of portfolios.

For example, when Sydney-based Perpetual Investments announced unrealised losses arising from the revaluation of credit securities in two of its largest cash funds, the fund manager said the adverse global credit markets had affected less than 1% of its A$4 billion fixed-interest funds. There are anecdotes of one or two smaller consulting firms advising superannuation fund clients to invest directly in CDOs rather than through a managed fund.

Fyffe says the vast bulk of CDOs sold in Australia reference mainly investment-grade corporates. Only a few transactions reference non-investment-grade corporate credits and then only 5-10% of the underlying. Principal-protected structures have become more prevalent in the past two years, while CDOs-squared are unpopular. "After two transactions, people decided they weren't a good idea," says Fyffe.

Westpac's Katerdjian says most CDOs are managed except for some early static transactions. Principal-protected combo notes have also been done. S&P's Da Silva says Australia's first CDO of CMBS only appeared in 2007.

As of September 30, A$12.5 billion of CDOs rated by S&P in Australia and New Zealand were outstanding. Fyffe, who travelled around Australia for five weeks selling transactions to investors, says there has been some buying back and cancelling of deals, as well as restructuring of institutional trades where there are only a few investors. It is too difficult to restructure middle-market transactions where there are a lot of investors, he adds. Westpac's Katerdjian says investors understand recent developments, given years of education from distributors such as ABN Amro, ANZ, Commonwealth Bank of Australia and Westpac.

By volume, S&P classifies just 13% of the past 22 months' issuance as arbitrage CDOs, typically tailored to investor requirements. These are largely sold to middle-market investors. Retail-targeted CDO issuance peaked in 2003, then tapered off as credit margins became too narrow to attract retail investors and to warrant Australia's rigorous listing and regulatory requirements for retail-targeted products, says Da Silva.

Yet hedge funds are not regulated and are open to retail investors, usually on advice from financial planners. Retail money was channelled into Basis Capital's group of funds through avenues including the BT Wrap, a Westpac-owned administration platform used by financial planners; St George Bank's wealth management arm, Asgard; and Macquarie Bank's own and independent financial advisors. Macquarie Bank advised clients in late October that it was marking its investments in the Basis Alpha Yield Fund at one cent in the dollar.

It is believed that the real horror stories have been cashflow CDOs that hedge funds bought in overseas markets and that were not rated in Australia; given how many banks, fund managers and advisors declined interviews for this article, there is clearly a lot of fear in the market and so the potential for more problems.

Limited exposure

Still, Australia's strong preference for synthetic CDOs over cashflow transactions, coupled with Australian fixed-income investors' strong preference for Australian dollar-denominated securities, means Federation is the only CDO of its type to have been distributed in Australia before the US subprime debacle. This has limited the level of investments in CDOs with US subprime loan exposure compared with that in Asia and Europe, where investors bought dollar-denominated CDOs backed by mortgage-backed securities, attracted by their diversification away from CDOs based on US corporate credits.

As for the Australian banks, Moody's Investors Service says they will sail through the US subprime loan troubles. In a special comment in October, the rating agency says that given the Australian banks' relatively high level of wholesale funding, the main danger to their stable rating outlook concerns whether securitisation funding remains scarce or pricing remains high for the medium term. Yet the major banks - ANZ, Commonwealth Bank of Australia, National Australia Bank, St George Bank and Westpac - would probably stand to gain the most from capacity constraints at their smaller, securitisation-funded rivals.

Moody's says the impact otherwise has been well contained, chiefly because the banks have close to zero exposure to US subprime mortgages or leveraged loans. Larger banks are providing liquidity support to asset-backed commercial paper programmes, but Moody's views the financial impact as manageable, thanks to the banks' solid profitability and capitalisation and the high quality of the conduits' assets.