Limited fallout



Australia has felt its fair share of the overall decline in credit liquidity following problems associated with the subprime housing market in the US. A number of high-profile hedge funds have seen direct investments in US subprime collateralised debt obligations (CDOs) go pear shaped. At the same time, Australian equity volatility has risen sharply in the past several weeks. At one point in late July the Standard and Poor's (S&P)/ASX 200 benchmark stock index had dropped 9.9% from its July 24 record of 6,422.3 points, although it was down just 4% from its peak in late August.

But, by and large, Australian investors are not holding large volumes of the affected CDO tranches, say analysts. The CDO market is a fairly recent phenomenon in Australia dating back to 2003, and domestic CDO issuance is generally limited to synthetic corporate paper.

"This market really took off in 2003 and it just started with synthetic CDOs and with corporate underlyings in the portfolios," says Mei Lee Da Silva, director of structured finance at S&P in Melbourne. "It is less established than its US or UK counterparts. It has been a slower start. Subprime mortgage-backed CDOs haven't been done before and I don't see it being done in the near future."

So far this year, CDOs/repackaged securities have constituted A$1.1 billion ($906 million) of the A$61 billion in new term securitisation issuance in Australia. Residential mortgage-backed securities (RMBSs) represent the vast majority of securitisation issuance in Australia with a total of A$53.3 billion completed by August 24, according to S&P's Australian Securitisation News. Of RMBS transactions, A$51.8 billion were based on prime securities and A$1.4 billion on subprime securities. In terms of currency, A$19.8 billion of the total RMBS issuance was denominated in US dollars, A$22.2 billion was denominated in local currency, and A$10.3 billion was denominated in euro.

And no commercial paper issued via asset-backed commercial paper (ABCP) conduits in Australia or New Zealand is based on underlying US subprime mortgage-backed CDOs, according to an August statement by S&P, which maintains ratings on 57 ABCP conduits in Australia and New Zealand.

"The conduits are exposed primarily to Australian-domiciled credit, including corporate debt, residential mortgage loans and asset-backed securities," S&P said. "Credit enhancement is provided at the pool level and in a variety of forms, including subordinated debt, cash reserves and over-collateralisation. In some cases, programme-wide credit support is also in place."

Of those 57 entities, five Australian conduits issue extendible ABCP - commercial paper that has a traditional structure but which gives the issuer the option to extend the maturity date, for which the investor is paid a premium. "All of these conduits benefit from either sufficient third-party liquidity from suitably rated banks or use cashflows from the amortisation of the underlying assets that do not include US residential mortgages," the statement added.

This corresponds with the broad market view of Australian CDOs as not being largely backed by troubled assets, particularly US subprime mortgage loans. "Clearly, there have been some asset-backed CDO transactions placed in Australia, but it is our impression that the vast majority was in synthetic corporate CDOs, which have no direct exposure to US subprime and only some limited indirect exposure via corporate holdings," says Rob Mead, head of portfolio management at asset management firm Pimco Australia in Sydney.

Although domestic CDOs may not be directly exposed, the market as a whole has suffered from indirect association with CDOs comprising subprime US mortgage securities as underlying assets. CDO issuance in Australia has dropped dramatically this year - only eight CDO/repack transactions have been launched this year so far, a 62% decline from the 21 issues in 2006. RMBS deals, on the other hand, have risen from 27 deals in 2006 to 32 in 2007, an increase of 18.5%, according to S&P.

"The lack of CDOs means we're not looking at a lot of activity in new ratings at this stage. We have 250 CDO tranches that we've rated in this market. We have a surveillance system on a monthly basis," says Da Silva of S&P. "There hasn't been any increase in activities in watching or ratings because, as we said, the portfolios are mainly corporate. For those portfolios, volatility is basically unchanged to date."

Market drivers

While the Australian CDO market may be experiencing a limited contagion effect, it is driven by technical factors rather than fundamental problems in domestic CDOs.

"There are legitimate fundamental concerns with the subprime market as a whole, so that's almost a given. However, the contagion into other markets has largely been technically driven rather than fundamentally driven," says Mead of Pimco. "This somewhat reflects the fact that the same global investor base that may have been investing in the products levered to subprime are also invested in products that have corporate bonds or loans as collateral, where the fundamentals are sound but the ongoing bid for those assets has reduced. The ramifications are that markets globally have decided risk premiums reached levels that were too low, and repricing has taken place in short order. But the direct exposure to the fundamentally troubled components is reasonably limited."

The volume of domestic commercial mortgage-backed securities (CMBS) issuance has fallen as well, with only seven issues this year compared with nine in the same eight months in 2006, according to S&P. "The commercial paper market is healthy and sound, but it has been caught up in the global headwinds of riskier structures in Europe and perhaps the US as well, so they are under some liquidity constraints currently," says Susan Buckley, general manager of global fixed interest at Brisbane-based Queensland Investment Corporation (QIC), which manages QSuper, the A$20 billion-plus superannuation fund for Queensland state employees and their spouses. "The Australian market is much higher quality and Australian residential mortgages are very high quality. Australian conduits have not had large exposures to US subprime mortgage CDOs, in comparison to the US or Europe."

While it is not difficult to establish how much rated CDO issuance there is in the Australian market, it is more difficult to determine which institutions and individual investors are holding CDOs. "It's going to be - and you're finding this already - quite difficult to find a reasonably reliable number on how much subprime paper is being held by Australian investors," says David George, head of fixed-income research at Mercer Investment Consulting's Sydney office. "Mercer's idea is that there isn't a great deal of direct exposure for Australian investors. There are some reasonably high-profile hedge fund-type products that have direct exposure and those were available to Australian investors. Beyond that type of investment, direct exposure is quite low."

Other industry observers agree that Australian investors are not heavily exposed to the US subprime mortgage CDO market. If investors do hold exposures, it is generally within the context of a global credit portfolio, meaning that the overall percentage of losses is minimal and in keeping with the relative size of the market globally.

"Most Australian investors won't have any significant direct exposure to US subprime debt," says Shane Oliver, chief economist and head of investment strategy at Sydney-based AMP Capital Investors. "Potentially, investors could be exposed to US subprime in two areas: firstly through high-yield hedge funds; and secondly through international fixed-interest funds, where international fund managers may have some exposure. But, if a fund is well structured, it would be well diversified and not heavily geared, so any impact should be minimal. Also, most yield funds have exposure to more traditional corporate debt or maybe infrastructure debt, which tends to produce steadier returns."

AMP Capital Investors manages its own Enhanced High Yield Fund and Structured High Yield Fund, which it says are not exposed to US subprime. It also offers investors access to funds with international fixed-interest investments that are managed by international managers, Oliver says. "We went through them all and the exposure to US subprime was trivial," he adds.

Local councils

The most dramatic instances of CDO-related losses have taken place at hedge funds. Australia has seen two hedge funds halt redemptions so far this year. Basis Capital - which had $1 billion in assets under management as recently as May 2006 - halted redemptions on two of its funds previously worth A$650 million, and Absolute Capital Group, which reportedly had $3billion in assets under management, also halted redemptions on two high-yield funds previously valued at A$200 million. Both funds dabbled in subprime US mortgage CDOs and both announced they were freezing redemptions in July. As Risk Australia went to press, no further funds had halted redemptions. However, on August 30, the Basis Yield Alpha Fund filed for bankruptcy protection in the US, citing an loss of more than 80% in its portfolio.

Meanwhile, Macquarie Bank has also announced that investors in two of its high-yield funds managed by Macquarie Fortress Investments may lose up to 25% of their money. Fortress Investments, which has A$873 million under management, was forced to sell assets to avoid breaching its loan agreements, the firm said in a statement.

Other institutions have confirmed small holdings in subprime CDOs. "We hold a very small exposure to ABS CDOs, the majority of which is in the better-rated debt tranches at the top of the capital structure. They have been held in a couple of our highly diversified strategies," says James Wright, director, fixed income at Sydney-based ING Investment Management (INGIM). "They represent a very small percentage of our total fixed-income holdings in those strategies."

Wright believes current spread levels represent an opportunity. "We also run a strategy in Asia for high-net-worth individuals and institutional clients, where we principally invest in collateralised loan obligation equity. In this fund, we hold a few small exposures to structured assets in the subprime area, although these were made recently to capture a couple of unique opportunities post the subprime meltdown," Wright adds. "The strategy is effectively a hedge fund, but it is not using leverage at the moment and currently has around 30% in cash. With credit spreads pushing out, and structured assets generally under enormous selling pressure, we are now putting this money to work at very attractive levels."

While the financial fallout and mass downgrades have prompted regulators in Europe and the US to launch investigations into the role of rating agencies (see pages 4-8), reaction from supervisors in Australia has so far been muted. The Australian Prudential Regulatory Agency (Apra) - which has limited authority over CDOs - the Australian Securities and Investments Commission (ASIC) and the Federal Parliament have yet to launch any investigations into ratings agencies or issuers.

"Apra does not seek to mandate lending or investment activities by the financial institutions it regulates, provided the relevant institution is able to demonstrate that it adequately understands and can control the risks associated with the investment," says an Apra spokesman. "Where such activities remain part of a balanced portfolio and a well-understood lending/investment strategy, Apra does not seek to intervene in commercial decision-making."

The Apra spokesman adds: "Diversification of investments - both individually, and by asset/sector type - is the main practical mitigant. Over time, a properly diversified portfolio should smooth the ups and downs of the performance of various classes of assets. Added to that, all Apra-regulated entities - banks, insurers and super trustees - must be able to show Apra not just that they have spread their portfolio across a large number of investments, but that the investments made are part of a sensible investment strategy and that the risks of the strategy are understood and, where possible, mitigated - for example, by extra information gathering to offset a lack of market disclosure."

Many of the large fund managers stress that ratings played little part in their decision to invest in CDOs, and add that they do much of the funamental credit analysis themselves. "From a QIC perspective, we never take the credit rating agencies' opinions at face value," says QIC's Buckley. "We assess the underlying exposures. We've been judging the US housing market to be in difficulty with risky lending practices and that was something we avoided."

However, she concedes that some investors have bought CDOs on the basis of credit ratings in the past - something she believes was foolhardy. "You don't get the extra yield without taking the extra risk, and that's come home to roost. Lack of liquidity is part of the premium as well. That has come to the fore in these securities, and that has been reflected down in the valuation of prices," says Buckley.

Some professionals - albeit after the event - say they were mystified as to how certain CDOs received their ratings in the first place. "A particular product we've used is the Perpetual Mortgage Trust. It's over 30 years old and I think it's had only two individual mortgages go wrong in that time," says Rob Keavney, managing director of Sydney-based Centric Wealth, a high-end wealth advisory group. "That says it's been focusing on loan-to-value ratios, on ensuring a good credit history of the borrowers and therefore are absolutely unaffected by the CDO vents. You've got to look through this stuff."

However, he adds that highly rated CDO tranches often contain a diverse portfolio of poor credits. "I don't know how ratings agencies came up with a rating. If someone says you should invest in a CDO, an analyst or an informed investor should ask, 'what is it? What sort of loan-to-value ratios do they apply?' In the US, a lot of mortgages are non-recourse. In Australia, that's exceptionally rare," Keavney adds. "If the loan is non-recourse, loan-to-value becomes essential."

But others take a more sanguine view of the ratings agencies. "It is important to understand the role of rating agencies," says INGIM's Wright. "They're simply trying to assess the probability of a corporate or structured asset defaulting based on their many years of experience of analysing companies and industries. When it comes to corporate loans, they have a very long track record. Ratings of mortgage-based structures are purely based on the characteristics of the underlying portfolios. They analyse a lot of data and base their ratings for the debt tranches used to fund these pools on the longer-term history for the underlying collateral - that is, the expected arrears, defaults and losses or the mortgages themselves."

Ratings agencies were not the only bodies to miss out on the problems in the subprime mortgage markets. "A vast majority of market participants didn't pick up the amount of fraud and the complete lack of due diligence in awarding mortgages in the subprime space. You can't blame the ratings agencies for that," says Wright. "The 2006 subprime mortgages have not performed in line with historical norms and are likely to be the worst vintage ever written. We are going to see the 2006 vintage continue to underperform and the ratings agencies will continue to downgrade the credit quality of structured assets used to fund them," he adds.

Wright contends that the agencies need to provide an opinion. "What they're saying is, on average, this security has a certain default probability and that can change. If they always got it right first time, you'd never have a single upgrade or downgrade ever," he adds.

As the Australian market comes to terms with the exact implications of the CDO miasma, market participants expect depressed synthetic credit activity for the rest of the year, as well as a shift to more simple structures. "The ongoing activity will be more limited in the second half of the year," says Mead at Pimco. "The other reality is that, going forward, deals in the CDO space will be much more simple in structure, reflecting, first of all, the transparency that investors require."

Mead reckons there will also be a shift towards managed, rather than static transactions. "If you're trading a portfolio over time, when you do get market events, the manager is able to allow for that in terms of altering the portfolio to change the risk profile. The investor base that has bought fully static transactions, or self-managed transactions, are the part of the investor base that is having the most difficulty with coming to terms with what they own."

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