No escape

Credit

With the exception of the collapse of Sydney-based hedge fund Basis Capital last September, Australia was proving itself resilient in the face of the US subprime debacle. Its strong economy, as well as conservative institutional investor mandates, appeared to be standing the country in good stead.

But in July, Melbourne-based National Australia Bank (NAB) - the country's largest bank - announced a loss provision of A$830 million ($742 million) on its portfolio of collateralised debt obligations (CDOs) containing US residential mortgages. The amount is in addition to a A$181 million charge taken on the same portfolio of assets announced in the bank's half-year results to March 31, 2008. The portfolio is now loss-provisioned to a level of nearly 90%.

In a statement accompanying the announcement, NAB chief executive John Stewart said: "This provision reflects the unprecedented conditions in global credit markets and, in particular, the rapid deterioration in the US housing market."

The NAB revelation comes on the back of a wave of scandals involving local council losses on CDO investments that started at the end of last year and has been breaking across antipodean shores ever since.

While institutional investors in Australia are renowned for their conservative investment mandates, the rules governing local council investments have been vague. Up until the losses, councils could invest in public debentures or securities, bank, building society or credit union interest-bearing deposits, as well as any securities with a credit rating determined by rating agencies - which included CDOs.

These products were appealing to councils because they promised to add spice to their investment portfolios with the illusion of little or no additional risk. By investing in a mezzanine tranche of a CDO, municipals could obtain a higher yield than would be available on a similarly rated corporate or government bond.

A flurry of deals was launched between 2002 and 2004, aimed at the so-called middle market. Macquarie, NAB and Westpac all dipped their toes into the space, along with ABN Amro, Deutsche Bank and Lehman Brothers (the latter of which offered CDOs via its brokerage, Grange Securities). Some of the later deals were structured to provide investors with more security on their principal, in an attempt to appeal to a wider range of risk-averse investors that may not have invested in traditional CDO tranches.

For instance, Westpac launched a synthetic CDO called Halcyon in June 2004. The six-year notes were referenced to a portfolio of 120 global credits and paid an initial coupon of 3.4% over the three-month bank bill swap reference rate (BBSW). The coupon reduces by 25% for each default in the portfolio, up to the fourth default, after which the investor receives no more payments for the remaining life of the deal. The principal, however, was guaranteed by Westpac.

So-called combo notes were also popular. In a typical combo deal, the principal is invested in a relatively highly rated tranche of a CDO, while the coupon is referenced to a more risky tranche, usually the first loss piece. For instance, Macquarie Bank launched the first series of its Generator Notes in May 2004. The seven-year deal offered an AAA rating on the principal, protecting investors against the first 10.3% of losses on a principal portfolio of 142 global credits. The coupon - referenced to an income portfolio of 111 global credits - was protected against the first 0.15% of losses, and paid an initial coupon of 2% over the three-month BBSW.

The Cole Report

But the subprime debacle brought the good times to an end. In April, Michael Cole, a respected figure in the local financial markets, released his government-sponsored Review of NSW Local Government Investments - otherwise known as the Cole Report. In it, he suggests councils be banned from investing in any more CDO-type structures until December 2009, after it emerged that 152 state councils had collectively racked up hundreds of millions of dollars in mark-to-market losses.

"The market value of the investments held by New South Wales (NSW) councils is currently $5.37 billion, a fall of $320 million from the book value," he wrote in the report (See figure 1).

Other recommendations include: tightening permissible investment products and clarifying some existing definitions; barring the manufacturers and distributors of investment products from acting as investment advisers to councils; suspending until December 2009 the ability of councils to make any new investment other than in land, cash, bonds or other councils; ensuring councils are more aware of their obligations by requiring a signature demonstrating understanding of the investment requirements; and issuing new investment policy guidelines for councils.

Paul Lynch, the NSW minister for local government, took up every one of the report's recommendations and made them enforceable. "It seems there were definitely some errors of judgement on the part of the councils, which are under constant pressure to deliver strong financial performance to their constituents," Lynch told Risk Australia. "At the same time, however, it seems local councils were also the victims of an aggressive and systematic effort by banks looking to sell CDO-related structures. Was there some mis-selling going on? It's hard to find precise evidence of that. Our mandate was really to focus on the process. And that is what we've addressed with these new investment practice guidelines."

At the forefront of the council loss scandal is a legal dispute that emerged last December between Wingecarribee Shire Council and Lehman Brothers over a CDO structure called Federation, sold by the US dealer in May 2007. The A$50 million five-year deal was rated AAA by Standard & Poor's (S&P) and was referenced to a portfolio of 40 US residential mortgage-backed securities, rated AA- to A. The deal offered 10% credit support and paid an initial coupon of three-month BBSW plus 1%.

And, in April, the municipal council of well-heeled Sydney suburb Woollahra also said it had engaged lawyers to take legal action against Lehman Brothers for selling it the Federation structure, claiming the dealer had breached the council's investment instructions.

"We are not interested in operating in a high-risk investment market and base our investment decisions on the best interest of the community. We rely on sound advice and investment decisions by our professional advisers that are consistent with our investment policies and instructions," Geoff Rundle, Mayor of Woollahra, said in a news release at the time.

Cole comments on the Federation CDO in his report: "The Federation CDO, backed by subprime mortgages, is currently priced at around 15% of the issue price. That is an 85% decline in value. S&P initially reduced the Federation CDO rating from AAA to AA, then to AA- credit watch - still above the investment-grade minimum qualification under the existing investment order (for local councils). The Federation CDO rating was only downgraded to CCC- in late February 2008."

Lynch says rating agencies are partly to blame for council losses because they were slow to react in downgrading some securities that had exposure to the subprime market. In general, investment mandates forbid councils from investing in any security rated below AAA. Had the rating agencies downgraded the securities in a way that reflected market sentiment, they would have breached the investment management mandates and an earlier sale would have been forced. "What stands out front and centre in the Cole Report is that the credit ratings on these instruments was extremely optimistic and at variance with public perception," Lynch says.

The Cole Report also fires a shot at rating agency practices: "Prior to the downgrade, the Federation CDO highlighted the serious difference in opinion between the market view of the CDO securities' intrinsic value and the credit rating agencies' forecast probability of default and loss. The market was strongly of the view that the credit rating was far too optimistic and it would significantly deteriorate in the period ahead. In the end, S&P was left to play rating catch-up by downgrading too late and to the investors' disadvantage."

Mei Lee Da Silva, a director in the structured finance ratings group at S&P in Melbourne, declined to comment for this article.

In the end, Wingecarribee Shire Council sold the Federation CDO in January 2008 at a loss of A$2.55 million. It is pursuing legal proceedings against Lehman Brothers on the grounds the firm engaged in misleading and deceptive conduct and breached a managed portfolio agreement, as well as its duty to exercise reasonable care and skill in advising the council.

Indeed, the Cole Report says there appears to have been a conflict of interest in many instances, as local councils signed investment management contracts with the very firms selling them the CDOs. "A limited number of distributors promoted products as well as acted as advisers to the councils," Cole writes. "In one case, the participant acted as product promoter, adviser and investment manager. A party performing more than a single function has an authority to deal with the conflict of interest in a transparent manner. There is anecdotal evidence this was not the case."

He adds: "The challenge facing product promoters offering complex investment products to NSW council investors with limited broad investment experience was to thoroughly explain all the product risks. The difficulty of this task is highlighted by a current court case between a NSW council investor and a product provider that misleading representations were made in relation to the security underlying the Federation CDO."

Some firms may have even deliberately overweighted investment portfolios in favour of the CDOs they were selling. The Cole Report found a number of NSW councils held in excess of 45% of their total investments in CDOs and/or capital- protected notes, with one council estimated to have losses of A$22 million on the structures.

Jim Gossage, director of corporate services at Tenterfield Shire Council in NSW, one of the 35 NSW councils to hold the Federation CDO on its books, says he is not in possession of a term sheet for the product.

"At the time, the council had delegated authority for its investment decisions to Grange Securities. Grange Securities is therefore in possession of the term sheet," he says. The council has not yet decided whether or not it plans to take legal action against the firm, he adds.

Sources close to the situation comment that, while term sheets were sent to most councils prior to trades, a contract note that contained terms of the trade was always sent out after a trade was placed, with a provision for the trade to be reversed at the council's direction at the prevailing market price. The sources say that, where Grange was given discretion over council portfolios, trades were made in line with agreed investment and government guidelines. However, the sources did not comment on whether investors should or should not have reserved the privilege to see the terms prior to each investment, as opposed to after.

There have been a number of settlements made with other councils, where Lehman Brothers either bought back the securities or restructured deals to convert them into more reliable assets, such as long-term government debt. In May, Lehman made a restructuring offer to Wingecarribee, but the council rejected the terms and is pursuing its claim.

Lehman Brothers issued the following statement about the case: "Lehman Brothers will vigorously defend any legal proceedings commenced where we do not feel there is merit. Lehman Brothers denies the claims Wingecarribee Council has made in its statement of claim filed with the Federal Court and will vigorously defend itself in this action in line with its filed defence." Sources say, to their knowledge, there is no legal case pending involving Woollahra.

NAB-bed

The scrutiny over CDO's has intensified further since NAB increased its loss provisions more than fivefold, a move that saw its shares plunge 13% in a day.

At first glance, the NAB announcement seems like just another hidden-loss shock that has become typical of the subprime disaster. On closer inspection, however, there seems to be more to it than that - with worrying implications.

Soaring mortgage defaults in the US had forced NAB to prepare for a worst-case scenario, stated NAB's Stewart. And, in a conference with analysts, he added: "Unfortunately, the behaviour of the housing market in the US leads us to believe that the worst-case scenario might not be too far away from the most likely."

NAB's exposure to the US property market through 10 CDOs held in two conduits is relatively small - $1.2 billion worth of structured finance assets (see figure 3).The assets themselves were all rated AAA, which technically means a one-in-10,000 chance of default. The 10 CDOs consist of two super-senior tranches and eight AAA rated tranches. NAB has now determined, on a worst-case basis, it will only recover half of the face value of the super-senior CDOs and none of the AAA tranches - a loss of more than $900 million worth of AAA rated debt securities. In other words, the securities have turned out to be worse than junk. This is based on the information that recoveries on US residential foreclosures are now down to 45% of the mortgage value.

"The continued deterioration in the US housing market has been further highlighted in recent weeks with foreclosures mounting and recovery rates from securities in some categories falling to less than half of the loan value," Stewart said.

It seems hard to believe that US lenders, when they take possession of homes in foreclosure, are recovering less than half of the mortgage but, according to NAB, it is true for loans made at the height of the subprime lending boom.

"NAB's conservative CDO provisioning has drawn attention to the ongoing deterioration in the credit quality of US housing loans, which is extending beyond subprime to Alt-A and even some prime mortgages," says Patrick Winsbury, senior vice-president at Moody's in Sydney.

NAB has said it would rather come clean now, even though these CDOs are technically still performing, rather than drip-feed the provisions out over several years as the truth about the situation in the US unfolds. The concern, of course, is that if NAB does it, other banks may be forced into similar moves.

"Because NAB has the necessary capital and a relatively small CDO exposure, it can implement a conservative stance. The bank has provided for over 90% of its CDOs with subprime content, and these CDOs are not held directly by the bank but within asset-backed commercial paper conduits to which it provides liquidity lines. However, other major banks - also with subprime-related exposures - may not be able to adopt such an approach because the size of their stressed assets positions is so much greater in terms of their overall balance sheets," says Winsbury. Only time will tell.

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