Confidence Game - Christine Richard [90]
These rumblings did little to dampen spirits as more than 6,000 people descended on the Venetian Hotel in Las Vegas for the annual American Securitization Forum conference in the winter of 2007. Participants were guardedly optimistic that the concerns about the subprime mortgage market would blow over. Between gambling, golfing outings, and dealmaking, panelists batted around a number of troubling issues.
Mark Adelson, a structured finance analyst with Nomura Securities, took notes during the conference and shared them in a research report. “One panelist feels strongly that BBB subprime ABS [asset-backed securities] are lousy investments because they exhibit cliff risk,” Adelson’s notes rather ominously read.
Adelson labeled one section of his notes “Scary Topics.” It included this idea: “A slowdown in housing can create a feedback loop in the labor market as construction, mortgage lending, and real estate industries contract.” And then there was this observation: “Borrowers may start to behave differently than they have in the past in deciding whether or not to default on their loans.”
Still, the mood was upbeat. One panelist suggested that the structured finance market was on track to turn out an astounding $1 trillion of CDOs during 2007. Countrywide Financial Corporation, one of the largest providers of credit to the housing market, sponsored a cocktail party networking event. Citigroup executives held court in the Tao bar. Tonight Show host Jay Leno headlined the group’s annual dinner.
“Looking toward the horizon, one sees the telltale signs of a possible storm,” Adelson concluded in his notes. “It could blow over and amount to nothing. Or it could develop into a tornado.”
One particularly fateful meeting at the Las Vegas conference was between executives from Financial Guaranty Insurance Company (FGIC), a bond insurer that for years had shunned structured finance in favor of the stodgy, predictable municipal bond business, and IKB Deutsche Industriebank AG, a bank that had lent to middle-sized manufacturing companies in Germany since the 1920s.
In 2001, IKB began to use more of its capital to invest in CDOs. In 2002, it created an off-balance-sheet SPV called Rhineland Funding to purchase these exotic securities. By holding the CDOs in an SPV rather than on its own balance sheet, IKB needed less capital. The CDOs purchased by Rhineland were highly rated: mostly triple A, or super senior, and supposedly better than triple-A risks.
Rhineland obtained funding through the commercial paper market. To attract the risk-averse investors who bought commercial paper, Rhineland needed to reassure those investors that someone stood ready to buy the commercial paper in an emergency. This was known as liquidity support. For awhile, IKB provided the liquidity support guarantee, agreeing to buy the paper if the market boycotted it for some reason. But as Rhineland Funding’s outstanding commercial paper grew to 12 billion euros, it was clear that the bank wouldn’t have the cash if it was called on to buy Rhineland Funding’s commercial paper. IKB had come to Las Vegas pitching a structure it called “Havenrock II” to solve that problem.
The German bank had developed a complicated plan. French bank Calyon had agreed to buy $2.5 billion of CDOs from Rhineland Funding if Rhineland couldn’t roll over its commercial paper. The proceeds would give IKB the cash or liquidity it needed to pay back some commercial paper investors. Calyon, however, sought to protect itself from any loss on that contract by entering into two credit-default-swap contracts with Havenrock II, a Jersey-registered SPV created by IKB.
Havenrock II was essentially a shell company that lacked the assets to meet its obligations. This is where FGIC came in. IKB executives