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August 17, 2007
Credit contagion and intangibles
Just how far with the collapse go? That is the question on everyone’s mind. So far it has reached the commercial Euro market (see Banks Again Feel Pinch Selling Short-Term Paper) and even the commodity market (see Markets Fear U.S. Woes Will Hit Global Growth). Earlier this week, the Wall Street Journal (How Rating Firms' Calls Fueled Subprime Mess) and the Financial Times (Rating agencies hit by subprime probe) ran overview pieces on the problems with the credit agencies' rating of the subprime mortgage debt. European leaders are already calling for an investigation of the credit agencies (see (see Trouble Tracks Far and Wide - washingtonpost.com). And just this morning, the Fed cut the discount rate. As Steven Pearlstein puts it in his Washington Post column today:
What we have on our hands here, folks, is a full-blown, global financial crisis comparable to the junk bond collapse of 1987, the S&L crisis of 1990 or the Asian financial crisis of the late '90s.So how does this affect intangible? In some cases directly. For example, the Financial Times reports that plans for a $1 billion fund to finance future MGM films has be shelved (while MGM is going ahead with a $500 million deal arranged by a different lender).
More importantly, the collateral damage may be in the use of intangibles as . . . collateral. There is a small but growing market in the securitization of intangible assets. That process is the same model of asset-backed securities (ABS) that is used in the mortgage secondary market. Assets are bundled in to a fund-like structure and bonds sold back by the revenues raised by that bundle of assets.
This is exactly the market which has collapsed. As subprime mortgages head to default, the bonds backed by the revenue of those mortgages become shaky. And everyone heads for the exit. As everyone tries to sell, the price drops to the point of being worthless. That fear then spreads to other market.
I'm sure that the mortgage secondary market will come back (already we are seeing the firebreak in the market where the smaller, high quality loans backed by Freddie Mac and Fannie Mae are doing fine). Likewise, the overall ABS market will come back. The problem here is that investors might stay away from the more esoteric ABS - like intangibles. As the Financial Times points out, investors "have lost confidence in their ability to value complex structured credit products that include some exposure to subprime bundled up with exposure to other underlying assets." Also, the much-needed tightening of credit standards in the mortgage ABS area may make intangible deals too expensive (by either giving such deals a worse rating thereby increasing the interest rate demanded by the market or by requiring greater levels of insurance).
On the other hand, intangible-backed deals tend to be overcollaterized with extensive credit enhancement (insurance and performance covenants) structures. Such enhancements may make these deals attractive to investors still smarting from the covenant-lite deals backed by no-document loans.
Ultimately, the issue will come down to trust in the valuation models. Again, as the FT puts it:
The loss of confidence in valuation may take longer to fix. If investors do not know how to value a security, the classic “price discovery” process by which sellers and buyers settle on a new equilibrium price may not function. Markets – for instance for complex structured derivatives and some asset-backed securities – could remain closed for some time.
Valuation of intangibles is especially tricky. But if the rocket scientist in the financial community can figure out a transparent and credible model, the intangibles-backed securities market may end up benefiting in the long run from the current melt down.
Posted by Ken Jarboe at August 17, 2007 9:10 AM
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