It’s doubtful that managers of structured investment vehicles will be too happy with Moody’s latest report. Realising it is time to play hardball, the rating agency is pulling no punches in its assessment of the SIV/ABCP market.
Moody’s has chalked up a whole load of downgrades on SIV paper. But it hasn’t done so because of immediate problems in the commercial paper market – until now the perceived Achilles heel of the SIV. Moody’s finds more worrying problems for SIVs elsewhere.
An SIV essentially arbitrages between short-term and long-term debt. SIVs issue short-term commercial paper to raise funds, which is continually rolled over to pay itself off. But the focus of their investments with those funds is in longer term securities and structured products.
Until now, the focus has been on the crisis in the commercial paper market. The credit crunch has left SIVs high and dry – unable to issue new short-term debt, they are left unable to pay off their old short-term debts.
Frozen CP markets have been largely responsible for most SIV wind-downs to date: Golden Key and Mainsail II failed their capital adequacy tests because they couldn’t issue new paper. A similar problem faced Sachsen Funding, who failed to maintain their minimum liquidity commitments.
But, if you root around in the transcript from a Moody’s teleconference on Wednesday, it appears there is a more troubling problem facing SIVs. Rather than liquidity in the short-term commercial paper market, liquidity problems in structured product markets – where SIVs conduct their trading and make their long-term investments – are wreaking havoc with the value of SIV portfolios.
Henry Tabe, managing director of Moody’s international structured finance team said Wednesday:
Short-term liquidity problems due to market disruption will not generally have consequences other than to suspend investment activities pending the cure…[but]…conditions of restricted activity in the secondary market for structured assets and significant spread-widening can cause realised losses if it cannot be addressed…Even in situations where liquidity may be available, falling market values can lead to rating actions.
Indeed, if the value of an SIV’s investment portfolio declines too much, a SIV will trigger its major capital loss test. In doing so, a SIV enters a mandatory wind-down: no opportunity to restructure, no opportunity to carefully unload assets. Instead, most capital loss tests stipulate the sale of assets to meet maturing debts as quickly as possible.
That is exactly what happened with Cheyne Finance last week. FT Alphaville dug out its major capital loss test:
The issuer shall breach the Major Capital Loss Test if the net asset value of the total euro capital notes outstanding is less than 50 per cent of the dollar equivalent of the outstanding principal amount of the euro capital notes outstanding.
And that net asset value (the amount by which the market value of a SIVs portfolio exceeds the senior debt, divided by the capital) has been falling across the SIV sector, according to Moody’s:
The average NAV across the traditional SIV sector was 102% at the beginning of June, 101% at the beginning of July, 94% at the beginning of August and approximately 85% by the beginning of September. In those SIV-lites and SIVs with significant sub-prime RMBS and RMBS CDO exposure, the decline has been more precipitous, from approximately 96% at the beginning of July to approximately 72% at the beginning of September.
Of course for some, like Cheyne Finance, the fall in NAV value was even greater – enough to trigger its 50 per cent ratio.
Selling assets as Cheyne Finance has been forced to do is troubling because of the domino effect it can create. Forced sales will depress structured asset prices more, and if there’s a convergence in the kind of products SIVs have been investing in, more capital loss tests will be triggered as prices slump further.
Cheyne Finance had an unusually high exposure to a single class of products – 48 per cent of its portfolio was invested in US RMBS according to Moody’s. But that’s no reason for others to rest on their laurels, because the contagion has already shown it can spread easily to other assets. While 48 per cent of the portfolio Cheyne has to offload was invested in RMBS, 52 per cent was not – selling those assets will depress their prices. Moody’s points out:
It is also worth noting that the decline in market value in these portfolios has come with very few downgrades of the assets and no defaults at all.
SIVs with no subprime exposure are thus being bounced ever closer to their major capital loss ratios by a systemic decline in the market.
But it is important to temper all of the above. Fortunately with Cheyne, the nature of its maturing short-term debt, and large bank credit lines – which it thoughtfully drew on – have ensured that despite breaching its capital loss test, it won’t be subject to a forced fire sale. The market can only hope that other SIVs will be equally prudent.
Banks are working hard to restructure their SIVs ahead of such trouble too. Fears over the threat of the capital loss test may be a key reason they are keen to take their SIVs back on balance sheet (HBOS/Grampian) or restructure them entirely (BarCap/Cairn).
Simply extending extra credit, as might befit a problem in the CP market, might not be enough.
“Injecting liquidity” into the banking system – and by extension and hope the CP market – won’t have an immediate effect on the SIV problem either, because it won’t necessarily restore confidence in the troubled assets – like subprime RMBS – in which SIVs have invested.
Nor can they just be left alone. There may well be a tipping point in the market, when asset prices are depressed sufficiently for the dominoes to fall in sequence. Although that point is probably not coming today, tomorrow, or next week, it will become more likely the longer the crisis drags on.
Accordingly then, Moody’s announced at close of play in New York on Wednesday that it was putting the following SIV ABCP on review for downgrade:
- Axon Financial Funding’s Mezzanine Note Programme currently rated A1
- Kestrel Funding’s Commercial Paper and Medium-Term Note Programmes, currently rated Prime-1 and Aaa, as well as its Income Notes, currently rated Baa2
- Harrier Finance’s Income Notes currently rated Baa2;
- Rhinebridge’s Senior Capital Notes currently rated Aaa, its Mezzanine Capital currently rated A3, and the Combination Notes, currently rated Baa2
- Victoria Finance’s Capital Notes currently rated Baa2.
And its rationale? All, says Moody’s, as a result of “deteriorating portfolio market values.”