Page 4 of
4 PATHOLOGY OF
DEBT PART 4: Lessons
unlearned By Henry C K
Liu
involved a US leveraged lease.
GE Capital arranged 100% of the financing through
a combination of a GE Capital equity investment
and non-recourse debt provided by an off balance
sheet asset-backed commercial paper conduit. This
structure enabled Flightlease to achieve 100%
financing of the equipment cost and off-balance
sheet treatment for the aircraft lease at an
attractive lease rate.
In 2002, the impact
of the squeeze in the CP market had been
limited to the bottom end of
the market, among companies with short-term
ratings of A2/P2. The spreads between rates on
individual issues has widened to between 50 and 75
basis points, up from 15 to 25 basis points. More
highly rated companies were not affected and
sector related.
GE, the world's largest
non-bank financial conglomerate that incidentally
also manufactures, issues credit at the retail
level through vendor financing to capture sales
for GE products. It gets its funds wholesale from
the CP market, which GE dominates because it has a
good credit rating. When GE credit rating was
downgraded, it faced being frozen out of the CP
market in the Fall of 2002, and had to revert back
to costly bank credit lines that adversely
affected its interest rate spread and
profitability.
In the credit squeeze of
2007, more than 20 companies, including San
Francisco-based Luminent Mortgage Capital Inc and
Thornburg Mortgage Co in Santa Fe, New Mexico,
have been unable to roll over asset-backed
commercial paper. Thornburg in October 2007 said
it sold US$20.5 billion of securities at about 95
cents on the dollar to pay down commercial paper
it couldn't refinance.
GMAC commercial
paper GMAC Financial Services is a global,
diversified financial services company. It
maintains a diversified portfolio of business
operations, including automotive finance, dealer
and personal line insurance, real estate finance
and other commercial businesses. At December 31,
2006, GMAC held more than $287 billion in assets
and earned net income for 2006 of $2.1 billion on
net revenue of $18.2 billion.
GMAC was
established as a wholly owned subsidiary by
General Motors Corporation (GM) in 1919, and
currently operates in approximately 40 countries.
It offers its commercial paper directly to
institutional and commercial investors in the US.
These short-term promissory notes are obligations
of GMAC and are generally available for one to 270
days. GMAC CP is issued on a discount or
interest-bearing basis at identical yields and is
payable upon maturity at a designated bank.
Settlement is made via Depository Trust Company.
In November 2006, GM sold a 51%
controlling interest in GMAC to a consortium of
investors led by Cerberus Capital Management, LP,
to insulate itself from potential credit downgrade
of General Motors, its parent. By the end of 1991,
money market funds were shying away from GMAC CP.
As the nation's second-largest issuer of the
short-term debt securities, GMAC had more than $23
billion in commercial paper outstanding, about $5
billion more than the value of GM common stock. In
the stake sale 15 years later, the Cerberus deal
was worth $14 billion payable over three years. In
2005, GMAC made a net profit of $3 billion while
GM overall lost $10.6 billion, reducing GM bonds
to junk status. The financial plight of GM
depressed GMAC's value against the Cerberus
transaction, which required GM to make good the
difference in value to Cerberus.
In
November this year, General Motors announced it
will take a $39 billion charge against
third-quarter 2007 earnings as a result of
writedowns in the carrying value of deferred tax
valuation allowances. The charges stemmed from
difficult business conditions in GM's US and
German operations and hefty losses at the ResCap
real-estate arm of GMAC, in which GM still has a
49% stake. ResCap reported a third-quarter loss of
$2.3bn, pushing GMAC's income down by $630 million
compared with a year earlier.
The
third-quarter results include various other
special items, including a $3.5 billion after-tax
gain from the sale of Allison Transmission, a
maker of heavy-duty transmissions, and charges of
$1.6 billion in pension service costs.
On
August 15, 2007, Fitch Ratings said Kohlberg
Kravis Roberts & Co. affiliates KKR Atlantic
Funding Trust and KKR Pacific Funding Trust might
have to sell securities because of losses. There
were about US$385 billion outstanding in SIVs and
23% of their assets were MBS or CDOs.
At
the same time, Barclays Capital had to provide
rescue financing to $1.6 billion Cairn High Grade
Funding I, a so-called SIV-lite. that it had
structured for hedge fund Cairn Capital that could
not raise short-term funding due to the ABCP
market seizure related to the US subprime mortgage
crisis. Barclays, which would provide the fresh
funding to pay off all maturing short-term ABCP,
said it had fully hedged its credit exposure to
the vehicle.
The US subprime mortgage
crisis has dealt structures like SIV-lites a
double blow. SIV-lites have been having difficulty
in raising short-term funding as investors grow
more risk averse, forcing ABCP yields to six-year
highs, and they have seen the value of their
longer-term investments, mostly in asset-backed
securities, fall sharply.
Bank holding
companies, including Citigroup, are not simply
limited to the risks on the balance sheets of
their banks. Little known affiliated investment
vehicles that issue billions in CP are partially
owned by large banks and create a whole new source
of risk. These vehicles, known as "conduits" and
SIVs, are run separately and because of US
accounting standards do not have to appear on the
holding company's balance sheet. Citigroup
controls 25% of the SIV market, totaling nearly
$100 billion under management. Citigroup-owned
Centauri Corporation holds $21 billion in debt,
which however is not mentioned in the holding
company's 2006 annual filing.
Citigroup
said it has given its SIVs $10 billion of
available financing, and the funds had drawn $7.6
billion of that financing as of October 31. The
move, disclosed in a quarterly filing with
regulators, may add to investor concern about the
firm's $83 billion of SIVs, which issue short- and
medium-term debt to finance their acquisition of
bank bonds, repackaged debt, and other securities.
The firm said in its filing that its credit lines
to the SIVs were done on ''arms-length commercial
terms'', and that the bank has no plans to list
the SIVs' assets on its own balance sheet.
The funding problems are likely to get
worse if Moody's cuts the ratings on some of
Citigroup's SIVs. At the beginning of November
2007, Citigroup and HSBC Holdings received warning
of possible downgrades to their structured
investment vehicles as Moody's reviewed its
ratings on $33 billion of debt. SIV "debt ratings
continue to be vulnerable to the unprecedented
large and sustained declines in portfolio value
combined with a prolonged inability to refinance
maturing debt," Moody's said in a statement.
At this late date, when dead bodies of the
credit market crisis are floating to the surface
and the carnage is no longer deniable, there are
still public voices trying to calm market
sentiment by presenting the raging crisis "in
perspective", pointing to the low percentage of
distressed mortgages in relation to the entire
mortgage market. Yet in a top-heavy structure
precariously balanced on complex mechanics, a few
small bricks removed at critical points can bring
the whole structure crashing down. It is
irresponsible for public figures to label the tip
of a massive credit iceberg as merely a fly in the
ointment so as to persuade a trusting public to
view the escalating crumbling of the financial
sector as a buying opportunity.
PART
5: Off-balance sheet debt
Henry C K Liu is chairman of
a New York-based private investment group. His
website is at http://www.henryckliu.com.
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