Wednesday, July 18, 2007

Understanding CIBC's Subprime Mortgage Exposure

The Globe and Mail, Fabrice Taylor, 18 July 2007

CIBC is having trouble assuaging investors who fear yet another cock-up from the accident-prone bank.

This time it's over its dealings in the U.S. subprime market. Media reports, leaning heavily on hedge fund managers, suggest the bank is whistling its way to a massive haircut on some investments in collateralized debt obligations (CDOs).

Nonsense, says the bank, beyond which it fails to mount a convincing defence.

Truth is, not even the bank knows what's in store for its subprime deals. CDOs are extremely complex to value. The net result for investors, however, is that this might prove to be as much an opportunity as it is a risk.

CDOs are pools of debt, usually junky debt. The CDO issues notes against the debt pool, but the notes are not created equal. The top group, or tranche, has first dibs on the assets and gets paid first. So if the CDO owns subprime mortgages, and, say, 10 per cent of them default, investors in the top tranche are okay.

Those in the bottom tranche are typically wiped out, while those in the middle tranches get burned but keep some of their capital. The higher tranches are usually AAA rated, the lower ones, often called equity tranches, are not rated at all. The interest payments are commensurate with the respective ratings.

By dividing the collateral pie into slices, CDOs turned lousy credit into gold-plated (AAA) bonds. At least on the surface. They also encouraged the U.S. housing bubble by helping supply credit to extremely suspect customers. Like all great financial ideas, they can be, and are, abused - especially when they morph into more complicated versions.

A CDO squared, for example, invests not directly in pools of mortgages or other loans, but rather in certain tranches of other CDOs. For example, a CDO might own the middle tranches of a large number of other CDOs.

These tranches are typically rated A or thereabouts, but again, through the alchemy of risk restructuring, lead becomes gold (well, in this case silver becomes gold.)

The CDO squared can now issue AAA-rated securities on the back of collateral of distinctly lower quality, which in turn rests, ultimately, on the credit-worthiness of Bubba Jones or, failing that, on his Tallahassee home.

It's in such CDOs that CIBC acknowledges an investment. Specifically, in the highest tranche of a vehicle called Tricadia 2006-07 Ltd., though it says it has other subprime investments too. BMO Nesbitt Burns, for instance, says CIBC also invested in Tricadia 2007-2008 Ltd.

Tricadia 2006-2007 invested in other CDOs that ultimately own mortgages originated in 2006 - one of the worst vintages. The bank's investment, it should be noted, is synthetic: that is, it used derivatives to replicate the economic behaviour of such a security. The bank earns small payments - under a million a year by our math - but is on the hook for defaults beyond a certain percentage. The worst-case scenario for Tricadia 2006-2007 is $330-million (U.S.), according to stated records.

But CIBC's Tricadia investments are AAA rated so what's the worry right? Well, it's not that simple.

The first problem is that the tranche CIBC is exposed to may well have not been so safe. Ratings agencies have been downgrading or reassessing tranches of CDOs. Expect more downgrades to come.

According to Bear Stearns, Tricadia's odds of getting kicked down the rating ladder are high. A downgrade might force CIBC to take a charge even if the loan keeps performing (CIBC officials declined to comment on this column).

But of greater concern is a wave of homeowner defaults, which investors appear to be betting on judging from indexes that track the performance of CDO tranches (see the accompanying chart that tracks A-rated tranches of loans originated in 2006). The values have fallen by about quarter.

Ratings agencies and lenders are ratcheting up their predictions for more mortgage defaults. The latest estimates are that around 7 per cent of subprime mortgages will default.

That may not sound like much, but here is why it matters for CIBC.

The highest rated tranche of a CDO might have a 40 per cent cushion beneath it: that is, as long as no more than 4 of every 10 mortgages defaults, the top tranche is fine - and that's an unheard of default rate. But a CDO squared's collateral might have a cushion closer to 10 per cent (remember that its assets are the lower rated tranches of other CDOs).

If defaults hit 7 per cent, then 10 per cent isn't far away. So much for a AAA investment.

One saving grace for the bank is that it's the only investor in some of the CDO tranches, so there's probably no market for them. That means we're depending on CIBC's disclosure and we might not hear all that much about it.

If there are massive defaults though, they aren't likely to bring the bank down. Remember that the Enron settlement - more than $2.4 billion (U.S.) - ended up creating a great opportunity to buy CIBC shares. Look at the charts. That's another way to turn lead into gold.