Defining the Credit Crisis

Vinny Catalano, CFA — Tue, 29 Apr 2008 16:14:00 GMT

Since the credit crisis began, investors have been bombarded with acronyms and phrases that most had very little direct experience with. Since the credit crisis is far from over and has both real and financial economy affects (that will result in a transformation of the US economy in the years ahead as the credit creation machine retools), it might be advisable for investors to get acquainted with some of the more germane acronyms and phrases as they will likely be with us for longer than many suspect.

Therefore, as a public service, I have listed below several key acronyms and phrases catalogued by area:

Products

Credit derivative: A financial contract under which an agent buys or sells risk protection against the credit risk associated with a specific reference entity (or specific entities). For a periodic fee, the protection seller agrees to make a contingent payment to the buyer on the occurrence of a credit event (default in the case of a credit default swap).

Collateralized debt obligation (CDO): A structured credit security backed by a pool of securities, loans, or credit default swaps, where securitized interests in the security are divided into tranches with differing repayment and interest earning streams. The pool can be either managed within preset parameters or static. If the CDO is backed by other structured credit securities, it is called a structured finance CDO, and if it is backed solely by other CDOs, it is called a CDO-squared.

Collateralized loan obligation (CLO): A collateralized debt obligation backed by whole commercial loans, revolving credit facilities, or letters of credit.

Credit default swap (CDS): A default-triggered credit derivative. Most CDS default settlements are “physical,” whereby the protection seller buys a defaulted reference asset from the protection buyer at its face value. “Cash” settlement involves a net payment to the protection buyer equal to the difference between the reference asset face value and the price of the defaulted asset.

Credit-linked note (CLN): A security that is bundled with an embedded credit default swap and is intended to transfer a specific credit risk to investors. The CLN issuance proceeds are usually invested in liquid and highly rated securities to cover the principal repayment at maturity plus any interim conditional payments associated with the underlying credit default swap.

Packages

Securitization: The creation of securities from a pool of pre-existing assets and receivables that are placed under the legal control of investors through a special intermediary created for this purpose (a “special purpose vehicle” [SPV] or “special purpose entity” [SPE]). In the case of “synthetic” securitizations, the securities are created from a portfolio of derivative instruments.

Structured credit product: An instrument that pools and tranches credit risk exposure, including mortgage-backed securities and collateralized debt obligations.

Structured investment vehicle (SIV): A legal entity, whose assets consist of asset-backed securities and various types of loans and receivables. An SIV’s funding liabilities are usually tranched and include short- and medium-term debt; the solvency of the SIV is put at risk if the value of the assets of the SIV falls below the value of the maturing liabilities.

Conduit: A legal entity whose assets consist of various types of loans, receivables, and structured credit products. A conduit’s liabilities are short-term commercial paper and are supported by a liquidity facility with 100 percent coverage.

Source: IMF “Global Financial Stability Report” April 2008

*To learn how to gain access to my weekly research report, "Sectors and Styles Strategy Report",click here

A Moment of Clarity

Vinny Catalano, CFA — Thu, 10 Apr 2008 15:26:00 GMT

“…it is now clear that the current turmoil is more than simply a liquidity event, reflecting the deep-seated balance sheet fragilities and weak capital bases, which means its effects are likely to be broader, deeper, and more protracted.”

IMF Global Financial Stability Report
April 2008

This has been a truly remarkable week, one that alcoholics refer to as a “moment of clarity”.

On the foreign policy front, US Senators and other congressional members awoke this week from their multi-year stupor and managed to pin the clarity tail on the Iraq donkey when they finally and pointedly asked the right question – what constitutes success? Combined with the now clear evidence, courtesy of the testimony of Gen. Patraeus and Ambassador Crocker, that in 2006 the Bush Administration, just prior to the midterm elections, “misled” (“misspoke’?, pick your euphemism for lying) the US public with statements regarding the state of affairs in Iraq, perhaps a more clear-headed discussion re Iraq can now ensue.

As vital as this matter is, it is the clarity that emerged on the financial and economic front that I wish to focus on.

This week witnessed the publication of a must read document for every investor – the IMF’s “Global Financial Stability Report”. Having just picked up my printed copy of the 208 page tome, I have begun to wade into the report and can see from the very first pages that this report will pin the clarity tail on the credit crisis donkey in a way that no other report or commentary has done thus far. Here is a sample of what I have read thus far:

• The report provides a clear recognition of not just the scale ($945 billion loss estimate) but the scope of the credit crisis, specifically it’s not just a subprime problem.
• The report identifies perhaps the most critical aspect of the crisis, namely deleveraging.
• “Macroeconomic feedback effects” are a high concern, specifically the likely consequences that deleveraging and the reduced credit lending capabilities of financial institutions will have on further economic activity. (This point has been noted on this blog and in recent reports published by my firm.)
• “Private sector incentives and compensation structures” will need to be addressed. This is a clear reference to the agent/principal problem that animal spirits unleash. Normally, a market problem only but not when bailouts and politics come into the mix.

Investment Strategy Implications

Any investor thinking that the credit crisis has passed is operating in a state of denial.

The ramifications of a new financial order cannot be over emphasized. The feedback effects on the real economy and its likely self-reinforcing aspects portend a double dip in the US economy in 2009. The respite equity investors are experiencing this spring might run even into the summer. However, Joe Battipaglia may be right (Beyond the Sound Bite interview last week) when he predicts that S&P 500 operating earnings will fall to and through the top down 2008 number of $80. When combined with the risk of rising inflation, the valuation target for equities could match the longer-term predictions of many technical analysts for a much lower market next year and into 2010, suggesting that what has been experienced thus far is a dress rehearsal.

All investors must and will come to their own moment of clarity on this issue. It’s just a matter of time.

*To learn how to gain access to my weekly research report, "Sectors and Styles Strategy Report",click here

Musing on the Markets : Global Financial Stability Report

Defining the Credit Crisis

A Moment of Clarity