Risk Mananging Asset Backed Securitization

GGP Q2 Results
General Growth Properties Q2 results were better than the markets expected. When you strip out exceptionals, many of which are related to Chapter 11 costs, the fundamentals are encouraging, and have rightly been reflected in a significant rise in the share price.

Taking a look at the breakdown, the immediate comparisons appear poor: Funds From Operation (FFO) are down by 73.8% year on year, Core FFO is also down 43.9%. However of much great importance is GGP's Net Operating Income (NOI) - down a much more modest 11% in total, and a very good figure both in comparison to GGP's major peers and market expectations. In fact, excluding the main drag from the MPC's (Master Planned Communities) - with those stripped out we reach the headline figure reported for the main Retail businesses, with NOI down a mere 2.1% on the previous year.

Relatively strong fundamentals adds further credibility to the GGP business model. The increasing market capitalization of the firm is a direct reflection of growing confidence across the market in its ability to successfully restructure without excessive equity dilution.

Bubbles & Risk Management
I fully admit to not seeing the credit crunch coming until it was too late, and if most people are honest they did not either. In fact, nor did most of the noted commentators - it was a rare few who warned of the dire effects of a credit withdrawal with the years in advance required to avoid these problems.

I thought the dot com and recent housing bubbles were both glaringly obvious, and stayed well out of both. However as I discovered with the credit crunch, bubbles are not always so clear - they have to be hard to spot to enable them to build up.

Risk management was a dirty word on the Street a few years ago. On a few occasions, I remember sneering with the best of them, as calls from risk management about positions being taken were viewed as unnecessarily cautionary. And consistently unnecessary as the high earners and income generators within my former bank confidently dismissed them as overly conservative. I was naively a believer in the pure capitalist argument that too much collateral tied up money that could and should be actively and productively used as part of the development of the 'new economy'. The financial instruments now in use were different; these managed risk as inherent in their design.

Whenever anybody starts justifying practices that generate extraordinary profits and inserts the word 'new' in the context of economics, it is time to beware. Things really weren't different this time of course, just as recessions and crises have occurred with startling regularity throughout the last century. My take on this is that it is the different generation of investors ultimately ensures that reoccurrence. Much like investment, few take the time to research before jumping in, and hence do not learn the lessons of history.

Additionally throw in the less sophisticated consumers in the emerging markets and bubbles in India and China in particular are a virtual certainty – that means the potential to exploit significant, quick profit in the coming years ahead for those willing to take the time to invest in these markets and not play safe at home (much more on this theme another time).

Risk Management of Asset Backed Securities
The one plus of this learning process for our generation is that the regulators have been taking a hard look at the woeful risk management practices in many of the large banks - particularly in the context of asset backed securitization.

The US government is proposing several key legislative changes, which are worth understanding for those inside and outside the industry:

1. Any bank, non-bank issuer or underwriter of an asset-backed security must retain at least a 5% interest of the credit risk in such assets for an as-yet unspecified period or form. Crucially that would be without hedging - the theory being that if firms are themselves exposed to what they are trading, they as shareholders and owners of the banks will take the issue of risk a great deal more seriously.
   
2. Requirement to continue reporting by issuers of asset-backed securities even if the number of holders falls below 300 - this has relevance to the low level issuance/ownership of Structured Purpose Entities (SPE's) that we have seen in General Growth Properties bankruptcy, whereby some creditors have effectively been the sole lender. At present these structures escape under the reporting radar, but soon no longer.


3. Requirement to disclose standardised asset-level or loan-level data and standardised compensation and risk retention information. This really does not have much bearing on risk management, and seems to have been inserted to placate those wishing to have some disclosure of bankers compensation.
   
4. Regulations on the use of representations and warranties in the asset-backed securities market that would require credit rating agencies to include additional analysis in their reports - this would require disclosure permitting investors to identify originators with clear underwriting deficiencies.


5. Elimination of the offering exemption for certain real estate mortgage notes and related participation interests.

If these proposals are adopted, the impact on the securitisation market will depend on the nature and scope of the regulations that are ultimately developed. However it is that first proposal relating to forced exposure which knowing the banks will be the most effective means of ensuring responsible behaviour.

As the cocky young traders I describe in my last entry have long proven, it is easy to play dice with other people's money – and in the right period for the economy a total muppet can make money. However put your own money on the table, and you think about the risk far more seriously. This links back to what bonuses are meant to be about - a performance linked assessment that incentivises traders to trade as effectively as possible – it is that glaring short-termist flaw in them that has been exposed and is rightly attracting criticism.

Bonus reforms remain another vital change that needs to be imposed on the sector, and if I can recognise that then you know there is no excuse for those disagreeing.

Is Quantitative Easing The Answer?

I have read a couple of interesting, contrasting views this week in the Telegraph on the subject of quantitative easing between Roger Bootle, the founder of Capital Economics, and Liam Halligan, the economics editor of the Telegraph.

Bootle's article in favour is here, whereas Halligan's exactly opposing viewpoint today is here. For the record, I am in favour of quantative easing, which for me has been highlighted starkly by the plight of General Growth Properties (GGP), and its urgent need for refinancing in order to service its debt load. As I have stated previously, GGP is a healthy company in terms of its asset base versus liabilities, and would be fine servicing its current debts before the credit crunch. Instead it is now left struggling to repay loans as they come due, because of the seizure of the CMBS market and a chronic loss of confidence in its financial viability.

Whilst Liam Halligan gives a useful perspective and balance to those calling for quantitative easing, I was left finishing his column still asking the question 'what precisely are we to do to ease the current credit crisis in that case?' He appears to suggest there is a rabid group of lobbyists suggesting any other viewpoint is held up as a heresy, which unless I am missing something is nonsense. Certainly it has become the consensus opinion amongst government and businesses, but I am quite open to alternatives if a convincing argument can be constructed.

The question is whether it is better to do nothing at all and to let banks and businesses all fail in order to avoid the spectre of inflation and short-term (significant) public debt.

Going back to the commercial real estate sector in the US, and Commercial Backed Mortgage Securities (CBMS) being near completely frozen as a going market. It would be like all banks suddenly refusing you when your fixed term mortgage deal expires, and instead demanding you sell your property at the worst possible moment in the economic cycle. It would lead to huge individual suffering for homeowners, and in the same way will see all manner of otherwise viable companies going to the wall throughout the economy - that means job losses, financial losses, and pain for many.

The US alone has a vast $200bn of such loans coming due in 2009/10 - without QE to fuel the TALF lending that will enable such businesses to refinance and ride out this period, they will simply go under. Why is that better than QE to buy those assets, and eventually sell them back onto the private sector as it thaws (and in effect 'undo' QE, reducing the money supply and trying to avoid inflation being controlled)? I fail to see why targeted action is not better than simply doing nothing.

It is one more week to go until GGP reaches its critical deadline for loan extensions on March 16 - this coincides with the repayment due to Rouse bondholders, who are a group owed money after GGP bought Rouse back in 2004. This ought to see some movement through meaningful announcements - the options being either GGP is forced to file for Chapter 11 due to Rouse bondholders, extensions being announced while TALF funding is still on the near horizon (the whole process is predictably dragging and will take months yet to take effect), asset sales ($400m has been offered for 3 properties on the market for example) to pay off key loans, or a GGP takeover/joint venture.

All are possible, to my mind all will benefit GGP's shareprice significantly. My only wish is that I had bought in now rather than in December, but I expect to see a huge improvement in my position on this trade in the next 6 weeks.

Investing for a Recession (Part II)

Having outlined how I have made some useful money from the recession to date, it would be worth now moving to my current main investment at present, so that there is some context when I update on this going forwards.

Apart from putting a proportion of my funds into a gold ETF, which is an excellent hedge both against recessionary worries, a devaluing dollar and future inflationary concerns from all the quantitive easing taking place, I have also placed a significant sum into something that is much less obvious in these turbulent times: US commercial property.

You might think that is insane, and is totally contrary to what everybody else is putting their money into at the moment. But part of investing is looking for value, and sometimes that means looking beyond the conventional wisdom. I have bought into something called a Real Estate Investment Trust (REIT) - these are essentially US commercial property companies, which by and large have plunged by enormous amounts in the last 6 months.

As such, several are rumoured to be on the verge of bankruptcy, and one in particular is down a staggering 97% since the summer of 2008. When you factor in a fall of that magnitude, you have to start looking at the price and ask why, and whether this is rational or fueled by other factors. The underlying reason is the credit crunch, combined with investor fear of a Chapter 11 bankruptcy filing.

To give some background here, REIT's have by and large used a previously acceptable business model, whereby they were highly leveraged and routinely took out large levels of debt to increase their asset base and buy up more property. They then serviced this debt, steadily paying it off while periodicially refinancing this - without problems in a normally functioning credit market. Of course, everybody now sees US property as having been in a huge bubble, and all associated loans as necessarily toxic. As such, suddenly some enormous commercial property companies are on the brink of bankruptcy - including the particular REIT I have invested in called General Growth Properties (GGP).

To put it into context, GGP is the second largest mall owner in the US. That is not an insignificant statistic in itself, and should it fold there would be enormous ramifications for the US retail sector, not to mention a political backlash. I would actually not mind if it did file for Chapter 11 within the next few weeks, for reasons summarised well in this Reuters article.

Estimates suggest that GGP's assets exceed liabilities on the balance sheet by several billion dollars already. Additionally it has no problems servicing its actual debts, just refinancing them. In effect the problems of GGP are not with solvency, as with normal bankruptcy risk, but liquidity - this is a direct result of the banks own liquidity issues that have made them more risk averse.

What is most interesting with GGP is also that the balance sheet is not fully marked to market, which means that if its assets are valued at today's prices instead of when purchased there will be a change. Many properties on its books were bought years ago and have never been revalued, so it is reasonable to expect many will be worth more than marked, even with the current woes of the US property market. As such, assuming GGP were to go bust, what does that mean for ordinary shareholders? Normally it is a disaster and means no money, but in this case it should mean that the US courts would order the banks to agree refinancing terms, after which GGP would emerge out on the other side without that perceived stigma. Meantime the shares will continue trading on the stock exchange.

Since the Reuters article, all indications are that GGP will not file for Chapter 11 however, with its banking consortium of lenders bending over to give multiple loan extensions (including one over the weekend through to mid-March). There are many factors at play in whether full refinancing of the loans due in 2009 will take place - that is what would remove the market risk of bankruptcy that has so severely depressed the share price.

The main sticking point for lenders is several billion dollars of loans that are currently unsecured (i.e. have no assets backing them up), which are due for refinancing. Understandably the banks want assurances they would have some collateral to offset should GGP go under at a later date, and at present the unsecured loans are not acceptable to them. As such GGP is looking to either sell assets to pay those off, or negotiate terms. Both are possibilities, but at this stage it is unclear which is the more likely.

Another factor is the recent extension of uses for the Troubled Asset Relief Program (TARP) by Barack Obama, to now explicitly include money for Commercial Real Estate. This bill has passed through congress, and the campaign is continuing - again it provides political pressure on the banks to lend and not push under a company as significant as GGP.

Once terms are agreed, or GGP manages to sell off a number of assets to enable refinancing, I expect there to be significant upwards movement on the stock price. I have gradually increased my long position on GGP from $1.61 down to $1.03 in the last 2 months, although it is worth adding that a recent sell off last week on fears ahead of the loan deadline (prior to extension again) lead to a sharp fall back to around 55 cents a share. As of yesterday, GGP's share price bounced up 30% on the news of the loan extension, and is now currently at around 80 cents a share as I type.

So I am sitting on an unrealised loss at present. Since I bought into this REIT in December, the share price has risen by 80% at its peak, and fallen by 50% from where I entered at its lows. I turned down the chance to cash in a £50k profit in early January because I am more interested in the bigger picture here. That's how trading works - I have a strategy which does not include day trading this stock, because I do not know when the news will be announced that will make the crucial difference.

To give you an idea of the potential rewards at stake here, if the share price were to rise back to just $3.50, where it was in October, I would make in the region of £150k from the trade.

I should add a cautionary note that this is considered a speculative play. I am speculating on the most likely outcome based on extensive research - what makes this unusual is that there appears to be significant upside regardless of whether GGP files for bankruptcy protection or not. To me the share price of GGP is significantly undervalued, and at some point the market is going to realise that.

Most people are not prepared to accept this level of risk, and that is entirely right, although it is worth pointing out that you can take a zero off the figures and it could easily be you making (or losing) these amounts. In my case, if everything goes as well as I expect, I could make over £1 million from the trade. Admittedly that is unlikely and would require me holding for a couple of years. I am looking at cashing in £250k as a more realistic profit, but it gives you an idea of how risk vs reward works in the markets.

I will keep you updated on the progress of this particular hot potato in the coming months. Anyway back to work.