Sept. 15 was a day of reckoning for Wall Street as the market said goodbye to two U.S. financial institutions, 158-year old Lehman Brothers, whose parts will be wrapped into Barclays Capital, and 94-year old Merrill Lynch, which will now exist under the Bank of America umbrella.
On most ABS participants' minds last week was the impact these events would have on the already ravaged structured finance market. Sources reiterated that the ABS market depends on the ability to access term funding, which has already been weakened by investor fears, though isn't changed dramatically by last week's events.
Spreads on the consumer ABS side have a subprime-like scenario built in, which is not expected to come to fruition, according to a senior ABS analyst from an investment bank.
While the stress of Lehman Brothers and Merrill Lynch layoffs will only exacerbate the rising unemployment rate and put further pressure on consumers, "this recession is not going to create collateral performance on the consumer side that is as bad as the subprime performance," the analyst said. "Some people will suffer from being over levered but there are still deals that will be okay. So there is probably still pretty decent relative value even if spreads widen out a bit further."
Centered on CDS
Concerns last week about ABS exposure at Lehman were centered more on the credit default swap (CDS) issue. "It is really the counterparty exposure through the CDS market that has to be sorted out," the ABS analyst said. This includes dealer-to-dealer counterparty exposure, and the counterparty exposure clients have to Lehman.
Many market players held swaps for derivative contracts with various Lehman entities other than the parent holding company, but where the parent holding company provided a guarantee. Many of those swaps became subject to events of default because, in these situations, a default or bankruptcy on the part of the parent guarantor constituted a default on the underlying swap itself, said Joel Telpner, partner at Mayer Brown.
Lehman acted as swap counterparty in 69 Fitch Ratings-rated synthetic CDOs: 31 in Europe, 35 in Asia and three in the U.S. In many of these transactions, Lehman Brothers Special Financing acted as the buyer of credit protection from the CDO as CDS swap counterparty, and Lehman Brothers Holdings acted as a guarantor or credit support provider.
The impact on CDO note ratings where a Lehman entity was a swap counterparty will depend on a number of factors. These include whether the CDO transaction faces an automatic unwind following the Lehman bankruptcy, whether the swap may be transferred to another counterparty, and the extent to which noteholders may be subject to the market value risk of eligible securities in the event of early termination of the transaction, Fitch said.
If Barclays acquires business activities that include some of these entities and ultimately takes on the positions, "the question becomes whether Barclays is assuming the obligations to unwind these swaps and whether the market would be willing to reconsider or rescind the decision to unwind some of these swaps based upon them being assumed by Barclays," Telpner said. However, it may be pragmatically too late, since players on the street have already begun to terminate swaps with Lehman, and to unwind hedges or enter into hedges as part of the unwind, he said.
While the technicals behind the Lehman deal with Barclays were still being fleshed out as of press time, counterparties on the street last week were calculating what they are owed and making those claims, creating confusion and uncertainty among other banks. "What this is showing you is that part of the problems we are seeing in these investment banks is to what extent they are exposed to one another through the CDS market," the bank analyst said.
"Banks want to keep CDS over-the-counter and non-transparent in terms of pricing. They want big bid offer spreads and everything that comes with that," he said. As a result, their solution to the clearing problems and counterparty risk is to have the clearing corp. do it. But the clearing corporation is owned by almost the same ten dealers, so they are just going to commingle their exposure, the analyst said. "That doesn't do much to unwind their exposure to one another."
Regarding the Bank of America acquisition of Merrill, the market will remain in a wait-and-see period until it knows to what extent various swaps can be assigned or transferred. "The question here becomes how they ultimately combine the entities and whether or not, as part of that process, there are attempts for different exposures to be assumed by entities or to consolidate them," Telpner said.
Bigger Piece of the Pie
What is consolidating in the ABS market is business competition as banks are wrapped into bigger players like JPMorgan and Bank of America. But the outlook is still not very optimistic for the remaining players, the bank analyst said. He did not expect an equitable distribution of market share to result from the restructuring on Wall Street. "It will push more business to the top of the league tables. I am not sure that a less crowded market is good for player number six through 10," he said. The analyst expected that Bank of America would eclipse Citigroup and JPMorgan to become the biggest universal bank in the country. "When all this shakes out and the credit crunch is over, they are going to be the big winner in the league tables."
But the U.S. capital markets will also see increased competition from overseas institutions. "[The liquidation and acquisition of U.S. financial institutions] will be destructive to the U.S. competitive advantage," said Robert Ellis, senior vice president at Celent, adding that the U.S. does not make products as cheaply and efficiently as other parts of the world. "The capital markets business has traditionally been a strong industry for the U.S. economy. This will reduce capability."
Ellis noted that while specialized teams leaving financial institutions in distress will continue to underwrite niche deals in the U.S., either by starting their own shops or moving to boutique firms, with Lehman being acquired by a British bank and the rumors of a potential acquisition of Morgan Stanley by a big international bank (as of press time), many deals will move overseas.
Indeed, regional and boutique firms are hiring to some degree, but with credit continuing to tighten, the challenge is for these firms to find professionals who can transfer their origination, execution and closing experience, said Richard G. Lipstein,managing director at Boyden Global Executive Search in New York. "If you were a fixed-income capital markets banker at a bulge bracket firm whose clients were not currently doing any business with your firm because of these markets, it would be very challenging to take these clients to a smaller firm without as strong a product capability."
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