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Subprimes Drain Conduit-Paper Liquidity
Asset Backed Alert, Harrison Scott Publications Inc. (August 10, 2007)

The pain caused by the subprime-mortgage crisis is getting worse by the day for companies that fund themselves through commercial-paper conduits - in some cases pushing the operators into a liquidity crunch.

With values of new conduit issues already plunging, market conditions grew even tougher yesterday as investors demanded extra returns on virtually any new offerings to hit the market. The deterioration was especially pronounced for "extendible" vehicles that can delay payoffs or conduits that incorporate mortgage-related products into their collateral pools.

"This is the worst day I've ever seen in this market," one conduit professional said.

Yesterday's rout came partly in response to the actions of extendible conduit operators American Home Mortgage, Luminent Mortgage and Aladdin Capital, which early this week took the unprecedented step of delaying payoffs on maturing paper. Fortress Investment apparently did the same a few days later for a conduit it runs.

Extendible vehicles only defer payouts on their paper when market disruptions render them unable to roll over the securities by issuing new product, as a sort of alternative liquidity backstop. The troubles that forced American Home and its peers to resort to that strategy have implications for players that rely on more traditional sources of liquidity as well, since they too are encountering trouble in issuing new paper at workable returns. That's even true of securities backed by high-quality collateral unrelated to mortgages.

"The asset-backed CP market is clearly not rallying," one industry insider said, noting that spreads on conduit paper are now running well over Libor. Spreads haven't been that wide since Russia's 1998 debt default touched off a global liquidity crisis.

How far over Libor are spreads? One investor pointed to a rate of 50 bp over Libor for securities-arbitrage conduits that contain large amounts of subprime-mortgage bonds and related CDOs. Even the most well-respected multiseller vehicles now have to pay 7-10 bp over Libor to get their deals done, compared to 3-8 bp over Libor earlier in the week and 4-5 bp under that benchmark two weeks ago.

At the same time, offered returns on extendible paper have ballooned by about 25 bp over the last week or two, to more than 30 bp over the Federal Reserve Board's overnight lending rate - at least for the deals getting done. That represents a sudden change from the past few years, when extendible issues typically priced 3-5 bp wider than similarly dated securities with traditional liquidity support.

Meanwhile, the use of the Fed funds rate as a benchmark, as opposed to Libor, reflects the fact that many buyers - as many as half, by one estimate - are shunning paper that takes more than a day to come due. The most popular conduit offerings typically mature in one to three months.

The result of all that is a drastically higher cost of funding for companies that securitize their assets via conduits. Expenses could rise even more in the months ahead as well, as extendibles stop serving as a viable source of liquidity support and more conduit operators are forced to pay for third-party backstops.

Over the last few years, many conduits have tried to save on the cost of such protection by issuing extendible paper. The technique became especially popular with mortgage lenders and other companies that rely on single-seller vehicles to warehouse pools of loans or securities backed by them.

However, those are exactly the types of deals that investors are blackballing. "Mortgage extendibles are gone now. They'll never happen again," one conduit banker said. "Nobody ever thought they would actually extend."

The ability to issue new paper is key to a conduit's survival, as the vehicle uses proceeds from the sales to pay off maturing debt and keep its assets funded. For money-market managers who prize liquidity and make up a tremendous chunk of the CP investor base, being forced to hold on to an extended issue is anathema.

American Home's Broadhollow Funding on Monday became the first conduit to extend payments, as the Irving, Texas, lender filed for Chapter 11 bankruptcy protection and revealed plans to sell its loan-servicing business and mortgage portfolios.

The lender had no choice but to go with the extension because it couldn't keep issuing through Broadhollow once its bad news got around. In addition, Moody's placed Broadhollow's top-rated commercial paper and subordinate term notes on watch for possible downgrades.

All of Broadhollow's $1.6 billion of outstanding paper is due to mature by the end of this month. Once it extends, Broadhollow must liquidate the underlying collateral, consisting of prime-quality jumbo and alternative-A loans, and repay investors within 120 days.

That's potentially bad news for ABN Amro, Bank of America, Calyon and Citigroup. As market-value swap counterparties for the paper, the banks must cover any shortfalls in the likely event that some of the mortgages have deteriorated in value. Thus, the banks were scrambling this week to figure out how much the assets are worth.

As American Home crumbled, San Francisco-based Luminent found itself unable to keep borrowing money to invest in agency and private-label mortgage bonds through its Luminent Star Funding conduit. Two other securities-arbitrage vehicles - Ottimo Funding run by Aladdin, of Stamford, Conn., and Windsor Trust run by New York-based Fortress - also got caught in the squeeze, as they were unable to see eye-to-eye with reluctant buyers of their paper.

Luminent, Aladdin and Fortress have about $5 billion of paper outstanding through their vehicles. All told, it's estimated that Broadhollow, Luminent Star, Ottimo and Windsor extended well over $1 billion of securities that were set to mature this week.

Two weeks ago, extendible notes accounted for about $185 billion of the $1.2 trillion of U.S. asset-backed commercial paper in the hands of investors. But the extendible component has since dwindled by $30 billion to $50 billion, and it's likely to keep shrinking as conduit operators turn to more affordable sources of funding as new offerings slow - including in-house cash, bank lines of credit, repurchase agreements and multi-seller conduits that employ traditional liquidity measures.



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