Today my friend referred me a link on the extremely great performance of the bet of Kyle Bass from Hayman fund, the Texas investor who has made tons of money from the credit crunch. And now he is betting on the collapse of Europe. It was reported that the potential reward for him could be 65,000%.
I was reading his letter to investors on July 2007 on subprime loans and the truth behind CDO and CLO and found it very interesting. In the letter, Kyle Bass said it was explained to him how and why the Subprime Mezzanine CDO business existed. This structured finance vehicle is 10x to 20x leverage which contains only the BBB and BBB tranches of subprime debt. Because the real money provided by U.S. insurance companies and pensions funds had stopped buying in mezzanine trances since 2003, they need to find a way to get rid of it. They did so by marking up those loans, packaging them and “exporting the newly packaged risk to unwitting buyers in Asia and Central Europe.” Bass was told that these CDOs were the only way to get rid of the riskiest tranches of subprime debt.
The buyers are the ones who got excess pools of liquidity, which was U.S. dollar denominated because of their trade surplus with the U.S. in USD and petrodollar recyclers, including banks in mainland China, Taiwan, Korean, German, France and the UK. They got orders for Wall Street to buy any U.S. debt rated “AAA” by the rating agencies in the U.S. With those demands on hand, the subprime debt should be structured in a way to turn a series of BBB and BBB tranches into AAA rating. How can they do that? Through “alchemy of Mezzanine CDOs.”
He wrote:“With the help of the ratings agencies the Mezzanine CDO managers collect a series of BBB and BBB-tranches and repackage the with a cascading cash waterfall so that the top tiers are paid out first on all the tranches – thus allowing them to be rated AAA. Well, when you lever ONLY mezzanine tranches of Subprime RMBS 10-20x, POOF.. you magically have 80% of the structure rated “AAA” by the rating agencies, despite the underlying collateral being a collection of BBB and BBB-rated assets...”
The debt was purchased at par, or in other words, 100 cents on the dollar. When those vehicles were downgraded, the foreign buyers to the U.S. would likely sell them, as they were only permitted to own “super-senior” risk in the U.S. Kyle thought these mezzanine tranches CDOs might fetch a bid around only 10 cents.
He pointed out the difference between the situations of subprime these days and the S&L crisis in the 1980s. Today, the mortgage lenders weren’t taking their own balance sheet risk when they underwrote the loans. The brokers got paid for quantity, no matter what the quality. “If you were 20 something, making mortgage loans in California, using someone’s balance sheet and being paid per loan (with no lookback on the performance of the loan), how many dubious loans would you underwrite?"
Last but not least, Bass was told that he was spending some time to survey the actual damage of these investment vehicles, (especially in California and Florida, which in total 55% of all subprime loans). The message he got was people believed 90% of subprime mortgages contained some kind of fraud. “Either borrowers lied about their incomes or mortgage brokers fudged numbers on the applications to make them pass muster with the needed ratios in order to get loans approved." It was said that 50% of applicants overstated their income by more than 50%.
At the time of writing, Hayman is shorting credit in the U.S. (both Subprime RMBS and corporate credit), long non-U.S. equities and debt. In addition, the fund shorted U.S. consumer based equities, preferreds and debt. He concluded: “I think the world is going to begin to decouple from the U.S. and realize that currency appreciation coupled with the globe’s best growth is an attractive alternative to fraudulent ratings, U.S. dollar depreciation, and financial inventions used to export risk."
I was reading his letter to investors on July 2007 on subprime loans and the truth behind CDO and CLO and found it very interesting. In the letter, Kyle Bass said it was explained to him how and why the Subprime Mezzanine CDO business existed. This structured finance vehicle is 10x to 20x leverage which contains only the BBB and BBB tranches of subprime debt. Because the real money provided by U.S. insurance companies and pensions funds had stopped buying in mezzanine trances since 2003, they need to find a way to get rid of it. They did so by marking up those loans, packaging them and “exporting the newly packaged risk to unwitting buyers in Asia and Central Europe.” Bass was told that these CDOs were the only way to get rid of the riskiest tranches of subprime debt.
The buyers are the ones who got excess pools of liquidity, which was U.S. dollar denominated because of their trade surplus with the U.S. in USD and petrodollar recyclers, including banks in mainland China, Taiwan, Korean, German, France and the UK. They got orders for Wall Street to buy any U.S. debt rated “AAA” by the rating agencies in the U.S. With those demands on hand, the subprime debt should be structured in a way to turn a series of BBB and BBB tranches into AAA rating. How can they do that? Through “alchemy of Mezzanine CDOs.”
He wrote:“With the help of the ratings agencies the Mezzanine CDO managers collect a series of BBB and BBB-tranches and repackage the with a cascading cash waterfall so that the top tiers are paid out first on all the tranches – thus allowing them to be rated AAA. Well, when you lever ONLY mezzanine tranches of Subprime RMBS 10-20x, POOF.. you magically have 80% of the structure rated “AAA” by the rating agencies, despite the underlying collateral being a collection of BBB and BBB-rated assets...”
The debt was purchased at par, or in other words, 100 cents on the dollar. When those vehicles were downgraded, the foreign buyers to the U.S. would likely sell them, as they were only permitted to own “super-senior” risk in the U.S. Kyle thought these mezzanine tranches CDOs might fetch a bid around only 10 cents.
He pointed out the difference between the situations of subprime these days and the S&L crisis in the 1980s. Today, the mortgage lenders weren’t taking their own balance sheet risk when they underwrote the loans. The brokers got paid for quantity, no matter what the quality. “If you were 20 something, making mortgage loans in California, using someone’s balance sheet and being paid per loan (with no lookback on the performance of the loan), how many dubious loans would you underwrite?"
Last but not least, Bass was told that he was spending some time to survey the actual damage of these investment vehicles, (especially in California and Florida, which in total 55% of all subprime loans). The message he got was people believed 90% of subprime mortgages contained some kind of fraud. “Either borrowers lied about their incomes or mortgage brokers fudged numbers on the applications to make them pass muster with the needed ratios in order to get loans approved." It was said that 50% of applicants overstated their income by more than 50%.
At the time of writing, Hayman is shorting credit in the U.S. (both Subprime RMBS and corporate credit), long non-U.S. equities and debt. In addition, the fund shorted U.S. consumer based equities, preferreds and debt. He concluded: “I think the world is going to begin to decouple from the U.S. and realize that currency appreciation coupled with the globe’s best growth is an attractive alternative to fraudulent ratings, U.S. dollar depreciation, and financial inventions used to export risk."
