Q & A with Emily Hollis

Emily Hollis
February 25, 2008 | COMMENTS

Question: I am worried about the corporate credit unions, US Central's downgrade, and their unrealized losses—should I be concerned?

On Tuesday, February 5, S&P announced it had lowered US Central's long-term rating one notch from “AAA” to “AA+”. Both Moody's and S&P continue to give US Central its highest commercial paper debt ratings of A1+/P1. The AA+ rating, the second-highest of eight investment grade ratings, is shared with only two other U.S. lending financial institutions: Bank of America and U.S. Bank. Only one institution, Wells Fargo, has a higher rating. While FHLMC and FNMA do hold the honors of the top AAA rating, these mammoth agencies have not been unscathed with mortgage-related problems and have had to raise capital in order to maintain this status. The following is an excerpt from the US Central press release.

“As investors began to shy away from MBS or investments secured by MBS (such as ABCP conduits) and to require higher yields for their existing MBS holdings, issuers began to dramatically slow or stop their purchasing of residential mortgage loans that would be packaged into MBS. The previously liquid market of mortgage origination and securitization became illiquid almost overnight. This lack of liquidity had made the valuation of MBS more difficult. Within just a few weeks, what started as a subprime mortgage crisis has evolved into the most severe dislocation in the credit markets of the modern era.”

The unrealized security losses that have been experienced by corporate credit unions are just that: unrealized. The question is what is the potential amount of realized losses? Let's consider the facts. According to Moody's “Default & Loss Rates of Structured Finance Securities, 1993-2005,” actual principal losses for AAA-rated structured product for the last seven years has been a cumulative 0.03 percent, or $30,000 per $100 million in AAA-rated structured bonds. S&P expects 2006 vintage performances to perform worse by an estimated 350 percent; therefore, historical realized losses could increase to $105,000 per $100 million. This is not annualized, but an historical loss over a seven-year period, a mere fraction of the unrealized losses currently reported by the markets.

If you read the publications produced by US Central and the larger corporate credit unions, credit enhancements appear ample to prevent a significant amount of realized losses. There currently exists AAA bonds that have been “credit shocked” to assume 100 percent of the pool would default and homes would be sold at 50 percent of the weighted average loan to value (in some instances 35 percent of the original value of the home) and there is NO loss of principal. US Central and the larger corporate credit unions have systems that can quantify how badly the market needs to get prior to losing the first dollar of principal and the answer appears to be “multiples.”

So you might ask why prices are so depressed? For instance, AAA-rated, 3-year floating rate asset-backed securities traded at LIBOR plus 20 to 40 basis points for years. Now, these securities are trading at LIBOR plus 100 to 400 basis points as shown in the chart below. Should the markets stabilize, there are AA securities that might see returns in excess of 15 percent. The simple answer is that the markets are panicking. A once-abundant demand for mortgage-backed product has dwindled dramatically. Reason being, most institutional investors are not like credit unions; they cannot buy and hold. Hedge funds were leveraged multiple times with asset-backed securities of varying ratings. Prices started dropping and they were forced to sell. Many mutual funds and institutional buyers have stop/loss provisions that are being triggered. Fund managers are worried about continued dropping of prices and staying power.

ALM First holds $22 million of asset-backed securities for its client credit unions, only 0.3 percent of our $7.5 billion of funds under management; however, given current levels, we anticipate more purchases.

So, the simple answer to your question is yes, we are comfortable with the credit worthiness of US Central and the corporate credit unions. Most corporate credit unions have ample liquidity sources with borrowing powers that almost equal their asset size. Therefore, forced liquidation is not an issue. Eventually the markets will correct themselves and like every other correction, there will be institutions that will make a lot of money and, in hindsight, people will question how this could have gotten so bad.

Emily Hollis is a CFA and president of ALM First Financial Advisors, LLC in Dallas, Texas . Contact Hollis at 800-752-4628 or ehollis@almfirst.com. Margot Strong, director of business development, may be reached at mstrong@almfirst.com.