It's all about "alchemy"

The CIBC’s (CM:TSX) reaction to a July 9 Barron’s story on its potential “subprime exposure” was as good as any PR professional can muster, but the bank’s recent history of challenges (Global Crossing, Enron, etc.) also serves to raise the credibility bar higher than it might be for other institutions.

It is amazing that a simple sentence in Barron’s about one of our Chartered Banks can cause such a ruckus; particularly when but one or two people might be behind that “$2 billion” subprime exposure reference. That’s all it would take for the Barron’s journalist to run the $2 billion number. (And it wasn’t even a new rumour {see post “ARMs are the next shoe to drop“, July 11-07} and Grant’s Interest Rate Observer, June 15-07 .)

In theory, Barron’s should have at least two different sources, given the word “observer” was used in the plural sense: as in, “some observers say”. In light of all of the reports (newsletters, Dead Tree Media outlets, blogs, etc.) that were chewing the fat on the subject, there were plenty of “observers” to refer to. Even if Barron’s didn’t specify.

It is now about ten days later, and the story still spins around the marketplace. As a student of such things, I find it interesting to watch how stories and their sub-themes ricochet around our corner of the universe. Follow the word “alchemy” as it transforms from being a neat depiction in the original article to what I assume is collective wisdom (ie., no identification of the original source of the concept) in a short space of time:

Garbage In, Carnage Out
By Jonathan Laing
Barron’s, July 9-07
excerpt:

How did the U.S. subprime-loan market morph into a ticking time bomb? The answer begins, and ends, with Wall Street’s ingenuity, which was enhanced by something curiously close to alchemy. To raise the aforementioned trillion dollars to purchase the flood of new subprime mortgages from lenders, brokerage firms invented residential-mortgage-backed securities, or MBS, which they sold to institutional investors. These securities consisted of different slices, or tranches, of bonds, with triple-A and other highly rated tranches having repayment priority as the original borrowers paid back principal and interest.

As one dealer in MBS told Barron’s, “Mezzanine subprime CDOs are all the same junk.” But because one slice of the CDOs was subordinated to the rest, the rating agencies allowed most of these highly speculative securities “to be turned into gold.”

– and –

Mezzanine subprime exposure is showing up in all sorts of surprising places. The Canadian bank CIBC has acknowledged ownership of around $330 million, though some observers say the figure could be more than $2 billion. That estimate would constitute a substantial chunk of the bank’s approximately $13 billion in shareholder equity.

To this news story:

“CIBC’s subprime exposure in the spotlight”
By Tara Perkins
Globe and Mail, July 9-07
excerpt

To raise the trillion dollars to buy subprime mortgages from banks and other mortgage lenders, brokerage firms invented residential-mortgage-backed securities, which they sold to institutional investors. The securities are made up of different slices of bonds, with different levels of risk. To make it easier to sell the riskier slices – those rated triple-B – Wall Street repackaged many of them into new securities called mezzanine collateralized debt obligations, or CDOs. Debt rating agencies rated about 80 per cent of the principal amount of the triple-B slices, or tranches, as triple-A, in a piece of Wall Street ingenuity that resembles alchemy, the Barron’s article says.

“Mezzanine subprime CDOs are all the same junk,” the article quotes one dealer of mortgage backed securities. But the rating agencies allowed most of these highly speculative securities to be turned into gold, Barron’s quotes the dealer as saying.

To a column:

“Understanding CIBC’s subprime mortgage exposure”
By Fabrice Taylor
Globe and Mail, July 18-07

By dividing the collateral pie into slices, CDOs turned lousy credit into gold-plated (AAA) bonds. At least on the surface. They also encouraged the U.S. housing bubble by helping supply credit to extremely suspect customers. Like all great financial ideas, they can be, and are, abused – especially when they morph into more complicated versions.

A CDO squared, for example, invests not directly in pools of mortgages or other loans, but rather in certain tranches of other CDOs. For example, a CDO might own the middle tranches of a large number of other CDOs.

These tranches are typically rated A or thereabouts, but again, through the alchemy of risk restructuring, lead becomes gold (well, in this case silver becomes gold.)

Having watched CIBC shares drop about $3 in the wake of the original newsletter subprime exposure story (a loss of $1 billion of market cap, against rumours of $2 billion in subprime “exposure”), it seems only fair, I suppose, that the bank’s strong denial has driven the stock price right back up to where it was trading four weeks ago — before the feeding frenzy began. The publication of the Barron’s piece served to essentially call the bottom on CIBC’s shares, and for all of the reporting (and re-reporting, and lifting of thoughts, etc.) since, CIBC has added about $1 billion back to its market cap.

I don’t doubt that the bank’s risk officers will be challenged to price out the possible outcomes of CDO pool ownership. It was just a few days ago that Bear Stearns (BSC:NYSE) was going to lend US$3.2 billion (that amount was reduced to US$1.6B in the end) to two of its own hedge funds to prop up the fund’s underlying subprime portfolios. On Tuesday, the Bear discovers that there’s no honey left in the pot (from the WSJ):

Investors in two troubled Bear Stearns Cos. hedge funds that made big bets on subprime mortgages have been practically wiped out, the Wall Street firm said yesterday, in more evidence of the turmoil in this corner of the bond market.

Bear said one of its funds was worth nothing and another worth less than a 10th of its value from a few months ago after its subprime trades went bad, according to a letter Bear circulated and to people briefed by the firm. The Wall Street investment bank — known for its bond-trading savvy — has had to put up $1.6 billion in rescue financing.

If Bear Stearns thought it made sense to risk US$1.6 billion a few days ago, only to have the subprime portfolio evaporate soon thereafter, the CIBC’s public affairs department will have to be patient while that marketplace waits, as Mr. Taylor perceptively pointed out in his column earlier this week, to see how their CDO book shakes out.

In the meantime, it appears that the bank is now being valued the same as it was before the subprime story surfaced. Odd, that, but a great vote of confidence that CIBC’s risk management team will outshine the one at Bear Stearns and allow the bank to shed the yoke of its accident-prone history.

MRM