Summary
Financial Mismatching - Without understanding the funding connections among an individual sub-prime mortgage, the securitized bond issued with the mortgage as collateral, the hedge fund or managed money sourced to purchase the bond and the commercial paper issued to on-lend into the managed money fund, one cannot understand the crisis in the debt markets. At each stage along the structured finance trail, there exists fundamental funding mismatches overlooked by analysts and more tragically ignored by the managers that made these investments. The design flaws are so fundamental that any Finance 101 student would recognize them, but for the air of sophistication that shrouds connecting financial instruments that should not be connected. Strip away the layers of obfuscating financial alchemy and you find, in essence, managers purchasing and trading fundamentally illiquid CDO's using short term funds to arbitrage interest rate and risk differentials - and they got caught.
Analysis
Racing back to fundamental financial analysis will help those trying to understand the current debt market turmoil. This is not a rating agency issue. This is not a regulatory issue. This is a fundamental financial strategy issue.
At the root cause is Financial Mismatching, a term I just coined.
Sub-prime loans, inherently an identifiable risk-reward properly named and properly priced financial product made by a (usually) responsible lender to a FICO-challenged home buyer. On its own a assessable risk and a standardized collatalized loan.
CDO's, long-term bonds collateralized with (in this case) with sub-prime mortgages. With structured financial enhancements (more sub-prime mortgages) these bonds are issued not by a corporate creditworthy borrower, but by the sub-prime mortgages themselves. The CDO's become the actual bond issuer because this is the essence of mortgage securitization.
Hereto, there is nothing inherently untoward about the underlying sub-prime mortgage securitization (the CDO) provided the investor intends to hold the bonds to maturity as part of its normal investment business strategy. The same risk applies to any long-term bond holder. Held to maturity, you take the risk of the bond and you earn your expected yield. Trading out of the bond prior to maturity, you take the added general interest rate risk at the time of the trade out.
Even at this juncture, the sub-prime CDO has an added risk, that until now was ignored by investors, which is the depth and breadth of the sub-prime CDO market under stressed conditions.
The magnitude of the current market crisis is compounded because the CDO's were not purchased with the intent to hold to maturity, they were purchased as part of a "balanced portfolio of various financial instruments". The mere purchase was an added risk not properly assessed by the owners/investors of the hedge fund or the owners or investors in the money market fund.
The next level of Financial Mismatching occurs at the hedge fund sourcing level. Although each hedge fund or managed money account has different investment parameters for liquidity or withdrawal, it is safe to say that few of the investors in the hedge fund invested with a time horizon that matched the term of the securitized sub-prime mortgage bonds.
The credit market problems worsen further when the CDO investors are bank-sponsored purchasers or hedge funds or money managers that lever up. These debt funding problems will be at their worst if the banks, hedge funds and money managers, are funded by commercial paper and especially if the funding source is "collateralized" commercial paper. Unbelievably, repayment terms are 30, 60, 90 or 180 days. This magnifies the Financial Mismatching in obvious ways, which are compounded when the "collateral" is an illiquid instrument that only increases the book losses when sold into a jittery debt market.
Drilling down into the sequence and magnitude of Financial Mismatching is the only way to identify the actual risk levels at specific institutions. Unfortunately, most analysts are not aware of Financial Mismatching or the companies being analyzed do not make this information transparent.
Financial Mismatching is the Core of the burgeoning credit crisis.
