A relationship not generally
understood by many investors is that between credit default swaps and the
subprime mortgage crisis. A credit default swap (CDS) is a form of credit
derivative, i.e., a method whereby a lender can shift part of the risk of
owning mortgages to another party. Specifically, the owner of the mortgages
makes a payment (or a series of payments) to another party in exchange for
the promise of the other party to pay a specified sum in the event of a
default by the mortgagors. The party receiving the credit protection is the
“buyer,” while the party providing
credit protection is the “seller.” In short, a CDS is a form of insurance
whereby the seller either takes delivery of the defaulted mortgages or pays
the buyer the difference between the face value and the recovery amount of
the mortgages. The credit risk thus is transferred from the buyer to the
seller. (Credit default swaps also can be used as a form of speculation by
hedge funds and other market operators.)
Merrill Lynch Transaction
In what may have been the largest credit swap transaction ever, Merrill
Lynch (buyer) agreed to unwind $3.7 billion of insurance it had bought on
its mortgage holdings in exchange for a payment of $500 million from a
subsidiary of XI Capital to close out an insurance contract. As reported in
the New York Times (August 10, 2008), the transaction had some remarkable
elements. Perhaps the most remarkable was that Merrill Lynch received only
13 cents on the dollar for the mortgages, reflecting their tremendous loss
of value. Apparently the reason Merrill Lynch did not receive the full
amount of the swap insurance was that the XI Capital subsidiary, Security
Capital Assurance, had seen its credit rating cut to junk earlier this year
so that the likelihood the company could fully satisfy its insurance
obligation seemed unlikely. This emphasizes that these deals are only as
good as the party on the other side of the swap.
True Value Revealed
Since the full amount of the insurance was not paid, the transaction
gave the mortgage market an idea of the true valuation of the
mortgage-related securities covered by the insurance. However, not every
swap will be valued at 13 cents, since each transaction will reflect
different probabilities as to the likelihood of future payment on the
mortgages and their maturities. As an example, another bond insurer unwound
a $1.4 billion insurance obligation at 61 cents on the dollar. According to
Eric Dinallo, New York’s insurance superintendent, valuations of many CDSs
remain highly optimistic on the books of the bond insurers. He said the
Merrill Lynch deal resulted from the fact that the insurer, Capital
Assurance, might have been subject to a regulatory takeover had Merrill
insisted on the full amount of the insurance, in which case Merrill may have
received no payment at all on the policy. As of last September, a total $656
billion in credit insurance on structured finance products had been written,
of which about $126 billion covers mortgage holdings. On the other hand,
total resources by the insurers to pay any claims stood at $54 billion. Mr. Dinallo believes that so-called “naked swaps” (by companies that lack the
full funds to pay off claims) should be disallowed and that such swaps can
be made only by insurers who can fully cover their obligations in the event
of claims.
Real Estate Focus is provided by Somerset’s Real Estate Team for our clients and other interested persons upon request. Since technical information is presented in generalized fashion, no final conclusion on these topics should be made without further review. For additional information on the issues discussed, please contact Michael Fritton, CPA. Whether you are a building owner, building manager, real estate developer, real estate professional or an investor, we hope to provide you with timely information so you may be proactive in making your business decisions.
This article was written by and published herein with the permission from professionals of BDO Seidman, LLP. Anthony La Malfa is a Senior Manager in the Real Estate & Hospitality Services Practice in BDO Seidman’s New York office. Somerset is a member of the BDO Seidman Alliance, a nationwide association of independently owned accounting and consulting firms.
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