The good the bad and the ugly of the US economy

Part I:

The good, the bad and ugly of US economy

As the US economy struggles to find recovery mode, Cayman’s financial services industry recently heard that the US is heading for even deeper problems once the 2011 budget kicks in and the dire state of each State’s public finances are revealed. On the upside, new opportunities are being revealed within the structured finance markets which may prove to be a much needed boost for Cayman’s own financial services industry. Business Editor Lindsey Turnbull reports.  Second in a two-part series.
Attorneys at Law Stuarts recently joined forces with RBC Wealth Management hosting a seminar entitled ‘The Implosion of US State Finance and Its Effect on the Cayman Islands’ at The Ritz-Carlton, Grand Cayman, which provided an important platform of discussion for financial services practitioners.
The discussion was a two-part event. Firstly Professor Andrew P. Morriss, the H. Ross & Helen Workman Professor of Law and Business at the University of Illinois College of Law gave a worrying presentation entitled ‘US States Are Going Bankrupt – Why You Should Care’. In the second half of the discussion, Professor Christopher L. Culp, an Adjunct Professor of Finance at The University of Chicago Booth School of Business and Senior Advisor for Compass Lexecon, which is a subsidiary of FTI Consulting, Inc then looked at the types of securitisations emerging as leaders within the field, of which Cayman could well position itself successfully to take advantage.
Dr Culp delighted in dazzling the audience with science, in the form of colourful diagrams explaining the securitisation process, with sub prime loans initially repackaged into residential mortgage backed securities (RMBS) and then into collateralised debt obligations (CDOs).
“Those in structured finance do a good job in making it look a lot more complicated than it is!” he said. Some blamed this process as being central to the credit crisis of late 2008 but Dr Culp said the centre of the crisis was really a public debt debacle.
“The credit crisis magnified the issue because CDOs were used to repackage existing sub prime housing loans.”
Dr Culp said that estimates suggested that for every U$1 invested in the initial sub-prime loan there were up to US$100 worth of CDO investment reliant upon that same initial loan.
“That’s not to say that a CDO is somehow “bad”. It was actually a very necessary tool for investors who wanted to purchase riskier investments when spreads elsewhere were insufficient for them,” Dr Culp said. “Securitisations are a mechanism for transmitting risk and the Cayman Islands is in the centre of the pipeline of the process.”
At the moment the CDO and CLO (collateralised loan obligation) markets were still stalled because the repricing risk on structured products still persists and investors are still demanding yields for CDO/CLO securities in excess of rates on most underlying sources of collateral. In addition, Dr Culp explained that new regulations and accounting policy changes had dried up supply.
Dr Culp said that there were signs of some structured market products bouncing back, including European corporate CDOs, auto loan-backed asset-backed securities, structured project financing and natural catastrophe insurance-linked securities (though the latter is largely Bermuda-based.)
Dr Culp then outlined the sovereign debt explosion and the role structured finance could play in this. In particular, Dr Culp focused on Greece’s economic woes and noted that, as some had suggested, credit default swaps (a method of facilitating credit investment enabling firms to manage risk) were not to blame. Rather, Dr Culp said that overspending by the Greek government, a failure to record military, hospital, and other significant expenses and ‘Eurostat’ accounting were really to blame.
“Such structures won’t solve public spending problems,” Dr Culp said, “but they do help to bear the brunt of the problems and spread the risk.”
Dr Culp believed that opportunities could arise from Cayman in this respect, saying that such structures were “a huge part of the financial architecture” with Cayman being a “main link” in the process.
Dr Culp then assessed the possibility of the return of the leveraged loan CLOs market.
“Prior to the economic crisis as much as 70 per cent of institutional leveraged loan issuance was purchased by CLO managers,” he confirmed. “And because of demands by investors for higher yields, many of these loans were relatively borrower-friendly.”
Leveraged loan issuance peaked in the third quarter of 2007 and bottomed out around the second quarter of 2009 and has been slowly increasing ever since.
“Leveraged loan-based CLOs have investment appeal; have default rates sensitive to macro conditions and have historically high recovery rates. However, new structures are priced significantly lower (at LIBOR plus 190 as compared with LIBOR plus 725 at the fourth quarter of 2009). In this respect, pricing is near to where the market sat in mid-2007, prompting a possible déjà vu effect.”  
Dr Culp’s ultimate words of wisdom for the Cayman Islands were as follows: “Stay current on trends in collateral and product design; preserve opportunities to participate and maintain the flow of financial structures within the overall pipeline and accommodate investor demands for simplicity and transparency.”


L-r Professor Andrew P. Morriss, the H. Ross & Helen Workman Professor of Law and Business at the University of Illinois College of Law; Chris Humphries, Head of the Corporate & Funds Practice at Stuarts Walker Hersant; Professor Christopher L. Culp, an Adjunct Professor of Finance at The University of Chicago Booth School of Business and Senior Advisor for Compass Lexecon