Project Death Star: [draft 8-3-07]

[Draft 8-3-07]

Project Death Star

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Part I: Money Market Instability Interconnected Crisis

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The Liquidity Engine Capital pulls deals through the global financial markets. These deals include everything from mortgages to LBOs.

Capital

Financial Markets

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Deals

It’s Adaptable This Liquidity Engine changes dimensions depending on the amount of capital and deals, but capital is the key. – Early in the cycle, capital is in excess.

Capital

Financial Markets

Deals

– Later, capital and deals match - an efficient market.

Capital

Financial Markets

Deals

– Finally, a confidence crisis dries up capital and the engine stalls.

Capital

Financial Markets

Deals

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Fueled by Capital By “capital” we mean money seeking returns globally. In the last 5 year period of unprecedented liquidity expansion, there have been several clearly identifiable sources: – Global GDP growth in the [3%-5%] range – quite high by historical standards. – China and India (1/3 of world population) emerging dramatically on the global economic scene with annual GDP growth in the 10% range. – Petrodollars flowing from (i) higher demand caused by economic growth and (ii) tighter supply due to upstream and downstream scarcity concerns.

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Liquidity Engine or Economic Engine? While all part of one system, it is helpful to think of them separately for the moment. The Liquidity Engine provides a framework for understanding the global money markets. The Economic Engine serves the same function for the entire global economy. To extend the metaphor, one might say that the Economic Engine provides the feedstock (capital) for the Liquidity Engine.

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How Does the Economic Engine Start? If the Economic Engine provides the feedstock for the Liquidity Engine, what starts the Economic Engine? Ignition comes from dramatic change, in this case three major events in the last 20 years: – End of Cold War – Information technology and telecommunications revolution – Political change in China (Deng Xiaoping) and India (1991 Reforms) Ignition

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And How Does It Work? Capital is created by ignition, which in turn needs to be invested somewhere. This investment begets financial and physical assets like houses and mortgages. Finally, those assets create more capital by yielding a return and by spurring further economic growth.

Capital Creation

Ignition

Investment

Assets Page 8

The Players With the stage set, we can move to the players. In the money markets we have – – – – –

Hedge Funds Private Equity Funds Banks Institutional Investors Rating Agencies

Then we have the mortgage industry.

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A Typical Mortgage Today 1. 2. 3. 4. 5.

Buyer Finds Real Estate Agent. Buyer agrees to buy home. Mortgage Broker connects Buyer to Mortgage Lender. Mortgage Lender makes loan – a Mortgage. Mortgage Lender sells loan into a portfolio of mortgages which, in a process called securitization, are packaged and sold to investors – a Mortgage-Backed Security. 6. Banks take the Mortgage-Backed Security, and using credit derivatives, slice it into different tranches based on the risk of default. The least likely to default, or best credit risk is deemed AAA. The opposite is “equity.” 7. These tranches are bought by various investors. Page 10

The Mortgage Industry How does the residential mortgage industry work? Residential Housing

Mortgages

Securitization

Credit Derivatives

Real Estate Developers

Mortgage Brokers

Banks

Banks

Home Builders

Mortgage Lenders

Rating Agencies

Hedge Funds

Real Estate Agents

Mortgage Servicers

Rating Agencies

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May I Have A Rating Please The rating agencies have a significant role in this interconnected web of relationships. They provide ratings for the Mortgage-Backed Securities, the credit derivatives built on them, and most of the financings underlying the M&A boom. One of the most interesting new developments has been the creation of the synthetic AAA security based on the CDO tranche that is affected last in a liquidation. Like other players, they have generated a great deal of revenue from their role in the Liquidity Engine. Page 12

Bank On It Banks have several roles in the Liquidity Engine. 1. Many are originators and servicers of loans including mortgages. 2. Banks hold part of these loans on their books, but sell most. 3. They create, structure and sell Mortgage-Backed Securities. 4. They create, structure and sell Collateralized Debt Obligations. 5. Banks make markets, trade, and invest in these securities. 6. Banks lend money to private equity funds and their targets for LBOs. 7. They create, structure and sell securities for long-term financing of these LBO targets. 8. Banks lend to hedge funds to allow them to take bigger bets. 9. Banks buy and create private equity and hedge funds. Page 13

Basel 2 To You Too The Basel Accord provides a framework for assessing and ensuring the stability of the global banking market. Among other things, it dictates how reserves are calculated and how much reserves are needed for a bank to be safe. The successor Basel 2 Accord has been finalized, and will come into effect in [2008]. It provides a new risk-dependent methodology for calculating reserves. This provides an incentive for banks to stock up on AAA-rated paper. AAA-rated companies are rare today because of (i) current corporate finance theory, which stresses the importance of debt in the capital structure, and (ii) cheap debt. Synthetic AAA paper from CDOs has provided a great source. Banks have stocked up in preparation for Basel 2.

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Cheap Debts The spreads on High yield Debt have steadily dropped in the last 3 years to reach their lowest-ever levels. [Insert chart]

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Don’t Hedge Your Bets Hedge Funds place large, risky bets to generate large returns. They are generally unregulated, and they use a wide array of strategies to make money. One of these strategies is to borrow heavily to buy the riskiest tranches, the so-called equity, of Collateralized Debt Obligations. This risky paper is sometimes called toxic waste. Because of the large bets and high leverage, they can make money on very small changes in the underlying fundamentals. They can lose it too. Page 16

Hedge Fund Accounting 101 Hedge funds report their results infrequently. When they do, they have to value their investments and positions. Under current accounting regulations, they and others have been using new modeling-driven methodologies to calculate value when there is no good way to mark to market. In the event a given position is unwound, a market value can be obtained. The data arising from sales of similar positions within a fund or by others can allow positions to be marked to market, translating a theoretical value to a real one. Page 17

The Prisoner’s Dilemma Credit derivatives are not very liquid. They do not change hands very regularly. Values are generally derived using models rather than market data. In the event a hedge fund wants to unwind a large number of positions quickly, market values can suddenly become available across the industry, allowing other funds to mark to market. But a rushed liquidation can mean a drop in prices. In a bear market for a given type of security, this can force many funds to reduce their value, forcing more liquidations, which in turn reduce prices and values, until a downward spiral is in full force. This scenario occurred when Bear Stearns management stepped in to close [2] funds after large losses. After seeing this problem begin to unfold, management stopped completely and decided to absorb any losses. Page 18

A Confidence Game The global capital markets are an astounding and intricate web of relationships. But like the prototypical bank, they are all built on confidence. If confidence is shaken, a period of instability occurs, the Liquidity Engine, and possibly the Economic Engine stall, and the process begins again. The LDC Debt Crisis, the S&L crisis, the Texas Real Estate and Banking Crash, the Asian Market Crisis, and LongTerm Capital were all examples of this phenomenon. Page 19

Anatomy of a Confidence Crisis All dates approximate

6/06 9/06 12/06 3/07 5/07

6/07 7/07 12/07

Real estate prices peak. Teaser rates on ARM mortgages begin to expire Sub-prime mortgage (the riskiest borrowers) default rates increase. With spooked investors, sub-prime originators are unable to place more paper. The market begins to dry up. Several originators are suddenly in trouble. With worries about certain mortgages and more attention on how risks are allocated, credit standards and spreads increase, making it harder to buy real estate. Inventory and downward price pressure increase. Several hedge funds announce large losses and plans to close. Other markets get jittery as overall confidence wanes. Unknown. Does the spreading of risk around the global system create stability or does it create a domino effect? Page 20

Phoenix The Death Star Project believes that there will be a significant financial crisis, led by the residential housing market, over the next 12 – 36 months. However, as with most cycles, the free global market for capital will allow losses to be taken and new winners to be created. Winners who will buy low and sell high. This bearish scenario creates an opportunity to create a Phoenix that will rise from the ashes. Is it a certainty that a crisis will occur? No. But is there a reasonable probability. Yes. Page 21