Jumping at shadows

It's unclear whether investors confused KKR Financial Holdings (KFN) with Kohlberg Kravis Roberts & Co., the giant private equity group that is affiliated with KFN's manager, KKR Financial. In any event, reports that KFN had again delayed payment of asset-backed notes funding more than $5 billion of residential mortgages spooked them. Significantly, the news caused barely a ripple in the US.

KFN isn't a sub-prime investor nor does it have exposures to the sub-prime market, structured investment vehicles or any collateralised debt obligations. Its involvement in the residential mortgage business was incidental to its primary business of investing in corporate debt. Indeed, the only reason KFN had any residential mortgages in its portfolio at all is that, when it was established in 2004, it wanted to gain the tax advantages of using a real estate investment trust structure, which necessitated some investment in property assets.

Last August it was one of the first to see that the sub-prime crisis was about to erupt, selling $US5.1 billion of mortgages just before the full force of the crisis developed. It lost about $US65 million on the sales, a fraction of what it could have lost had it held onto them. It chose to write off its entire $US200 million or so equity exposure to the portfolio, including the $US5.3 billion of mortgages remaining.

The residual portfolio of highly-rated performing loans had been funded, on a non-recourse basis, with asset-backed note facilities issued by two conduits. The notes were short-dated. Last October KFN negotiated an extension to the maturities of the notes, with half of them due for repayment on February 15 and the other half on March 13.

The report that rocked markets in this region was a rescheduling of the February deadline to give KFN and the noteholders an extra two weeks to negotiate a restructuring of the conduits.

Under current conditions, there is no funding available for asset-backed securities, even good quality residential mortgages. KFN is unable to refinance the notes.

That, however, isn't KFN's problem, as the market response might have suggested. The funding is non-recourse to KFN, which makes it the noteholders' problem. KFN is trying to be helpful, but it could simply walk away without any further loss.

The noteholders have two choices – continue to roll over the funding in the hope that credit conditions improve (which could take a while) or take the mortgages themselves. With an average maturity of about three years and a very low default rate, the noteholders would eventually get their money back with interest. That is, however, their problem and not one that has any implications for KFN's financial stability, let alone KKR's.

The fact that an SEC filing of a statement that simply extended a known status quo of little significance in the context of the real credit market trauma is, however, disturbing in the insight it gives into the willingness, almost the eagerness, of investors to find any excuse to flee the markets.