And it is a crisis – probably the defining financial event of this decade, which will impact global economic growth for the next few years at least. Most of the time, financial markets are in offensive mode. Investors are happy to put their money into assets with varying degrees of risk, and banks are happy to lend money to investors for this purpose. Every so often, the financial markets become defensive, and investors start worrying about whether they could lose money on their investments not just from market risk (changes in interest rates or FX rates, for example), but from credit risk, where a default could devastate the value of an investment portfolio.
Global financial markets are now in full defensive mode. The global financial plane has set down on the runway with its reverse thrusters roaring, and the pilots are hoping just to keep the plane from skidding off the surface. The outcome is uncertain, and clearly not all passengers are going to survive this forced landing. Just to complicate things, there is an earthquake underway that threatens to rip apart the runway; it all depends on how far the runway is from the epicenter of the earthquake.
Or, to put this analogy in more practical terms, it all depends on the extent to which the global financial markets are at risk from the sub-prime mortgage mess, because that is the epicenter of the earthquake. Don’t be fooled by what Treasury Secretary Henry Paulson said yesterday; the sub-prime mortgage mess is not “contained”. Problems are spreading to all sorts of financial sectors. Let’s look at these shock waves market by market.
The Epicenter
Real people who have real problems meeting their mortgage payments in the U.S. are at the very center of this financial crisis. These are decent people who in past markets would not have been able to get a mortgage, but in the free-wheeling mortgage circus of the past five years they’ve been able to obtain loans with very beneficial terms such as no proof of employment. They were given low teaser rates that are now setting at much higher market rates, but these are higher than current market rates, because they have to compensate the banks for the cost of providing the low teaser rate in the first place. Depending on which mortgage executive is admitting to what, anywhere from 15% to 25% of these borrowers are behind on their payments to the bank, or in foreclosure. These are very high default rates historically, and given the hundreds of billions of dollars of sub-prime mortgages that have been booked, there is a serious amount of money that is going to be lost.
At the epicenter, it is best to remember we are talking about direct credit losses from customer defaults on the loans they were given. As we move further out to the concentric shock waves, this pure default risk is not a problem, at least not yet. In the outer fringes, the problems relate to portfolios that need to reduce leverage, and to investors and bankers retreating from reckless lending policies in place for most of the past five years.
Wave 1 – Sub-Prime Investors
In olden days (about 10 years ago), the bank that made the mortgage would hold on to it and bear the burden of these credit losses. But in the past decade a whole new market has arisen that securitizes these mortgages, by bundling together thousands of them, and then selling the cash flows as bonds. Large, institutional and presumably sophisticated investors can buy these bonds, almost all of which were rated by S&P or Moody’s as AAA because the great bulk of the mortgages in the bond were rated highest quality prime, and only a small portion were sub-prime mortgages.
Bear Stearns, the New York investment bank, announced a few weeks ago that two of its hedge funds had invested in these types of bonds, and the hedge funds were now broke. If the investments had only a small percentage of these sub-prime mortgages, how could the entire hedge fund go under? The answer here is the miracle of leverage. Bear Stearns for one of its funds had raised about $600 million in cash from investors, but then borrowed over $5 billion more from banks to leverage up the profits in the fund. This leveraging is routine in the hedge fund business, and is the main reason why so much debt has been taken on in recent years in the financial markets. All it took therefore was a not unusual 10% devaluation in the value of $6 billion in bonds to wipe out the $600 million in cash equity in the entire fund. The real problem here is that a not terribly large change in value can act as a force of destruction through leverage.
The second problem is that the banks that lent the $5 billion to Bear Stearns changed the rules. In order to lend this much money, the banks had all the assets of the fund assigned to them as collateral in case the value of the fund’s assets ever fell significantly. When the crisis began, and they saw that 10% of the value of this collateral could disappear, they did some worst-case scenarios and realized that potentially much more damage might occur. They demanded more collateral from Bear Stearns, which really meant that Bear Stearns had to sell some of the fund assets at a time when prices were heading downward. That only makes the price depreciation accelerate, and before you know it – poof! – $600 million of equity is wiped out.
Yesterday two more investors in hedge funds alerted the markets to a similar problem. Radian Group Inc. and MGIC Investments claimed that about $1 billion in investments in sub-prime mortgages were now worthless. It’s not yet clear whether leverage played a role in this problem as well. What is really noteworthy is that both of these companies are mortgage insurers – their business is to protect investors who hold mortgages. What does that say about the mortgage market when the insurers themselves are starting to take sizeable losses?
Wave 2 – Alt-A Investors
A step above sub-prime mortgage borrowers is the Alt-A category. These borrowers do not have the high credit scores and solid payment history of prime borrowers, so they fall into an A- category. It was only two weeks ago that market experts were insisting that there was no contagion in this category from sub-prime problems.
Countrywide Financial, the largest mortgage lender in the U.S., said last week that indeed Alt-A and even prime mortgages were now experiencing a surge in late payments. Yesterday, American Home Mortgage Investment Corp, which specializes in Alt-A mortgages, announced that it no longer had liquidity to continue making new mortgages. This has stranded thousands of potential borrowers with nearly $500 million in mortgages waiting in the pipeline. AHM’s problem is an investors’ strike combined with a lenders’ strike. The investors that bought the securities holding AHM mortgages are demanding that AHM buy back these securities because of the unexpected default rates. On top of this, the banks that lent money to AHM are shutting down access to this credit, and companies like AHM can’t stay in business without the banking industry’s support.
The banks are back-tracking not just because they understand how damaging these high default rates can be, but because they are running stress tests on the mortgage markets and coming up with much higher damages from worst-case scenarios than they had previously thought. Also, some of these big financial institutions, like UBS in Switzerland, and CNA Corp., have announced substantial losses of their own from sub-prime mortgage investments. Top bankers in these institutions are losing their jobs, and there is nothing like a banking executive being put out on the street to elevate the fear level of all bankers.
So much for Henry Paulson’s view about containment. The U.S. now has thousands of borrowers with good credit who cannot get a mortgage.
Wave 3 – High-Yield Bonds
High-Yield corporate bonds are long term debt obligations that receive an S&P or Moody’s credit rating below investment grade. In other words, they have a significantly higher risk of default than investment grade bonds. They therefore offer a higher yield, but in recently years the difference in the interest rates on poor quality versus high quality debt has shrunk dramatically, so that recently this “spread” was at historically low levels.
That is now changing. The market is “repricing risk”, according to Henry Paulson, and part of that process involves investors selling some of the low quality paper and moving into safer investments.
Macquarie Fortress Investments is a hedge fund managed by Macquarie Bank of Australia. This fund invests in high-yield corporate bonds, not in sub-prime mortgages. Yesterday this fund announced that it has lost about 25% of its value, because it was “forced to sell assets to reduce borrowings.” It’s our old friend leverage at work again, this time in a pernicious way. The fund simply had borrowed too much money in comparison to its cash equity – the amount actually put in the fund by investors. Depending on the leverage ratio, it would not take that big a decline in the value of the high-yield bonds to wipe out 25% of the equity of the fund.
Yet another casualty in this market is Sowood Capital Management LP, managed by a former hedge fund guru from the Harvard University endowment, which has been the premier hedge fund investor among university endowments. Harvard even put in $500 million of its own endowment into this fund when it was started a few years ago. The fund has now lost $1.5 billion, or 50% of its equity, seemingly from leveraged investments in high-yield instruments. Sowood Capital has now been purchased at a deep discount by Citadel Investments, a so-called vulture hedge fund that specializes in scooping up distressed hedge funds, and which can continue in this business as long as its banks continue to provide financing.
Wave 4 – Asset-Backed Securities
Asset-backed securities are even further removed from sub-prime mortgages. These securities act like bonds, composed of thousands of small loans made to finance automobile purchases, or retail purchases using credit cards.
Bear Stearns runs the Bear Stearns Asset-Backed Securities Fund, which has $900 million in assets, less than ½ of 1% of which are sub-prime mortgages. This fund also has $50 million invested in cash, a 5.6% cash ratio which is about average for such funds. The fund has no debt whatsoever, so leverage does not come into the picture. Yesterday Bear Stearns announced it was halting all investor withdrawals for this fund. Apparently investors in the fund were so worried about the name Bear Stearns that the redemptions were forcing asset sales, which Bear Stearns as manager felt was inappropriate. None of the assets is in default, and Bear Stearns’ logic is that it should wait out the current turmoil in the market rather than enter into forced liquidations. The rules of such funds can force the investors to sit and wait for indeterminate periods before they can get their money out. It’s another example of the market freezing-up, and it’s a case also of contagion, this time through the sour reputation of the Bear Stearns brand.
The Seismologists
Registering the strength of the earthquake are any number of marketable securities and indexes trading on public exchanges, measuring such things as the credit-worthiness of bonds issued by banks. As an example, the iTraxx Crossover Series 7 Index consists of the bonds of 50 European companies, each bond worth Euros 10 million in value with a five year maturity. If you buy a contract, you are purchasing insurance protection against the risk of default in these bonds, so the higher the purchase price, the greater the perceived risk of default. Yesterday the contract value jumped Euros 59,000 to a total cost of Euros 459,000. Compare this to the contract size of Euros 10 million, and you get the idea that the market thinks the default risk for these European companies has jumped to 4.59% over the 5 year maturity of the bonds. That’s an extraordinarily high default rate, on the level of junk debt.
Similar indexes around the world are showing a sudden jump in the cost of protection against default. The prices in the secondary market for bonds issued by Bear Stearns, Merrill Lynch, Goldman Sachs and other Wall Street banks have now fallen so low that they are trading like junk debt.
All these measures and trading instruments show the same thing: credit default risk is considered to be dramatically higher in the market now compared to even a month ago; spreads between poor quality and high quality paper are widening, and the contagion is seeping into newer areas of the market.
The Regulators
Other than the U.S. Secretary of the Treasury, how come other regulators, such as central bankers, haven’t come to the rescue of the market with press statements of reassurance, urgent meetings of banking executives, extended lines of credit to commercial banks, or other similar measures?
One reason may be that the speed of the collapse of the credit markets has caught many observers by surprise. Second, it is critical to remember that the epicenter of the earthquake, and the hedge fund industry that is clustered around the epicenter, are not regulated by the central banks or agencies such as the SEC or Financial Services Authority in London. Like the rest of us, the central banks know very little about what the hedge funds own or even how much they have borrowed.
This is a crisis that is happening in an information vacuum, which means that rescuers will be in short supply and operating with limited tools.
How bad could it get?
This crisis could metastasize into something very serious. Many more hedge funds could disappear, the banks can become panicky over calling for more collateral (thus forcing even more sales of assets in poor market conditions), and the real spillage into the economy of normal people, such as those Alt-A borrowers who now cannot obtain mortgages, could push the U.S. into a recession. Once the U.S. succumbs, China will not be far behind.
This scenario is possible but it is very hard to rate its likelihood, because we simply don’t know much about the exposures of the hedge fund industry, which is the sector which is the source of contagion since it touches so many different markets.
Another possibility that would be far preferable is one in which the announcements of problems taper off in the next week or two, and then disappear altogether. In this best of circumstances, the financial markets will still be left in paralysis for many weeks or months before credit risk-taking can resume. Moreover, it is highly unlikely even then that the markets will return to the “golden age” of unlimited and ill-advised credit that well-known leveraged buyout king Henry Kravis was bragging about just a month ago. There has been too much damage already for the hedge fund and private equity industries to be able any more to swagger and bully their way into obtaining mega-billion dollar loans.
Are there any clues provided by the stock market? Equities have taken a severe battering in the past two weeks once the extent of the sub-prime problem became known. Stocks like Mizuno Bank of Japan have dropped 10% or more merely from announcing some losses in their investment portfolios. In the case of American Home Mortgage Investment Corp., that stock has fallen 90% amid market rumors that the company is facing bankruptcy.
The good news is that almost every indicator of stock market strength shows that the markets worldwide are very oversold, and thus they are ready for a one or two week bounce back. That may be indicative as well of some stability forthcoming in the credit markets, and maybe – just maybe – a market meltdown can be avoided, at least for now. If so, we are left at least with some temporary paralysis in the debt business, giving the markets enough triage time to sort out the irretrievably doomed from the walking wounded, and a little bit more time to ask how this disaster came about.
