Structured Credit

Why the rollercoaster ride is not over yet

Originally published in the October 2007 issue

The objective of this column is to shed some light on the credit markets and how they, like all financial markets, are driven by fundamental, technical and behavioural patterns. To add some subjectivity, I will share my view on what the future might hold. In this first instance, I will highlight some of the more overlooked themes that have played a part in the current housing turmoil and the often fear-driven spillover into other markets.

On a global scale, interest rates set by the main central banks were kept at far too low levels for far too long. Coupled with what many observers have called the Eurasian savings glut (Europe and Asia saving too much), this provided the ‘perfect’ setting for the US consumer to drive the world economy by overspending via mortgage equity withdrawals. Apart from creating unsustainable asset bubbles, an environment with low yields forces many investors to look for ways to enhance returns, the easiest and most risky being leverage. One problematic way to achieve leverage is to pack for example, securitised mortgages into structured products like CDOs.

Securitisation in itself is a good idea, but combined with sub-prime mortgages it turned out to be a recipe for disaster. Basel I does not discriminate between different classes of mortgages (of which the main ones are prime, Alt-A and sub-prime), so banks had (as it seemed up until this year) everything to gain from focusing on the securitisation of higher yielding sub-prime mortgages. To keep volumes up even as interest rates started to soar, lending standards were lowered to perverse levels.

What risks and where?

Already at this stage there are evident troubles, but in a move to further exacerbate problems, these loans were pooled into asset-backed securities which were in turn packaged into CDOs. Alarmingly high delinquency and default rates are only one part of the problem, the big issue that is causing fear and loathing and contagion is the question of who will suffer from it: there is considerable opacity regarding who sits on what risks. What you need to bear in mind though, is that most of the blowups have been fairly isolated and one-of-a-kind in their nature. One example of how we are dealing with rather unique circumstances is the troubles of some German banks. The business of lending money to German corporations is inherently low-yielding, which forced some less fortunate teutonic banks to over-expose themselves to the increasingly murky waters of sub-prime mortgages.

Yet another aggravating issue is the fact that the secondary market for CDOs is intrinsically illiquid. As was discussed in an article ingeniously titled A Tale of Two Funds in the July/August 2007 issue of The Hedge Fund Journal, the fall-out of the two Bear Stearns high grade structured credit hedge funds illustrated the impracticality of the whole business. A vicious circle starts when one player has to liquidate assets in order to meet margin calls. The secondary market being impossibly thin, prices are pushed down and other funds having to mark their securities to market get margin calls from their lenders, starting the next iteration of the process.

During the previous times of complacency, most structured credit securities were marked to model. Updated models might be at least part of the answer when there effectively is no market. In theory, to make CDOs liquid, one would have to standardise the terms and trade the instruments on an exchange. In practice, such vain dreams would only serve to defeat the original purpose of the whole CDO business and it would be more realistic to expect its complete disappearance.

“Rating agencies and their behaviour have played a significant part in the current credit pandemonium.”

The rollercoaster markets of August provide anexample of how correlation can rally from zero to one during times of stress. In the first weeks of this not so august month, seemingly unrelated bond markets and even equity markets suffered sharply. Some of the equity turbulence was due to quite a few of the more celebrated quant hedge funds entering their own vicious circle. As one Lehman Brothers’ analyst put it, fund managers experiencing drawdowns in their fixed income portfolios looked to sell more liquid stocks. In closing profitable positions both on the long and the short side, they disturbed many of the indicators that the majority of the quant funds rely on, thereby causing losses to spread. In order to mitigate their losses, a majority of the funds de-levered their portfolios, spreading the problem even further.

Rating agencies and their behaviour have played a significant part in the current credit pandemonium. Their reaction was slow and when they finally started downgrading, it was necessarily harsh. As a result, more than a few people have lost faith in S&P, Moody’s and Fitch, especially since they are overly involved in the structuring of CDOs and extract rather large shares of their revenue from this business.

Heightened risk through fear
No matter how you view the present state of affairs, it is clear we are going in the direction of heightened risk aversion. As a timely illustration of how excessive risk aversion can cause just as much loss as too much risk taking, lenders in the commercial paper space are holding back on deals just out of fear instigated by a few mortgage lenders having to extend the loan periods of their asset-backed commercial papers (the link to housing). A stagnating commercial paper market could put a hold on the short term borrowing that many companies depend on (although there are other funding sources). Areas such as these were the main target of the Fed liquidity injections and discount window operations. Using more fine tuned tools is a good way to alleviate the problems of the ‘Fed put’ (the Fed bailing out Wall Street whenever there is a problem and thereby creating moral hazard problems). As Paul McCulley of PIMCO put it so eloquently, the question is not whether the Fed Put exists, but where its strike price is located. According to the same fixed income expert, the Bernanke put is much further out-of-the-money than its Greenspan predecessor. It is also wiser not to use the Feds fund rate to rescue Wall Street, but rather help Main Street (focusing on full employment and low inflation) just as was done on 18 September.

The monumental debt pipe line for autumn (depending on whom you ask, the size ranges from $300 to $400 billion) is also adding anxiety to the structured credit markets (first and foremost the CLO one). The bulk of the loans consists of LBO-related debt that is still on the balance sheets of large banks. Much of it has not been placed yet, but the mere fear of what it will do to tomorrow’s prices puts downward pressure on today’s. A lot of potential investors are actually sitting on the sidelines, waiting for even lower terms than in the current environment where you should not be surprised if you find loans selling for 87 cents on the dollar.

To sum up and get some perspectives on the rationality behind the recent developments, we might contemplate FD Roosevelt’s words “the only thing we have to fear is fear itself.” As we have experienced over and over again, “only” is a significant understatement. However, if fear is the major driver, things should sort themselves out or at least normalise relatively quickly.

When you read this, things might already be significantly better.