The Economist takes a detached, often ironic, tone in its articles. So when one reads a piece that exudes worry, as this week’s “Bearish Turns” does, it’s noteworthy.
The piece recites a litany of likely developments in the credit markets, all negative: the indeterminate state of the Bear Stearns subprime hedge funds; the near-certainty of downward revaluation of lower-credit-quality mortgage paper; the poor outlook for US housing; the likelihood of rating agency downgrades; the parallels to LBO lending (and unmentioned by the Economist, to commercial real estate lending).
None of this is news to any reader of this blog, but seeing it presented in this fashion in the Economist suggests these facts have not gelled in the imagination of the public at large. That in turn suggests at least some business owners and consumers will change course as the events forecast come into being.
T.S. Eliot said that, “Human beings cannot bear very much reality.” Bill Gross of Pimco’s forecast of a rate cut looks more and more likely.
From the Economist:
“They kept pointing to the juicy yield, but our guys soon saw the paper for what it was: nuclear.” Thus one chief executive, recounting his investment firm’s decision to spurn an offer of securities backed by subprime (low-quality) mortgages from Bear Stearns, a large investment bank. The radiation appears to have seeped out at its source, leaving two of Bear’s own hedge funds terminally sick. Coming less than two months after UBS, a Swiss bank, closed a fund that had lost over $120m as the subprime market crumbled, the incident is a clear sign that concern is shifting from small, specialist lenders—dozens of which have gone bust—to the supposedly more sophisticated Wall Street firms that package, distribute and trade bonds tied to home loans.
Of the big securities houses, Bear is the most exposed to subprime. So no one was shocked when it announced a 10% fall in underlying profits for the latest quarter. But the fate of its year-old, unfortunately named High-Grade Structured Credit Strategies Enhanced Leverage Fund and its sister fund, the High-Grade Structured Credit Strategies Fund, has raised eyebrows. Run by Ralph Cioffi, an industry veteran, they were thought to be among the shrewdest actors in the mortgage-debt markets. Their downfall suggests that hedging at the highest levels is not as adept as it might be.
The enhanced-leverage fund lost 23% of its value in the first four months of the year as the subprime market collapsed, then stabilised, then fell again. The fund’s problems were compounded by its borrowings, which were ten times bigger than its $600m in capital. This made it more vulnerable when things went wrong.
Last week Bear’s funds, besieged by disgruntled investors, offloaded securities with a face value of at least $4 billion to free up capital. This fire sale was not enough for one creditor, Merrill Lynch, which seized collateral and threatened to auction it off to cover its losses.
Bear persuaded Merrill to stay its hand by agreeing to negotiate a rescue with a consortium of banks. At one point an injection of $500m in new capital looked possible, with Bear itself offering to lend an additional $1.5 billion. But the plan fell apart. On June 20th Merrill began hawking some of the funds’ assets to other hedge funds, while other creditors, such as JP Morgan Chase and Deutsche Bank, worked with Bear to unwind their positions. But there were few buyers for the bank’s subprime-backed debt, even the highest-rated paper.
The sale weighed on the shares of homebuilders and mortgage insurers as well as lenders. It raises the prospect of a wave of repricings, as banks and funds take a fresh look at their asset-backed holdings. Many of these are illiquid and still booked at their original, inflated prices. Assigning new values to them will be tricky, not to mention bad for banks’ share prices.
This week an index that tracks bonds consisting of subprime loans made in 2006 dipped below 60 for the first time, down from 97 in January (see chart). One cause was the continuing deterioration of loan performance as mortgage rates have risen: almost one in five subprime mortgages are now delinquent by more than 30 days or in foreclosure. The index also reflects fears that other large funds will suffer the same ignominy as Bear’s. The number of hedge funds focusing on mortgage debt ballooned along with the underlying market in 2005-06. Their woes are the latest “morbid preoccupation” of subprime investors, says Michael Youngblood, an analyst with Friedman, Billings, Ramsey.
Other squabbles are adding to the drama. A group of hedge funds recently urged regulators to investigate banks, including Bear, for alleged manipulation of the market for mortgage bonds and the booming derivatives linked to them, such as collateralised debt obligations (CDOs). The funds accuse the banks of protecting their own positions in derivatives trades—in which hedge funds are often counterparties—by propping up the prices of dodgy mortgages bought under the pretext of helping struggling borrowers.
The recriminations are likely to grow as rating agencies, slow to act at first, bow to the inevitable and revise their opinions. In the first of what is expected to be a wave of downgrades, Moody’s has cut the rating of 131 subprime bonds because of higher-than-expected defaults. It is reviewing hundreds more. Meanwhile, as more loans turn bad, it is dawning on the banks, hedge funds, insurers and pension funds that hold “senior” (highly rated) portions of CDOs that their investments may not be as bullet-proof as they thought. CDOs offer higher yields than similarly rated mortgage-backed bonds, but are more susceptible to losses if the underlying loans decay.
With some $100 billion of adjustable-rate subprime mortgages due to reset to higher rates by October, investors are likely to remain twitchy. Moreover, lenders have tightened underwriting standards across the board for both prime and subprime mortgages, making it harder for borrowers to refinance loans.
There is also another way in which owners of mortgage-backed securities could be hurt. As regulators debate the merits of new rules on abusive lending—the Federal Deposit Insurance Corporation is keen, the Federal Reserve sceptical—some politicians in Washington, DC are pushing the notion of “assignee liability”, which would hold secondary-market investors responsible for homeowners’ losses. Never mind that the most forceful attempt to introduce this so far, in Georgia in 2002, ended in disaster. As securitisation dried up, so did the primary-lending market. The law was amended in 2003.
But perhaps the most worrying thing for financial institutions holding mortgage-backed paper is not the subprime market itself, but the unnerving parallels with an even bigger one to which they are also exposed: leveraged loans to companies. As Daniel Arbess of Xerion Capital Partners points out, corporate lending’s giddy leverage echoes the high loan-to-value ratios in subprime; the explosion of “covenant-lite” deals and payment-in-kind notes mirrors that of interest-only and negative-amortisation mortgages; and leveraged buy-outs have their own form of mortgage refinancing in the so-called dividend recapitalisation. Subprime, says Mr Arbess, might well be “a dress rehearsal for something bigger and scarier.”