I’m a bit late to this item, from Friday’s Financial Times: “Credit crisis to worsen as banks cut and run,” which is an unusually vivid headline.
The FT story describes how margin requirements for mortgage-related CDOs have been made considerably more stringent. AAA rated CDOs, which used to be haircut at 2-4% in January are now at the 8-10% level. For single A, the January level of 8-15% has become 30, and equity tranches, which used to margined at 50%, will no longer be leveraged (as in the investment banks won’t lend against them).
The question now becomes how quickly this development will work through the system and now many players will be affected. We’ve already seen Brookstreet forced onto the shoals by margin calls; the question is how many other hedge funds will follow. The secondary effect will be that hedge funds who have subprime exposure are facing redemptions (some like United Capital Markets have halted them). They were already faced with the prospect of having to sell fund assets in a weak market to pay exiting investors; reduced leverage will only make a bad situation worse (the implicit vote of no confidence by the dealer community will make it less likely that speculative buyers will step forward).
The good side is, if we believe the report in a recent issue of Bloomberg Magazine, hedge funds are smaller participants in the subprime-related CDO market than thought earlier, owning 3% of the investment grade portions and 10% of the equity tranches.
From the Financial Times:
The fallout from the crisis at two Bear Stearns hedge funds in the broader market for the complex securities they hold is likely to worsen, as investment banks cut their credit exposure to funds involved in the field.
It is far from certain how significant the direct impact of these cuts will be and even more uncertain are the knock-on effects to other areas of structured credit and debt markets beyond.
But some in the market say that whatever the outcomes, the current troubles in collateralised debt obligations of asset-backed securities are a sneak preview of what the next broad-based downturn in markets might look like.
CDOs of ABS pool together groups of bonds that are backed in turn by pools of mortgages or other loans. The pools are then sliced into different tranches with varying risk and sold onto investors. The products have been heavy buyers of the mortgage-backed securities that facilitated the boom in US subprime mortgage lending.
The Bear Stearns hedge funds were big holders of these instruments and the news two weeks ago that the funds were in serious trouble has led to much greater concern about the valuation of CDOs of ABS held by other funds.
According to bankers and hedge funds involved in these and similar markets, this has led investment banks to begin reassessing their exposure to funds that are investing in ABS and CDOs of ABS with borrowed money.
Matt King, analyst at Citigroup, has estimated that funds invested in CDOs of ABS are likely to see some significant increases in the amount of margin they are required to post against their investments.
This “margin” in simple terms governs the amount of leverage, or borrowed money, they can use in their investments.
For example, Mr King expects that for the safest AAA-rated slices of these deals, margin requirements would rise from about 2-4 per cent now to nearer 8-10 per cent.
At the other end of the scale, the riskiest equity tranches would see margin rates increase from 50-100 per cent, which is to say banks will not lend to funds investing in these slices of risk.
“Over the near term, the biggest risk [for CDOs of ABS] is probably that of forced selling driven by potential margin calls [’haircut’ increases] or investor redemptions,” Mr King says.
“We argue that this is likely to be a big problem only for a small number of people, but that its full effects may not yet have been seen.”
The few bankers involved in the hedge fund financing business who would speak off the record about this subject agreed that such moves were already happening, with some saying that margin increases across the board were coming for some funds.
It is a sensitive topic because forcing hedge funds to withdraw liquidity from these markets could contribute to further valuation concerns in CDOs of ABS and could have knock-on effects for the health of other areas such as collateralised loan obligations, which are also widely bought by CDOs of ABS.
The CDO markets already faces a further test of nerves once Bear Stearns releases the results of its revaluation of its funds’ holdings in about 10 days time.
However, others involved in the credit markets do not think that the banks’ moves are the start of a systemic cutting of liquidity. One London-based hedge fund specialising in credit says that the long-term trend continues to be greater liquidity from the top-tier banks because of their more sophisticated portfolio-based risk assessments and margining requirements.
These help to lower margining by taking account of the diversity of a hedge funds holdings.
Steve Dulake, European credit analyst at JPMorgan, says that for European credit funds, June and July look to be poorer performance months rather than setting the scene for a bad year.
“This would suggest that there’s perhaps a little too much chatter and concern regarding forced liquidation as a result of margin calls on the part of prime brokers.”
Others say that there are warnings for the broader structured credit markets in the problems at Bear Stearns.
“All we’ve seen here is a foretaste of what happens when funds invested in illiquid assets have to be unwound,” says Jonathan Laredo, partner at Solent a London-based specialist credit investor.
“If you want to think about what the next downturn is going to look like, this has been a foretaste. A lot of buyers are holding onto CLOs [similar illiquid assets] in the belief they can sell them when they need to,” Mr Laredo says.
I guess the real question is how much time the banks give the funds to come into compliance with the new margin requirements.
I could see how a bank would figure that phasing the new limits in would kill a fund just as surely as if they did it all at once, but that it would hopefully minimize the inevitable loses.
By happenstance, the FT gave a helpful factoid in its Saturday edition, that most hedge funds have term credit facilities, so the investment banks can’t pull the plug at once. That means while there still will be selling pressure, we hopefully won’t see many forced liquidations.
You can find more detail in: