The South African Index Investor

www.indexinvestor.co.za

Newsletter: August 2007

A Credit Bubble Deflating

By Daniel R Wessels

In last month’s newsletter I wrote about one of the major risks to global economic growth, namely the debacle (scandal) evolving around the loose lending practices applied to accommodate subprime borrowers (those who do not qualify for market-related interest rates due to bad credit history) in the U.S. housing market and the subsequent “financial engineering” by investment banks, assisted by credit-rating agencies, to spread the potentially high credit risk among greedy investors (typically hedge funds) around the globe.

At the time I mentioned that although the direct impact of the subprime mortgage meltdown is modest in comparison with the overall U.S. mortgage market (10% of the total market), it is rather the broad spillover effect that such a meltdown would have on creditors in tightening their lending standards across the whole market, that would create the most difficulties.

This is precisely what transpired over the past few weeks as debt, bond and equity markets across the globe showed real nervousness and retracted sharply (5-7%) in response to the growing unease and uncertainty about how the latest crisis of credit de-ratings will unfold.

Credit-rating agencies, such as Moody’s, Standard & Poor and Fitch, have de-rated many high credit-risk structured products, which are backed by subprime mortgages, over the past few weeks – even though the credit-rating agencies themselves have initially issued unrealistically high credit ratings (i.e. “low risk”) to these asset-backed products. For example, Moody's downgraded 399 of these bonds, while Standard & Poor's, a rival, indicated it was preparing to downgrade some 612 bonds, worth $12 billion.

Subsequently, liquidity for these products has dried up, meaning that holders of these products (typically hedge funds) have now assets on book worth far less than they initially thought. Last month I reported that Bear Stearns, a giant U.S. investment bank, already had to close down two of their hedge funds, resulting in massive losses for investors, but by all indications it is the start of more to come. Another hedge fund in Australia recently reported the failure of its fund due to losses stemming from its exposure to the subprime housing market in the U.S.

But the re-appraisal of credit risk is not stopping at subprime mortgages only. The “darlings” of the investment industry over the past two years, namely private equity funds, have been experiencing problems lately to find willing financiers for highly leveraged buy-out strategies. At the moment many of these deals are put on hold or cancelled due to a lack of financial support. For example, brokers were not able to raise sufficient financing for Cerberus Capital Management’s proposed $12bn buyout of Chrysler. Elsewhere, Kohlberg Kravis Roberts failed in their attempts to raise sufficient financing for the leveraged buyout of U.K. retailer Alliance Boots.

Thus, the current nervousness in credit markets is not only about the expected losses stemming from subprime lending (estimated to be anything between $50bn-$100bn according to official estimates, while commentators like John Mauldin expects the losses to reach $250bn), but rather whether the market in its “wisdom” has priced risk correctly over the past few years. This in turn affects all types of credit, in all spheres of the world, and – especially relevant for South African investors – how emerging market debt will be assessed in the future.

In all fairness the latest round of developments is no real surprise. In my December 2006 newsletter I commented on the housing market bubble deflating in the U.S., but already in my October and November 2005 newsletters I sketched a future scenario of rising inflation and interest rates and that the bubble in credit markets was unsustainable. In short, fancy, “engineered” lending practices and products will come home to roost in a higher interest rate environment. That time seems to be upon us.

First, let me briefly (and simplistically) re-visit how this debacle started: Five years ago central banks across the globe, most notably in the U.S., Japan and Europe had cut interest rates to historic lows in an attempt to jumpstart their economies after the slump of the 1990s equity bubble, 9/11 and fears of deflation. Low interest rates encouraged borrowing money which eventually led to a surge in global liquidity, which in turn fuelled spectacular gains in assets, not least of which was the U.S. housing market bubble. While housing prices continued to surge lenders became more lenient towards normal lending practices and enter the fray of subprime lending.

Mortgage lenders became very lenient to otherwise non-qualifying individuals. For example, no deposits or proof of income were required to qualify for such loans. Furthermore, households were offered mortgages whereby the initial interest payments were very low, say 1%, but would drastically increase to, say 8%, by year 3. But this is not where it all ended. In fact, what happened next was what John Mauldin described as alchemy – turning lead into gold, and in some cases sewage into gold.

“Smart” financial engineers at investment banks structure these inherently risky loans into investment products offering high yields at supposedly low risks, by packaging them into diversified pools, called collateralised debt obligations (CDOs). Credit-rating agencies then came along and issued unrealistically high credit ratings (AAA and AA ratings) to some of the CDO tranches, basically because quantitative models predicted very low default probabilities. [A further indication of these unrealistic credit ratings is that in 2005 only nine major, multi-national companies enjoyed a triple-A rating, the likes of General Electric, Exxon Mobil, Johnson and Johnson, and Warren Buffet’s investment holding company, Berkshire Hathaway!]

Obviously, investors (hedge funds) following the credibility of the credit ratings issued were lured into this market as if these investments held no or little default risk. While interest rates remained benign and housing prices soared this endless money making scheme worked very well, both for the investment banks, credit-rating agencies and hedge funds. For example, it was reported that subprime debt credit rating contributed about 40% to the profits of one credit-rating agency!

But as inflationary pressures kept gaining momentum in the economy, the Federal Reserve had to continue hiking interest rates, but perhaps more importantly, had to keep rates higher for longer than most expected. The U.S. housing market started to crumble in 2006 as households, especially at the subprime end, struggled to cope with higher debt servicing cost. Delinquencies and foreclosures started to rise, meaning that interest payments and capital repayments on many of these mortgages did not materialise any more, many subprime mortgage lenders had to file for bankruptcy, and a drastic devaluation in CDOs took place.

Chart 1 (page 4) shows how spectacularly these type of asset-backed securities lost value. At the moment some of these products are worth only 40% of the value it had at the beginning of 2007. The latest sharp drop is led mainly by the fiasco with two Bear Stearns hedge funds which were heavily invested in CDOs, but at the same time highly leveraged. The Bear funds had borrowed in addition to enhance the fund returns, and in doing so had to post collateral (the CDOs) with lenders, known as prime brokers. When the funds started to loose money one of the brokers, Merrill Lynch, tried to sell this CDO collateral but soon stopped when it transpired it was only succeeding in driving prices of the CDO paper sharply lower. Eventually, Bear Stearns had to pledge $3.2bn of its own money to fill the gap. The net result of this fiasco was that investors lost all their money in one fund ($9bn) and 90% in the other.

Chart 1

Source: Financial Times, 26 July 2007

The Economist recently reported that fund managers think the risk of rising defaults is now the biggest threat to markets, according to a survey by Merrill Lynch; and that more than two-thirds of bankers and dealmakers questioned in another poll reckoned that credit markets will be in worse shape a year from now.

Anxiety is fuelled largely by doubts about the quality of paper held in CDOs and other vehicles linked to asset-backed securities. These were marketed as offering decent returns with minimal risk. But as rating agencies have downgraded lower-rated tranches of this pooled debt—and raised the possibility of marking down the better-quality debt—it has become clear that these instruments are not all “low risk”.

At the moment, CDOs are difficult to price and the secondary market is illiquid. Many of these CDOs are held at questionable valuations. Further downgrades would force holders to mark their paper to market (real value, rather than some notional value). Hence, analysts at Credit Suisse think CDO losses could easily reach $50 billion, while other forecasts run as high as double that figure.

While South African investors will tend to perceive the above ongoing crisis (correction) in credit markets as predominantly an American issue and thus isolated from how our markets should behave, reality dictates otherwise. The deflating of excesses in the credit market has widespread ramifications. Basically, the foundations of trust and confidence in understanding and pricing risk have been dealt a serious blow. Risk premiums in such an environment need to be re-priced. Only then will markets return to a relatively stable state.

What will happen in financial markets globally during these uncertain times of re-assessing credit standards and valuations is to a certain extent “predictable”. First, there will be a major shift towards quality – investing in low risk, government bonds and divesting from higher yielding emerging market bonds and corporate bonds. Second, and in line with the first expectation, there will be a strengthening of “hard currencies” at the expense of emerging market currencies, and third, expect the return of significant volatility on stock markets – frantic “mood” swings from day to day, and perhaps less rational market behaviour all around.

These trends are confirmed by the following charts which track bond market yields, currency exchange rates and stock market volatility. Chart 2 illustrates how the yield spread between a basket of emerging market sovereign bonds and U.S. treasuries diverged over the past weeks, while the U.S. ten-year bond rates strengthened over the same period. Clearly, a pattern of flight to safety and quality by international investors emerges.

Chart 2

Source: Data supplied by Glacier Research


Chart 3 shows how the rand exchange rate weakened against the major currencies, US dollar, sterling pound and euro, over the same period. Chart 4 indicates how stock market volatility has picked up during the last weeks of July after being in a declining trend for most of the year. Basically, it implies that large movements in investors’ sentiments are possible and this makes predictions about future market returns vastly more difficult.

Chart 3: Rand exchange rate data over the past three months

Source: Moneyweb

Chart 4

Source: Data supplied by Glacier Research

What does all this mean for ordinary investors? Are we facing a major slump in equity and bond prices? I do not know, but I am certain we are dealing here with an uncertainty that is not going to dissipate overnight. Inter alia it means we will have to deal with market volatilities we have not seen over the past few years. If history is any reasonable guide of future returns, previous periods of such higher volatilities normally indicate that positive equity returns are still a strong possibility, but at subdued levels because of the occurrence of large negative equity returns from time to time.

Basically, I am worried about possible sharp retractions on equity markets, but still optimistic that equity investments will be a better investment than bonds and other asset classes for the foreseeable future, except if interest rates increase by, say, another 100 or 200 basis points from the current level. At that point I believe cash will be king. Until then I believe the sound economic fundamentals will weigh more heavily than the possible negative influences of a tighter, less liquid credit market.

There is still one other essential weapon in one’s investment arsenal, namely diversifying into offshore assets. The popular saying “local is lekker” certainly did apply over the past four years. However, I am of the opinion that the rand exchange rate will be under pressure during the “flight to quality”, simply because of our nation’s propensity to spend much more than we save; hence the dependency on foreign capital to finance the shortfall. While this shortfall was comfortably financed over the past few years this might change in a period of re-assessment of risk. All indications lead me to believe we are entering that period.

1