23 May 2007

A stretched credit cycle, a more savage downturn -FT

High finance has never been more sophisticated. Bankers have never been more clever. Yet in the US subprime lending boom, banks fell over themselves to advance 100 per cent loan-to-value mortgages to out-of-pocket deadbeats. According to industry folklore, even an insolvent arsonist was given accommodation.

Lending standards to private equity are collapsing just as risks rise and returns are being competed away. "Cov-lite" loans are the order of the day, meaning that restrictions on a borrower's interest cover and balance sheet leverage cease to apply. This has prompted Anthony Bolton, Britain's most admired fund manager, to warn of impending doom. So what is the explanation for such apparently aberrant behaviour? At one level, it is simply that banks no longer have to worry about loan quality in securitised markets where the loans they originate are immediately sold. So the more pertinent question is, why do investors buy from the banks? The answer, as Henry Maxey of the Ruffer fund management group argues in a forthcoming paper for the Centre for the Study of Financial Innovation, is that Wall Street has solved their most pressing problems with its invention of structured products. Take the hedge funds, in which conventional investors such as pension funds invest increasingly via hedge fund of funds. These intermediaries typically aim for positive returns of 1 per cent a month, net of fees, with low volatility. If the hedge funds they back fail to deliver on 3- to 6-month performance figures, they are culled.

The hedge funds need to make about 20 per cent gross a year, before a welter of fees, to provide that 1 per cent a month for their backers. Such a spectacular return can be gained either by market outperformance, which is beyond most fund managers, or by taking on leverage through borrowing, or trading in derivatives. For most, that means adopting leveraged strategies in illiquid assets, to avoid leaving capital values hostage to market volatility.

Structured credit products are tailor-made for this task. Collateralised debt and loan obligations (CDOs and CLOs) invest in poor-quality assets such as subprime mortgages or loans to super-leveraged buy-outs, and sell matching liabilities to investors. Yet the sale involves an alchemical transformation. The package is sliced and diced into high- and low-risk tranches, with usually up to 80 per cent being rated Triple-A or AA and the residue being very lowly rated or unrated.

For pension funds and managers of official reserves, the resulting high-grade paper is a boon in a world where the number of Triple-A corporate borrowers has dwindled to a handful.

For hedge funds the low-grade paper, which provides a cushion against default risk in the high-grade tranches, is likewise a boon, especially since, as Mr Maxey points out, it lends itself to arbitrage whereby hedge funds take long positions in the high-risk tranches and short positions in the low-risk tranches, which are relatively expensive. This ought to increase market efficiency since more investors can buy into a given pool of low-quality credit-enhanced assets.

The peculiarity of this trade is that profit is never arbitraged away in the benign phase of the credit cycle because positions are not constantly marked to market. Their illiquidity requires them to be marked to a model approved by credit rating agencies. As we saw after Enron and the subprime mortgage fiasco, rating agencies, who are paid by those who they rate, do not adjust ratings to reflect deteriorating economics. They close stable doors after profligate horses have bolted.

It follows, as Mr Maxey notes, that relaxing lending standards is perfectly rational. To increase lending volume, banks could either reduce their interest rates or reduce underwriting standards. Given the hunt for yield, this is a no-brainer. So collapsing standards will now stretch out the credit cycle while ensuring the delayed downturn will be more savage when the defaults finally happen. This subverts the argument that structured products uniformly enhance market efficiency. Credit is being mispriced, courtesy of credit rating agencies that are insensitive to market risk. Stand by for systemic consequences in due course.

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