25 June 2007

Gerard Minack Sydney

Markets continue to be unsettled by the fall-out from sub-prime mortgage market in the US. Wall Street fell on Friday, and there do now appear to be some safe-haven flows, as evidenced by sharp fall in short-end Treasury yields (Exhibit 1). The focus is now on losses at two hedge funds run by Bear Stearns. Here are some comments:

First, some commentaries have compared the Bear Stearns' funds with Long Term Capital Management (LTCM). From my understanding – and here all I have to go on is the wire reports – the two episodes are in a different league. Reports on Bloomberg suggest that the Bear Stearns funds, which specialise in mortgage bonds, have lost as much as 20% of their value. The same reports suggest that the funds had invested US$11 billion, of which $9 billion was borrowed.

Compare those figures to LTCM. Before LTCM ran aground it had equity of around $4¾ billion, which supported borrowing of around $125 billion. In addition, it had off-balance sheet derivative positions of $1¼ trillion. This was an order of magnitude (or two) larger than the capital at risk now.

Second, while LTCM's threatened collapse clearly posed systemic risks, there are no sign of that now. That's in part because the gross exposure seems far smaller. While it's not at all clear what the ultimate losses may be in the specific funds, it seems likely to be smaller than the ultimate losses at LTCM (around $4.6 billion), and smaller than those recorded by, say, Amaranth when it failed last year.

Moving away from the specifics of the Bear Stearns funds, there are a few other points to note about what's happened.

First, it seems that things will get worse before they get better with sub-prime mortgages. As Exhibit 2 shows, a large numbers of ARM resets fall due this year. In addition, house price indicators continue to deteriorate, reducing the prospect of a borrower in trouble being able to sell the home and repay the loan. Refinancing is more difficult now that lending standards have been tightened.

How much of this is in the price of mortgage-related securities is a moot point. Prices on at-risk mortgage products have already reacted (Exhibit 3 – although note that this is weekly data; the sub-prime index apparently finished Friday at new price lows).

Second, part of the concerns with the Bear Stearns' funds relates to the pricing of the more exotic instruments in their portfolio. Because liquidity is low, it's not clear what is a fair market price – or what prices other funds are carrying similar instruments on their books. One concerns is therefore that the forced sale of some of those instruments may establish a low market price, forcing other funds to mark down their asset values. No one, it seems, wants to admit what's becoming increasingly obvious: these have been poor investments.

This highlights two of the problems with the ‘new technology' of debt: first, that in the absence of a transparent market, pricing is difficult (and hence, as Warren Buffet noted, parties on opposing sides of a deal can both assume that they are ‘winners'). Second, liquidity is often an issue.

There is another potential problem with the new world of securitised debt: coordinating creditors becomes an issue. The New York Fed famously brokered a deal with LTCM's principal creditors, and 16 participants injected $3.6 billion to prevent the fund collapsing. Arranging a similar deal now, if ever it were required, in a world of sliced, diced and securitised debt would be far more difficult.

Finally – and importantly – it still seems that investors are ring-fencing the problems in the mortgage market, with broader credit markets remaining well-behaved. Exhibit 4 shows spreads on generic credit default swap spreads.

My view is that the problems in sub-prime are indicative of a bubble that extends through credit markets. Ultimately, many of the problems now appearing in sub-prime – excess borrowing, with low lending standards on tight spreads, the lack of transparency and liquidity in secondary markets – will likewise affect corporate credit. But it remains unclear when.

The closest analogy I can see to the behaviour of credit markets now is in the latter stages of the TMT boom. Although often forgotten, internet stocks caved in through the first half of 1999 (Bloomberg's internet index halved in value). That setback was likewise ring-fenced from the broader bubble, and TMT overall continued to do well. (Full disclosure: the internet index then tripled between August 1999 and March 2000.)

So it may be that the overall credit bubble may persist even as one of its offshoots pops. However, this now needs to be watched closely: to state the obvious, if the problems in sub-prime do start to infect the overall credit universe, it would be very important for investors in debt and equity.

Gerard Minack

Morgan Stanley

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