18 February 2008

The Worst May Keep Getting Worse

Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).

2007 may come to associated with the start of the "big" credit crunch. 2008 has begun with a number of "unresolved" items. Hope of an early resolution seems to be fading. In the words of Lily Tomlin, the American comedian: "Things are going to get a lot worse before they are going to get worse."

The total level of sub-prime losses is still far from clear. Based on current trading levels of ABS indices, estimates of losses range between US$ 150 and 400 billion, not all of which has been written off to date.

Interest rates on large volumes of sub-prime mortgages – estimated at around US$ 900 billion are due to reset by end 2008. Interest rates and repayments will rise significantly. The impact on delinquencies and losses are unknown. The rate reset freeze plan (which has not been in the news since being announced) and its impact are also still unclear.

As America’s mortgage markets began unravelling, economists initially pointed to sub-prime mortgages issued to low-income, minority and urban borrowers. Closer analysis reveals risky mortgages in nearly every corner of the USA. Analysis by The Wall Street Journal indicates that from 2004 to 2006, when home prices peaked in many parts of the country, more than 2,500 banks, thrifts, credit unions and mortgage companies made a combined US$1.5 trillion in high-interest-rate, high risk loans. The potential losses on these loans are unknown.

There are also emerging concerns in the US$915 billion credit card debt markets. Credit card providers are all boosting loan loss provisions. There is anecdotal evidence that cash strapped mortgagors are using credit cards to make mortgage payments. Analysts expect credit card delinquencies to increase if consumers unable to use home-equity lines of credit to pay off their credit card debt start running up higher card debt. A number of banks have begun to boost reserves against anticipated losses.

Financial institutions have already incurred losses of over US$100 billion. A substantial volume of assets is likely to return onto bank balance sheets as off-balance sheet structures and hedge funds are forced to sell. The total amount to be re-intermediated by banks may be in the range of US$1 to 2 trillion. This will make substantial depends on bank liquidity and capital.

There are already signs that the major banks are hoarding liquidity in anticipation of the return of assets. They will also inevitably have to raise substantial amounts of capital. In the second half of 2007 commercial and investment banks raised US$83 billion in equity. This was an increase of more than 20% on the corresponding period in 2006.

Asset backed conduit vehicles and SIVs ("Structured Investment Vehicles") may need to sell assets as they breach their rules. Hedge funds face substantial redemption requests in the coming months. This will exacerbate the demands on bank capital and liquidity.

The credit issues have widened beyond banks, investors and hedge funds active in structured credit.

In the conventional mortgage market, Fannie Mae (Federal National Mortgage Association) and Ginnie Mae (Government National Mortgage Association) have recorded losses and been forced to raise capital. This suggests that the problems in the housing market are deep seated.

Mortgage insurers and monoline insurers have suffered serious collateral damage. A significant downgrade in the rating of insurers will be particularly damaging. It will affect around US$ 2.5 trillion of municipal bonds guaranteed by the insurers. It will also affect other bonds wrapped by the insurers. This may trigger further selling pressure and contribute to decline in prices as well as absorbing increasingly scarce liquidity.

There is already talk of a plan to re-capitalise the insurers. The sum being talked about is between US$15 and US$200 billion. It is not clear where the substantial amount of capital needed to recapitalise the banks and financial guarantors is going to come from.

The US$ 2 trillion of European pfandbrief or covered bond markets have also experienced liquidity problems.

The sub-prime model is also used for leveraged funding in private equity, infrastructure and commercial property financing.

US$300 billion of leveraged finance loans made by banks is still effectively "orphaned" - they can’t be sold off. In late 2007, there were signs that the loan logjam was easing. Underwriters pointed to some sales of risky assets.

Caution is needed in interpreting these developments. Firstly, the sales only related to the less risky tranches and loans. The more risky exposures remain with underwriters for the moment. There are also concerns that some of the sales were not "genuine". The banks had provided the buyers with a variety of favourable terms including the ability to sell the loans back to them at a future date at a guaranteed price. Alternatively, MFN ("most favoured nation") clauses mean that the selling bank will need to compensate buyers if loans are sold at lower prices during an agreed time from the initial sale. Current prices indicate steep discounts will be needed to shift the paper to investors.

The crisis shows signs of spilling over into other markets. In Great Britain, Ireland, Spain, Australia and other markets strong house price appreciation similar to the US led to similar growth in mortgage and real estate lending. If economic growth slows and housing prices fall then similar problem may emerge in those economies as well.

There are already signs that there will be significant litigation against the banks. There may also be regulatory investigations and potentially prosecutions. State Street recently provided over US$250 million against future litigation claims. The total cost of all this is still unknown.

The financial elements of the credit crunch are becoming clearer - higher credit costs; lower availability of debt; forced de-leveraging of hedge funds and conduits/ SIVs; significant capital losses for financial institutions. The real economy effects will be slower to emerge. Higher credit costs and tighter credit standards will affect all business.

The US housing industry is badly affected with no immediate prospect of a quick recovery. The outlook for US house prices is poor. Growth forecasts for the US have already been lowered. The dreaded "R" word – recession – is now being talked about.

The fall in asset prices has "wealth" effects. Then there are employment and income effects. Wall Street has already issued "pink slips" by the thousands as banks and mortgage lenders shed staff. More will be issued in 2008 as the slowdown in the financial services business continues.

A slowdown in economic activity will affect many financial transactions. Corporations with significant debt face refinancing challenges. The shares of an Australian real estate firm – Centro – fell over 80 % as a result of difficulties in refinancing its short-term debt secured over commercial property, some of it in the US. Commercial property financing has slowed, the cost has risen significantly and terms have tightened affecting commercial property prices.

Private equity deals in recent years were predicated on a combination of a growing economy, cheap debt and a buoyant stock market allowing the quick resale of the company. Weaker earnings and more expensive debt could lead to losses and distressed sales over time. Recent private equity deals also face re-financing risk. Some US$ 150 billion of leveraged loans come due in 2008. Financial engineering techniques – toggles, pay-in-kind securities and covenant-lite (lack of maintenance covenants) structures – will delay the problem but probably cannot forestall the inevitable rise in defaults.

Non-investment grade bond issuance over the last few years was concentrated in the weaker credit categories and is vulnerable to deterioration in economic conditions. Since 2003, 42% of bonds of high yield bonds issues were rated B- or below. In the first 6 months of the year that percentage rose to around 50%. Some commentators believe that the losses of corporate bonds will peak between 10% and 20% leading to significant losses.

Warren Buffet once observed that: "it’s the weak link that snaps you…in financial markets, the weak link is borrowed money." In the present credit crisis, all companies and business models reliant on debt – especially cheap and abundant debt - look vulnerable.

The real economy effects will feedback into the financial markets. A weaker economy are likely to see higher levels of actual defaults. This may set off new phases of the crisis.

CDS contracts used to hedge credit risk have significant documentation and operational problems. If actual defaults in markets increase and the contracts do not function as intended then there would be additional complexity. A significant volume of CDS contracts is with hedge funds and other investors secured by collateral agreements. The counterparty and performance risk of enforcing the contracts may be challenging. It is important to note that the structured credit market in its current form is substantially untested. If defaults rise and the CDS contracts prove to be difficult to enforce then bank exposures to losses may well much higher than anticipated.

Credit markets remain gloomy. Unlike their equity and emerging market cousins, they are waiting anxiously for "the shoes to fall", except it seems that the shoes are from Imelda Marcos’ collection.

At the time of publication the author or his firm did not own any direct investments in securities mentioned in this article although he may be an owner indirectly as an investor in a fund.

© 2008 Satyajit Das All Rights reserved.

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