FYI | Jun 21 2007
By Greg Peel
The Dow Jones Industrial Average fell 140 points last night, accelerating towards the close on news regarding JP Morgan, Bear Stearns, two hedge funds, and the US collateralised debt obligation (CDO) market.
According to reporters Vikas Bajaj and Julie Creswell, the story began in New York’s morning trade when lenders to two hedge funds at a unit of investment bank Bear Sterns made a preliminary ring around to see just how much they might get if it they tried to offload US$2 billion worth of mortgage-backed securities into the market. The response was underwhelming.
The mortgage-backed securities were not high quality. They formed the basis of what has been one of the fastest growing new risk asset classes – the collateralised debt obligation. These instruments provide the potential for high returns through the aggregation and securitisation of batches of lesser quality loans – in this case sub-prime mortgages. About US$316 billion in mortgage CDOs were issued in the US last year, up from US$178 billion in 2005.
Interest began to wane in the sub-prime mortgage market back in February, when a surprise fall in the Chinese stock market exposed fears of overstretched risk in various asset classes. Most attention was focussed on sub-prime.
The market recovered, and disaster was averted, but since February the screws have been tightened on the sub-prime mortgage market, making it harder for credit-unworthy Americans to secure a housing loan, and harder for issuers of sub-prime securities to borrow from investment banks. Nevertheless, there are still a good deal of such CDOs being held in US hedge funds. One such fund is Bear Stearns’ succinctly named Bear Stearns High Grade Structured Credit Strategies Enhanced Leveraged Fund which, along with a sister fund, ran into troubles last month, leading to a halt in redemptions.
Last night the lenders to these funds put out the feelers. When no one bit, the news spread quickly around Wall Street. The New York Times heard that Merrill Lynch was ready to auction off US$850 million in collateral, while Deutsche Bank was in the market with US$600m.
It is expected to take several days before potential buyers of the debt will be able to ascertain just what price should be offered. The situation is complicated by the fact that some 33-45% of the US$2 billion in CDOs on offer are investments in other CDOs.
The greatest concern is that the unwinding of this particular parcel, although relatively small, will have a cascading effect through the entire debt market. US regulations require the value of CDOs to be marked to market (revalued at the last equivalent market traded price). However, CDOs are not instruments that change hands very often. They are more of a set-and-forget part of a risk portfolio. Hence it is possible that many CDOs are currently on the books at past inflated prices. The Bear Stearns sale could force a new valuation benchmark that may well spark a calamitous round of selling.
This fact is not lost on the Morgans, Goldmans and BAs of the world. They would probably rather not buy the debt at all, but if forced, would only buy at a low price. In so doing, they risk triggering a general risk asset sell-off that could have further-reaching ramifications for their own existing portfolios.
Rumour has it that Merrills and Deutsche are indeed cognisant of the ramifications, and as such are touting their loans very quietly to a group of possible buyers. The plan is to make good the transactions and alleviate the situation outside of the glare of Wall Street. Non-listed CDO trades need never see the light of day.
The problem is, however, is that the genie is somewhat out of the bottle.
While the initial slump in the US housing market was an unsurprising reaction to a long-run bull market, hopes of a housing recovery have lately been dashed as data fail to foresee any imminent recovery. As late as Monday and Tuesday, Wall Street was trying to put a brave face on housing data as the most recent figures were not as bad as expected. However, they were simply less negative, rather than positive.
The sub-prime mortgage crisis sparked in February has had a lot to do with the failure of the US housing market to find its feet. Builders were caught out when increasingly lax credit requirements (a result of excess global liquidity) were immediately tightened. Off-the-plan houses were left unsold. Foreclosure sales also jumped. There were suddenly a lot of dwellings on the market.
Morgan Stanley notes there is currently a six and a half month inventory of new homes for sale in the US. At the peak of the cycle there were only four month’s worth. Five months is considered average. Despite the more enthusiastic views of some, Morgan Stanley believes US housing activity will continue to deteriorate. It will have less of an impact as a percentage of GDP, but house prices will nevertheless need to fall and that can translate into lower consumer spending, and a weaker US economy.
However, it appears the only sector of the US economy suffering weakness at the moment is the housing sector. Macquarie Bank strategists note leading indicators suggest overall US growth will reaccelerate in the second half of 2007. Says Macquarie:
“This growth momentum is resulting in a major repricing of the debt markets. Positively sloping yield curves are being re-established, with the long end of global bonds selling off substantially. We believe this adjustment phase has further to go to unwind the effects of the debt bubble of recent years as well as to allow for the resumption of monetary policy tightening in the US next year.”
Nowhere is this “major repricing of the debt markets” suddenly more apparent than is this latest sub-prime mortgage scare, courtesy of Bear Stearns. The major US investment banks are working hard to stave off any rolling collapse, but as bond yields push higher, risk asset prices and credit spreads are coming under a good deal of pressure. It may not be long before something really breaks.
