FYI | Jun 23 2007
By Greg Peel
In 1998 it was Russian debt. In 2006 it was natural gas. In 2007, it’s sub-prime mortgage securities.
The global financial market went very close to collapsing in 1998 when the world’s largest hedge fund – Long Term Capital Management – went to the wall when Russia defaulted on its sovereign debt. LTCM had built up an enormous position, buying the cheap Russian debt and selling gold derivatives. In order to avert a crisis, the US Treasury called in the major global investment banks – all lenders to LTCM – to cover the US$3.6 billion in losses. At the same time the Bank of England, under instruction from the Chancellor of the Exchequer, sold half of its gold reserves in order to avoid a collapse of the US dollar. The Dow Jones fell 10% in a month.
The ghost of LTCM was recalled last August when US hedge fund Amaranth booked US$6 billion in losses trading natural gas. Despite nearly doubling LTCM’s losses, Amaranth did not go under given much of the loss represented a reversal of previous profits. The Dow was spooked, but quickly recovered.
On Friday night Bear Stearns announced it would bail out one of its two hedge funds that are staring at massive sub-prime mortgage security losses, to the value of US$3.2 billion. By so doing, global investment banks have been relieved of the need to find buyers for the sub-prime debt in order to save not only their own loans, but the mortgage market in general. However, Bear Stearns has to date only bailed out one of its two hedge funds. The other is holding similar positions worth US$6 billion.
It is uncertainty over the second fund that weighed on the stock market last night. The Dow fell 185 points or 1.4% to close on its lows. It has now fallen a net 275 points over three days since the Bear Sterns story broke. Why it rallied 50 points on Thursday is anyone’s guess. Most heavily hit across the market were the financials, which at around 20% make up the largest slice of the S&P 500 (down 1.3%). Every single financial sector stock posted a loss in the face of sub-prime uncertainty – except one.
The world’s largest private equity firm Blackstone Group listed on the NYSE last night at US$31 and closed up over 13% at US$35.06. This values the company at US$38 billion while CEO Stephen Schwarzman, who is expected to cash US$450 million out of the IPO, found his stake in Blackstone valued at US$8 billion.
Stephen Schwarzman has now found himself as pin-up boy for the Democrats, but not in a way he would have hoped.
Twelve Democrat representatives introduced a bill into Congress last night that has quickly been dubbed the “Blackstone Bill”. While the move was not unanticipated, it could not have come at a more inconvenient time for Wall Street. The fall in stocks last night has been attributed to not just debt, but taxes. And as we all know, in this world nothing can be said to be certain, except debt and taxes. (With apologies to Benjamin Franklin).
The Blackstone bill formalises earlier rumblings from the Democrat-majority Congress seeking to address the perceived income tax imbalance between Stephen Schwarzman and, for the sake of argument, a nurse. The high end income tax rate in the US is 35%. The minimum rate is 26%. Under rules that allow partnerships to treat their income as capital gain, Schwarzman will pay 15%.
The Democrats are seeking to lift the tax rate on partnerships – which in this context includes hedge funds, private equity firms and venture capitalists – from 15% to 35%. Those who oppose such a move (which, incidentally, does not include all Republicans) consider the 15% rate to be critical to the encouragement of entrepreneurship – a necessity for a strong economy and what made America great etc etc. Those supporting the bill are seeking to put an end to the great rich-poor divide which sees Nurse Betty paying a higher rate of tax than Stephen Schwarzman.
While the bill is likely to be passed in the Lower House, commentators are not entirely sure it will make it through the Senate but nevertheless, it can always be vetoed by President Bush. Either way, Wall Street was not happy last night at being attacked right where it lives.
Tax aside, the buzzword in the bars around New York’s financial district after the market close last night was “contagion”. Just how much of the Bear Stearns crisis can spill into the greater sub-prime mortgage market or, worse still, the debt market in general?
The problem with sub-prime mortgage securities, and the collateralised debt obligations (CDOs) that form the particular instruments in question, is that they do not trade on a listed market. They are an over-the-counter security and as such their price movements are not transparent. No one knows just how little Bear Sterns mortgage debt is presently worth. There are rumours of only 10-20 cents in the dollar, but you can imagine what sort of rumours are going around. However, the ultimate impact is one of forced price discovery.
CDOs do not change hands very often. They tend to be created, issued, and left alone. To complicate matters, CDOs often hold part of their portfolios in other CDOs, which in turn yadda yadda. Under US law CDO value on the books must be “marked to market”. This means that if transaction does occur, and a price discovered, all CDOs need to be revalued at that price. However, transactions rarely occur and besides, CDOs are not not necessarily homogenous, leading to revaluation complications.
It is fair to say there will be vast numbers of CDOs on the books of hedge funds and investment houses in the US that have not been “marked to market” for some time. If the Bear Stearns crisis forces a new mark to market, many of those firms could be staring at losses. The real problem would then begin if there were a wholesale sell-off.
A wholesale sell-off could, in theory, spark a global credit rout that would force revaluation of everything from corporate bonds – which are trading at historically low risk spreads – to US bonds – which have just begun to spike up in yield. Then again, the spot fire may simply be contained within the low quality end of the debt market, and in fact bolster the high quality end. If a shift out of risky assets into safe ones would occur then there is every chance corporate bond spreads could blow out, equity markets could correct, but Treasury bonds could find themselves supported.
Or is it a case that global excess liquidity had led to debt that is simply too cheap right across the spectrum?
Says Morgan Stanley’s Gerard Minack:
“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.
“Importantly…it still seems that investors are ring-fencing the problems in the mortgage market, with broader credit markets remaining well-behaved.”
The US ten-year bond market was indeed relatively steady last night at 5.14%. The US dollar continued to lose ground to the euro, which at 1.33467 is starting to get back to break-out territory, while it gained further ground against the yen as carry traders just keep on plugging away. Clearly the bulk of carry trades prefers the safety of US Treasuries or even high-yielding New Zealand bonds to the “junk” that is sub-prime CDOs. This is heartening.
Gold rallied as the dollar fell, rising US$2.40 to US$653.60/oz, indicative of a quiet night for most assets other than stocks. Oil rose slightly and nickel pulled back another 1%.
