FYI | Jul 26 2007
By Greg Peel
It only has a 5% exposure to the US subprime mortgage market, but Australian hedge fund Absolute Capital has suspended redemptions until October nevertheless. Following on the heels of the Basis Capital shutdown, Absolute management fears a run on its two funds worth $200 million at a time when selling credit securities is nigh on impossible. Were Absolute to allow redemptions, and investors decide it would be better to take their money out now and avoid any further losses, Absolute would be forced to sell assets to raise cash for redemption payments. Sell to whom? No one is buying.
In other words, Absolute has decided to avoid technical bankruptcy ahead of some return to normalcy in the global credit markets. It doesn’t matter that, as far as the fund is concerned, the bulk of its assets are not of the riskier variety.
Remember Italease? FNArena reported on this Italian bank earlier in the month. In commenting on the bank’s sudden substantial losses from credit market derivatives, a bank spokesman suggested “These derivatives were very complex and suddenly turned against us”, as if he’d been photographing rhino in the Kruger National Park. It would come as little surprise then that the bank’s board was in an emergency session last night amid reports that the Italian central bank was about to step in. The 2 billion euro bank has lost 75% of its value.
The bank has been in the middle of an E600 million capital raising, but the understatement award (and probably Michael extraction award) goes to the London Daily Telegraph’s erudite Ambrose Evans-Pritchard in suggesting the issue “may be in doubt”. Italease still has E120 million of unsold derivatives on its books.
In other news, Australia’s favourite recalcitrant and ex-prime minister of Malaysia, Dr Mahathir Mohamad, has called on the Islamic world at a conference to start using the gold dinar (coin) for international trade instead of the US dollar, which Dr Mohamad suggests is “worth nothing”.
Dr Mohamad came to fame in the financial world in 1997, when he suggested that the Asian currency crisis was a Jewish conspiracy. This was largely because the currency crunch was set in train following massive selling from legendary hedge fund trader George Soros. So thanks for your input again, Mo.
But moving on to respected commentators, consultant Charles Gave of GaveKal has likened the US subprime mortgage crisis with his familiar experiences of walking Asian streets and being offered $5 Hermes ties or $10 Longines watches. While Gave has usually been astute enough to suspect that something might actually be not quite right, US subprime security investors he suggests, alas, have not. If a AAA bond is being offered at 6.5% instead of 4.5%, is it the genuine article?
Add to this the guarantee of a return of invested capital, irrespective of what might happen in the market, and the investor should have become very, very suspicious.
Gave has long held the belief that bear markets only come about as the result of one of two things. They are triggered either by the government, or the market participants themselves. In the first case, a bear market can result from policy moves such as increased protectionism, tax increases, bad monetary policy or the like. In the second case, bear markets result from “Ponzi schemes”.
Ponzi was an ingenious investor who guaranteed high returns to his existing members by borrowing from new members. As the returns kept flowing, so did new memberships until the whole scheme hit negative cashflow and you can guess the rest.
Gave suggests the subprime crisis actually had its roots in the post tech boom market not just because capital became readily available, but because of indexation. When pension funds et al did their lot on dotcoms, there was a regulatory shift away from active stock-picking and into passive portfolios that did no more than track the broad market indices. Two things occurred as a result of this. (1) All the best young-gun funds managers ran off and set up hedge funds of their own and (2), the pension funds were trapped underweight equities and needed something to invest in to generate returns. If you can’t invest in equities, you invest in bonds. But with the world awash with liquidity as the central banks turned on the taps to restimulate economic growth, debt market returns were paltry. And as Gave notes, Wall Street will always find a way to satisfy demand.
Join the dots on that, and we come to the $5 Hermes tie. At last, says Gave, we a had a junk bond with a AAA rating.
So where to from here?
Gave notes that implied volatility in the equity market began to rise quite a while ago. The cash market, on the other hand, remained oblivious that something was wrong. Higher volatility should immediately trigger a move to reduce risk. There had already been a lot of activity in equity market put options. Now we are seeing the same scenario play out in the bond market. It was a crunch that had to come.
And it will likely have further to run, suggests Gave. He will not rule out a test of the March low (11,973 in the Dow – 1,812 points below here). But the reality is that this could actually be great news for the stock markets.
For if the Ponzi scheme has collapsed, and the bond market is no longer throwing up attractive alternative investments, the only competition in town to stocks and commodities has disappeared. A good sell-off, says Gave, could set the stage for a rotation. US equities, for one, are not overvalued.
