FYI | Jun 27 2007
By Greg Peel
There was little consensus on this morning’s (AEST) edition of Kudlow & Company, CNBC’s daily Wall Street wrap and general forum for financial market debate. Mind you there is rarely consensus, as the ranting and raving (but somehow likable, and certainly knowledgeable) Larry Kudlow always ensures both sides of any argument are equitably represented in his heated round table slugfests.
On one side there was the opinion that the US mortgage crisis will remain relatively contained within the sub-prime market, and while uncertainty and weakness will reign for now the whole episode will be over within a couple of weeks and then it will be business as usual.
On the other side was the opinion that the crisis will on expand and accelerate into the US financial sector in general, setting off a correction that could last months.
As Wall Street has twice tried and failed to rally 100 points in consecutive sessions, the question is now being asked as to whether the bull run is over. But despite a comment from a US property writer calling a “sub-prime Chernobyl” (the biggest headline in the financial world at present), both Kudlow’s guests, as well as the great champion of free-market capitalism himself, agreed that the longer term global bull market trend (in equities) will remain intact.
This is not Long Term Capital Management all over again, they agreed. There has not been a major bail-out required from all the major global investment banks as there was in 1998. However, over the last week credit spreads on everyone from Bear Stearns – at the centre of the crisis – to Morgan Stanley – not specifically involved – have blown out by some 20-50 basis points, quite sharply. In other words, the market is cautiously assuming an acceleration of the crisis at least until more is known. It’s hard to know much at present, as the sub-prime mortgage market is over-the-counter, and all financial institutions have slammed close the shutters. In the meantime, the financial sector, which represents 20% of the S&P 500, is taking a hit on the bourse. It is very hard for rallies to be posted under such duress.
Nevertheless, the market quickly recovered from LTCM. (We just won’t discuss how much gold was sold by Britain in order to save the world, and the US dollar, nor should we need mention a thing called the tech boom).
A report by Lombard Street Research, also making headlines at present, was a little less circumspect:
“Excess liquidity in the global system will be slashed. Banks’ capital is about to be decimated, which will require calling in a swathe of loans. This is going to aggravate the US hard landing.”
A lot of the fear has been crystallised as a result of Merrill Lynch revealing what actually happened last week. The whole crisis began when markets learnt that Merrill Lynch and fellow investment bank Deutsche were touting around billions in sub-prime CDOs (collateralised debt obligations) in order to save their loans to a Bear Stearns hedge fund that was teetering. Little was understood at the time, but it has come to light that Merrills was trying to find buyers of the paper at 85 cents in the dollar, but could not find bids better than 30 cents. To avoid calamity Bear Stearns announced it would save the day by bailing out its hedge fund for US$3.2 billion. That figure has now been revised to US$1.6 billion, but another more risky US$6 billion fund has been left to go under.
There is currently US$750 billion of what Lombard describes as “dubious paper” in the form of CDOs out there in the market. The world presently has no idea what this debt is worth “because the investment banks shut down the market in a cover-up so that nobody would know”. We do know, however, that the banks holding the US$750 billion have a capitalisation of US$850 billion.
The London Daily Telegraph reports 86 major US mortgage lenders have now gone bankrupt since the sub-prime crash began. The sub-prime market first took a dive in February following the Chinese stock market correction. The correction proved to be short lived, but while many mortgage lenders quickly tightened their lending criteria the vultures moved in – in the form of hedge funds that decided the paper was now cheap and worth buying. One can only assume Bear Stearn’s funds were among those who thought a bargain was available.
“These highly illiquid securities have been priced so far on unrealistic and distorted credit ratings as the ratings industry has been complicit,” railed economics professor, consultant, and well known bear Nouriel Roubini. “They have not been re-rated in a way that is consistent with rising sub-prime default rates,” he said. “That is why Wall Street is in a panic. Losses will be massive once these assets are correctly priced to market.”
Lombard Street suggests Bear Stearns is just the tip of the iceberg. The great risk lies in the “toxic tranches” of lower-grade securities held by banks, The Telegraph reports. The worst of the US property crisis is yet to hit.
Lombard is referring to another style of US mortgage, known as the adjustable rate mortgage (ARM). ARMs work in a similar way to some credit cards that provide an initial interest rate honeymoon before hitting the borrower with a sharp jump in rate at a later stage. Many borrowers could see interest payments jump by 50-100%. There are some US$2,000 billion of these instruments out there as well.
Australians would be familiar with the type of borrower that may be holding an ARM. Picture the truck driver who was able to stretch and buy that McMansion when interest payments were low and the property market was soaring. If the truck driver is forced now to sell, he would be selling into a void. In Australia, where the variable rate mortgage rules, borrowers are constantly susceptible to changes in the RBA cash rate.
Americans favour thirty-year fixed rate mortgages, but even this rate has jumped 65 basis points over the last six weeks making mortgages more expensive and keeping buyers at bay. Mortgage defaults are now at their highest level in 37 years. Records began being kept 37 years ago.
While average American home-owners may be suffering, attention has also turned to hedge funds themselves who have invested in the CDOs, or securitised mortgages of the lower income citizen. If a lot of rich people, who have invested in hedge funds, are hurt when a hedge fund goes under, will anybody care? When Amaranth lost US$6 billion in August trading natural gas the world blinked and life went on.
Former SEC commissioner Harvey J. Goldschmid spoke to Associated Press:
“In theory, hedge funds are about wealthy people investing. But, by practice, pension funds, endowments, and other financial institutions invest in them, and a few big hedge funds going down can spread an awful lot of harm among real people.”
Consulting firm Greenwich Associates told AP that pension funds and other endowments had sunk $1 out of every $10 into “alternative” investments last year, such as hedge funds or private equity funds. This 1% in turn represents about 24% of investment in the larger hedge funds. 1% doesn’t seem like much, and in fact seems very conservative for an investment portfolio, but for the hedge funds it represents 24% of at least US$1.5 trillion in assets. Hence there is a sense of urgency amongst the top Wall Street firms.
Investors in the second Bear Stearns hedge fund – the one that won’t be bailed out – are said to be looking at a 50% loss. Bear Stearns is the fifth largest investment bank in the US. Larger banks such as Goldman Sachs, JP Morgan Chase and Citigroup also manage tens of billions in hedge funds, according to Moody’s. A Citigroup report on Monday suggested Goldman’s sub-prime issues are currently being downgraded by ratings agencies faster than any other, AP reports. I’m sure Goldman’s are thankful to their mates at Citi for pointing that out.
If the mortgage crisis does accelerate and the pain trickles down to the “little guy”, expectations are that there will be a push on Capitol Hill for more regulation of hedge funds and private equity.
If only I had a US dollar for every time I’ve heard that one.
Mind you, if the Democrats win power the threat may be more real, but talk of greater regulation of derivatives and hedge funds has been going on since 1987, and nothing much has ever happened.
If this crisis does spiral into something bigger, is it Armageddon?
Unlikely. The more likely scenario is that the market will be well served by shaking the over-extended, overly risk-aggressive players out of the market for now. Risk spreads will return to something more realistic. There will be short term pain, but that can mean longer term gain.
Take the example of the Chinese stock market. This whole sad state of sub-prime affairs was triggered by a 9% fall in Shanghai back in February. Shanghai has fallen about 6% in the last two days but nobody seems to care (except Mr & Mrs Wong, one assumes). An anticipated incremental interest rate rise is being blamed for the fall, which is all part of the Chinese government’s plan to ease the economy back from bubble conditions. The Shanghai stock market – considered by many to be a bubble as well – will not be hurt by a bit of a pullback. In fact, it would really not be hurt by a lot of a pullback, considering how hard and fast it’s run. Releasing some pressure can only be a good thing.
How much will global stock markets be hurt by a purge of risky hedge funds?
The analysts at GaveKal – serial bulls all – suggest there are only three things that could cause the end to equity bull markets: (1) valuations are overstretched; (2) economic growth collapses; or (3) the liquidity environment becomes tighter. At the moment, there is no problem with (1) or (2), they suggest. But (3)? Well this is what we’re looking at now really.
As long as there is “more money than fools”, says GaveKal, a market will always be bullish. This will turn when there are “more fools than money”. While we have witnessed the former for a while now and may be seeing an example of the latter, the game’s not over yet.
GaveKal suggests investors prepare for what may be “a tremendous buying opportunity”. In the meantime, they are suggesting their clients take out some form of portfolio insurance. In other words, don’t sell, just protect from losses and get ready to buy again when this whole thing settles down.
There is no specific suggestion as to when that might be.
