Subprime coming home to roost?
By John Authers
Copyright The Financial Times Limited 2007
Published: July 26 2007 19:27 | Last updated: July 26 2007 19:27
At least some people are benefiting from the pain being felt by American homeowners. Word on Wall Street is that the head of one trading desk, after making a lucrative bet against securities backed by mortgages to people with bad credit histories, has had T-shirts made up that cheerfully proclaim: “I’m short your house”.
Few share this glee. Difficulties for the US housing market have been evident for at least a year and data this week showed the overhang of unsold existing homes at its highest level since 1992, at the end of the nation’s last housing recession.
Nowhere are the difficulties more evident than in so-called subprime mortgages, extended to people with poor credit histories, for which the losses could be as high as $100bn (£49bn, €73bn), according to the Federal Reserve. The ABX index, a popular measure of bonds backed by subprime mortgages, is down 60 per cent this year.
A rash of bankruptcies at subprime lenders prompted a market wobble in February and March but traders swiftly decided the problem was contained. Equity markets across the world continued to rally, while the credit market remained phenomenally high in historical terms, thanks in large part to the growth of credit derivatives. These prompted optimism that it had become easier to spread risk and so it was justifiable that even the riskiest companies could obtain credit cheaply.
That mood of optimism is over. Fear now rules the credit markets, where the effective cost of ensuring against a default, in both Europe and the US, has increased by more than half in barely a month. A steady drip of bad news has prompted fears that the subprime debacle could trigger a credit crunch, raising the cost of financing worldwide as investors are forced to sell healthy investments to make good their losses.
Problems at two hedge funds run by Bear Stearns, the New York investment bank, perhaps did most to change the mood. Both had heavy subprime exposures. Markets were unnerved both by initial difficulties placing a value on those securities – showing that the market was illiquid – and by the result, which saw one fund wiped out and the other written down by 90 per cent.
Subprime-related woes have afflicted hedge funds as far away as Australia. Meanwhile, banks have failed to raise the bond and loan refinancing they sought after backing several big acquisitions. The latest examples are the postponement of a $12bn DaimlerChrysler loan deal, a consequence of the huge transaction that will see control of its US Chrysler division pass to Cerberus, the US hedge fund, and the failure by banks to sell £5bn of senior loans to fund the UK’s biggest leveraged buy-out – of Alliance Boots, the pharmacies chain.
Added to this is evidence that “prime” US mortgages are also becoming affected. Countrywide, one of the largest US mortgage banks, said that was the case when announcing poor results this week. This would move the problems into a vastly bigger market and affect mainstream investors who had shunned subprime exposure.
In turn, such concerns have prompted fears for stocks, which have received great support in recent years from “de-equitisation” – using cash to retire shares, either through corporate buy-backs, debt-funded mergers or private equity buy-outs. All push up share prices by reducing the amount of stock in circulation and all have relied on historically cheap debt.
It was only on Thursday that stocks finally grasped the grim consequences for the mathematics of de-equitisation. The FTSE-100 suffered its worst day since the invasion of Iraq, almost wiping out its gains for the year amid great volatility. But the S&P 500, despite a similar sell-off, remained only 4.5 per cent below its all-time record set last week.
There are two starkly opposing explanations for stocks’ belated reaction. Bears say that cheap credit has provided the stock market with crucial support and that valuations can no longer be sustained. Jeremy Grantham, the respected founder of GMO, a large fund manager, goes so far as to liken the stock market to a dinosaur. “As yet the equity market seems totally unaffected, with volatile and risky stocks still making the running. Although the brontosaurus has been bitten on the tail, the message has not yet reached its tiny brain, but is proceeding up the long backbone, one vertebra at a time.”
A more positive view is that the credit market is undergoing a healthy correction and that it is natural for the credit and equity markets to diverge. Private equity investors, and companies themselves, are raising credit cheaply and using it to buy back shares. This directly favours equity investors at the expense of credit investors, who are left lending to companies with more debt on their balance sheet and hence a higher risk of default.
Larry Hatheway and Jeffrey Palma of UBS make this point forcefully in a recent note. “Shareholder-friendly behaviour in the form of mergers and acquisitions, leveraged buy-outs and buybacks should benefit equity investors relative to bondholders,” they say. They describe recent moves as fundamentally consistent and “rational”.
On this reading, there is no reason for equities to fall until returns for shareholders and lenders have been brought into balance.
Jonathan Morton of Credit Suisse said in a note that 28 per cent of S&P 1500 non-financial companies have free cash flow yields higher than their cost of capital – classic conditions for a private equity buyout. He added that it would take a five percentage point rise in corporate bond yields, which still looks highly unlikely, before this fell to less than 10 per cent of companies. Thus he expected private equity to remain a feature of the market, but not the principal driver.
Marc Chandler, currency strategist at Brown Brothers Harriman in New York, says: “While tighter credit is a concern, we posit that conditions are simply returning to a more ‘normal’ level after ‘abnormally’ loose conditions over the past few years.”
Practitioners on the ground in the credit market find it hard to be so sanguine. Rather than an orderly correction, they confront a situation where the market for riskier forms of credit seems to have come to a complete halt. US issuance of high-yield, or low-quality, debt stayed below $1bn for the third successive week, according to Thomson Financial. The last week of June brought $9.7bn of high-yield issuance; by last week that had fallen to $322m. This financing is crucial for private equity deals.
“The cancellation of high-yield deals and the inability of the large banks to syndicate their leveraged loans is causing the credit markets to shut down,” says T. J. Marta, strategist at RBC Capital Markets. “Something has to give here: either equities have to give it up or credit is going to implode.
“We knew this was coming,” he adds, “and the question is whether we reach a critical mass that causes a financial seizure or an economic event.” He says the next six to eight weeks, usually a quiet time for markets as many traders take their vacations, will be critical.
Problems for the credit market have also translated into further weakness for the dollar, which was already at its lowest level for more than a decade against various currencies before the credit market’s woes began in earnest.
One big support for the dollar is the inflow of foreign money used to buy US debt securities. If demand for these securities continues to collapse, the dollar will lose another support. Another perverse effect is that government bonds, subject to a dramatic sell-off last month as traders reacted to stronger economic data, are recovering. This is because investors are seeking a low-risk “safe haven”.
David Ader, rates strategist at RBS Greenwich Capital, says: “If it were only a story of the economic data, yields would be higher for sure. But it’s not a case of the data but this grinding unwind of risk and decrease in risk tolerance. It’s a process, it’s a theme, and it won’t end tomorrow.” Admitting he does not know the answer, he says traders are betting either that this return of risk aversion hits stocks and hurts the economy or that it merely hurts Wall Street, leaving Main Street unscathed.
Regulators, however, still appear to believe that the problem will not cause a systemic crisis for the market and will require no external intervention. Ben Bernanke, Fed chairman, in publicly estimating subprime losses at $50bn-$100bn, declined to reassure investors that the problem would not spread to other markets. But the central bank still seems confident that the process at work is a healthy one that will remove excesses.
“The punishment has been meted out to those who have done misdeeds and made bad judgments,” said William Poole, governor of the St Louis Fed, last week. “We are getting good evidence that the companies and hedge funds that are being hit are the ones who deserve it.”
This may justify the confidence of investors. Yet equity markets were sending some warning signals before Thursday’s plunge. Financial stocks have sharply underperformed, while the largest stocks are outperforming smaller companies. This “narrowing” of the market to the biggest names typically happens at the end of a long bull market.
But equities can also point to separate means of support. US corporate earnings appear to be on course to grow at an annual rate of more than 5 per cent in the second quarter – impressive after four years of uninterrupted strong growth. Companies are not heavily geared, so costlier credit will not much dent their profits.
Until Thursday, emerging market equities were still within 1.5 per cent of their record highs, while the price of emerging market debt has fallen much less than that of US corporate debt over the past few weeks. This suggests that confidence in the secular growth of the big emerging markets remains intact, despite the current wave of risk aversion.
Nor is the credit market the only source of liquidity. The large sovereign wealth funds of oil-rich states and successful Asian economies have a surfeit of cash and a need to place it somewhere. China’s purchase of a stake in Blackstone, the giant private equity house, and its role in Barclays’ bid for ABN Amro suggest that this cash will continue to support the market.
Hence even some of the most aggressive bears suggest stocks could avoid a decisive turn downward for another year. As Mr Grantham puts it: “A few more bolts in the bridge may fail, but in the end you have to bet that the bridge will hold, supported by amazing animal spirits. The odds of failure rise but they probably don’t become high until October 2008.”
For the time being, there is less optimism in the credit market. Jim Reid, credit strategist at Deutsche Bank in London, Thursday recommended buying back into credit, having for months advocated betting on spreads to increase. But he said he expected the credit cycle to end “very messily” thanks to the “indiscriminate leverage” seen during the bullish period.
He added: “As a minimum the thing we are in little doubt about now is that having a huge derivative credit market does not give us a new paradigm of permanently tighter spreads, but instead a potentially violent and volatile credit market.”
