How to stay safe in the credit bubble
Sep 05, 2007
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The continuing narrow spread between yields on the riskiest and least risky credits shows that markets remain confident that the developing unpleasantness in the dodgiest sector of US housing finance – “sub-prime” lending to high-risk borrowers – will not expand into a much wider debt crisis.
That would be dangerous for the US and world economies – and really bad news for equity investors.
What could precipitate a crisis?
One who believes that such a crisis is a high-risk possibility is the strategist at CLSA Asia-Pacific Markets, Christopher Wood.
He says that much of the lowest-grade mortgage paper – once famously described as “toxic waste” - is buried in the $4 trillion global market for collateralized debt obligations.
CDOs are packages of loans of different types and risk ratings sold to investors, mainly financial institutions. Many contain significant proportions of high-risk debt. The two riskiest classes of loans amount to 40 per cent of the US market in mortgage-backed securities, for example.
Current delinquency rates in sub-prime mortgages alone already suggest potential losses of $170 billion, Wood says, “even if, optimistically, there is no further deterioration in house prices.”
Last year a quarter of all new mortgage loans in the US were sub-prime. Most of those have not yet adjusted to higher interest rates - most such mortgages start with a low rate to attract borrowers. The rate ratchets up later.
CDOs’ lack of transparency has deferred marking-down of their values now, to reflect the lower market value of higher-risk components, “at the potential cost of a greater shock to the system later.”
Investors ignorant about what they have been buying - but hungry for yield – will wake up to what is contained in “these leveraged synthetic structures.”
Wood warns that US housing debt is “a deflationary disaster waiting to happen.”
CDOs sold to unwary investors
But credit risk is spread much wider than that. The core of the problem is that banks have been lending money on terms that make no sense, because they have no intention of retaining the loans on their balance sheets. They have been packaging them and selling off the packages to unwary investors.
The private equity boom has also been built on razor-thin credit spreads.
As investors become more cautious about buying into or holding such higher-default assets, “the risk will grow that hitherto easy access to cheap credit will be cut off” by investment banks – “to the chagrin of the world’s leveraged speculators.”
Wood reports that one product recently being marketed to high net worth investors employed 30 times leverage to offer a guaranteed annual return of 10 per cent.
That such a product could be sold “with a straight face, highlights the scale of the potential unwind if risk tolerance ends. It also underlines the fact that the rich, especially the asset-rich cash-poor rich, will be badly hurt in such an unwind.”
The booming private banking industry “has been encouraging investors globally in recent years to exploit cheap financing to capture seeming ‘guaranteed’ returns” and better income yields.
“The affluent have been doing it increasingly with leverage, either directly themselves or by investing in fund-of-funds or hedge funds which are themselves leveraged.”
Will the Fed come to the rescue?
However, the good news for investors is that “at the first sign of real financial distress in terms of rising credit spreads and falling share prices,” the Fed is likely to start cutting interest rates.
“If this view is wrong and the Fed continues to worry about inflation amid growing market panic about a perceived housing meltdown, then the short-term downside risk for Wall Street-correlated equities will be much greater.”
However, any such distress will represent a giant buying opportunity in equities, especially Asian shares, “for those with cash left to invest.”
By MartinSpringin On Target, a private newsletter on global strategy
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