Specialists are insisting that nothing’s wrong. But “there is a sense of crisis in the credit markets”, says Lex in the FT. Last week the turmoil in the subprime mortgage market crossed the Atlantic, with two UK-based hedge funds, Queen’s Walk and Caliber Global Investment, reporting large losses owing to mortgage-linked derivatives; the latter is to be wound down. This followed the near-collapse of two leveraged Bear Stearns hedge funds, one of which required the biggest bail-out since the rescue of LTCM in 1998. And now investors have grown cold on other forms of debt, raising fears of a global credit crunch.
The major worry is the market for collateralised debt obligations (CDOs), whereby subprime mortgage loans are packaged together with other assets and sold on. They consist of different sections based on risk and interest paid. The top tranches can receive top credit ratings (so institutional investors who aren’t allowed to buy low-rated debt can still snap up CDOs), even though many are ultimately backed by subprime loans. Lump together enough securities beneath the top tranche and the buffer is eventually deemed big enough to merit a top rating. Welcome to the “wacky world of modern financial engineering”, says Lex.
There is no active market for CDOs. They are valued with financial models, and as one analyst told The Sunday Times, “you can treat the model to the assumptions you want” and thus “lock in a very nice remuneration packet for yourself”. The only way to establish a market value is by selling them, which prompts other investors to revalue the securities. The losses at Bear Stearns have raised fears that “the CDO emperor” has no clothes, as the FT’s Gillian Tett puts it.
Merrill Lynch forced the markets to price CDOs when it sold off some of Bear Stearns’s; the top tranches fetched just 85% of face value and the auction was then called off. What’s more, debt ratings agencies failed to price CDOs accurately in the first place, says bond investor Bill Gross: they were bedazzled into awarding triple-A (the highest grade of debt) by the derivatives’ “make-up and six-inch hooker heels… many are not high-class assets”. Now Bloomberg reckons 65% of bonds in indices tracking subprime mortgage debt no longer meet the ratings criteria that were in place when they were sold, so agencies are masking mounting losses.
When they eventually downgrade, many investors would be forced to sell, rocking the $1trn CDO market. “You’ll see massive losses” from “banks, insurance companies and pension managers”, says Joshua Rosner of Graham Fisher & Co. The downward revaluation of mortgage-backed securities raises the spectre of “a mass of margin calls, asset seizures and fire sales”, making Bear Stearns’s problems look like “a walk in the park”, says Antony Currie on Breakingviews.
No wonder, then, that jitters over the mortgage market have led to “a global retreat from risk in credit markets”, says Francesco Guerrera in the FT. For the first time in years, investors have balked at risky bonds. Only $3bn of the $20bn in junk paper planned for issue last week was sold; companies ranging from steel group Arcelor Mittal to US retailer
Dollar General have had to shelve their debt offerings; and lenders are refusing “covenant-lite” deals for leveraged buyouts, says Ambrose Evans-Pritchard in The Daily Telegraph. The “window of cheap credit” is slamming shut for buyouts or companies trying to refinance. “This is how a credit crunch starts.”
“Confidence in cheap credit could have had its last call,” agrees Tom Stevenson, also in The Daily Telegraph. As credit spreads widen and central banks hike rates further to combat inflation, corporate earnings and the “arithmetic of the takeover boom” that have underpinned equity markets are under threat. According to Albert Edwards of Dresdner Kleinwort, “all investment portfolios will be shredded to ribbons. This is the big one.”