Indiscriminate, Irrational & Illiquid Capital Markets

September 2007 Dr. Hans Black & Salvatore Ruscitti

For years, we at Interinvest have warned about the systemic threats posed by the vast proliferation of increasingly complex financial instruments and their fostering of excessive speculation and debt leverage. Over the past three years, in a series of articles, we have focused our clients on the exponential growth of derivatives. In recent months, we have expressed deep concern over the potential for the U.S. housing slowdown to spill over into other parts of the economy. The financial market events of the past two months are a stern reminder of how a global financial system rendered increasingly interconnected by exotic financial instruments can take a crisis such as the sub-prime lending debacle and spread risk to various associated and previously considered safe havens in the credit markets.

Financial markets received their first taste of this contagion earlier this year when in late February the growing sub-prime mortgage defaults forced a number of Wall Street firms to stop underwriting several large sub-prime lenders. Important international banks, such as HSBC, also began to warn of large losses in their mortgage portfolios. Investment dealers began demanding that these lenders buy back their poorly performing mortgage loans. The resulting retraction of liquidity pushed many sub-prime mortgage lenders into bankruptcy in the early spring, thus wiping out their public shareholders. As these events unfolded, investors began discovering that poor-performing mortgage loans collateralized a veritable alphabet soup of securities, some of which are known by their now infamous acronyms (i.e. C.D.O. - Collateralized Debt Obligation; C.L.O. - Collateralized Loan Obligation; R.M.B.S. - Residential Mortgage Backed Securities; etc.). We commented at length in late June on the dangers we saw with these instruments and, particularly, with the ratings that were attached to them. These collateralized debt and mortgage loan obligations populated a large number of hedge fund portfolios, most notably two funds sponsored by Bear Stearns & Company. Margin calls on bad mortgage bets led to losses of as much as $1.6 billion and the subsequent closure of two Bear Stearns funds.

After several quiet weeks, things began to unravel once again in late July with the news that the subprime mortgage default issues were spreading globally. Banks and hedge funds in Canada and in countries as far away as Australia and Germany began reporting problems financing their operations. The next big shock was disclosed on August 9th as the French banking giant B.N.P. Paribas S.A. suspended redemptions in three of its short-term investment funds after markets for debt securities linked both directly and indirectly to sub-prime mortgages virtually seized up, thus making it impossible to value their holdings. In addition, it can be argued that the large French bank acted quite correctly as daily redemption features to their funds forced them into selling those assets that were still liquid while keeping those assets where for all practical purposes no market was active. In short, older, loyal shareholders of these short-term funds were being punished at the cost of those who wanted to get out immediately. No wonder, then, that within a few days the European central bank decided to intervene massively and quell a situation that could have turned very ugly, very quickly.

All of these events in early August also saw a new drama begin to play out, this time in the commercial paper market, a key vehicle for funding the day-to-day operations of several large companies. Specifically, problems started to reveal themselves in the asset-backed commercial paper (A.B.C.P.) market. Banks typically dominate this market, but in recent years several structured finance firms have emerged as key players, repackaging home and auto loans and selling them as short-term instruments to investors. Since A.B.C.P. earns higher rates than government treasury bills, it became a popular place for firms to park some of their short-term cash. However, when the largest Canadian seller of non-bank A.B.C.P., Coventree Inc., disclosed a few weeks ago that some of the assets backing its commercial paper were under-performing subprime U.S. mortgages, it set off a violent chain reaction of events in the credit markets. Demand for A.B.C.P. literally dried up overnight and threatened to spill over into the much larger global commercial paper market. After domestic banks refused to refinance Coventree, an organized bailout by the largest pension fund in Canada and some major global banks prevented a much larger crisis from unfolding. In the meantime, as Canadians were dealing with their very new crisis, Europeans were once again exposed to additional difficulties within the German banking system.

As these events were unfolding, however, a wave of indiscriminate panic selling washed over the credit markets. A buying strike ensued in most credit securities not backed by government or governmentchartered companies. Instead, investors piled massively into government treasury bills. As a result, yields on treasury bills collapsed, underscoring the refusal of investors to recycle money back into the economy and a near complete aversion to risk. The seriousness of the credit market paralysis compelled a number of global central banks to inject billions of dollars of liquidity into their banking systems. Additionally, the Federal Reserve lowered its discount rate and tilted its bias away from worrying about inflation and towards concerns over economic growth, hence hinting that it may have to lower its benchmark policy rate in the weeks ahead. Meanwhile, the dramatic spike in the equity volatility that accompanied the seizure in global credit markets claimed more hedge fund victims. A number of market- neutral quantitative hedge funds, implementing mean reversion trades with large leveraged books, suffered significant losses when asset price movements did not conform to risk models.

Concerted global central bank liquidity injections appear to have restored some semblance of calm to the markets. However, the non-bank structured finance market has virtually shut down, thus denying a number of companies access to financing. According to the latest figures from the Federal Reserve, the total amount of commercial paper outstanding has fallen sharply in the past few weeks. Clarity regarding exposure to under-performing loans remains elusive. Everyday, it seems, new disclosures of losses arise from both financial and non-financial companies. Even Bank of America’s $2 billion rescue of U.S. mortgage lending giant Countrywide Financial looks tenuous.

As we are working on this article, the head of the Federal Reserve board of the United States, Ben Bernanke, is speaking in Jackson Hole, Wyoming, to the annual Kansas City Fed Think Tank on monetary policy. Although we will have to digest further the implications in the next few weeks, it is very clear from our early review of his comments that Mr. Bernanke and the current Federal Reserve Bank do not intend to simply bail out the irresponsible actions of previous lenders and borrowers. Specifically, Mr. Bernanke has told those listening “that it is not the Fed’s responsibility to protect lenders and investors from the consequences of their decisions.” By signaling these comments to the markets, the Fed is probably ushering in a new era and, certainly, a large departure from the practices of Mr. Greenspan in years past. It is important to remember that a much smaller crisis, namely the collapse of Long Term Capital Management in 1998, led to an immediate change in Fed policy with the consequences of an even larger bubble forming in many financial markets during 1999. In addition, many have alluded that Mr. Greenspan’s insistence of keeping interest rates extremely low for a long period of time in 2002 and 2003 led, in good part, to the bubble we have seen in the real estate market in recent years. We sense that the new Fed of Mr. Bernanke somehow wishes to depart from the actions of his predecessor. It is also important, in our opinion, that within hours of Mr. Bernanke’s speech, President Bush, in an attempt to alleviate concerns regarding the sub-prime mortgage default saga, has reiterated “that it is not the role of the U.S. government to bail out speculators.” Unfortunately, in recent years markets have shown that too often speculators have indeed been bailed out, particularly when they were very large and deemed too important to fail. It will be important to see what ramifications these new policies will have on the markets.

Credit markets will get their real test later this autumn when the corporate debt issuance calendar becomes seasonally more active. For starters, there is a large pipeline of deals expected to hit the market thanks to the granting of many bridge loans to finance the recent flurry of L.B.O. activity. In addition, some 50% of the nearly $1 trillion asset-backed commercial paper market comes due in the next sixty to ninety days. It is far from certain that buyers will step-up and given Mr. Bernanke’s shifting policy, we are likely to descend deeper into this credit crisis.

Irrespective of the outcome, the recalibration of global risk appetites will almost surely exact a toll on economic growth. The credit boom that created an unprecedented number of U.S. homeowners and financed a record amount of takeover activity appears to be fading fast. The inescapable irony of recent events is that one of the greatest financial innovations of the past two decades, loan securitization, originally designed to distribute risk rationally and create deeper more orderly capital markets, may have unwittingly multiplied risk. Unwinding the resulting complex web of counter-parties and their egregious lending practices may imply more indiscriminate, irrational and illiquid capital market behavior in the months ahead.