Credit markets outlook

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Credit markets are in turmoil. Rising defaults on US subprime mortgages - home loans to borrowers with poor credit histories – have forced dozens of lenders to close, and caused market mayhem.

Gavan Nolan, research analyst at Markit Group, the independent data provider that supplies prices for the iTraxx credit index family, answered your questions in a live debate on Monday from 2pm BST.

How do you think commodities will be affected by the recent volatility in credit markets?

Gavan Nolan: The commodities markets tend to have little correlation with other asset classes, so in theory the volatility in credit shouldn’t have a meaningful effect. The supply/ demand imbalance due to the surging Chinese economy should ensure that prices in hard commodities are supported. It is also possible that gold and other precious metals could benefit from a flight to quality. A credit crunch could make capital investment more expensive and squeeze refining capacity .

Is the UK housing credit market any less vulnerable than the US?
David Immanuel, London

Gavan Nolan: I think the UK housing market is less vulnerable than the US. The sub-prime sector is still in its infancy in the UK, whereas sub-prime and ALT-A make up around 20 per cent of the total US mortgage market. It also doesn’t suffer from the oversupply of housing that some areas of the US suffer from (quite the contrary). Having said that, the UK, along with Spain, is one of the most highly stretched in Europe on affordability and income multiples.

The effects of rising interest rates haven’t fully emerged, and a rise to 6 per cent this year, as predicted by the futures market, would put house prices under serious pressure. It’s also worth pointing out that the London housing market is largely driven by foreign money and the affluence of financial workers. If the City entered a downturn, then the housing market could follow.

How likely is the credit market risk in the US likely to spread to Global equities and also to debt-based investments. In particular, do you think contagion will reach Asia-Pacific and Australasia?
Michael Walker, Auckland, New Zealand

Gavan Nolan: Equities have already been severely affected by problems in the credit markets. Volatility is at its highest level for some time, and was primarily stoked by the sub-prime crisis. This triggered a reappraisal of risk. This has a direct effect on equities through the appetite for Leveraged Buyouts. Private equity groups have helped fuel the rally in equities by borrowing huge sums to fund takeovers. However, a number of banks have been left with large leveraged loan positions on their balance sheets after they were unable to place the debt in the secondary markets. It will now be very difficult for private equity to finance buyouts on the favourable terms seen in the last couple of years.

The contagion will reach Asia and Australasia as financial markets are now highly interdependent. The effect on the yen carry trade could also be factor. Volatility in interest rates and exchange rates could make the trade less attractive and lead to outflows from countries with high rates, such as New Zealand.

With US mortgage resets having been only $197bn in the six month period ending June 30 2007, set to rise to $318bn in the six month period to December 2007, and, then rising further to a level of $511bn in the six month period to Jun 30 2008 - do you feel that the market has already adjusted sufficiently to take into account such a rapid escalation of future mortgage debt-servicing costs due to such future resets? Indeed have you factored this information into your analysis at Markit? Also - from your knowledge and experience what percentage of funds out there would you say have now truly marked to market - and how many instead still mark to model/formula?
Mike Small, Dubai

Gavan Nolan: Yes, I agree that the sheer volume of mortgage resets will have a major impact on spreads. The poor quality of the late 2005 and 2006 vintage will start to become clear in the coming months as foreclosures rise. Many investors are pinning their hopes on loan modifications. This has already started to happen. However, this could be problematic on a large scale.

Falling house prices could mean that it makes more sense for the lender to foreclose rapidly and cut their losses rather than modify the loan. We can expect more pain for sub-prime loan servicers and this likely to affect financial spreads across the board. Whether this affects the wider economy will depend on whether banks retrench and cause a genuine credit crunch. The effect on consumer spending from falling house prices will also be a major factor. However, research from the Bank of England shows that the correlation between house prices and consumer spending is not as strong as previously thought, at least in the UK.

On the percentage of funds marking-to-market, I think this is one of the most important questions at the moment. It is impossible to place a figure, but there are still significant amounts of funds marking-to-model. This will become more apparent when more hedge funds unwind. Many are still calculating their valuations for the second quarter, and having difficulty doing so, due to the illiquidity of much of their investments. Use of skilled third-party valuations specialists in now even more crucial, a fact highlighted by the FSA in its Financial Stability report.

There seems to have been a broad failure of the ratings companies in the US to properly downgrade assets (e.g. CDOs) based on home mortgages. Do you think this gap in credibility will continue? What needs to happen for people to get a clear re-assessment of financial risks for these investment vehicles?
Pete, California

Gavan Nolan: I agree that the ratings agencies credibility has taken a knock on CDOs. They belatedly took action some weeks ago and there is no doubt further downgrades to come. There now seems to be a clear distinction between a AAA rating on corporates/ sovereigns and a AAA rating on a structured security, i.e. one has credibility and the latter is now in question. I don’t think there is an easy answer to this. The rating agencies might have to completely reassess their models and try and stop arrangers from arbitraging their ratings.

Do you think the subprime/credit turbulence is likely to negatively affect the value of a US based bond fund that holds a lot of mortgage backed securities and AAA-BBB corporate bonds (70 per cent or so of holdings)? US Treasuries make up only about 10 per cent of the holdings of this mutual fund.
Bret Larimer, Denver, Colorado, US

Gavan Nolan: I don’t know the exact composition of your fund, but I would think itprobably already has been negatively affected by the current turbulence. The performance of the mortgage-backed securities would depend on the underlying collateral, but if it is AAA prime then should have held up relatively well. However, spreads on investment grade bonds have widened considerably in recent weeks, particularly in the financial sector. In fact, nearly all sectors have deteriorated, so performance on the fund might well have suffered.

The average banking stock is approximately at the level of mid 2002. Is there a buying opportunity here?
John Dewit, UK

Gavan Nolan: According to our data, the average single A financial credit is still some way off mid-2002 levels. I think the important fact is the dispersion within the sector. Broker-dealers such as Bear Stearns and Lehman have obviously widened considerably due to their direct exposure to US sub-prime. Deutsche Bank recently surprised some with their solid results. They were on the right-side of sub-prime, which shows that the effects of the contagion are unpredictable.

The sector will almost certainly face further volatility in the coming months with more bad news from sub-prime emerging. An escalation of hedge funds is also expected and this could hurt banks with prime brokerage businesses. IKB’s recent ABS losses also shows that risk is now dispersed throughout the financial system. Overall, the widening in some names could be an overshoot and it would probably be wise to steer clear of banks with significant - and known - ABS exposure.

How large is the CDO market? Can you summarise the profile of its investor base? What percentage of underlying assets are subprime RMBS?
Raymond Wong, Hong Kong

Gavan Nolan: The CDO investor base is largely determined by the rating of the tranche. Banks are the largest participants in AAA and AA tranches, with monoline insurers also very active. Further down the capital structure fast money investors are the main players. Hedge funds are the largest investors in equity tranches, or ”toxic waste” as they are sometimes known. Pension funds are also active.

In terms of total size it is difficult to come up with an accurate figure, but JPMorgan estimate that notionals for US mezzanine ABS CDOs and high grade ABS CDOs are $128bn so far this year. The total amount for this year is likely to be lower than $300bn in 2006. The proportion of ABS CDOs as a percentage of the total CDO universe is also likely to decline.

Could you please share your views on the outlook for the US subprime market and the enlarging spread yield these days?
William, Hong Kong

Gavan Nolan: The outlook for the US sub-prime market appears bleak. The ABX BBB- index, which reflects movements in sub-prime CDS of ABS, has plummetedin recent months and is now at a record low. Several lenders have filed for bankruptcy and Countrywide, the largest mortgage lender in the US, was forced to issue a statement confirming it had adequate liquidity. The unfortunate bullish investors in the sector, however, are unlikely to see things improve this year.

The loans originated in late 2005 and 2006 were of particularly bad quality. Many are Adjustable Rate Mortgages (ARM) and are due to reset this year. A significant amount of borrowers could only afford the mortgages on the low fixed rate given for the initial two years. The rise in rates since then will mean that they will face considerably higher repayments. Foreclosures are already high and are likely to go even higher as homeowners are hit by the double whammy of higher rates and falling house prices. Indeed, there are already signs that the downturn is going beyond subprime and Alt-A and affecting better quality borrowers.

Is the current turbulence just a market over reaction or is it the beginning of a bear market? What will the effect of the current market turbulence have on corporate bonds?
Peter Koh, Italy

Gavan Nolan: The current market turbulence was triggered by the sub-prime crisis in the US. This led to a broader repricing of risk as investors reassessed the LBO boom of recent years. Liquidity has been readily available and the concomitant growth of the leveraged loan market fuelled the private equity sector and led to takeover structures becoming more and more risky. I think the large covenant-lite loans and PIK bonds are unlikely to return on any significant scale in the foreseeable future. Whether this is a true bear market is another matter.

Fundamentals are still relatively strong and corporate balance sheets are robust compared to the 2001/2002 downturn. It will depend on whether the travails of the financial sector spill over into the real economy. This could happen in two ways. The losses in sub-prime and the overhang from a huge pipeline of LBOs could cause a real credit crunch. We’re not quite there yet, as credit is being denied to largely risky borrowers. But the recent margin calls on mortgage lenders with prime borrowers suggest this could escalate. The other mechanism is the effect on household spending. Consumers have been fairly resilient in the face of falling house prices but this may not continue. The construction sector will also suffer as homebuilders run into further difficulties.

Most of the headlines regarding the credit markets have focused on the iTraxx and CDX indices, and rightly so. They are the most efficient vehicles for taking short positions and hence should reflect the scale of the correction. However, the fact that the investment grade indices have widened more than the high-yield suggests that much of the movement is driven by technical hedging activity. Corporate bonds have widened but not as much as CDS. This partly reflects the relative ease of going short via CDS as compared to bonds. The issuance of bonds at the moment is difficult due to the hostile debt conditions, and a number of high-yield offers have already been pulled. Issuers are likely to find the market unreceptive to risky structures.

Do you believe that the introduction of new governmental policies and innovative conceptual ideas in the field of mortgage re-financing can help us to avoid the spread of existing American problems in credit markets on the global scale? Could you please let us know your point of view on the possible remedy to solve the volatility related crisis in capital markets?
Viktor O. Ledenyov, Ukraine

Gavan Nolan: I generally think governments should ony interfere in markets when it is absolutely necessary. A prime example was the US savings and loans crisis of the 1980s. The scale of the losses (estimated at $150bn) and the obvious threat to the real economy necessitated government action. I don’t think the current sub-prime problems are near that level. In any case, coordinated supra-national state intervention would be very difficult from a practical perspective given the different structures of mortgage markets across the globe and the political obstacles.

I’m of the opinion that the financial markets are more than capable of managing this risk effectively. The advent of structured credit (CDOs, etc.) has helped diversify credit exposure geographically and across different classes of investors. Having said that, the losses suffered by IKB recently show that market participants need to have adequate risk management and product control infrastructures. National regulators, especially in some of the smaller, less mature countries, need to be aware of the pitfalls of investors becoming involved in financial products that require sophisticated understanding.


Mr Nolan is responsible for producing commentary and analysis on the credit markets. Having joined Markit in 2001, Mr Nolan has been involved in the company’s development from a start-up to a leading derivatives data and valuations provider. Prior to this, he worked at JPMorgan in interest rate markets.

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