Listen to this article
Credit markets are in turmoil. Christian Stracke, analyst with CreditSights, answers your questions on what it all means.
What will be the financial and economic effects on the various emerging market regions, and please identify the critical factors to evaluate.
M J DeLeon
Christian Stracke: The major emerging markets economies have been swept up in the same global liquidity glut that helped to pump up the subprime sector, Spanish real estate, commodities, etc. Fortunately, most EM governments have been avoiding a lot of borrowing from foreign investors (with a few important exceptions, of course), so we don’t have to worry as much about a classic debt crisis the way investors had to deal with the debt crisis of the 1980s, the Tequila crisis in 1994-95, the Russia crisis of 1998, and most recently the Argentina default.
That’s not to say, though, that foreigners are not still exposed to emerging markets, nor are EM financial markets not exposed to capital flight. Portfolio flows into some EM economies, especially Turkey, South Africa, Indonesia, India, and Thailand have all recovered sharply in recent years. To make matters worse, foreign bank lending to emerging markets has almost returned to its previous highs in early 1997, just before the Asia crisis. The factors – concentration of portfolio flows and foreign bank lending, together with dependence on commodities export revenue – will be what to watch as EM grapples with the US subprime crisis.
I’m looking at the iTraxx benchmark indices for indications of credit concerns in the European markets, we’ve seen some widening today and this has had an impact on the euro and US dollar. My question is, how would a credit crunch in the US and Europe affect short term and medium term liquidity in the major currency crosses, namely euro/dollar, Swiss Franc/dollar, dollar/yen and pound/dollar? Does this have an impact on Asian economies?
Syed Sharaf, Dubai
Christian Stracke: Syed, yes, there’s another wave of turmoil in the CDS indices again today, and again most equities markets are shrugging it off. In the short term, the dollar is going to have a difficult time avoiding further weakness on the back of ABS selling. ABS, with subprime RMBS as a leading ingredient, was one of the main vehicles of choice for all the foreign investors who financed the US current account deficit over the years. We are not part of the camp calling for a further maxi-depreciation of the dollar, especially because the depreciation over the last five and a half years has already been fairly extreme. But in the context of foreign investors growing less willing to put money to work in the US ABS market, the dollar depreciation probably still has some way to go before it’s over, especially against the European currencies.
Given all the bad press the equity tranches of CDOs are getting, is it not reasonable to suggest that the outlook of CLO equity tranches is not gloom and doom provided we get a generalised widening in credit spreads without a spike in defaults in leveraged loans?
Daniel Pun, Hong Kong
Christian Stracke: Daniel, the market perception of equity tranches in any market (be it CDO or CLO) is currently that many are toxic waste. You are correct in your assertion that a widening of spreads with a lack of defaults in the underlying does not necessarily hurt the return of the equity tranches, however it is the mark-to-market and mark-to-model volatility of those tranches (which can be difficult to value) which cause the bad reputation. Given a lack of defaults, the instruments should perform fine if one can survive the P&L volatility of the tranches.
You’ve also hit upon the dilemma of the buy-and-hold investor who operates in a mark-to-market world. This investor faces near-zero liquidity in the lower tranches and equity piece, an inability to mark the asset any way other than down, but the lingering potential for long-term upside if the models hold true in terms of defaults and deal economics. That gets back to avoiding any major capital unwinds by other investors in the same ABS deal that would put pressure on where investments have been marked to market and creates a potential problem with the auditors. It is almost like a work-out instrument where you are waiting to exit value to be determined. On top of that, many will face ongoing pressure from clients and investors who are always looking for updates on high risk positions with static marks.
Who is going to take advantage of credit crunch arising from subprime mortgage crisis? Under current circumstances do private equity funds have enough appetite to appreciate cheaper acquisition price for NPL in the secondary market, or even those financial institutions in turmoil? Who are the most likely players and targets? When would be the hottest time for the distress assets investment in this context?
Michio Suginoo, Tokyo Japan
Christian Stracke: This is probably one of the most interesting questions right now: who will clean up this mess and make a killing? The big problem is that nobody has a good sense for where prices will level off, and how long it will take to get there. In the 10 years from the end of 1996 to the end of 2006, house prices on the Pacific coast of the US tripled. Given that kind of price appreciation, price declines of 40 per cent, especially in the red-hot subsectors where so much of the subprime boom was concentrated, are by no means out of the question. Meanwhile, with so many questions out there about the reliability of ratings on RMBS and CDOs that hold RMBS, it will take some time for investors to figure out what the true value of the various ABS and CDO tranches should be. The sell-off will likely overshoot, and many investors will be kicking themselves for not having bought at the lows, but that is simply the nature of asset bubbles popping.
I am about to sell my house. Do I need to hurry as interest rates are about to sky rocket?
Reba Brown Augusta, USA
Christian Stracke: Mrs Brown, I would say the real risks right now are probably more linked to saturated housing markets rather than interest rate risk. Thirty-year fixed rates in the US have been trading sideways for the last few weeks, and it would probably take a big jump in inflation to push rates a lot higher. Inflation expectations are very well controlled right now, though, with the difference between 10-year US Treasury yields and 10-year inflation-linked TIPS approaching one of its lowest levels ever. The Fed should remain vigilant about inflation, but the market at least is signalling that inflation should not be much of a risk going forward.
I just wonder about what is the cause of this subprime mortgage problem?
Christian Stracke: Enkhtaivan, I’d say it all originated with a global imbalance between the supply of credit and the demand for credit. Global Central Bank let monetary policy move to a nearly unprecedented accommodative stance, pumping money into the system. At the same time, corporates, the traditional mainstays in terms of borrowing funds to invest, moved to a defensive stance, having grown much more conservative in the wake of the Enron and WorldCom fiascos. Finally, the major developed countries began to gain a measure of fiscal discipline, with budget deficits shrinking, which further reduced the demand for credit on a global basis. That imbalance between investors flush with cash and the traditional borrowers not really needing or wanting that cash meant that investors had to look for new markets to invest in. As the ABS market had been taking off and coming into the mainstream, a natural target was the subprime borrower - borrowers who in the past had wanted to borrow but who had been locked out of credit markets. Eager lenders met eager borrowers, with the mortgage originators, ABS underwriters, and credit ratings agencies playing the role of matchmaker, and the subprime boom was born.
In your view, can the Credit Derivatives such as the Collateralized Debt Obligations (CDO), Constant Proportion Debt Obligations (CPDO); and investment protection mechanisms such as the Synthetic Collateralized Debt Obligations (SCDO), Credit Default Swaps (CDS), Credit Default Swap Index (CDSI), Loan only Credit Default Swaps (LCDS), Credit Default Swaps of ABS (ABCDS), Variance Swaps (VS), Constant Proportion Portfolio Insurance (CPPI), Contracts for Difference (CFD) contribute to the liquidity of capital markets? What is the underlying mechanism of this process?
Viktor O. Ledenyov, Ukraine
Christian Stracke: We do believe that the recent batch of innovations within the credit markets does indeed increase the liquidity of those markets, especially at the single name (non-tranched) level. Regardless of the innovation, the simplest mechanisms to keep your eye on is the fact that these new products 1) create additional supply and demand for credit market risk via repackaging and tailoring of risks and 2) provide a market that did not easily exist previously - the ability to easily short credit. The basic tool of all of these innovations with respect to the corporate markets is the credit default swap (CDS) market. This tool has allowed market participants to short risk where a short position was not easily employed before, provided a fungible and standardized form of corporate credit, and has insulated credit from major instrument specific attributes such as rate risk and covenant protections. As such, corporate credit has become easier to trade and has attracted market participants who would not previously been involved in credit. This increased volume should drive down bid/offer spreads and illiquidity premia in credit, making the capital markets more liquid overall.
A few days ago the Fed said that it does not have sufficient supervisory power over the institutions that have given rise to the excruciating problems in the subprime loans market. Would you agree with the view that the regulatory and supervisory authority in the US has indeed failed in its duty to ensure prudence in the credit market?
R. Basant Roi Mauritius, Indian Ocean
Christian Stracke: We would agree the regulatory authorities have come up short on many fronts, but we would also add the regulators seldom agree on who has what responsibility. The political impulses ahead of an election year seldom zero in on any arcane regulatory process and tend to go for maximum headline value, so it is difficult to gauge where it goes from here. The first major round of hearings of the Senate Banking Committee under Senator Dodd back in March took aim at the failure of the various regulatory bodies and their unwillingness or their perceived (or real) inability to take action. The criticism of their apparent lack of focus and lack of understanding of their role was harsh as was the fact that they had not put their hand up when problems were clearly of the sort they should have been expecting when excess takes hold. The regulators were the main whipping boys day one and that cut across the Fed, the Comptroller of the Currency, the Office of Thrift Supervision, and the FDIC. Of course that was before Washington shifted back to those they really want to target for political value, which is Wall Street, and to a lesser extent the Rating Agencies.
The problem with regulators saying they need more power and the risk of aggressive political grandstanding gets back to what action will be taken and how much political wind blows into that process. That process too often targets Wall Street, too often has a chilling impact on the market mechanism, and the impact ends up with less liquidity, inflated price action, and even more extreme pain than what otherwise might have been felt. It does not seem that long ago that the forced liquidation of thrifts to close out the 80’s high yield boom generated nightmarish losses. That told a clear story of how regulatory action can make the cure worse than the disease-for all investors from the banks to the pension funds and from institutional to retail.
We tend to be more sceptical than cynical (at least in our view) around what Washington brings to this process. The regulators should be armed, but the cleaning up the process seldom gets the political value of throwing a wider net over the street, so it tends to miss the mark and just prompt liquidity to pull back. It is far too early to tell what comes out of this in terms of specific new legislation.
What is a strategic outlook for the microfinance development in emerging markets in short and long terms perspective? Do you agree with the statement that the emerging markets, which are among the best performing investment asset classes at this time period, will continue to be a source of stability, but not a source of systemic risk in process of economic globalisation?
Viktor O. Ledenyov, Ukraine
Christian Stracke: Viktor - It’s our view that emerging markets will have a difficult time enjoying stability if the global financial markets are in turmoil. This would be especially true if financial turmoil breeds generalised economic weakness, which would probably hit commodities prices and hurt all of the EM commodities exporters. We’re still a long way from that scenario, but we see no reason for the emerging markets to be more resilient than the global economy as a whole.
If, as seems likely, the subprime debacle discredits the credit ratings process for collateralised debt obligations, isn’t the liquidity provided to other markets, eg leveraged loans, going to be permanently impaired? And won’t this eventually take the “bid premium” out of equity markets? And thank you for such good work on the frailties of the ratings process.
Henry Maxey, London
Christian Stracke: Henry - It is natural to assume that if the methodology is discredited within one asset class, then it is likely to be incorrect in another, but we feel that as much as no single methodology would be completely correct, the market undulations we are currently experiencing will have different effects other than permanent impairment.
We see the current volatility as having the effect of 1) making market participants more acutely aware of the effects of miscellaneous assumptions with structured products across asset classes and 2) causing the underlying assets to not trade at such a premium as was previously the case. In short, a repricing of risk across all sectors and asset classes that are a part of the structured products universe. This repricing of credit risk, could, in turn, cause the leveraging events currently prevalent in the equity markets to subside somewhat, but we would point out that we are still at long cycle tight ranges for credit across the board and that the movements needed to completely dissipate this equity bid are likely quite large.
With spreads moving out strongly what is happening to those CPDO products which were launched last year?
Christian Stracke: By our calculations, the net asset value of a CPDO that launched at the roll of Series 7 CDX / Series 6 iTraxx in September 2006 (when the first deals were emerging) will be roughly 96 per cent of the par invested. This assumes the instrument was launched using maximum leverage, which for those initial deals was 15 times, and a leverage multiplier - the Constant Proportion - of three times.
We have heard that some of these early deals are being quoted even lower than this. In our view this highlights one of the major drawbacks to structured products - the speed with which liquidity can dry up during periods of stress. This can lead to jumps in price that are more reflective of dealers protecting their balance sheets than underlying fundamentals.
Mr Stracke, I am very confused by this whole subprime ordeal as well as the proliferation of credit derivatives, and how all this is connected. Could you please explain in laymen’s terms: What exactly was the subprime collapse, why it happened and what this has to do with credit derivatives - in a nutshell! That would be very helpful. Thanks.
Christian Stracke: Great question, we probably should have answered this one first! Very simply, investors over the last few years have been looking for places to put money to work. Corporates haven’t been borrowing, and even governments have enjoyed improving budget balances and have had to borrow less. Forced to find a place to put their money to work, investors began to look to subprime borrowers - the individuals with either low income or bad credit or both - as a potential investment option. Banks would provide the cash for mortgage loans to subprime borrowers, and then they would bundle those loans up into one big package, sometimes called a pool, and then sell securities whose value was linked to the performance of the pool of mortgages. Investors could buy the securities and were effectively lending money to the subprime borrowers, with the banks serving as the middlemen.
The collapse has been due to something very simple: people lent money to borrowers who couldn’t pay it back. Now the process is beginning to snowball; subprime borrowers are defaulting, which puts homes on the market for a forced sale, which drags prices down, which makes it more difficult for other subprime borrowers to refinance their mortgages into loans with better terms, which then causes more defaults.
Mr Stracke, would you be able to 1) elaborate on long term implications of subprime lending on the US economy and 2) its impact on India in the short term scenario and 3) is there a way of hedging that risk? Warm Regards.
Rohan Pai, Mumbai, India
Christian Stracke: On the impact on India, we think the subprime crisis should have an only minimal direct impact on India’s economy. Indian financial markets could be a different story, however, if the subprime meltdown accelerates and drives risk aversion much higher.
What sort of impact would government intervention by insisting on workouts for mortgage holders in arrears, new regulations on lending, etc., have on mortgage backed securities?
Marc Safman, Long Island City NY
Christian Stracke: It is theoretically possible that government intervention could bail out some homeowners close to default - and the holders of the RMBS linked to their mortgages - but such a move would inevitably create a new layer of moral hazard in the market. If the government is going to force mortgage servicers to modify the terms of the loans in order to keep homeowners out of foreclosure, what incentive would there be to remain current on a mortgage? And what would that mean for credit card borrowers or those with auto loans?
To what extent the subprime mortgage crisis will affect the way rating agencies assign best AAA ratings to asset backed securities?
Macro, Auckland New Zealand
Christian Stracke: Everyone involved in the ABS and CDO space is going to have to reassess the meaning of a AAA rating on a structured product. We know what it means to be AAA-rated as a sovereign or a corporate: it means you have an extremely low chance of defaulting, and that there is generally a low probability of even a downgrade. We have almost a century of experience with issuers and credit ratings to use to support this. In the structured product world, however, we now have to assume that the AAA ratings - and perhaps all the ratings - are much less reliable than AAA ratings on governments and corporates.
Speaking as an investor in the USA - and also a home owner who recently sold his house, I can tell you that the housing market here is bad and getting worse. It is generally worse than the statistics that are discussed on Wall Street on a weekly basis. By no means have we touched the bottom. Things are particularly bad in Florida, where everyone is in agreement that the local economy is already entering a recession (depression). So there is no question in my mind that the impact on the US credit markets will be big. My question to you is - how much transference of this problem do you see to Europe and Asia? How much does this become a global problem? Thanks.
Christian Stracke: Pete, very good point about the carnage still going on, especially in certain regions. This is a critical point, because all too often the initial credit ratings on a lot of residential MBS (or RMBS) looked at national housing market patterns rather than region-specific trends. It may be that some housing markets are holding up well right now, but the subprime loans that got stuffed into RMBS were concentrated in the areas that are now suffering the most damage, especially California and Florida. It doesn’t really matter to an RMBS bondholder if the housing market in Seattle is strong, it’s the previously red-hot markets that matter, because that’s where the loans were originated to get put into RMBS.
On what this could mean for other markets, there has been far less RMBS issuance outside of the US, especially subprime RMBS. But issuance has been heating up fast in a few markets, especially the UK and Spain. Spain is already beginning to come under stress, and the UK RMBS market could follow, especially if monetary policy continues to tighten in the UK. I think the most important point is not that the hot housing markets outside of the US could be in danger, but that the US experience shows that the models used to build RMBS credit ratings, whether in the US or elsewhere, are subject to some serious questions.
What do you see as the likely implications of US sub-prime turmoil for investors’ appetite for mortgage risk from Latin America and, by extension, for the rapidly developing MBS markets of Mexico and Brazil?
Stuart Allen, Miami
Christian Stracke: Hi Stuart, so far emerging markets have managed to avoid any serious panic selling on the back of the subprime crisis, but if the sell-off in the credit markets continues I think it will be very difficult for EM to avoid further pain. On EM mortgage-backed securities (MBS), it may be that in the short term the mortgage markets of Mexico, Brazil, and other countries should be relatively uncorrelated to the US housing market, but demand for MBS, especially exotic MBS, may get hit by general risk aversion in the sector.
The problem is especially acute when you consider that much of the concern on US subprime MBS market right now stems from doubts about the accuracy of the ratings of the MBS paper. Given that the agencies had even less historical information about mortgage performance in places like Mexico and Brazil than they had for their US subprime ratings, one has to assume that the ratings of EM MBS are just as roblematic as those for US subprime.
Are there any additional concentration issues you are seeing related to subprime? It appears, with $1T in total paper out there, there must be some additional investor leverage towards this asset class. Should we start worrying about bans and insurance companies with respect to this re-pricing?
Eric Swearingen, Kansas City
Christian Stracke: Banks, insurance companies and brokers have already been repriced to some degree in relation to this move as investor’s paranoia has risen about potential hidden losses related to subprime loans at big banks and brokers’ outright residual/CDO holdings. Also, the slowdown in the mortgage markets combined with more home builder troubles and flattening-to-declining regional home prices (California, Florida, rust-belt Midwest, and parts of the Northeast) have contributed to fiercer headwinds in revenue outlooks for mortgage players in general.
Though most investors acknowledge the pass-through nature of the risk in subprime products to these institutions, fear is a great motivator and the lack of transparency on the degree of exposure, the potential for trading losses, the likely reduction in capital markets volumes and the potential risk of litigation have all weighed on spreads across the US finance sector. The finance sector is in the headlights for further selling related to additional ”risk” news and for some time we have been warning of the risks particularly to broker bond spreads of their activities in ”New Age Finance.” Nevertheless, the spread widening of the last week seems to be overdoing even our near-term concerns regarding New Age Finance and the over-concentration of leverage lending.
In 1998, a crisis in Emerging Markets and overleveraged hedge funds had a significant, but temporary, effect on most other asset classes. In 2001-02, the dot-com bubble, accounting scandals and fraud, terror and wars caused a much more severe credit crunch. Today we have a true crisis only in sub-prime rather than EM (thus far), but also several hedge funds going under, stretched valuations in EM equities (rather than the Nasdaq), and possibly some loss of faith in ratings (as opposed to accounting). Will contagion spread to credit and equities like in 2001-02, or does the current situation resemble 1998, with the non-mortgage world likely to recover the way the non-EM world did then? Or is neither historical analogy useful in predicting how things play out this time around?
David Nowakowski, New York
Christian Stracke: Both analogies are useful as they both offer examples of ways of the pattern of a bear market - though as you note the particulars of each are different. There are however, similarities to both. The 1998 LTCM crisis demonstrated the exposure of the market to leverage and counterparty risk. The 2002 example honed in on the effect on risk appetite if one of the components of the underlying pricing of risk was called into question.
To date the subprime crisis has been far more limited - but with credit spreads just as tight as they were in 1998, leverage even more widespread and the technical base heavily dependent on the bid from the structured market, which in turn is heavily dependent on the credit ratings of the deals, the transmission mechanisms exist for the trouble to become far more widespread. Remember that Russia had only $136bn in public external debt at the start of 1998, and much of that avoided default. Russia’s external debt was a miniscule portion of total global financial markets, but the concentration of leverage in Russia and related EM assets magnified the pain.
Credit fundamentals are currently strong, default rates are low, and the growth outlook is picking up. All of this augurs well for the market to cope with the negatives posed by subprime. But both the equity and credit markets were priced for perfection up until very recently, the loss of risk appetite that has been sparked by the subprime crisis is eroding the technical base, financing for LBOs is becoming more difficult (which will undermine the equity market strength) and the market is highly sensitized to potential further losses at hedge funds.
Counterparty risk and a widespread spate of structured products downgrades (possible if CDO rating methodology is called into question next) will likely be the main forms of contagion. One final point on the relevance of the 1998 and 2001-02 crises is that we are currently in untested waters regarding ABS and CDOs. These are very liquid securities which generally attract very high amounts of leverage, and their dependence on credit ratings at a time when the methodology behind ABS and CDO ratings is being question adds another layer of complexity. In 1998, there were at least liquid proxies you could hedge against your Russia risk (Brazil, Mexico, etc.) with a generally liquid repo market to put on shorts. The same can be said for the credit crises in 2001-02. There is no liquid market for hedging exposure to ABS and CDOs of ABS, however (the ABX index gets a lot of headlines but is not very liquid), so investors cannot efficiently protect themselves against a worst-case scenario.
As an investor who has accounts in a large European bank, should one avoid investing in the banks own products and funds? Do the banks try to steer account holders into investing in their own products?
Eileen V Pearson de Brito, Chile
Christian Stracke: Eileen, banks may try to steer customers into their own products and funds, and regulations vary across Europe as to how they are allowed to do this and what disclosures they have to make around it. But their own funds are no more or less likely to have exposure to subprime than third-party funds, so if you are looking to avoid exposure, it is more important to check on a fund’s investment profile and objectives than its ownership links with a given bank.
Since the CDO market has shown resilience before (auto bond downgrades, Amaranth, etc), is this different? Much of the CDO market has MBS in the baskets; is this just a hiccup or will it flatten the growth?
Caleb Avery,San Francisco
Christian Stracke: As much as we hate to utilize the phrase ”this time it is different” we believe this current round of CDO woe is a bit different from the examples you give. Previously the volatility in the underlying assets caused volatility in the structured credit markets. Once the underlying volatility subsided, the movement of structured credit subsided too.
In the current case, however, the volatility of the underlying has caused not only structured product price movement, but a deeper examination by the markets of the methodology behind CDO ratings and pricing. We do not feel the structured product market is dead by any means, but rather that the market will view the instruments as having additional ratings volatility versus like-rated assets as well as a degree of price volatility commensurate with their levered nature.
We do feel that the trade that is blamed for bringing this vol to the market - subprime mortgages - will experience a negative growth rate for the medium term until the asset class provides a return high enough to entice investors to accept its risks. In short, we view the current situation as hiccup in the CDO markets large enough to cause the underlying assets to reprice risk and cause a short term decline in growth. Once again, growth in the asset class will resume once the assets have repriced to a degree commensurate with their risk and volatility of ratings.
Please indicate your view on what are the probable next stages in the subprime meltdown and its probable (initial) knock-on effects in the credit markets. Secondly, what might move the Fed to take their foot off the brake in order to relieve the squeeze?
Fergus Killoran, Barcelona
Christian Stracke: Much of the initial knock-on effect is already playing out, at least in the credit markets if not in equities. But the peculiarities of the asset-backed securities (ABS) market are making it difficult for this to unwind quickly. Most ABS, including most of the subprime MBS out there, does not really trade in a liquid secondary market, so it’s difficult to say what the true value of these securities are. That means that investors don’t have to aggressively mark down the value of their holdings. And if investors have used leverage to buy this subprime paper (which is generally the case), the banks providing the leverage don’t have to issue a wave of margin calls all at once.
When the deals begun to get downgraded and in some cases go into outright default, however, investors are going to have to own up to how much capital they have lost. This is one reason why hedge fund difficulties are only just now popping up, even though the erosion in subprime mortgages has been going on for seven to eight months already. So it could take a while longer for the full impact of the subprime crisis to be felt.
For the Fed, we think things would have to get far worse before the Fed begins to see a need for a bail-out of the financial markets. It is in danger of creating a moral hazard - in some ways it enabled this mess by keeping monetary policy too loose for too long, so now it cannot be seen to be holding the market’s hand now that the dangers of excess ending to weak borrowers are coming to light.
It seems that the problems in the subprime market are having an impact on attitude to risk in general. How do you think these problems will affect large leveraged yen carry trade positions, and if they do, is likely to cause global inflationary or deflationary pressure?
Brian Williams Hale, Cheshire
Christian Stracke: Brian - The yen carry trade only works if you expect low volatility in the yen going forward. With implied volatilities moving higher, the yen carry trade begins to look less and less like a sure bet, even with the spread between Japanese and other major country interest rates having widened. The yen carry trade will live for a while longer, but at some point volatility will show that these trades are not one-way bets.
I don’t think the unwind of the yen carry trade should be massively inflationary or deflationary, however; exchange rates should adjust without a big move in relative prices in most countries.
How significant will the subprime lending bust be for the economy over the next five-10 years? In 2010 in the US baby boomers are retiring. What role will globalisation play for college graduates with MBAs?
William H., Memphis TN US
Christian Stracke: William - I think a good outcome from the immediate crisis would at least be more rigour in documentation standards and due diligence, since the subprime asset class by itself does not have to be inherently as risky as it is in this current meltdown. The current worst of all worlds situation came out of the lack of discipline along the origination-to-packaging-to-rating-to-underwriting cycle that can be tied to a number of factors from fraud at the origination end by mortgage brokers to competitive pressures to generate profits and apparently lax rating agency standards that maximised the size of the higher rated tranches. After all, volume pays off. With the overlay of easy credit conditions, it fed the worst of all worlds. But hopefully markets will learn something from this, impose more discipline on structured lending, and that should get the US economy into better shape over the very long term. That’s not to say the economic shake-out can’t still be more painful, but it’s better that this happened now than if the excessive lending had continued even longer.
Another worry about the subprime crisis, though, is that we are midst of a major echo boom from the first baby boom, and there will be a very strong and growing base of demand for homes and apartments. Credit availability will be critical in making this a macroeconomic positive in the manner in which it is viewed in the automotive sector (e.g. the echo boom is among the various reasons why Toyota and Honda are growing their production capacity in the US). Consumers early in their career cycles will be very aggressive consumers, so the opportunities and risks there will be considerable in multiple credit markets. A precipitous pullback in mortgage credit due to risk aversion or excessive regulation could sidetrack a major positive economic variable in the years ahead.
If credit concerns are the biggest concern, why haven’t corporate or high yield spreads widened more? Why did default risk-free markets like Treasuries seemingly get hit more in May and June than corporates? We’re still well below Enron and LTCM spread levels. Follow-up: Another cause for the May-June price decline in default risk-free Treasuries occurred to me. Could troubled investors like the Bear Stearns hedge funds have sold highly liquid Treasuries to cover prime brokers’ collateral calls because they couldn’t sell riskier, less liquid assets? Thank you for informing FT readers!
Shawn McFarlane St. Paul, Minnesota, USA
Christian Stracke: Relatively healthy corporate balance sheets and very low corporate default rates (just 1.4 per cent over the last year on high-yield corporates) are a big part of the reason why corporate and high yield spreads haven’t widened more, but we wouldn’t want to minimise the widening that we’ve seen so far. If you look at credit default swaps (CDS), there has been a very sharp jump in spreads from all-time lows just two months ago, and that increase in spreads is continuing today.
Mr Stracke is an expert in the field, an analyst with CreditSights, a leading independent credit research firm. His analysis focuses on the macro drivers of credit markets such as liquidity, global monetary policy trends, trends in corporate borrowing, and the interplay between shifts in global fiscal balances and growth in official foreign exchange reserves. Mr Stracke also monitors the performances of emerging markets.
Prior to joining CreditSights in 2002, Mr Stracke was Head of Latin America Strategy at Commerzbank Securities and was in charge of sovereign credit analysis, fixed income relative value research, and credit derivatives strategy pertaining to Latin America. From 1998-2001, Christian also was the Latin America Local Markets Strategist at Deutsche Bank. CreditSights assesses the risk of corporate and sovereign debts and advises investors on market strategy and credit products. With more than 50 analysts, CreditSights has more than 700 institutional clients ranging from hedge funds to banks to multinational industrial companies.