Cracks start to appear in credit pipe

Against the expectations that many had at the beginning of this year, this is a very happy bonus season from one end of the global street to the other. Whatever the real source of excess global liquidity – I think it’s extraterrestrials unable to find sufficient uses for their cash, since even the Chinese can’t be saving that much – it has led to some fat cheques being written by the compensation committees at banks and dealers.

Will it turn out to be the last such season for a while? It could be. I think it may be the time to sell the broker dealers, either as individual shares – though I do not know who buys those any more – or as indices.

Two words you have not heard for a while, save in boring central bank seminars: systemic risk. A couple of weeks ago, there was an indication that it was back. The dollar interest rate 10-year swaps spread widened out by 2.5 basis points on December 7. That may not sound like much but in what has been a very complacent market for the past year it was a five standard deviation daily move, and it tells us that there could be trouble in paradise.

The dollar interest rate swap market, which you probably do not spend much time thinking about, had, as of June, about $65,000bn in notional outstanding value, or something like five times the US gross domestic product. It is big, invisible plumbing and, like water mains, it is of little interest most of the time. Until, of course, there is a gurgling and nothing comes out of the pipe. To use analogies from the more visible markets, a five standard deviation move in the Dow Jones Industrial Average would be a decline of 350 basis points, or a 40-point drop in the S&P 500. That would have got your attention.

Now you would expect that sort of move following, say, the start of a war in some place with oil, or another visible macro event, but there were no headlines like that. “We were sitting around, scratching our heads, wondering what the market was thinking,” says a credit strategist at a global bank. As Bank of America’s credit desk noted: “The usual suspect, mortgage convexity hedging, appeared an unlikely candidate as there was little movement in interest rates on Thursday (December 7).” There was one event out there: the closure of Ownit Mortgage Solutions, which called itself one of the 15 top sub-prime mortgage lenders.

Companies such as Ownit fail all the time, in every part of the business cycle, with few ripples beyond sad gatherings in the bar in the nearest mall. In this case, though, says Jay Diamond of Annaly Mortgage Management: “Ownit may have been the canary in the coal mine.”

When mortgages, or other debt instruments, are chopped up for securitisation, the less risky pieces are packaged up for insurance companies, pension funds, central banks and other conservative investors. The more risky slices may go to high-yield mutual funds and people who think they are sophisticated investors.

The interesting part is what happens to the “residual risk”, “first loss” or “equity” slices. Those go either to hedge funds or are retained by the dealers or banks who package the securitisations. Those dealers and banks, not the public, are the participants in the interest rate swaps market. And just as their managers were calling happy staffers into meetings to discuss the size of year-end bonuses, the credit market was, in effect, downgrading their creditworthiness in that five standard deviation move.

How much residual risk is on the books of the dealers? “That is the question,” agrees Mr Diamond. “The answer would tell you what systemic risk is posed by the sub-prime mortgage market.”

Since the financial crises of the 1970s and 1980s, central bankers have looked to hedge funds to assume the risks that could lead to banking system failure if they were to be concentrated in big institutions. It was not a bad strategy – why shouldn’t the rich people who own hedge funds, and can afford the losses, take the risks? That way, depositors and taxpayers are not at risk. But in recent years, risks have migrated back to the dealers and banks, as the profitability of the big institutions’ core businesses has thinned. Among those risks is the risk of write-offs of residual risk portfolios.

“The key question,” says a banker, “is at what price the residual risk is held on the dealers’ books. The 5 per cent residual piece of a sub-prime mortgage securitisation might be written down to zero. That would be the conservative approach.”

However, the income from that written down asset is still counted when rating agencies, and swaps market counterparties, assess the creditworthiness of a bank or dealer. In other words, it may have disappeared from the asset side of the balance sheet but it remains on the profit and loss statement. On December 7, the 65th anniversary of the Pearl Harbor attack by the Japanese Navy, the swaps market remembered that.

“This is all the more reason at this point in the cycle to own AAA assets,” says Mr Diamond. “We see flights to quality on both sides of the balance sheet.” Annaly only buys government-guaranteed Ginnie Mae, or Fannie Mae or Freddie Mac, mortgage-backed paper. That is not always the most profitable strategy but there are times when it is the most comforting one. Annaly still assumes interest rate risk, which hurt it during the Federal Reserve’s tightening phase, but should help its profit and loss account in the period ahead.

“We should be a little humble in admitting what we don’t know about the risks on dealers’ balance sheets,” says our banker. The rating agencies always sound sure of themselves when they issue an opinion.

I do not think this is a good time to take a long position in the big investment dealers. Retained residual risk is one reason for that caution.

FT Wealth is taking a break for the holidays. John Dizard’s column will return on January 9. Wealth at the Weekend will return on January 13.

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