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The recent turbulence in global markets and the woes of the US subprime mortgage market have refocused investors on investment risks. There are few better people to assess those risks than Glenn Reynolds, chief executive and co-founder of CreditSights. Voted the leading independent credit research firm in Europe and the US in 2006, 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.
Prior to setting up CreditSights in 2000, Mr Reynolds held a variety of roles at Deutsche Bank including head of global credit research. An industry veteran, he has also been a director of global credit research at Lehman and a credit analyst at Prudential Insurance Company. Mr Reynolds also has testified before the US Senate, the House of Representatives, and the Securities and Exchange Commission on topics including credit rating agency reform and the collapse of Enron.
Here is your chance to ask him questions on issues ranging from the broader impact of the US subprime mortgage crisis, which emerging markets look more vulnerable, is there a bubble emerging in fasting growing credit derivative industry, how are hedge funds affecting the credit industry, has risk in financial markets been diversified and what is the most likely catalyst for fresh financial market turmoil.
Q: We have been watching credit spreads closely with the latest market turbulence but see little spread widening. In the bear market of early 2000’s it was the telecom paper that really got hit, and I was wondering if- given a private equity problem (i.e. less liquidity) or general economic deterioration, which sectors have been the biggest debt issuers and which sectors might be safe havens?
Brian Gilmartin, Chicago, Ill
Glenn Reynolds: The spread volatility has been contained in select subsectors of the market this month and the term loan and secured loan repricings keep marching along with tighter pricing and lighter covenants. With the exception of those on the receiving end of negative event risk and the subprime direct fallout, a lot of that widening such as in automotive had nothing to do with direct changes in fundamental risk and were much more technical in nature.
In a general economic deterioration, the first question will be what the main source of the macro pain is and how that is applied to a portfolio context in framing relative value. If we are dealing with a modest setback in consumer spending and pressure in jobs creation, then the more leveraged cyclicals will get hit pretty hard with autos right up there at the top and suppliers vulnerable. In addition, leveraged retailers will feel serious headwinds under that scenario. We do not see that as set to occur, however, even if the consumer taps the brakes. We think making the leap from subprime stress to a general systemic meltdown is the purview of the “broken clock bears.” There are legitimate concerns here around macro pressure, but the extremists tend to want to predict 100% of the crises even if they miss 1,000% of the rallies. A bigger threat than subprime would be any signs of major problems in China, more geopolitical stress (as in more bombs dropping in new places), or a domino counterparty problem that starts with a few failed leveraged players. This last risk is where we are most concerned about subprime, since that is where a major re-marking of assets can translate into a fresh wave of margin calls in other asset classes.
The good news about this recent financing wave versus the 2000-2001 swoon in telecom and power is that the largest issuers this time around apart from financials include M&A-driven spending in power and oil and gas. In addition, a lot of the defensive refinancing down the credit spectrum in segments such as autos was to build liquidity to avoid a financial crisis, not to bet the ranch on spending as we saw with telecom in the last credit wave. The last time around power was grossly overbuilt as was telecom, and arguably telecom was built without a real revenue model in the fiber binge. For sectors such as the automotive OEMs and suppliers, the companies have moved to limit refinancing risk in a downturn by extending maturities and keeping secured lines available to weather the storm. That does not mean the storm will not win in some cases, but it is a more prudent liability management program than what we saw in 2000-2001 when the convertible arbitrage players probably kept Lucent and Nortel out of bankruptcy.
If we see a steep downturn, the carnage will be broad-based and not limited to any handful of sectors. It will be that CCC wave of issuers finally getting turned into equity. The logical targets for stress in heavy cyclical downturns such as autos may ironically be offering much better recovery rates than leveraged retailers and tech companies without the hard asset protection and post-restructuring story value. Safe havens will be more about asset class (1st lien loans) and not as much about sectors.
Q: Do you think the market has factored in the implications of the defaulting subprime mortgage borrower defaulting on credit card and auto loans?
Jorge, New York
GR: Our first inclination is to say that the auto and card asset class will be more resilient against subprime woes, and the market either agrees or has not cast a vote yet. That is, we have not observed the violent spread widening in autos/credit cards that is present in the subprime market. Spreads in autos/credit cards have widened, but not to an enormous degree. In auto retail credit, the relatively better performance is for very good reasons, namely that those are not traditional low quality consumer credit markets and have historically shown very resilient asset quality over the course of numerous cycles. The largest auto finance companies such as GMAC and Ford Motor Credit have in fact continued to evidence very strong asset quality metrics even if some early hints of weakness are being seen now.
Subprime consumers will have a follow-on effect on the used car market, however, and again we need to stay on the alert for how that flows up the chain and impacts operating lease residual values over time, collateral values on retail contracts, and in turn loss severity on repossessions. For the non-captive auto finance companies, we also need to watch how any retrenchment in consumer credit in the subprime tiers impacts new car demand as well or slows the replacement cycle. The auto companies themselves appear much more focused on the housing market and the prime borrower and that consumer’s disposition. That remains a more immediate issue than the subprime woes for their new car cycle.
On autos/cards issuers, we have yet to hear the horror stories from the unsecured issuers that might be coming and default rates have remained relatively stable thus far in the credit card space. Partially clouding this trend is that legislation enacted in 4Q05 caused an exodus in portfolios as tougher bankruptcy laws caused likely candidates to file before the laws went into effect – we have not yet seen a return to normalcy following this front loading of filings. We would note, however, that there might be good reason for this stability as the credit card industry is a bit more adept at pricing its product, having weathered such storms in the past.
Many people took risk from the credit card and auto market and transferred it to the mortgage market via cash-out refinancing and home equity loans. These cash-outs were sizable enough to cause credit card issuers to complain in 2006 about the higher-than-expected payment rates. That jump in payments might well have been a blessing in disguise. As such the mortgage market has a considerable amount more of the low documentation/low credit quality loans than ever before. This proliferation gives the market more of a problem compared to its unsecured cousins. We dislike saying that this time is different, but this transfer of moral hazard risk combined with a high level of speculative activity in real estate might make it easier for homeowners to hand back the keys to the bank than in previous default scenarios. The credit card issuers might have come out ahead assuming balances did not re-lever to previous levels.
We would also note that the consumer financial obligations ratio that the Federal Reserve publishes has been steadily declining for the last four years, from a peak of 6.85 per cent of disposable personal income in early 2002 to 6.48 per cent at the end of 2006. This ratio measures all consumer credits, including credit cards, auto loans, durable goods payment plans, etc., so the decline suggests that the US consumer is better prepared to service these types of debts than in recent years. Of course, one primary reason for the decline has been the consumer’s ability to swap consumer debt into home equity lines of credit, which generally charge lower interest rates and are often tax-preferred. The mortgage financial obligations ratio, similar to the consumer ratio but measuring mortgage debt as a share of personal disposable income, has exploded to record highs in recent years, from 9.0 per cent in early 2000 to 11.7 per cent at the end of last year. That has left a number of consumer durables companies on edge about the next leg of demand.
Q: Is it true a lot of funds have to take huge profit on equities. Are they currently taking them in order to provide for risks in subprime and inflation? According to inflation figures it seems the fed will slowly cut rates going into the end of 2007. Will it create a rebound in the market for election year?
GR: On why some institutional investors are taking profits and moving more into cash, it may have less to do with specific fears of a subprime meltdown and more to do with the incentives that recent monetary tightening has created. Institutional investors can now get upwards of 5.5 per cent on high yield money market rates in the US and the UK. Given the outlook for slowing earnings growth, with or without a shock from the subprime mortgage sector, an increased allocation to cash is much more compelling now than it was a year or two ago. We would also point out that many investors are asset-class-constrained and maintain moderate cash balances to deal with redemptions. There are also many pension funds still sticking with a high stock percentage in their target asset mix and that does not get dramatically shifted year to year, so we do not agree that there are a slew of sellers waiting to get out.
As to whether the Fed will be cutting rates and generating an election-year rebound, we think the FOMC will be very careful to avoid any suggestion that its monetary policy decisions have political motivations. The Fed is also still very concerned about pipeline inflation pressures, and is probably unlikely to cut rates much if asset prices begin to recover sharply. The Fed, along with many investors, is concerned that excessively lax monetary policy towards the end of the Greenspan era helped drive a housing asset bubble, which in turn created inflation pressures. So the Fed is probably unlikely to aggressively cut rates this year unless the economy fares much worse than expected (say, GDP growth less than 1.5 per cent QoQ annualized in the first and second quarters), or, more importantly, if problems in the subprime sector or some other shock were to seriously threaten the banking sector. Because inflation remains uncomfortably high, we believe the Fed doesn’t have room for much more than one cut this year unless a worst-case scenario of a recession or banking crisis were to materialize.
With the Fed unlikely to move aggressively this year, the markets - especially the credit markets, which are still trading at such strong levels - will probably have a difficult time staging a significant rally any time soon. If the economy turns out to be better than expected and handling the subprime problems without a hitch, that should help reassure the market about default rates and earnings growth, but it would also reinforce fears of inflation at the Fed. In this scenario, these two factors should balance each other out.
Q: How likely is the sub-prime problem to spread to CDO’s, so that investors won’t know a proper valuation of them, and thus be reluctant to buy them?
Donald Benson, Johannesburg, South Africa
GR: Since asset backed or structured finance (SF) backed paper makes up the vast majority of CDO issuance, we do see backlash within the CDO market. One great thing about typical asset backed deals is that they are actively managed and the manager can trade the structure to exit the subprime exposures if she chooses and the mechanics of the deal allow it. That being said, there is no doubt that the lack of subprime bids will migrate up the credit quality spectrum as buyers of the paper issued off of the deals become wary of the asset class. Subprime will not fall in a vacuum, and higher quality issues will suffer as well. The effect might be somewhat mitigated by the ability of managers to utilize the new liquid indices (the CDX.ABX) and their respective tranches to hedge exposure. These indices, although narrow in scope, have become the de-facto speculative and hedging instrument for ABS and the subprime market. The clarity of the CDO market is difficult as most asset backed structures contain close to 200 issues. We see an unwinding of the ‘set a FICO floor and forget it’ mentality of the past few years and believe that a few quality managers will have the opportunity to separate themselves from the pack via active management.
The question that remains is how does this trickle into the corporate credit world? CDOs with corporate collateral might have some exposure to the large mortgage insurers or issuers, but direct exposure to true subprime risk is likely to be very low. If the buyers of CDO paper still have the need to purchase those liabilities, we could conceivably see an uptick in corporate CDO issuance as the product continues to have low default rates and fairly attractive spreads out the curve. We feel sub-segments of the corporate backed CDO market might prove attractive to those fleeing the asset backed world.
Q: What is your take on new VC’s transaction?
GR: The new $500 million tranche on Visteon’s term loan just drives home that this company does clearly need additional liquidity at its domestic operations to keep more pronounced liquidity pressure at bay as they work through some asset sales during a period of negative cash flow. From the standpoint of the secured lender, VC offers excellent asset protection and will not likely have any trouble getting this deal done. In many ways, VC has become a company that is worth more “dead than alive” in the sense that the pieces are worth more to strategic buyers of assets than as a stand-alone. Unfortunately, the weaker pieces of its mix are tied to the high volume risk of Ford North America. That reality is making for a very rough transition and negative cash flow story until the restructuring is complete. Tapping the well for more balance sheet liquidity could also be a sign that VC does not want to lose leverage at the negotiating table in dealing with asset buyers, and also might signal that the process is dragging on for too long and that prices may not be what the company expects. Some of VC’s targeted, smaller-ticket asset sales are dependent on striking deals with the UAW at the plant level, and that process is only going to get more tense and will have overtones for the Big Three round and Delphi negotiations. So the UAW is unlikely to move fast to cave in.
At the same time, VC does not seem to want to rush to sell its best assets. So the event risk situation—positive and negative—remains a tough one to trade with all the hedge fund activity and Valeo noise (Pardus etc.). VC has really lost the positive event risk momentum since the late summer. It is the only fallen angel auto name to move to a new 6-month wide on CDS in the recent spread wave while even Lear—with its LBO deal pending—has not come close to its 6-month wides. The secured paper looks fine, but the wrong set of macro scenarios could start to challenge the unsecured recovery rate story. Doing this deal makes a lot of sense as a defensive move even if it heightens structural subordination risk that much more for those down the capital structure.
Q: Is the high-yield bond market fundamentally overvalued; is there a significant difference between what you see in the cash and derivatives markets in high yield, or crossover; and does the increase in the proportion of lower rated debt mean we are necessarily headed for a big spike in defaults?
Paul J Davies, London
GR: On whether the high yield market is fundamentally overvalued, we say yes. The liquidity drivers have been much discussed, and the good news at least is that the most aggressive deal chasing has been in the loan market, where structural rights are better, asset protection much more comfortable, and covenant packages at least provide the ability to get an earlier seat at the table in the event of more credit stress or if the company misses its projections. Whether it is too much money and too many originators going after subprime loans or going after high yield deals, the end of this story is hardly a new one in historical perspective. The “deal too far” gets done, the underwriters dance a little too close to the fire on the quality of the asset brought to market (the “we are all big boys” rationalization) and then the market gets set up for a re-pricing of risk on some event or series of events. With default rates down near historical lows, the direction of the next trade is pretty clear. The incubation period for the usual post-CCC-wave nightmare has been perhaps artificially extended with the boom in global liquidity.
Typically during boom periods of high yield you get a spate of marginal issuers coming to market that wouldn’t normally get financing. The classic example of this from the last boom is Iridium, the satellite company which issued debt into the market during the heyday of the mania for anything technology or anything wireless. That company ended up going bust and returning only cents on the dollar to the bank creditors even as litigation waves tortured underwriters throughout. This is obviously an extreme example but if you look at the shape of cumulative default curve for CCC-rated companies, it is steepest in the 3-7 years. This suggests to us that if credit markets do start to tighten, we should start to see a tick up in default rates and in less investor-friendly workouts.
On your Cash vs. CDS question, we have a few comments. As the high yield market is usually dollar based and less sensitive to spreads over LIBOR and more granular with smaller cash issues (and thus less liquidity) than investment grade, we have noticed that the basis (the credit derivatives spread minus the LIBOR spreads of the cash bonds) tends to be more negative – i.e. cash bonds are cheap in many cases versus credit derivatives as a rule. We would expect this to gradually correct as the high yield CDS market matures and the significant differences are arbitraged out by the market. An exception to the negative basis trade during a period of heightened volatility would be some of the liquid fallen angel names such as the US auto names.
Q: I want to invest in a highly diversified emerging market fund. Is this a good time to invest? Is it too late to ”buy low and sell high”? What impact will the cooling housing market and foreclosures have on high end housing prices, say over $700,000. I live in the Washington, DC area.
James Taylor, US
GR: On the first part of the question, our view is that most of the value has been squeezed out of a lot of the emerging markets over the last year or two, and now is probably not the best time to put a lot of fresh money to work in the sector. Many EM countries have seen important improvements in their fundamentals over the last few years, so we do not expect emerging markets to suffer a full-blown crisis in the immediate near term. There are pockets of overheating and overlending in a few of the major emerging markets countries, however, and we do not think investors are being adequately compensated for those risks. Over the very long term the emerging markets will probably continue to deliver healthy returns, but the volatility in EM should steer most investors to gradually build up exposure rather than investing in EM all at once.
On the second part of the question, the still relatively healthy US labour market and strong growth at the top end of the income pyramid should help to prop up demand for higher-end houses in the established markets for the time being. Deflation will be on average more muted on that end of the spectrum, but every comment on the housing market these days has to have caveats based on region and area profile. The problem is that not all luxury markets are alike. Areas where excess liquidity has poured into the market in recent years, like luxury condos, new high-end single family developments in the outer suburban rings, and some vacation areas have all been highly dependent on easy financing. There has been a disproportionate mix of speculative buying with the expectation of higher prices, and the balance sheets of speculative buyers will be feeling some stress even if they are not subprime in profile. The housing slowdown will have winners and losers, and these overbuilt sectors will be among the losers.
Our homebuilding team has written extensively on the subject and with the relevant historical frames of reference for the percentage of “spec” buyers, but to make a long, convoluted and complex story short, spec buying has been more than triple the historical average and too frequently has been at unrealistically nigh loan-to value ratios. Second mortgages also have become a way of life for the overstretched, so that usually comes to head when the macro picture goes the wrong way. One under-researched macro stabilizer in the US that we have commented on in the past is the very favourable demographic trends that could help ease some of the pain as the high base of new, young working-age adults hit the job markets and the traditional “dual-income-no-kids” couples (the once-renowned “dinks”) hit the market in greater numbers. The tight rental market also provides some silver lining of hope for the next migration to regions such as DC, but the pain trade and remarking of mortgage loans along the way still has to be taken. The silver lining is still usually on the other side of the lead exterior, and this year will remain ugly for housing.
Q: Do you think the S&P 500 or the dax will return more than 10 per cent this year? And which one do you expect to outperform?
GR: The German economic recovery is at a slightly lagged stage than the US’s. Having experienced back-to-back quarters of negative growth in 2003, the economy has since been growing at a reasonable speed and recorded growth of 3.7 per cent in 2006. On a political front, Germany held elections last year. Merkel has already begun to enact budget reforms which mean VAT tax increases, however this has done nothing to dampen business confidence – the important IFO survey of business climate climbed above 100 in at the end of 2005 and has continued to climb almost unbroken since then. In addition, Germany has not had the same degree of excess lending in the housing market that the US has had, so we think the German economy faces less risk of a serious shock related to its housing market than the US does this year.
But none of the major developed economies is immune to a turn in the global liquidity tide. The recovery in Germany has been dependent in large part on strong export growth; German exports were up 41 per cent in the fourth quarter of last year versus where they stood in the fourth quarter of 2003. Much of that export growth, however, has been driven by the boom in China and elsewhere in the global economy, which itself has been due in large part to generous global liquidity conditions. The lagged impact of monetary tightening by the world’s major central banks is already beginning to hurt the US housing market, but in time it will also have a general dampening effect on Germany’s major export markets. There may be more volatility in US markets given the concentration of risk in the mortgage market, but the world’s major stock markets will remain highly correlated this year.
However the DAX is a far less diversified index than the S&P 500 with only 30 names versus 500, this makes it more susceptible to individual name performance.
Q: I have been following keenly the recent surge in private equity deals and my question is what in your view is the impact of private equity to financial institutions and the financial industry as well. Do the private equity have the muscle to reshape the global financial sector totally eclipsing the status quo?
GR: In short we see the private equity wave as reshaping the status quo and nature of the institutional investor asset allocation process, but not eclipsing the status quo. After all, the status quo structure also provides the take-out bid for the deals later. So the private equity players are in the end pretty dependent on the current global structure of the exchanges to take their profits. Those exchanges may be configured differently in future years and in terms of who wins by region (London vs. New York is always a fun debate), but in the end that is the system that the private equity players themselves are leaning on as well.
In terms of the current “global bulge,” we do not see that as changing all that dramatically either in that regard. Someone still has to provide backstop financing, distribute and disintermediate the risk, provide counter party lines and financing, and they will be in there taking their slice of deals through their merchant banking wings just like they always have. The menu may change, but the same group of chefs will be doing the cooking.
There is no question that the soaring base of private equity investors and readily available supply of bank loan and high yield credit have fostered a very favourable backdrop for this base of funds to drive a lot of deal activity. That said, the continuation of record deal size and hitting all-new records for deal totals still is somewhat tied to a benign liquidity backdrop, a favourable yield curve, and robust credit fundamentals. That may hardly be the case by 2008, and the ability to drive a hefty deal flow may not be anywhere as favourable as it is now. Right now we are seeing a confluence of very favourable conditions for private equity deals. The best asset class out there right now with the flat-to-inverted curve and solid demand for credit is a leveraged 1st lien loan, not an investment grade corporate bond with weak covenants. That has prompted an asset allocation shift in the marketplace that has fuelled the recent wave. Add a recession, a steep curve and tighter credit (tighter in liquidity, structure, and less generous pricing), and people will see deal flow altered dramatically. In fact, more leveraged funds will be back in the distressed business by then, and more private equity funds will be as well.
Q: We own 230 shares of Scottish Power and are wondering what to do since they have been acquired by Iberdrola? Would you sell or keep the shares?
GR: Our European Utility team has a view on that issue. We see this as one to sell at current valuations. The Iberdrola offer is part shares, part cash (an SPW shareholder will receive 0.1646 Iberdrola shares an 400p in cash for each SPW share), but based on the current value of Iberdrola shares is worth about 779p. SPW shares are trading at 778p, and for the six months prior to the deal announcement traded at an average of around 600p (so the offer is at around a 30 per cent premium). The offer values Scottish Power at an EV/EBITDA of over 10x against a sector average of about 8.5x.
The deal is being done via a UK scheme of arrangement which means as long as the majority of shareholders accept, Scottish Power shares will cease to exist and you will end up with shares in Iberdrola (and cash). Iberdrola is a good company but in our view it is overpaying for Scottish Power in what is essentially a defensive move.
There is also some deal risk in that the Spanish energy regulator (the CNE) is considering launching an inquiry into the deal. This seems totally unwarranted in my view but if it is launched this could mean a delay of several months in the completion of the transaction. Given everything else that is going on in Spain there has been some speculation that a CNE enquiry could be politically motivated and might be aimed at delaying the deal long enough so that the Spanish government can engineer some kind of Iberdrola/Union Fenosa merger, which could mean the SPW deal falls through, and the share price falls back.
Unless you specifically want to be invested in Iberdrola and are happy to accept that there may be some risk to the deal we would sell.
Q: In an interview with Mohamed el-Erian of Harvard Management Company, I heard that retail investors can buy extremely cheap insurance to protect against a major correction(fat tail event), e.g. > 20 per cent. How does one do that?
GR: In an institutional credit portfolio, the most effective way of hedging against downside risk is to buy credit protection through the default swap market. This functions like an insurance policy against a default or significant decline in creditworthiness of a company. Another way to hedge against fat tail risk in credit is to move up the capital structure into loans or other instruments that are senior and will perform better in a market meltdown.
We are not experts in equities, but it strikes us that a similar approach may be appropriate. One way to protect against a 20 per cent plus move in equities might be to purchase deep out of the money puts on the index. Another way could be via futures or options on futures but we are getting into complicated trades where an investor would be much better served by consulting with his financial advisor. We’d caution that these strategies are not suitable for all investors. As a finance professor once remarked to us, “The best way to learn about options is to lose a lot of money trading them.”
Further background reading:
In depth: Subprime lending crisis
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