Like young Halloween revellers, investors spent years grabbing all the candy, in the form of high-yielding bonds and loans. That binge ended in spectacular fashion with August’s credit crunch, as investors suddenly decided the high-yield treats were worth less than they thought. But two months on, the credit markets still look decidedly sick.
On October 24th Merrill Lynch reported its first quarterly loss for six years thanks to huge write-downs by the investment bank of $8.4 billion. Worries about more such losses have made markets jittery. “We’re now in a state of fear,” is how Alan Greenspan, the former Federal Reserve chairman, described it at a conference this week.
The big question is whether the current mood is temporary, as investors digest their high-yield excesses, or whether the sickness will prove a more lasting malaise. Much depends on how America’s housing bust plays out. Like a toffee apple with a maggot inside, the debt markets have been tainted by their links with America’s subprime mortgage crisis. Those loans to dodgy borrowers have been bundled up into fancy financial vehicles known as structured products, and it is proving hard to sort out the mess.
But it is also clear that the financial system is less sound than it seemed. Conventional wisdom held that the process of slicing debts into numerous structured products dispersed risk and thus reduced it, especially for banks. But it turns out that the risk that banks ushered out of their front doors sneaked in again through the back. This is because the new owners of structured assets are either big clients of the banks or have borrowed from them.
Furthermore, structured finance’s dependence on leverage and illiquid assets has left it prone to crisis. New institutions, such as hedge funds and conduits—what Paul McCulley, of Pimco, a fund management group, has called “the shadow banking system”—are highly dependent on borrowed money, or leverage. And they are also highly attracted to illiquid assets, which offer outsize returns. But when markets turn, those institutions are caught on a hook: they are forced to cut their borrowings but find it difficult to sell assets. And if they receive only rock-bottom prices, they may be forced out of business. That is why what seemed like a liquidity problem may turn out to be one of solvency.
In many ways, the structured-debt malaise stems from success, particularly that of central banks. Their record of taming inflation, moderating recession and riding to the rescue whenever financial crises threatened has encouraged investors to take risks, in particular to lend to less creditworthy borrowers and to invest in illiquid assets. This trend can be self-reinforcing. When risky borrowers find it easy to get credit, they are less likely to go bust, which makes them appear less risky. And when lots of investors buy illiquid assets, trading volumes increase, making the assets seem more liquid.
Borrowing to invest in higher-yielding or risky assets is one form of the “carry trade”. This was the strategy of obscure bodies known as structured investment vehicles (SIVs) and conduits. They borrowed short-term and invested the proceeds at a higher yield, often in complex products linked to bundles of loans. The margin was their profit. Such assets offered an excess return to compensate investors for their illiquidity.
Both high yields and illiquid assets are also attractive to hedge funds, which have become the rising powers of the fund-management industry. Because of the high fees they charge, hedge funds need to make big gross returns to deliver decent net returns to their clients.
Historians of the financial markets will recognise that what the SIVs and some hedge funds were doing was, at heart, the oldest game in the business: borrowing short and lending long. The strategy depends on the continual ability of investors to renew their funding or to sell their assets (at a decent price). When one part of the equation goes wrong, so does the other: if investors in general are unable to obtain funding, there will be few willing buyers.
Things duly went wrong in August. Both the credit and money markets became frozen, while in the stockmarket, computer-driven trading models that had worked for years suddenly failed. At the same time, it became clear that the modern financial system had dispersed risk much less successfully than people believed.
Many of the most dubious assets were, indeed, held by hedge funds. But most hedge funds obtain their finance from the banks and 60% of hedge-fund assets are handled by three prime brokers (all of which are big investment banks). In addition, hedge funds own the same assets as banks’ trading desks. This means that when the hedge funds are forced to sell, the trading desks are likely to lose money.
Similarly, the SIVs and conduits were not wholly independent of the banking system. Conduits were “off balance-sheet vehicles” that allowed banks to be exposed to complex bonds without requiring them to hold reserves against them. Many SIVs were operated by banks, had banks as investors or had arrangements to call on bank financing when their conventional sources of liquidity failed.
Don’t banks and hedge funds employ mathematical geniuses who develop highly sophisticated models to control these risks? They do, but they have a difficult task. The standard statistical approach to risk management is based on a “bell curve” or normal distribution, in which most results are in the middle and extremes are rare. It is the bell curve to which investors are referring when they talk about a “nine standard deviation event”. But financial history is littered with bubbles and crashes, demonstrating that extreme events or so-called “fat tails” occur far more often than the bell curve predicts.
In a fat-tail world it is very hard to monitor how much risk you are taking on. Many banks use a “value at risk” approach, which tells them the maximum daily loss a portfolio might face, based on measures of past volatility. This requires a trader to cut his positions when volatility rises. But if all traders are trying to do the same, volatility will rise even further, well beyond the limits the models suggest.
The same difficulty faces investors who control their positions on the basis of daily market volumes. Ideally they want trading to be heavy so they can sell without shifting prices against them. When times are good, volumes are usually high; but when times are bad, they can be non-existent.
That suggests models should have been built on the assumption that liquidity can disappear overnight. But apart from the mathematical complexities involved, that would have created another difficulty. In the short term those using conventional models would take greater risks and earn higher returns for their clients. The cautious firm would lose business and see its star employees lured away to firms that can pay bigger bonuses. By the time the crisis occurred, and the cautious firm was proved right, it could be too late.
Investors accordingly assume that markets will stay liquid or that they can exit before anyone else. In August they found out how wrong that assumption could be. “It turned out that only two markets were truly liquid: German-bond and US-Treasury futures,” says Manoj Pradhan, a fixed-income analyst at Morgan Stanley.
The world is still sorting out the mess. This week Royal Bank of Scotland entered into exclusive talks with a struggling SIV, a $6.6 billion fund run by Cheyne Capital, which may result in a refinancing.
On a grander scale, there are plans for a $100 billion bail-out fund known as the super-SIV. Backed by four American banks it plans to acquire assets from so-called “orphan SIVs”—those without bank backing. If forced to unload their assets all of a sudden, these “orphan SIVs” could cause a sharp drop in prices. That would force other investors to lower their balance-sheet valuations, making the crisis worse.
What is not clear, in either case, is whether the device will solve the problem. The hope is that the super-SIV, in particular, will improve confidence by setting a market price for the fund’s assets. However, the super-SIV intends to buy only the most creditworthy notes from other SIVs, leaving them stuck with the rest, euphemistically known as “toxic waste”.
Furthermore, the super-SIV seems to embody a contradiction. In August the worry was that banks were overexposed to SIVs. The new fund will only extend their exposure. If the mortgage-backed market does go to hell in a handcart, the banks will have an even bumpier ride.
That raises the question of whether SIVs and conduits ought to exist at all. “It’s not clear that the business model of SIVs and bank conduits can survive in the current form,” says Mark Benson, of CQS, a hedge-fund manager.
With the picture so blurry, investors will remain nervous. The cost of insuring high-yield debt against default rose by the biggest amount in one day since late July on October 19th. The spread (excess interest rate) paid by high-yield borrowers is only around half a percentage point lower than it was at the height of the crunch.
Thundering to blundering herd
Merrill Lynch’s disastrous third quarter indicates more trouble might be in store. Its results encompass a difficult period in September, unlike those of other Wall Street banks, which reported earlier. That suggests their fourth-quarter numbers could be bad, too. Many of the write-downs related to “super senior” AAA-rated securities, indicating even the best structured products are not very good.
Just as the housing market was dependent on subprime borrowers, the structured-debt markets were dependent on subprime investors. Both were too reliant on borrowed money, and suffered when their ability to borrow was taken away.
This crunch in structured debt could still undermine the global economy, by prompting a broader tightening of credit conditions that chill consumer spending. Alternatively, if the economy deteriorates before the credit problem is solved, the damage to the financial sector could be immense. As the Bank of England’s latest financial stability report warns, “In the short run, the financial system in the advanced economies remains vulnerable to new shocks.” Never mind the ghosts and goblins; it is the credit crunch that should keep investors awake at night.