Archive for July/2007

The credit squeeze is rattling the markets. The leveraged buy out fever is facing the absence of high yield/ high risk investors and the end result is that the underwriters (banks) of those deals are loading their balance sheet with unwanted corporate debt. A group of banks failed this week in their attempt to obtain sufficient finance for two of the major private equity deals, those of Chrysler and Alliance Boots. This failure implies a burden in the creditworthiness of banks that see their balance sheet full of unsold corporate debt. The easiest way to evaluate the creditworthiness of the banks is the behavior of the credit default swaps written on the debts of these institutions. These CDS provide an insurance against the default or non-payment of the bank

More and more sub prime news are coming into the spotlight. What supposed to be limited to a few states in the US has spread worldwide suggesting a small credit crunch.
Loses in hedge fund investment are not confined to the Bear & Stearns funds, last week an Australian hedge fund announced huge losses sub prime related.

Last Friday S&P, in its more proactive recent policy reduced the rating in 14 European CDOs tranches. The sudden consequence was a flight to quality as some feared that European financial institutions might be affected by this re-rating. This demand for long term European debt has the 10 year bund delivering roughly the same return as the short term Euribor. Last month fears of higher inflation expectations have been buried.

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CDOs have been hit hard recently. In the last week the underlying backing many deals has been revised on their creditworthiness and the CDO market is in a downward spiral that is rattling the markets. But risks are not just limited to this market. Another market that is been followed closely and has resemblance with the CDO market is the market for collaterized loan obligations (CLO). CLOs are debt securities backed by a pool of commercial loans. A recent report by the Bank of England (www.bankofengland.co.uk/publications/quarterlybulletin/mo07may.pdf) pinpointed resemblances between the market for sub prime mortgages and that for poorly rated corporate credit, highlighting concerns about the CLO market. Similar to a CDO, in a CLO banks assemble pools of corporate debt, and then break them into tranches. Investment firms (acting merely as intermediaries) will sell them to investors. Among the different tranches, those carrying more risk are those with no credit rating and referred as equity. The return on these tranches has been high in the last years, exceeding 20 %. But high returns go hand by hand with high risks. If loans go bad, losses are immediately suffered by investors holding equity tranches. Last year just 1.3 % of investment firms with credit rating below investment grade defaulted on their loans but this percentage might be on the rise.

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Rational herding offers an explanation to the recent sub prime meltdown. The question is why a bunch of well trained investors ignored the warnings about an overheated and overdone market? The reason is that in any bubble type environment it pays off to follow the crowd, even if investors acknowledge wide risks. Because many investors are judged on relative terms, they might be better off fully invested regardless of the fundamentals, to avoid potentially been caught wrong relative to their peers. We have seen that a bubble can go on for longer that expected and it is difficult to predict the inflection point. The dot com bubble went on longer than many predicted and even those who judged it right were badly hit because of wrong timing. One example of this was the Tiger Fund that sold the market much before its sharp decline. Rational herding explains why many investors herd the market even if they know it is unsustainable based on fundamentals. Still it is difficult to distinguish among rational and irrational herders. However, the formers even if they follow the trend are probably more prudent on their risk taking.

Yesterday Bernanke lectured on inflation issues. Mr. Bernanke was missing his academic job and recouped part of that allure yesterday in a speech at a conference of academic economists in Cambridge, Mass.
He delivered interesting hints on his view on policy making. According to his words he does not believe that short-term rates are a tool to pop asset bubbles. Contrary may be to the Bank of England that has tried to fight hard with a bubbling housing market.

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The seed of the sub-prime mortgage debacle is the fact that more than 6 millions individuals in the US borrowed 100 % of the value of a house when the real state sector was peaking. Moreover these borrowers had a bad history (or just no history at all) on credit borrowing. These borrowers represent a cohort of borrowers that later had a high rate of foreclosure as soon as housing prices started to fall. This was just the countdown of the process, but how did thing proceeded?

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