Summer Rerun: Has the Credit Contraction Finally Begun?

This post first appeared on July 11, 2007

Readers of this blog know that I have been concerned about the state of the credit markets for some time. We’ve had (until the last month or so), rampant liquidity feeding asset bubbles in virtually every asset class except the dollar and the yen, tight risk spreads (that means inadequate compensation for risk assumption), lax lending standards (that helped create the aforementioned bubbles), and increasing inflation pressures.

Now what inevitably happens when credit gets too cheap is that borrowers go and buy stupid things, like housing they can’t afford or illiquid faith-based paper or overpriced companies, and at some point enough of this speculation, um, investment, turns out badly that lenders get nervous and start turning off the liquidity spigot. And the wilder the party has gotten, the worse the hangover.

Now heretofore, I have merely fulminated about this situation, because at some point, the correction will begin. But it’s very easy for people like me to expect things to get rational way before they do (look how long the 1980s LBO wave, the Japan bubble, and the dot com mania lasted).

So as much as I have felt for a long time that these conditions were not sustainable, and were likely to end badly, I have refrained from making a call. Smarter people than me, like Martin Wolf of the Financial Times, have similarly pointed out that the global equity markets are considerably overvalued and are certain to mean-revert, but he pointedly refused to say the markets were near a peak.

But the few times I’ve made a specific investment call (and it’s been very few times, believe me), I’ve been proven correct. So as a mater of public service (and doubtless ego as well), I’m making one now.

The bear credit market has begun.

Why do I think now is the turning point? There has been considerable nervousness over the last few weeks, due first to the Bear Stearns meltdown and the parallel development of a sharp, pattern shattering rise in Treasury yields that many felt was the sign of a fundamental change in sentiment. And if I am right and the contraction has begun, many will legitimately see the Treasury break as the starting point.

But I see the following as the signs:

Liquidity is falling on a widespread basis. Bond yields are rising in all major bond markets (hat tip to Michael Shedlock for the chart) below):

Investors are increasingly reluctant to shoulder risk. A number of LBO financings have either not gone forward or have had to offer improved terms

The reaction to the downgrades by Moody’s of 399 subprime bonds from 2006 and another 52 from 2005, about $5.2 billion in face value, and the announcement by S&P that it will likely downgrade 612 issues, representing $12 billion in original issue price and about 2.1% of the market, has precipitated a reaction that at first blush is way out of proportion to the event. After all, $5 billion or even $12 billion worth of bonds isn’t much at all, even if there are forced liquidations (any pension funds or insurance companies holding formerly investment grade paper that has been downgraded to junk will in most cases have to sell for regulatory reasons).

Now as we go through the rest of this post, skeptical readers will doubtless think, “But this is mainly about subprimes. This is contained.” Yes and no. Forced sales. losses and general embarrassment (if not loss of capital) will create new found sobriety, which will lead to less liberal credit terms across the board. As we said yesterday, nearly all participants have been playing a game of musical chairs, trying to stay in the game until the last possible minute so as to extract maximum profits, under the cheery assumption that there won’t be a rush for the exits.

Now contrast that fact set with this Bloomberg story, “Subprime Losses Drub Debt Securities as Credit Ratings Decline“:

On Wall Street, where the $800 billion market for mortgage securities backed by subprime loans is coming unhinged, traders are belatedly acknowledging what they see isn’t what they get.

As delinquencies on home loans to people with poor or meager credit surged to a 10-year high this year, no one buying, selling or rating the bonds collateralized by these bad debts bothered to quantify the losses. Now the bubble is bursting and there is no agreement on how much money has vanished: $52 billion, according to an estimate from Zurich-based Credit Suisse Group earlier this week that followed a $90 billion assessment from Frankfurt-based Deutsche Bank AG.

Even the world’s second-largest company by market value must “triangulate” the price of an asset-backed bond when it gets bids from traders, said James Palmieri, an investment manager at General Electric Co.’s Stamford, Connecticut-based GE Asset Management Inc., which oversees $197 billion.

“We do not foresee the poor performance abating,” Standard & Poor’s said yesterday as it threatened to downgrade $12 billion worth of securities backed by subprime mortgages. Losses “remain in excess of historical precedents and our initial assumptions,” S&P said.

Moody’s Investors Service went further, lowering the ratings on $5.2 billion of subprime-related debt.

Why Now?

More than a few investors would like to know what took the New York-based rating companies so long to discover a U.S. liability of Iraq-sized proportions.

“I track this market every single day and performance has been a disaster now for months,” said Steven Eisman, who helps manage $6.5 billion at Frontpoint Partners in New York, during a conference call hosted by S&P yesterday. “I’d like to understand why you made this move now when you could have done this months ago.”

Eisman was referring to the rise in borrowing costs that has forced thousands of Americans to default on their mortgages.

A total of 11 percent of the loan collateral for all subprime mortgage bonds had payments at least 90 days late, were in foreclosure or had the underlying property seized, according to a June 1 report by Friedman, Billings, Ramsey Group Inc., a securities firm in Arlington, Virginia. In May 2005, that amount was 5.4 percent.

Investors depend on guesswork by Wall Street traders for valuing their bonds because there is no centralized trading system or exchange for subprime mortgage securities. Credit rating companies supported high prices because they failed to downgrade the debt as delinquencies accelerated.

Headed Lower

While there’s no consensus on prices, traders agree that the bonds are headed lower. Some of the securities have already declined by more than 50 cents on the dollar in the past few months, according to data compiled by Merrill Lynch & Co.

One subprime mortgage bond, Structured Asset Investment Loan trust 2006-3 M7, is valued at about 91 cents on the dollar to yield 9.5 percent, according to the securities unit of Charlotte, North Carolina-based Wachovia Corp. Merrill Lynch in New York puts the price of the same security at 67 cents to yield 18 percent…..

The downgrades may force sales, giving investors who have relied on estimates real prices to value their own holdings. That would be novel in the market for asset-backed bonds.

The securities, backed by everything from student loans to auto payments to mortgages, almost doubled to about $9 trillion outstanding since 2000, according to the Securities Industry and Financial Markets Association.

Masking Swings

At least a third of hedge funds that invest in asset-backed bonds pick and choose values for their investment that help mask wide swings in performance, according to a survey of 1,000 funds worldwide by Paris-based Riskdata, a risk management firm for money managers.

“If you have five different brokers you will get five different quotes, so if you don’t have an objective valuation process you can choose the quote which for you is the most interesting,” said Olivier Le Marois, chief executive officer of Riskdata. “There’s no consensus on where the market price is.”….

Wall Street has benefited from keeping the so-called structured finance market opaque. Securities firms collected $27.4 billion in revenue from underwriting and trading asset- backed securities last year alone, according to Kian Abouhossein, an analyst at JPMorgan Chase & Co. in London.

Investors struggle when they need to set values for subprime and lower-rated debt because the bonds trade infrequently, said Dan Shiffman, vice president at American Century Investment Management in Mountain View, California.

“If it’s a bond that requires a lot of credit work and if that bond hasn’t traded for some time, it’s very difficult to assess,” Shiffman said. American Century manages $5 billion in mortgage-backed and asset-backed bonds….
Trace system. Levitt is a director of Bloomberg LP, the parent of Bloomberg News…

Traders in subprime and low-rated asset-backed securities may resist any move to shine a light on the trades because they benefit from having their moves kept under wraps, said American Century’s Shiffman. “They might get better execution rather than having the bonds flagged all over the market,” he said.

So what do we have here? We have a fairly large amount of bonds in aggregate, and for many of them, even the most sophisticated players didn’t know what they were worth in a good market. A bid of 91 from one dealer and 67 from another on the same security is a staggering difference. And now we are having forced liquidations, and it’s unlikely there will be enough buyers because more downgrades are in the works. Speculators are likely to wait till the carnage gets worse.

But the real news isn’t these immediate downgrades. It’s the fact that the rating agencies have finally gotten religion and are going to start going through these instruments with a much more jaundiced view. Mind you, they’ve started with subprimes, but they will get around to CDOs, so this is the beginning of a long and painful process. And even if they are cautious and late to the game, this process is going to force more trading, and the price discovery is going to be very painful.

And most important is that Standard & Poors has announced it is changing its methodology (and we imagine Moodys and Fitch will have to follow). Tanta of Calculated Risk was good enough to post the bulk of S&P’s lengthy press release. Let me give you a few of the high points:

Many of the classes issued in late 2005 and much of 2006 now have sufficient seasoning to evidence delinquency, default, and loss trend lines that are indicative of weak future credit performance. The levels of loss continue to exceed historical precedents and our initial expectations.

We are also conducting a review of CDO ratings where the underlying portfolio contains any of the affected securities subject to these rating actions…On a macroeconomic level, we expect that the U.S. housing market, especially the subprime sector, will continue to decline before it improves…

Although property values have decreased slightly, additional declines are expected. David Wyss, Standard & Poor’s chief economist, projects that property values will decline 8% on average between 2006 and 2008, and will bottom out in the first quarter of 2008.

It’s pushing 3 AM, so I will be terse in my comments here. An 8% decline is a much bigger number than most mainstream forecasters have put forth (although some specialists have put forth even grimmer estimates). That in turn has nasty ramifications for the economy, and frankly seems inconsistent with a bottom in 1Q 2008.
Back to S&P:

Data quality is fundamental to our rating analysis. The loan performance associated with the data to date has been anomalous in a way that calls into question the accuracy of some of the initial data provided to us regarding the loan and borrower characteristics. A discriminate analysis was performed to identify the characteristics associated with the group of transactions performing within initial expectations and those performing below initial expectations. The following characteristics associated with each group were analyzed: LTV, CLTV, FICO, debt-to-income (DTI), weighted-average coupon (WAC), margin, payment cap, rate adjustment frequency, periodic rate cap on first adjustment, periodic rate cap subsequent to first adjustment, lifetime max rate, term, and issuer. Our results show no statistically significant differentiation between the two groups of transactions on any of the above characteristics. . .

Translation: they lied to us. Remember, rating agencies don’t do due diligence. Back to the press release:

In addition, we have modified our approach to reviewing the ratings on senior classes in a transaction in which subordinate classes have been downgraded. Historically, our practice has been to maintain a rating on any class that has passed our stress assumptions and has had at least the same level of outstanding credit enhancement as it had at issuance. Going forward, there will be a higher degree of correlation between the rating actions on classes located sequentially in the capital structure. A class will have to demonstrate a higher level of relative protection to maintain its rating when the class immediately subordinate to it is being downgraded. . . .

OK, now they will be quicker to downgrade higher rated tranches if the lower graded tranches that were providing credit support get whacked. That only makes sense, and one has to wonder at how they could have justified their old posture. To S&P:

Given the level of loosened underwriting at the time of loan origination, misrepresentation, and speculative borrower behavior reported for the 2006 vintage, we will be increasing our review of the capabilities of lenders to minimize the potential and incidence of misrepresentation in their loan production. A lender’s fraud-detection capabilities will be a key area of focus for us. The review will consist of a detailed examination of: (a) the overall capabilities and experience of the executive and operational management team; (b) the production channels and broker approval process; (c) underwriting guidelines and the credit process; (d) quality control and internal audits; (e) the use of third-party due diligence firms, if applicable; and (f)secondary marketing. A new addition to this review process will be a fraud-management questionnaire focusing on an originator’s tools, processes, and systems for control with respect to mitigating the potential for misrepresentation.

Oh, so they are going to do due diligence? Tanta doesn’t think so; she envisages a questionnaire. But that’s still progress of a sort.

As MarketWatch noted:

Standard & Poor’s just drove a huge harpoon into the heart of the mortgage credit bubble, and it’s going to take a long time to clean up the mess once the beast finally dies.

S&P, one of the three main credit-rating agencies that served as enablers of the subprime-mortgage boom, announced Tuesday that it would lower its ratings on 612 bonds, a small portion of the mortgage-backed securities it had given its seal of approval to.

But the bigger news is that S&P isn’t going along with the charade anymore. S&P said it would change its methodology for rating hundreds of billions of dollars in residential-mortgage-backed securities. And it would review its ratings on hundreds of billions of dollars in the more complex collateralized debt obligations based on those subprime loans.

A lot of debt will be downgraded to junk status. A lot of that debt will have to be sold at fire-sale prices. A lot of pension funds and hedge funds that once thrived on the high returns they could get from investing in subprime junk will now lose a lot of money.

S&P’s announcement is a death warrant for the subprime industry. No longer will mortgage brokers be able to help buyers lie their way into a home. Fewer stressed homeowners will be able to refinance their mortgage, thus extending and exacerbating the housing bust.

“We do not foresee the poor performance abating,” S&P said.

Prices will fall, and foreclosures will rise. More mortgage fraud will be uncovered as the tide goes out.
And hedge funds will have to find another way to beat the market — if they survive this blow, that is.

Now that may sound terribly melodramatic, but consider this tidbit from (of all places) the UK’s Telegraph:
When creditors led by Merrill Lynch forced a fire-sale of assets, they inadvertently revealed that up to $2 trillion of debt linked to the crumbling US sub-prime and “Alt A” property market was falsely priced on books.

Even A-rated securities fetched just 85pc of face value. B-grades fell off a cliff. The banks halted the sale before “price discovery” set off a wider chain-reaction.

“It was a cover-up,” says Charles Dumas, global strategist at Lombard Street Research. He believes the banks alone have $750bn in exposure. They may have to call in loans.

The reason I take this seriously is that I heard rumors after the Feb 27 global selloff, in which subprime related paper took a bit hit, that if the downtrend had continued much longer, the margin calls to hedge funds would have forced a larger wave of selling that would likely have damaged dealers.

The rest of the Telegraph piece is sobering reading:

Not even the Bank for International Settlements (BIS) has a handle on the “opaque” instruments taking over world finance.

“Who now holds these risks, and can they manage them adequately? The honest answer is that we do not know,” it said.

Markets have been wobbly since the surge in yields on 10-year US Treasuries, the world’s benchmark price of money. Yields have jumped 55 basis points since early May on inflation scares, the steepest rise since 1994. It infects everything; hence that ugly “double top” on Wall Street and Morgan Stanley’s “triple sell signal” on equities.

Wobbles are turning to fear. Just $3bn of the $20bn junk bonds planned for issue last week were actually sold. Lenders are refusing “covenant-lite” deals for leveraged buy-outs, especially those with “toggles” that allow debtors to pay bills with fresh bonds. Carlyle, Arcelor, MISC, and US Food Services are all shelving plans to raise money. This is how a credit crunch starts.

“This is the big one: all investment portfolios will be shredded to ribbons,” said Albert Edwards, from Dresdner Kleinwort.

The BIS had warned days earlier that markets were febrile: “more risk-taking, more leverage, more funding, higher prices, more collateral, and in turn, more risk-taking. The danger with such endogenous market processes is that they can, indeed must, eventually go into reverse if the fundamentals have been over-priced. Such cycles have been seen many times in the past,” it said.

The last few months look like the final blow-off peak of an enormous credit balloon. Global M&A deals reached $2,278bn in the first half, up 50pc on a year. Corporate debt jumped $1,450bn, up 32pc. Private equity buy-outs reached $568.7bn, up 23pc. Collateralised debt obligations (CDOs) rose $251bn in the first quarter, double last year’s record rate.

Leveraged deals are running at 5.4 debt/cash flow ratio, an all-time high. As the BIS warns, this debt will prove a killer when the cycle turns. “The strategy depends on the availability of cheap funding,” it said.

Why has such excess happened? Because global liquidity flooded the bond markets in 2005, 2006, and early 2007, compressing yields to wafer-thin levels. It created an irresistible incentive to use debt.

What is the source of this liquidity? Take your pick. Goldman Sachs says oil exporters armed with $1,250bn in annual revenues have been the silent force, sinking wealth into bonds; China is recycling $1.3 trillion of reserves into global credit, a by-product of its policy to cap the yuan; Japan’s near-zero rates have spawned a “carry trade”, injecting $500bn of Japanese money into Anglo-Saxon bonds, and such; the Swiss franc carry trade has juiced Europe, financing property booms in the ex-Communist bloc. And, all the while, cheap Asian manufactures have doused inflation, masking the monetary bubble.

The deeper reason is the ultra-loose policy of the world’s central banks over a decade. They “fixed” the price of money too low in the 1990s, prevented a liquidation purge to clear the dotcom excesses, then kept rates too low again from 2003 to 2006. Belated tightening has yet to catch up.

Don’t blame capitalism. This is a 100pc-proof government-created monster. Bureaucrats (yes, Alan Greenspan) have distorted market signals, leading to the warped behaviour we see all around us.

As the BIS notes tartly in its warning on the nexus of excess, this blunder has official fingerprints all over it. “Behind each set of concerns lurks the common factor of highly accommodating financial conditions” it said.

Rebuking the Fed, it said Japan and Europe have turned sceptical of the orthodoxy that central banks can safely let asset booms run wild, merely stepping in afterwards to “clean-up”.

The strategy leads to serial bubbles, creates an addiction to easy money, and transfers wealth from savers to debtors, “sowing the seeds for more serious problems further ahead”.

If you think we are too clever now to let a full-blown slump occur, read the BIS report.

“Virtually nobody foresaw the Great Depression of the 1930s, or the crises which affected Japan and south-east Asia in the early and late 1990s. In fact, each downturn was preceded by a period of non-inflationary growth exuberant enough to lead many commentators to suggest that a ‘new era’ had arrived,” it said.

The subtext is that you bake slumps into the pie when you let credit booms run wild. You can put off the day of reckoning, as the Fed did in 2003, but not forever, and not without other costs.

So the oldest and most venerable global watchdog is worried enough to evoke the dangers of depression. It will not happen. Fed chief Ben Bernanke made his name studying depressions. He will slash rates to zero if necessary, and then – in his own words – drop cash from helicopters. But his solution is somebody else’s dollar crisis.

On it goes. Perhaps governments should simply stop trying to rig the price of money in the first place.