Schizophrenia in the Financial Times on CDOs, Subprimes, and General Woefulness

OK, schizophrenia is a bit too strong a word, but it got your attention, right? “Dissonance” is closer to the mark, and differing points of view in a plugged-in, market-savvy paper like the Financial Times is an interesting sight to behold.

Both stories address the same general topic, namely, whether the current mess in subprimes is likely to lead to a a broad scale credit contraction. The FT editorial page gives a largely reassuring view in “Global credit woes,” while its capital markets editor Gillian Tett sounds a more worried note in her report, “Banks become barometer of woes in credit markets.”

My view is that framing the question in terms of subprime contagion is the wrong way to think about it. The very fact that we have had overeager credit extension on so many fronts: subprimes, CDOs, commercial real estate (it’s as frothy as subprimes before their rude awakening), LBOs, emerging markets means at some point we are bound to have a serious credit contraction. Pick a risky credit, any risky credit, and you got boatload of dough, no questions asked. The last time we saw this movie, in the late 1980s, there was also frantic lending, but not in anywhere near as many categories, yet the aftermath back then still brought the US and Japanese banking systems to their knees. So a correction, and a very large and broad based one, seems inevitable.

So it almost doesn’t matter whether subprimes will be the catalyst or not. Personally (and this distinction may be so subtle as to be irrelevant), I believe the trigger will be the need to revalue CDO paper. A massive amount of this stuff has been issued and is being carried at prices that are likely too high. Subrprimes may have been the trigger, but at some point the day of reckoning was going to come.

Tett has another take on it: she sees a pullback as being triggered by banks’ concerns about their reputation. That view has merit. Bear Stearns, once one of the most cocksure firms on the Street, is now so rattled that even its London private equity unit, which is about as remote from its hedge fund mess as you can get, is defensive (see “Eau de Panic at Bear Stearns“). An SEC investigation into its hedge fund woes is going to keep a harsh light on Bear. Similarly, Lehman was shellacked yesterday in the Wall Street Journal for its role in promoting subprime financing (“How Wall Street Stoked Mortgage Meltdown“). Hedge fund failures, admittedly relatively small ones, seem to be cropping up daily. Continuing bad press will engender caution.

The editorial sets up a straw man. Its view is that there won’t be a “systemic meltdown in the credit markets” but one can have plenty of credit tightening and a resulting economic slowdown without the problem rising to the level of a “systemic meltdown.”

First, the meat of the editorial, “Global credit woes“:

[W]idespread, lasting contagion from the subprime crash seems unlikely, because alongside these wobbles has come broadly good economic news. Real interest rates have risen as US investors reassessed the prospects for growth, and the chances of the Federal Reserve cutting interest rates this year.

Credit spreads remain unusually low – perhaps driven by global financial integration – and there is no question that the markets for securities such as high-yield corporate bonds are vulnerable to a fall. But a more substantial trigger than subprime will probably be needed for that setback to materialise.

The CDO market needs to grow up, fast. Participants need to improve the transparency and independence of pricing and develop more liquid markets for secondary trading. If the subprime slide does get worse, this lack of liquidity could lead to a wider crisis.

But balance of probability is that we are just seeing a shake-out in a market – subprime – that was always high-risk. If investors in other assets take note, and moderate their appetites for risk, today’s jitters may prevent a nastier credit crunch in months to come.

Now to Tett’s “Banks become barometer of woes in credit markets“:

As the shockwaves from the woes in America’s subprime sector spread, one of the biggest transatlantic hedge funds held an intensive internal debate yesterday to assess whether the big tipping point had finally been reached in credit markets – or not.

The conclusion? This fund apparently believes there is a 60 per cent chance the current bout of jitters is just a bout of modest(and badly needed) risk repricing, as opposed to a nastier crunch. But this is notably more gloomy than during the last bout of creditturmoil three months ago, when it had a75 per cent plus belief that calm would soon be restored.

“The credit market feels like a boxer in a ring,” one official told me. “It keeps taking blows, but then staggers back up. But you have to feel there is a limit to how many times you can get up from the mat.”

Quite so. On paper there are still plenty of reasons to think these current subprime-related jitters are just a temporary phenomenon that will subside soon. After all, the global economy remains strong, earnings are high, liquidity is rife – and the subprime sector, for all its gory drama, remains very small in the global scheme of things.

But markets, as financial history shows, have a nasty habit of overshooting when psychologies change. And I suspect the real key to whether we are now reaching a tipping point lies not so much in the technicals but in some subtle debates that are likely to be waged in the coming days behind the closed doors of hedge funds and investment banks.

After all, on June 30 the second quarter of the year ends and many of these funds are poised to calculate their performance data. It may take some time for these results to be given to investors and creditors for funds dealing with illiquid instruments such as subprime securities, since – as my colleagues point out on the opposite page – valuing complex instruments is a time-consuming affair.

However, some institutions are already mulling over whether to cut hedge fund exposures, alongside other credit risks. And there are at least two reasons why they may be feeling jumpier than macro-economic factors might imply.

One is that the penny is now, belatedly, dropping that some of the valuation techniques underpinning the recent explosion in the structured finance world may be dubious, not just in the subprime sector, but in the much larger leveraged finance world too.

But second, some senior bankers are rediscovering a long-ignored truth, namely that while modern financial whizz-kids may be brilliantly clever at moving credit risks off the books of banks, it is much harder to offload reputational risk.

If a highly leveraged buy-out deal blows up, in other words, this not only causes economic damage, but can also hurt the reputation of the banks that arranged the deal. Similarly, when a hedge fund goes down, this is embarrassing for any bank with close links to that fund. Just lookat the public relations woes besetting Bear Stearns, on top of its tangible economic losses.

No doubt some dealer banks will simply shrug their shoulders about this. But others may not. Or not when it is also becoming clear that the banks have not always offloaded quite as much economic risk as was widely assumed. It is instructive, for example, to see how rapidly Merrill Lynch has recently acted to extract itself from various embarrassing credit messes. No doubt the senior management at many other banks are now also debating whether it is time to pull in the horns, by imposing new haircuts or credit limits (or banning some of the nuttier things recently in vogue, such as providing equity bridges for buy-out deals).

It remains an open question whether this will lead to much tangible action. But if banks do start quietly turning off the credit spigot in the coming weeks – and it remains a big “if” – then we are indeed near a tipping point. Either way, if you are exposed to the credit sector, better not plan to take too much holiday this summer, particularly given how thin (and thus potentially volatile) the markets tend to be in late July and August.