As 2007 drew to a close, I surveyed some shell shocked Australian fixed income to get their insights on the credit crunch. Little did they know 2008 would be a whole lot worse...
Insto Bond Diary
***2007- A challenging year (20 December 2007)***
As 2007 draws to a close, Insto met representatives of the fixed income investor community to reflect on what was an extremely unsettling year for global bond markets.
It was a year when the world turned upside down. The focus at the end of last year, when a QANTAS buyout loomed, was on event risk in the corporate sector. Twelve months later it is the chaos in the financial sector that is causing sleepless nights for fund managers.
The year will go down as the most turbulent in credit markets, and one from which Australia could not escape.
It presented a number of challenges that markets have taken for granted such as confidence and trust in the financial system.
"There are some bigger picture issues that the market had to do some thinking about,” said an investor.
The trouble in markets began in July and continued in waves throughout the end of the year. Despite showing signs of a recovery in November, the market was plunged back into despair as offshore banks announced massive write downs.
Many regard the crisis as more severe than any before as financial markets grappled with the uncertainty and complexity of the problems for over six months.
Australian credit and fixed income markets stalled during this period. Liquidity was by far the biggest issue for investors. The primary and secondary corporate cash market remained virtually shut throughout the second half of the year. Funds struggled to find bids as brokers retreated.
Once the credit crunch began, investors in general attempted to shed exposure to credit. They needed liquidity to ensure they could meet redemptions and avoid further mark to market losses as spreads remained volatile
Bids were hard to come by and those that were on offer were unpalatable. The era of free liquidity had come to an abrupt end.
Exactly what constitutes a liquid asset also has to be reassessed following a widening of swap rates. At times, only cash at bank could be deemed truly liquid.
The market was also reminded of many wisdoms it had abandoned – leverage is a double edge sword, liquidity is only there when you don’t need it, a AAA is not a AAA, don’t lend to people who can’t repay, borrowing short and lending long is fraught with danger, and history keeps repeating itself.
The market was also retaught the concept of “systemic risk” and the need to prepare for the possibility that things will go wrong down the track in every deal.
Some new risks were also introduced.
“CDOs allowed low quality credit risk to be enhanced through securitisation. The global chase for yield took the compensation for this risk to ridiculous levels. Complexity, liquidity and leverage have all been re-priced in a very short period of time,” said Fred Mellors, UBS Global Asset Management.
The role of the rating agencies has been scrutinised but investors emphasised that they do not rely on ratings as an assessment of credit worthiness.
Investors did, however, identify where the agencies had gone wrong. Their models proved inadequate driven by a number of factors including a lack of historical data, poor assumptions, conflicts of interest and the ‘gaming’ of models by arrangers.
A few positives did emerge in 2007.
The repricing of risk has made credit an attractive sector again with abundant value and opportunity, although the severity of the process caused substantial pain.
Credit quality is also likely to improve as banks tighten their lending standards and investors demand better ABS collateral and more robust structures.
Also, fund managers feel that there will be more tiering of their abilities and good performance will be more visible.
Another positive has been the credit derivatives market which has proved to be a crucial alternative or enhancement to the physical market. Credit Default Swaps was a critical tool to a number of managers looking to manage their risk when liquidity dried up.
The extremities of 2007 are most evident in the RMBS market. The disparity between deals completed at different points in the year demonstrated just how much the credit environment had been altered.
“Comparing CBA’s Medallion 2007-1G which priced at the sweet spot of the year with Bluestone’s Sapphire 2007-2, which priced at the worst point. In just two deals you can sum up the entire shift in sentiment over the course of the year. One was huge, global and very expensive while the other was small, a struggle to be completed, heavily oversubordinated and at eye watering spreads. Complete complacency in early 2007 gave way to paranoia in December,” said Nick Bishop, Aberdeen Asset Management
The market faces critical challenges as many issuers struggle to fund themselves. An oversupply of paper due to an unwinding of offshore structured vehicles, which hold the bulk of outstanding paper, is keeping spreads at wide levels.
A host of issuers are desperate for funding and are waiting for market conditions to improve.
Investors are concerned that once markets show signs of a recovery, a rush to the gates will result in further oversupply.
“When they can issue, we will see a wave RMBS issuance and there might be an overhang of supply which makes us negative on any quick recovery in the market,” the market,” said John Sorrell, BT Financial.
Fund managers are comfortable with Australian mortgage assets, which have performed well as credits, but are warning issuers that they will demand a substantial liquidity premium to participate in RMBS deals going forward.
Structured credit in general faces a crisis of confidence. Investors feel that sectors of the structured market will vanish. ABS CDOs and other re-leveraged products are unlikely to survive. Balance sheet CLOs, where banks package exposure to manage credit risk, will continue to be issued and investors remain open to participating in deals. The less complex and more economical the structure, the more it will be accepted.
For now markets remain uncertain. It must deal with another wave of bank results that investors hope will reveal the extent of their exposure to the crisis. The credit standing of monoline insurers who insure trillions of dollars of bonds and the fate of non bank lending institutions around the world are also questions marks.
Fund managers all agree that 2008 will be characterised by further volatility.
It could be the period when corporates begin to feel the effects of increased funding levels.
“Liquidity could start to sort itself out but we could be heading into a fundamental credit downturn,” said a fund manager.
It will also be a year in which credit markets repair themselves and the process to do so has already begun.
By all accounts, the pain is not over but most are glad that it is for 2007.
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