Who was to blame for the credit crisis ?

Insto Bond Diary 

Covering credit markets as the credit crisis unfolded was fascinating. ANZ held a structured credit conference  weeks after the Bear Stearns hedge fund imploded. It turned out to be a charged gathering where lenders (including a stressed out treasurer from RAMS) and investors discussed the bleak outlook and who was to blame. 

 ***ABS market takes stock (20 August 2007)****

Australia’s asset backed issuers and investors gathered against a background of turbulent credit market conditions for ANZ’s annual ABS Outlook conference in the NSW Hunter Valley last week.

While issuance is firmly on hold, the gathering provided a unique opportunity for the market’s sharpest minds to assess an extraordinary few weeks in credit markets.

Last year’s ABS event, held in an environment of tight spreads and private equity, seemed like a lifetime away. The “unprecedented disruption” in markets has put many on the back-foot wondering when activity will return and at what levels.  

A snap survey of the 90 attendees produced some interesting results. Issuers saw ABS AAA spreads between 18 and 22 basis points, while investors see 28 to 32 basis points as a fairer level.

Not surprisingly, the majority of issuers felt that credit markets had overreacted, while investors viewed markets as having acted accordingly.  Issuers are well funded at present, with 83 per cent stating that they do not need to access the capital markets until the new year. Investors are sitting out too and holding a fair split between cash, bank bills and commercial paper.  

Both issuers and investors agreed that while the credit and liquidity crisis was not quite the end of the world, it was very material, significant and disruptive.   

An animated panel discussion tried to make sense of the credit crisis that began with hedge fund implosions and continued with a liquidity crunch and central bank intervention. The fuse was lit by the collapse of the sub-prime home lending market in the United States and the participants tried to interpret the cause and effects.

“The people in the US sub-prime market who have a history of not paying are...not paying,” said Nick Fyffe, director- investor sales, ANZ. 

Over the next 18 months, US$600 to US$800 billion worth of mortgages in the US will have rate resets. The step up in the interest component is expected to have a significant impact.  As loans mature from interest only to include principal repayments, the expectation is that delinquency rates are quite likely to  materially exceed current levels.

“A lot of these US sub-prime loans will see their interest rate reset period at the end of 2007 and 2008. Given current market conditions, the servicer will have to work with borrowers to modify loan terms so that borrowers can still afford to make their payments," said  Moody’s US based analyst Debashish Chatterjee.

Those directly exposed to subprime are home loan originators, loan servicers and to a lesser degree the monoline credit wrappers who have insured sub-prime deals. Hedge funds who took exposure to sub-prime backed structured credit products have also felt the burn with many reporting huge losses.

“In Australia, we have only really had one month of fund asset revaluations  and that was on the  31 July. Market moves in August have to dictate that the next revaluation is  going to be much more severe. It’s going to be causing problems of more magnitude and across more funds,’ said Sarah Percy-Dove, head of credit research, ANZ.

“The credit issue and the market issue are different. If the credit quality hasn’t changed and the liquidity has, then over time you should get your money back. The tail is now wagging the dog in this market,” said Fyffe.

Economists assume that losses resulting from sub-prime will total between US$100 billion to US$125 billion. 

The ABX BBB- index, which is used as a measure of sub-prime securities performance, has plummeted. 

“Even though it has declined a long way, very quickly there will be funds at some point  wanting to enter the market. This will put a floor at some level. Hedge funds take a lot of  blame in these environments but importantly they also provide liquidity.  The shorts in the market will unwind at some point,” said Percy Dove.

With equity volatility indexes still nowhere near historic highs, the fall in stock markets may be far from over.

The outlook is unclear and the ripple effect in the equity market has only just begun. They (the equity market) haven’t figured out what is going on and they still have to adjust quite considerably,” added Percy-Dove.

The proliferation of leverage in the system has exacerbated the credit issues that began with the US sub-prime crisis. 

“Corporate balance sheets are in good shape but I would be a little concerned if I just started working in a leveraged finance department at an investment bank. That’s where you will see the slowdown in private equity and M&A,” said Fyffe.

The leverage of households may be the bigger issue.

“The big uncertainty is the leverage of household balance sheets. What will be important is the extent of pressure a tightening of financial conditions puts on households. That is where we could get a general deterioration in credit quality across the economy,” said Warren Hogan, head of economics and strategy, ANZ.

Hogan, however, feels that the next 12 months will be rosy for earnings and GDP growth and that stresses to the system will be managed by central banks. 

The panel also speculated as to who is to blame for the credit crisis.

Was it banks and other lenders that aggressively wrote business in the knowledge they could sell exposure?  Have the rating agency models failed to serve their purpose or have yield hungry investors abandoned their valuations and oversubscribed to risky deals?  

The debate was lively but there was a general consensus that this had as much to do with the system as it did the interests of various participants.

“This is a natural cyclical process in a market system after a period of excessive liquidity growth. There has to be a transition into normal financial conditions and unfortunately that process is happening in the presence of a unprecedented amount of leverage, causing distress,” said Hogan.

Many uncertainties remain in a financial system that has grown ever more complex.

 With volatility comes opportunity and real money remains cashed up. 

“People looking to enter the market have money to be put to work and they recognise that the volatility provides buying opportunities. But they are not buying until they get a sense of stability. Once they are prepared to re-enter, there will be a stabilising effect,” said Percy-Dove.

The conference also featured discussion on growing and emerging asset classes. Commercial Asset Backed issuance has experienced significant growth as property trusts engage in capital recycling. Also as Australia continues to grow older, securitisation techniques are being applied to cash flows from retirement properties in the form of deferred management fees. 

Another new product set to hit the wholesale shelves is shared appreciation mortgages (SAMs), which could assist home owners by allowing them to trade the capital appreciation of their homes for more affordable rates.

In Australia, the media has attempted to draw parallels to the sub-prime chaos in the US, but the market here remains fundamentally sound.

“We are not seeing the problems today being talked about in the media. Some of the interesting statistics are very headline driven. An article last week stated that claims on mortgage insurance were up 329 per cent in a year but that total claim was A$210 million on a market of A$800 billion, which is less than 5 basis points of losses. If anything it shows there is a long way to go before we have problems,” said Ben McCarthy, managing director, Fitch Ratings.

As the market waits for calm to be restored, there are some concerns of the long term fallout of the sub-prime crisis. Some speculated that there could be a political reaction, resulting in industry scrutiny and regulations similar to Sarbanes Oxley type legislation.

Participants took comfort in the fact that securitisation presents far more solutions. The technique of risk transfer has arguably done far more than any policy to promote asset ownership and is regarded as one of the greatest financial innovations of the last 100 years. 

The last few weeks have been some of the most challenging for capital markets, asset backed issuers and investors are patiently observing credit markets, positioning themselves to resume activity.

Former Wallaby skipper Phil Kearns offered some advice to weary market participants, which includes credit traders who have spent many a weeknight awake on their sofas clutching their blackberries, on how to handle adversity - Keep composure, stick to doing the fundamentals and everything else will fall into place.