US financial meltdown: it ain’t over till it’s over

The size of American banks' write-downs on mortgages has led many people to believe the worst is over. But overexuberance in other markets is just beginning to surface, reports Cris Sholto Heaton

"It ain't over till it's over," once opined Yogi Berra, the famed baseball player and legendary mangler of the English language. No one seems to have asked his views on the credit crunch, but if they did he could refer them back to that quote. The news that US banks Washington Mutual and Wachovia will have to raise $7bn to offset their latest write-downs, together with the market-shocking drop in profits at GE's financial divisions, demonstrate very clearly that it ain't over yet.

It's understandable why many think the worst must be past the sheer size of the write-offs so far could easily lead you to wonder how much more money can be lost. After all, banks have already written down $245bn and raised $150bn in capital to repair their balance sheets. But the truth is that this is more likely to be the beginning than the end. Not only have we not seen all the losses from the mortgage debacle, but the reckoning from overexuberance in other parts of the credit market has barely begun.

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The first thing that we should note is that the problem is not just subprime. It's not even subprime and Alt-A. (Alt-A means the borrower has a decent credit score, but the application doesn't conform to prime standards often there's limited or no proof of income.) If truth be told, some of the prime out there looks, well, not that prime after all foreclosure rates on prime adjustable-rate mortgages are now following subprimes.

The fact is that we are in uncharted territory with US mortgages, both in terms of the scale of the bubble and the slackness of the lending standards. The question is: how bad will the damage be? Estimating likely losses is very tricky since we don't have accurate precedents to go on. But one attempt, by a group of economists including Jan Hatzius of Goldman Sachs, tries three different approaches and finds all point to losses north of $400bn.

Of this, they forecast that a bit over half around $240bn will be borne by the leveraged financial sector: banks, broker-dealers, hedge funds and finance companies. The rest will fall on investors such as pension and insurance funds, who own mortgage-backed securities (MBS) bonds backed by the cashflow from pools of mortgages or collateralised debt obligations (CDOs) built in turn from pools of MBS.

Although all these losses are important, it's the financial sector losses that matter most. That's because it's the erosion of the banks' capital through write-downs that forces them to cut lending and interferes with the supply of credit to the economy. The credit crunch won't be over until the bleeding stops and the new injections of capital let banks open for business once more.

With that in mind, the situation doesn't look too bad. Although not all the write-offs so far are mortgage debt, it looks reasonable to conclude from the size of them that we're fairly far through recognising the losses especially since those by more private holders such as hedge funds will have been recognised, but won't be acknowledged so publicly. Meanwhile, the rights issues so far are going a good way to replacing vanished reserves. As far as US mortgages go, the end may be in sight. So what's the snag?

The problem is that residential is just the beginning. Consumers aren't just in trouble on mortgages they're in trouble everywhere. If people default on their mortgages, we should expect them to default on credit cards, car loans, student loans, home loans and every other form of debt that has been recklessly advanced for the last few years. And that's exactly what we're seeing. Latest data from the American Bankers Association show consumers falling behind on payments at the highest rate in 15 years. This, remember, is before we're even fully into a US recession.

These types of debt aren't as big as the mortgage market, but they're significant there's around $2.5trn in consumer credit outstanding, compared with $10.5trn in mortgages. And, like mortgages, these loans have been distributed through the financial system, by being placed into asset-backed securities (ABS) or sliced and diced into CDOs. In other words, they are waiting to wreak havoc in just the way that mortgages already have.

Goldman's analysts expect total losses of $145bn for credit cards and $78bn for car loans. The good news for financial institutions is that the hit to them is likely to be smaller (relatively speaking) because they have less exposure to these losses Goldman estimates losses of $38bn and $13bn respectively. But it does bring a whole new group of potential losers into the frame, such as specialist credit card lenders as well as less-obvious victims such as car firms, through their finance arms.

However, consumer problems don't account for everything at risk. US commercial real estate and construction and development lending also got carried away. While the excesses weren't as great as in residential, there's no doubt that lending standards slipped, overbuilding took place and prices were bid up beyond reason.

Now the strains are showing. Delinquency rates on commercial mortgages almost doubled during 2007, even while the non-residential construction boom continued. Now construction appears to have peaked and is poised to follow residential down. Vacancy rates are rising in many areas. Meanwhile in the usual case of the stable door slamming behind the departed horse the Fed's Senior Loan Officer survey shows commercial lenders steadily tightening their standards.

Commercial real-estate losses are starting to show up in banks' write-downs, but the majority is still to come Goldman estimates losses to the leveraged financial sector of $83bn. But the loss profile may be a bit different while the big banks are heavily exposed to residential mortgages, commercial loans are concentrated with mid-sized US regional banks (see chart below). These firms may have dodged a bullet by not being so heavily exposed to residential mortgages, but their reckoning is coming.

Leveraged loans

It's not just a consumer problem and real estate problem. Anyone who looks at recent write-downs in any detail will have noticed the words leveraged loan' cropping up with increasing frequency. Leveraged loans are loans to companies that have a higher risk of defaulting on the debt they're the loan equivalent of a junk bond. The two are also known as high-yield loans and high-yield bonds respectively, reflecting the fact that the borrower must pay more interest to compensate for the higher risk of default.

Leveraged loans were part of the start of the credit crunch. Banks had been advancing loans to private equity groups to fund their buyouts, with the loans then being syndicated (sold on to other investors) or repaid when the borrower raised money in another way such as issuing high-yield bonds in the bond market. For arranging this temporary loan, the bank pockets a sizeable fee. It was a good business until the credit crunch hit and buyers went on strike, leaving the banks stuck with a sizeable backlog of loans on their balance sheets.

At its peak, the backlog was estimated in the region of $300bn, although it has now been pared down to somewhere above $200bn. But to shift these loans, banks are being forced to sell at big losses. Prices around 85-90 cents on the dollar are common, with some deals being reported in the 60s.

At first, this looks strange. Unlike mortgages, where losses are already taking place, and consumer loans and commercial real estate, where default rates are picking up, the stress in corporate debt is pretty much confined to the price it fetches in the market. Default rates remain very low ratings agency Moody's report defaults of 0.1% on leveraged loans and 1.3% on high-yield bonds for 2007. So why are investors running scared?

By now, it's widely known that lending standards in the mortgage market were lamentably low for many years. What fewer people realise is that standards in lending to businesses slipped drastically as well. Just as mortgage firms lent at increasingly high multiples of salary, corporate lenders grew less stringent about borrowers' financial strength (see chart below). Covenants on loans became laxer. Riskier debt such as second-lien and mezzanine loans which rank behind other loans when it comes to getting paid in the event of a default proliferated, while the ratio of lower-rated to higher-rated bonds increased.

Meanwhile, like mortgages and consumer credit, much of the debt was securitised into collateralised loan obligations (CLOs) and sold on, spreading the impact further through the system. In short, corporate lending had its own subprime problem.

While default rates remained low, this relaxed approach to lending standards seemed fine, but that benign environment is unlikely to continue. Moody's forecasts that US bond default rates will increase to 5.3% by the end of 2008 and loans to 3%. However, this would merely take it back to near long-term average levels and assumes neutral liquidity conditions return if liquidity remains as tight as it is currently, analysts say 10%-plus default rates on bonds (and an implied rate of 6% or more on loans) are possible.

What's more, because loans have been distributed among lenders to a greater extent than before, there could be a substantial difference between this credit cycle and previous ones, says Willem Sels, head of credit strategy at Dresdner Kleinwort. In the past, a defaulting company would often be dealing with one lender the bank that originally made the loan. This time, most will be dealing with several lenders on each loan, who have different agendas and whose interests may not be aligned with each other or the borrower.

The result may be less-than-ideal for all involved borrowers are forced into bankruptcy or rushed asset sales, while lenders get back less than they might otherwise have done. Consequently, Sels thinks that recovery rates are likely to be well below their historic average of 35% for high-yield bonds and 65% for leveraged loans.

Goldman estimates that the leveraged financial sector will take losses of $53bn on corporate loans and $33bn on bonds, bringing the grand total to around $458bn. Overall losses, including investors such as pension and insurance funds, may top $1.2trn. These figures involve a lot of assumptions that may be too pessimistic or too optimistic; in addition, there's no allowance for the bursting housing bubbles elsewhere in the world. But the message is clear banks are nowhere near to finishing their write-downs. And until they do and raise enough capital to patch the resulting holes in their balance sheets the credit crunch won't be over.

So what does this mean for investors? If you're invested in a financial company, it's no good being reassured that it has little subprime exposure you also need to know its exposure in other debt classes and other lines of business, such as prime brokerage (lending to hedge funds that may in turn be invested in risky debt). Consider Citigroup's proposed sale of $12bn in leveraged loans, which will see the bank provide 75% of the finance for the deal while it will no longer be on the hook for the first slice of the losses, it certainly hasn't shifted all the risk.

It's also important to know where funds are investing their money. We've already seen problems with funds that held risky mortgage debt in an effort to eke out more yield, and discovered that many AAA-rated CDOs weren't really AAA. The same problems are likely to crop up with other forms of debt.

Lastly, investors in companies with a high debt load should be aware of a higher risk of default. Check its funding arrangements is it in danger of breaching covenants (such as the level of Ebitda/interest cover) or does it have debt that needs to be refinanced soon? The prospects aren't good for firms that need more money in these markets and existing shareholders are likely to get little in any restructuring.

The final question is how to make money from the crunch. Any credit crisis such as this creates opportunities. Panicked investors fail to differentiate between good and bad, giving you the chance to pick up oversold, but solid debt and to invest in distressed companies that may survive. We look at two ways to make a play on this below.

Two risky ways to profit from the crunch

Investing in mispriced debt or distressed companies is high risk. Securities that seem too cheap may be so for a reason, while turnaround investments often fail to live up to the name. That caveat aside, times like this throw up some interesting opportunities and here are two ways to play these themes.

Prodesse (PRD) is a specialist investment company that invests in AAA-rated securities from US Government Sponsored Entities (GSEs). Bond investors have long treated the GSEs as carrying a US government guarantee, but this isn't true; only Ginnie Mae is guaranteed and the other two explicitly point out that they are not.

Recently, GSE bond prices and credit default swaps have been volatile as markets question the assumption that the government would always bail them out. But while the GSEs could technically default, the chance is incredibly slim the disruption that it would cause in the market would be so vast that it's impossible to imagine the government allowing it to happen.

Investing in these securities when traders are panicking over non-existent threats looks a good bet but bear in mind that Prodesse uses leverage to increase returns and consequently carries higher risk.

Although you can invest directly in distressed companies and hope for a turnaround, entrusting your money to a specialist fund may be a better option, since it will have enough clout to affect the future of the company. There are a few investment companies whose investing styles cater to this Chris Mayer of Capital & Crisis picks out Leucadia National (US:LUK), a New York-based conglomerate that practices "the epitome of distressed investing". Buying shares in a firm like this involves putting your trust in the management's judgment. However, Leucadia's track record, stretching back to 1979, looks pretty good.