How will the Bear Stearns saga end?
We are at a critical point as far as markets are concerned. Is the recent trouble in the subprime market enough to turn investor sentiment negative and trigger a sell-off?
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We are at a most interesting point so far as markets are concerned. China is crashing whilst many of the world's important stock markets such as the UK FTSE 100, the S&P 500, the German DAX and the French CAC 40, are struggling close to their year 2000 highs, something we pointed out in the previous issue. At such levels, negative investor psychology can take over and trigger selling, particularly because there are threats in the air, all of which seem to be appropriate - Central Banks tightening, hedge funds losing money from investing in CDOs and commercial property markets in many parts of the world visibly weakening.
How will it all pan out?
There is nothing to worry about because according to a headline in The Financial Times on July 5th "Takeover activity to fore as credit worries recede". Given that the news about the two hedge funds at Bear Stearns blowing up was only two weeks ago and the consequences are so far reaching, we would take that headline with a big pinch of salt. We think more likely than not that the Pandora's box has opened and no amount of headlines will shut it.
One clue to solving the investment puzzle is that the VIX which is we think poised to explode upwards rather than subside downwards. Following the VIX's coming surge, the world will be different as people's attitude to risk will dramatically change as the credit crunch bites hard.
Anyone who has been reading the financial press over the recent fortnight will have been overcome by articles about the Bear Stearns hedge fund story and all that emanates from it. There have been a number of news items about other hedge funds also affected, the most recent of which is Unit Capital Asset Management, a mid-sized Florida hedge fund. They have been forced to suspend redemptions from several funds holding asset backed securities. Prior to that, the London fund Calibre Global, who are selling assets and returning funds to investors following an $8.8m net subprime loss. Prior to that but also following the Bear Stearns news, Cheyne Capital Fund were reported to have lost £45m from CDO investments.
The American subprime mortgage market which is the root of the problem was an act of madness by mortgage lenders who should have known better. How can it be good business to lend 100% of the purchase price of a property to applicants who not only had no money, but no credit worthiness, nor sufficient income to meet the eventual true servicing cost of the loan? To then package those toxic loans with other better quality loans into CDOs and sell them is a process only justified by the big fees. Some of the buyers were hedge funds, others were pension funds. Almost all were institutions.
A Collateralised Debt Obligation (CDO) is a pool of mortgage-backed assets that are sliced into parts or tranches that carry different risks. For many of the CDOs, subprime mortgages comprise a meaningful percentage. It has been calculated that subprime mortgage securities make up about $100 billion of the $375 billion of CDOs sold in the US in 2006. According to data from Moody's and Morgan Stanley, half contained subprime debt of as much as 45% of the total contents. As John Mauldin explained in his recent letter, which we recommend you to read (to do so, go to his website www.frontlinethoughts.com), as foreclosures increase, subprime securities in CDOs begin to crumble. This almost certainly leads to a ratings downgrade below investment level. If that happens, many institutions will be forced to sell the CDOs they own because they are only allowed to hold rated paper. Who will they sell to and at what price? That is the question. John Mauldin also reported that according to Risk Analytics, who write computer programs for accounting firms, 25% of the face value of CDOs is in jeopardy.
"Oh what tangled webs we weave when at first we practice to deceive" - a famous saying that fits the bill absolutely. Intelligent people know that bad credit is a bad credit. Prudent lending practices work but imprudent practices destroy money and reputations. The marketplace has, over recent years, been riddled with imprudent lending practices operated, incredibly by intelligent, financially astute people who have made huge amounts of money by creating and passing on financial junk, labelled as investment grade, to experienced investors who ought to have known better.
Imprudent lending begets debt forgiveness (polite words for bankruptcy). Debt forgiveness begets bank and investment losses. It's therefore not surprising that the financial sector of the stock market is performing badly. Falling profits translate stock market valuations based on price-to-earnings (P/Es) ratios from being modestly ok, as the "E" component falls, to being expensive. As P/E ratios rise on the back of falling earnings, investor complacency evaporates.
As we have repeatedly said in the past, the unprecedented credit expansion will inevitably be followed by an unprecedented credit contraction and there is a very good chance, we think, that this is now underway.
By John Robson & Andrew Selsby at RH Asset Management Limited, as published in the Onassis Newsletter, a fortnightly newsletter that gives insight into the investment markets.
For more from RHAM, visit https://www.rhasset.co.uk/