I’ve been away for six weeks. Much been happening?
You could say that. Financial markets have been in turmoil. Central banks have
had to extend emergency lines of credit to cash-strapped banks. Hedge funds
have collapsed. Institutions have been bailed out using taxpayers money.
Scores of planned mergers and acquisitions have been cancelled. Normal
service in the City has, for the present, been abandoned.
Hold on a moment. When I left the country in mid-July, the FTSE 100 was at
6,700 and things seemed reasonably rosy.
You’ve missed a roller-coaster. From that high point for the year, the index
of blue chips slumped by as much as 12 per cent to a nadir below 5,900 and,
after huge spikes up and down, stands at just over 6,200. That pattern was
replicated in share markets worldwide. But the real fear and loathing has
been in the credit markets.
The credit markets?
The markets for corporate and packaged-up consumer debt. There has been a
sea-change in attitudes to risk. Investors in bonds and many other forms of
debt suddenly became much more risk-averse. That translated into higher
prices: they demanded a much higher yield. But also into supply shortages:
many just wouldn’t lend at any price. Suddenly the entire banking system,
built on borrowing short-term and lending long-term, looked precarious.
What brought this on?
Two words: American sub-prime. Investors came to a shuddering realisation that
much of the $300 billion (£150 billion) in home loans to America’s poor and
others with patchy credit histories wasn’t going to be paid back. Enticed
into home loans with attractive “teaser” initial terms, many were unable to
meet monthly interest bills once the loans had reverted to normal money
market rates. The rising interest-rate environment added to the pain. And
falling house prices in the United States meant that lenders were left
nursing losses even when properties were repossessed.
Early in the year, HSBC sent the first tremors through the financial markets
when it wrote off £5 billion of these loans. Since then a steady trickle of
other sub-prime lenders and brokers announced difficulties. In June, Bear
Stearns revealed that two of its hedge funds were in trouble because of
investments in securities backed by sub-prime mortgages – but it wasn’t
until mid-July that the full horror of the fallout became apparent. It took
a forecast from Ben Bernanke, Chairman of the Federal Reserve, that $100
billion or more could be lost for the unease to curdle into outright fear. A
few days later another consultancy predicted that banks would foreclose on
1.8 million American home-owners this year.
Ugly, but isn’t this just an American problem?
No, it is much wider than that. There were two factors. First, huge numbers of
these sub-prime loans were packaged up into CDOs and CLOs and sold to
institutions around the globe.
Whoa there! CDOs, CLOs?
Collateralised Debt Obligations, Collateralised Loan Obligations. At their
most simple, these are packages of mortgages parcelled up and sold on to
pension funds, hedge funds, special investment vehicls and other investors
enticed by the promise of a decent yield and – with hindsight – not
concerned enough about the credit-worthiness of the end borrower. Investors
have been just as likely to be German banks and French insurers as US-based.
Many UK banks, including HBOS, Lloyds TSB and HSBC, have created special
purpose vehicles investing in tens of billions of dollars of them. And then
there are jitters over SIV-lites, too, similar special-purpose vehicles with
the same weakness – a reliance on constant replenishment of their coffers by
short-term lenders.
And the other reason?
The realisation by investors that they had misjudged the risk of US sub-prime
borrowers led to a wholesale rethink of other risks. The conclusion was that
risk had been mispriced in all kinds of debt markets, in particular
leveraged buyouts, or LBOs. Banks happily lent money to LBOs confident that
the loans could be sold on or syndicated to other investors. When the mood
swung abruptly last month, banks were left holding huge amounts of
unsellable debt. In Britain the institutions that bankrolled the £9 billion
sale of Alliance Boots, the high street chemist, have been unable to sell on
this debt.
Why were these sub-prime home loans made in the first place?
A combination of sheer greed and a profound change over the past few years in
the way that banks do business. Bank employees and mortgage brokers were
paid and received bonuses according to how much money was lent. The quality
of the borrower and their ability to meet interest payments was regarded as
secondary. Institutions that originated the loans weren’t so bothered,
either, because they held them on their own balance sheets for only a few
months before selling them on in CDOs and CLOs.
So who, exactly, bought this stuff?
We don’t know yet, because the holders are anomymous. So far the casualties
range from hedge funds to sovereign states. And, anyway, it is infinitely
more complicated than that. More often than not, the mortgages were sliced
and diced. One CDO might hold the riskiest portion of thousands of
individual mortgages, another might hold the safest portion. Moreover, many
institutions bought insurance policies against defaults – known as credit
default swaps – in the derivatives market. Identifying who actually holds
the “toxic waste” is almost impossible until they admit to it themselves.
Bill Gross, managing director of Pimco, the huge bond investing institution,
likens it to the “ Where’s Wally?” puzzle books – Where’s Waldo? in America
– in which readers have to find the cartoon character amid crowds of other
people. The Waldos are bad loans and defaulting sub-prime paper. “While
market analysts can guesstimate how many Waldos might actually show their
face over the next few years – $100 to 200 billion-worth is a reasonable
estimate – no one really knows where they are hidden.”
So what happened next?
The machinery started to seize up. Banks were in a funk. There was a mad dash
for cash and the safest securities, such as UK Government gilts and US
Treasury bills. Loans were called in. Margin calls were made. Even strong
banks needing overnight loans to balance the books suddenly found that none
of their peers was prepared to lend to them. That was when central banks
started to step in. Both the US Fed and the European Central Bank have been
making credit available to inject some much-needed liquidity into the
system. The Bank of England has also made credit available, albeit at a
punitive rate of interest. Some of the biggest banks in the world, including
Citigroup and Barclays, have taken advantage of this credit. The impact has
been felt in many corners of the financial markets. Northern Rock, the
Tyneside-based bank, has been a particular casualty. It relies on the
wholesale money markets rather than small savers to finance its mortgages.
That source of finance has dried up. Rock shares have fallen by around half
from their highs at the start of the year.
The carnage extended even into the currency markets as investors scrambled to
unwind their favourite bet – the yen carry trade. By borrowing in Japanese
yen at ultra-low interest rates, converting the money into US dollars,
Australian dollars, euros and pounds and investing the money in
higher-yielding securities, it came to be seen as the perfect arbitrage. The
only possible risk was a bounce in the yen. Cue . . . a bounce in the yen.
Ouch! Still, presumably all these hedge funds that promised absolute returns
regardless of lurches in any particular asset class will have been safe from
the carnage? Er, no. Some of the biggest casualties of the market upheaval
have been quantitative hedge funds. These beasts, known as black-box
investors, simply trade according to preset computer programs designed to be
proof against anything the markets can throw at them. Global Equity
Opportunities, a $5 billion black-box fund managed by Goldman Sachs, lost
$1.3 billion in the space of a few days. Man Group’s black-box investment
fund AHL also posted big losses.
So have there been any winners?
Yes. Some hedge funds have made good money “shorting” sub-prime securities and
vulnerable-looking organisations – betting that their prices would go lower.
Traders who got in ahead of the herd have done well as the flight to safety
pushed up prices of blue-chip government securities. Anyone loaded up with
cash is in a strong position to buy assets cheaply. Insolvency firms and
lawyers will do well dismantling and picking over the corpses of failed
investment vehicles. The lesson that leverage is a two-edged sword has been
usefully relearnt without, so far, cataclysmic damage to the financial
system.
How the sub-prime squeeze has spread
Hedge funds
Hedge funds have been at the centre of the credit market rout. Investors on
both sides of the Atlantic became alarmed in late June when it emerged that
Bear Stearns, the Wall Street bank, planned to bail out two of its
struggling credit hedge funds, both heavily invested in American sub-prime
mortgage assets. Between them, the two funds had racked up about $1.5
billion of losses after defaulting borrowers sent the value of
mortgage-backed securities sliding. Bear offered to take on $3.2 billion of
liabilities, eventually extending a $1.6 billion line of credit so that the
funds could meet margin calls. Despite the bailout, less than a month later
Bear had to tell investors that their assets were, in effect, worthless. One
fund lost all its equity, the other had investments worth just nine cents in
the dollar.
Fears of credit contagion spread. Hedge funds were exposed and their
investments lost value. In the last week of July, the sector suffered its
worst returns in four years. Inevitably, individual firms suffered. Man
Group’s closely watched AHL Diversified Futures Fund fell 6.7 per cent that
week. Over the next ten days, GLG Partners’ $2.3 billion European equity
fund fell 4.4 per cent during the first ten days of August. Hedge funds run
by banks such as Goldman Sachs and UBS reported falling asset values. Few
trading strategies escaped unscathed. At the same time, investors rushed to
withdraw their hedge fund assets. Bear Stearns had to cancel redemptions on
its $850 million Asset Backed Securities fund to prevent further
withdrawals. The good news for hedge funds is that they were able to switch
strategies quickly. The bad news is that the market still expects a
collapse. (Miles Costello)
Investment banks
The past six weeks have been agony for the banks – in the main, American
consumer banks – directly exposed to sub-prime lending. And their pain is
getting worse. Last week, First Magnus Financial became the fourteenth
lender since December to seek bankruptcy protection and Countrywide
Financial was forced to tap a $11.5 billion (£5.7 billion) credit line after
failing to raise short-term debt. British banks have not escaped unscathed.
HSBC shocked investors in February when it set aside $10.6 billion to cover
bad debts for 2006, 20 per cent more than expected. Last week, HSBC shut its
home loan office in Indiana, cutting 600 jobs.
Others hit include banks with direct investments in CDOs or structured
investment vehicles (SIVs). Like other equity investors, banks’ proprietary
trading desks saw the value of their assets fall as markets around the world
plunged. Those with in-house hedge funds have been damaged by both bad
sub-prime investments and the subsequent fall in equities. Goldman Sachs
pumped $2 billion of its own cash into its Global Equity Opportunity fund
after the investor failed to cope with wild market fluctuations. Two funds
controlled by Bear Stearns went bust and UBS is expected to book a $300
million loss on troubles at Dillon Read Capital Management, its defunct
hedge fund business. The banks’ leveraged finance operations are sitting on
as much as $400 billion in unsyndicated, highly leveraged lending. It is
expected to take them months to parcel out the loans and only after
improving terms for investors at the expense of their fees. (Christine Seib)
Stock markets
For music fans, August 16, 2007, was significant for being the thirtieth
anniversary of the death of Elvis Presley. For equity investors, it will be
remembered as the day on which the full force of the summer’s sub-prime
credit crunch was most keenly felt. Unsettled by comments from Hank Paulson,
the US Treasury Secretary, that financial turmoil would “extract a penalty”
on US growth, stock markets worldwide lurched simultaneously downwards,
leaving the FTSE 100 more than 250 points lower: its biggest one-day
percentage loss in more than four years and its fourth-biggest points fall
ever. In the space of five weeks, the benchmark index dropped nearly 13 per
cent and that day alone saw £60 billion wiped from its value.
Every one of its constituents fell – even those, such as ICI, where the
backing of an agreed cash offer should have kept them in check. Falling
equity prices had created margin calls, where investors who have borrowed
cash against the value of their equity portfolios were forced to sell
equities to satisy their lenders – serving only to drive down the value of
their remaining holdings and forcing them to sell again. This meant that the
shares that suffered most were those that had attracted the heaviest weight
of short-term money. Yet even supposed “safe-haven” stocks suffered in the
rout. With fund managers seeking to take profits wherever they lay, that
often meant the selling of the more liquid stocks in their portfolios, in
which it is easier to deal. So it was that the likes of Tesco, down 16 per
cent from its peak, suffered even worse than the wider stock market. (Nick
Hasell)
Central banks
Central banks have been working overtime to restore confidence, but their
biggest challenge lies ahead: working out whether to put aside moves for
tighter policy and start cutting rates. With banks refusing to lend to each
other, the European Central Bank (ECB) started to inject billions of euros
of liquidity into the market, lending directly to institutions to ease the
pressure on overnight lending rates. Despite the global turmoil, the ECB has
hinted that it may still press ahead with a September rise in interest
rates, to 4.25 per cent, clearly signalled before the squeeze began. In
contrast, the Bank of Japan has already shelved a planned rate rise.
The US Federal Reserve has also been enhancing liquidity. On August 17, it cut
its discount rate for emergency bank lending from 6.25 per cent to 5.75 per
cent and extended the term of the loans to 30 days. Yet stigma surrounds
borrowing at the discount window, which is priced above the Fed funds target
rate, the Fed’s main instrument of policy. The four biggest American banks
borrowed $2 billion last week from the discount window to encourage others
to do so. The Fed also indicated that it is now more concerned about growth
than inflation, a change of position. Ben Bernanke, its Chairman, is under
considerable pressure to lower rates from 5.25 per cent. Analysts expect two
cuts by Christmas.
By contrast, the Bank of England has refused to cut its penalty rate for
direct lending to institutions and has taken no steps to increase liquidity.
However, the chances of rates going to 6 per cent now look much fainter than
they did a month ago. (Gabriel Rozenberg)
Private equity
It was June and the masters of the universe were busy scooping up public
companies and taking them private on an almost daily basis. They had
multibillion-dollar funds to spend and the market had never been so good –
but little did they know that the party was just about to end. News that
thousands of cash-strapped American families had started to default on their
mortgages did not trigger panic immediately, but when two American hedge
funds went bust as a result, nerves started to fray. After all, wasn’t it
the same people who invested in the sub-prime mortgage market in the United
States who also bought up private equity’s leveraged loans? It turns out it
was. The result was devastating. Overnight, the market for cheap credit
totally dried up and, with it, billions of dollars of deals were put on
hold. Yet it was the banks that felt the real pain. After years of frenzied
lending, their excesses came home to roost. JPMorgan, Citigroup, Deutsche
Bank, RBS and Barclays had aggressively undercut each other to underwrite
massive buyouts, including the €13.5 billion acquisition of Alliance Boots
and the €7.57 merger of Saga and the AA. As investors fled, so banks got
stuck with the debt on their books. More than €80 billion of unsyndicated
loans were left hanging in Europe and $280 billion in the United States.
Amid that backdrop, The Blackstone Group, an American buyout firm, brought
forward its initial public offering (IPO), but the stock took a hammering
and lost about 17 per cent of its value. Kohlberg Kravis Roberts, its rival,
put its IPO on hold for fear that investors would snub it, too. (Siobhan
Kennedy)
