Investment

Liquid air

The growing derivatives market and the birth of new and complex financing structures are the culprits for the unease in the markets, according to Chris Hills. The victims are likely to be private individuals rather than institutions

Like most readers, this writer grew up in an era when many car drivers, faced with a malfunctioning engine, would think nothing about lifting the bonnet and getting their hands dirty to rectify the fault. Today’s highly complex computer-driven technology found under an almost identical bonnet is an entirely different proposition. Most drivers would not dream of attempting to solve any such problem themselves.

The initials ABS not only stand for “anti-lock braking system” (hence the mention of cars), but also for “asset-backed securities”. These are just as baffling to many investors, and recent problems have raised concerns about both economies and stock markets having a more torrid time. Even cash in the bank is suddenly regarded in a new light.
So how has a problem, which began in the US housing market, suddenly become such a global concern? Or is it more a question of investors collectively losing their nerve when the fundamentals have yet to record much of a deterioration?

Early indications
The early warning signs began in the spring when it became clear that defaults were rising among American homeowners, in particular those with a type of US mortgage that has subsequently become known as “subprime”, as it identifies those borrowers who are of higher than average credit risk.

In past cycles, US mortgage-providers would have had problems with any bad debts or defaults resulting from higher interest rates or falling house prices but, thanks to the development of the derivatives market and the advent of complex new financial structures, the ownership of the potential bad debts is now much less easy to identify. The cure that might be provided by central governments is correspondingly more difficult to administer.

Several years ago, Warren Buffett, the legendary investor, compared the business of derivatives to that
of hell: “Easy to enter and almost impossible to exit”. It is the existence of derivatives, however, together with the sophisticated computer modelling of the investment banking and hedge fund community that has allowed this US housing problem to grow.

Recent trends
In the past two or three years, it is estimated that as much as a trillion dollars has been channelled into securities to fund these US mortgages. So how do these linkages work?

Lending money to homeowners has become increasingly competitive in recent years, when house prices have been strong and interest rates comparatively low in the wake of 9/11. So much so that many lenders could make little or no margin on a mortgage above their cost of capital.

This meant that much of their profit came from the upfront arrangement fees that they could charge their borrowers. The consequence of this was, of course, that if they could sell the ownership of the mortgage to another investor, they could reuse their capital on granting another mortgage and earning another upfront arrangement fee.
Here enters the ingenuity of the investment bankers, who saw an opportunity to invent a new class of security, which they could offer to institutional and other investors.

By purchasing these “second-hand” mortgages in large volume and packaging them together, they created asset-backed securities (ABS). These were, in practice, one large portfolio of mortgages, but the portfolio could be divided into different slices, with the top slice having priority over the receipt of interest payments by the mortgagees and over the capital value of the underlying housing assets.

Grading time
Banks prevailed on the rating agencies to grade these top slices AAA, which enabled them to be in great appeal to institutional investors, who have been keen to increase the bond element of their portfolios. The lesser tranches, which clearly had much lower priority over both interest and capital, offered much higher rates of interest and were in demand by hedge funds and other investors believing in the momentum of the US economy and the fact that defaults in the American mortgage market would remain at low levels. Returns for these investors could be enhanced if they engaged in the so called carry trade, in which the requisite capital would be borrowed in yen (where interest rates were still not much over 1 per cent) and the proceeds invested in these lower-rated and higher-yielding tranches.

There would be little cause for concern if borrowers continued dutifully to pay interest on time and house prices continued to advance. As banks were only really interested in granting the mortgage, pocketing the arrangement fees and securitising the loan into a new owner’s hands, it is easy to see that due diligence on the creditworthiness of the borrower has become less thorough than when the bank retained the mortgage throughout its life.

Once defaults occur, these structures look much less appealing, not only to the underlying investors but also to the banks who have provided the loans. The problems have been magnified by the different nature of the “owners” of these mortgages. Banks have always had a mismatch between the nature of their source of funds (depositors who could in theory withdraw money at the drop of a hat) and that of their assets (longer term loans and mortgages); banks stayed solvent because it was extremely unusual for enough depositors simultaneously to withdraw funds to create a shortage of funding. Were that event to occur (as happened with Northern Rock), the central bank could step in and provide emergency funding, enabling the bank to remain in business.

Shortcomings
The new owners of mortgages had also financed them by short-term borrowings (in this case in the commercial market) but, unlike the banks, they could not rely on a central bank to step in and finance them if their supply of capital was no longer forthcoming. In the present environment, once defaults started to rise in the US, the providers of funds in the commercial market became more cautious, leading to many of these structures collapsing and the assets being taken as collateral by those banks that had provided capital.

Unlike traditional securities, for which there is ways a trading price even in the wake of poor news, any of these collateralised debts were unlisted and had no secondary market in which investors could exit. This could force investors, especially hedge funds, to liquidate other assets from their portfolios in order to provide comfort to their lenders, hence precipitating falls in economically unrelated asset classes.

Until it is clear in whose hands the problem parcels are, the cost established to those holders of a recovery strategy in which borrowings are repaid, losses are red by a number of investors and lessons learned, it is likely that credit markets will remain nervous. Currently, there remains a liquidity crisis, rather than a credit crunch, and has not yet transmitted itself significantly to the real economy. The risks, however, are on the downside – it is evident that there has been a sufficient increase in the use both of debt and derivatives in the economy to mean that even an increase in circumspection by banks with each other (as exhibited by the sharp spike in inter-bank yields) could imperil normal commercial activity levels in the economy.

While in the very short-term, fundamentals can be subservient to sentiment and confidence levels in markets, in due course they will reassert themselves. The corporate sector in the western world is in good financial health, but individuals could easily feel the need for some belt-tightening. With consumer spending accounting for a substantial proportion of economic activity, it is easy to see predictions for growth being reined back and interest rates being cut to stimulate recovery. Elsewhere around the globe, consumer savings are much higher, so growth forecasts should be under less downward scrutiny.

Chris Hills is chief investment officer for Rensburg Sheppards.

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