Serious Money: Turmoil in America's sub-prime mortgage market has finally reached Wall Street. The so-called experts argued only a month ago that the meltdown would be easily contained but recent events in the credit markets have shown this assertion to be false.
The implosion of two Bear Stearns hedge funds with significant exposure to residential mortgage-related collateralised debt obligations (CDO) has raised concerns that this could be the catalyst that sets off a dramatic reassessment of risk in the credit markets.
The debacle comes just weeks after UBS, a Swiss bank, closed a hedge fund which had lost more than $120 million in the sub-prime mortgage market. Some observers believe that Bear Stearns' troubles are just the tip of the iceberg and that a credit crunch will become inevitable as the losses across the financial sector are uncovered.
Credit markets have undergone dramatic change in recent years due to the surge in demand for higher yielding assets in a low-return world. Strong investor demand, particularly from hedge funds, has resulted in explosive growth in the supply of esoteric credit instruments.
CDOs, for example, which were first introduced in 1987, have seen new issuance increase from just $2 billion a decade ago to more than $500 billion in 2006.
Unfortunately, investors' hunt for yield has not been accompanied by an appreciation for the additional risks such instruments entail and, as recent events illustrate, even the savviest investors can be caught off guard.
What is a CDO and how does it work? It is a security that is backed by assets or collateral - typically bank loans and bonds, though mortgage securities have come to dominate in recent years.
The security can be thought of as a company that pools assets and issues liabilities. The assets are purchased with the funds raised from the issuance of notes and provide the cash flow to service the liabilities. The notes issued or liabilities are broken into parts or tranches with differing degrees of risk, which include senior and mezzanine tranches. The notes are rated by the rating agencies. The structure also includes an equity component, known as "toxic waste", which is unrated.
Senior notes have a priority claim on the collateral and their cash flows and are protected from credit losses by one or more mezzanine tranches.
The debt tranches are attractive to investors including banks, hedge funds, insurance companies and pension funds because of the higher rating-adjusted yield that the notes offer, which arises primarily from the liquidity risk and inherent complexities of the structure.
The equity component is the riskiest tranche since it absorbs the asset pool's first losses. Equity investors receive all cash flows in excess of the debt tranche requirements and consequently, earn all the upside on the underlying assets. The equity tranche is attractive to investors, particularly hedge funds, because they receive non-recourse term financing with leveraged exposure to the underlying assets.
The number of hedge funds specialising in the mortgage-related CDO space has mushroomed in recent years. Unfortunately, their leveraged structure combined with the illiquidity of the securities, which are rarely traded, can accentuate any decline in the value of the underlying collateral in a market downturn.
Fund redemptions typically rise as collateral declines in value and performance suffers. However, the more leveraged a fund is, the more difficult it becomes to satisfy redemption requests. Meanwhile, the institutions that have provided the leverage will ask for additional collateral, which places further pressure on the fund.
The downward spiral continues and inevitably the fund is liquidated. This vicious cycle was evident at Bear Stearns' two imploding funds.
The Bear Stearns' debacle has also revealed that the collateral underlying most mortgage-related CDOs has not as yet been marked to market and remains on the books of investors at highly inflated prices. Bear Stearns recently called off the auction of $800 million of mortgage-backed assets underlying one of the troubled funds having received bids on the top-rated collateral at just 85 per cent of face value. This suggests that the market value of the lesser-rated assets is substantially below the recorded book value.
The dent to investors' capital when CDO collateral across the financial sector is eventually marked to market is likely to be significant.
Recent developments illustrate how hedge funds' short-term, margin-based leverage can destabilise a market segment rapidly. The mortgage mayhem has not surprisingly, negatively impacted other segments of the market. A mere $3 billion of the $20 billion of junk bonds planned for issue last week were actually sold. Additionally, investors have become increasingly reluctant to accept aggressive structures such as "covenant-lite" loans and "payment-in-kind" notes.
However, fears of an imminent credit crunch are overstated at this time, though it should be clear to investors that the price of risk is on course to return to more normal levels.
A focus on capital preservation and quality is the appropriate action in today's credit markets.
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