[A-List] The coming savage downturn

[Michael Keaney]

A stretched credit cycle, a more savage downturn
By John Plender
Financial Times: May 22 2007

High finance has never been more sophisticated. Bankers have never been
more clever. Yet in the US subprime lending boom, banks fell over
themselves to advance 100 per cent loan-to-value mortgages to
out-of-pocket deadbeats. According to industry folklore, even an
insolvent arsonist was given accommodation.

Lending standards to private equity are collapsing just as risks rise
and returns are being competed away. "Cov-lite" loans are the order of
the day, meaning that restrictions on a borrower's interest cover and
balance sheet leverage cease to apply. This has prompted Anthony Bolton,
Britain's most admired fund manager, to warn of impending doom. So what
is the explanation for such apparently aberrant behaviour? At one level,
it is simply that banks no longer have to worry about loan quality in
securitised markets where the loans they originate are immediately sold.
So the more pertinent question is, why do investors buy from the banks?
The answer, as Henry Maxey of the Ruffer fund management group argues in
a forthcoming paper for the Centre for the Study of Financial
Innovation, is that Wall Street has solved their most pressing problems
with its invention of structured products. Take the hedge funds, in
which conventional investors such as pension funds invest increasingly
via hedge fund of funds. These intermediaries typically aim for positive
returns of 1 per cent a month, net of fees, with low volatility. If the
hedge funds they back fail to deliver on 3- to 6-month performance
figures, they are culled.

The hedge funds need to make about 20 per cent gross a year, before a
welter of fees, to provide that 1 per cent a month for their backers.
Such a spectacular return can be gained either by market outperformance,
which is beyond most fund managers, or by taking on leverage through
borrowing, or trading in derivatives. For most, that means adopting
leveraged strategies in illiquid assets, to avoid leaving capital values
hostage to market volatility.

Structured credit products are tailor-made for this task. Collateralised
debt and loan obligations (CDOs and CLOs) invest in poor-quality assets
such as subprime mortgages or loans to super-leveraged buy-outs, and
sell matching liabilities to investors. Yet the sale involves an
alchemical transformation. The package is sliced and diced into high-
and low-risk tranches, with usually up to 80 per cent being rated
Triple-A or AA and the residue being very lowly rated or unrated.

For pension funds and managers of official reserves, the resulting
high-grade paper is a boon in a world where the number of Triple-A
corporate borrowers has dwindled to a handful.

For hedge funds the low-grade paper, which provides a cushion against
default risk in the high-grade tranches, is likewise a boon, especially
since, as Mr Maxey points out, it lends itself to arbitrage whereby
hedge funds take long positions in the high-risk tranches and short
positions in the low-risk tranches, which are relatively expensive. This
ought to increase market efficiency since more investors can buy into a
given pool of low-quality credit-enhanced assets.

The peculiarity of this trade is that profit is never arbitraged away in
the benign phase of the credit cycle because positions are not
constantly marked to market. Their illiquidity requires them to be
marked to a model approved by credit rating agencies. As we saw after
Enron and the subprime mortgage fiasco, rating agencies, who are paid by
those who they rate, do not adjust ratings to reflect deteriorating
economics. They close stable doors after profligate horses have bolted.

It follows, as Mr Maxey notes, that relaxing lending standards is
perfectly rational. To increase lending volume, banks could either
reduce their interest rates or reduce underwriting standards. Given the
hunt for yield, this is a no-brainer. So collapsing standards will now
stretch out the credit cycle while ensuring the delayed downturn will be
more savage when the defaults finally happen. This subverts the argument
that structured products uniformly enhance market efficiency. Credit is
being mispriced, courtesy of credit rating agencies that are insensitive
to market risk. Stand by for systemic consequences in due course.


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