Tuesday, January 1, 2008

Just Wait For A Replay

Credit Crisis? Just Wait For A Replay

By Floyd Norris, NYTimes.Com | 1 January 2008

What if it’s not just subprime?

As 2007 ends, it seems that the financial world shakes every time a company reveals some new exposure to the disastrous world of subprime mortgage lending. But just how different was subprime lending from other lending in the days of easy money that prevailed until this summer? The smug confidence that nothing could go wrong, and that credit quality did not matter, could be seen in the many other markets as well. That was particularly true in the corporate loan market. Loans were cheap, and anyone worried about losses could buy insurance for almost nothing. It was not an environment that encouraged careful lending.

"The severity of the subprime debacle may be only a prolog to the main act, a tragedy on the grand stage in the corporate credit markets," Ted Seides, the director of investments at Protégé Partners, a hedge fund of funds, wrote in Economics & Portfolio Strategy. "Over the past decade, the exponential growth of credit derivatives has created unprecedented amounts of financial leverage on corporate credit," he added. "Similar to the growth of subprime mortgages, the rapid rise of credit products required ideal economic conditions and disconnected the assessors of risk from those bearing it."

There are differences, of course, and they may be critical in averting a crisis. To start, there are virtually no defaults in corporate lending now, and even if Moody’s is accurate in its forecast that defaults will quadruple in 2008, the default rate on speculative loans and bonds would still be below the long-term average. That hardly sounds like a crisis.

And there is no reason to think that fraud was a big factor in the corporate loan market, as it seems to have been in subprime. But the history of junk bonds provides a warning that defaults start to rise a few years after credit gets very easy. By that standard, says Martin Fridson of the research firm FridsonVision, a new wave of defaults is overdue. Already, even without defaults, he says, about a tenth of high-yield bonds are trading at distress levels— levels that provide yields of at least 10 percentage points more than Treasuries.

If a recession does occur, one can easily foresee a wave of defaults in junk bonds and their bank-loan cousins, leveraged loans. With highly leveraged structures supported by some of those loans, the surprises could be greater. It is sobering to realize that the issuing of leveraged loans set a record in 2007, even though the market contracted sharply late in the year. If this was the year that many readers— not to mention financial reporters— learned what C.D.O., M.B.S. and SIV stood for, 2008 could be the year of C.D.S. and C.L.O. (For those who came in late, those abbreviations from 2007 are shorthand for collateralized debt obligations, mortgage-backed securities and structured investment vehicles. The new ones are credit default swaps and collateralized loan obligations— a special kind of C.D.O. backed by corporate loans.)

We have learned in the last month that credit insurers took big risks in backing C.D.O.’s and other exotic things. Some are scrambling to raise more capital to stay in business. One, ACA, may well go out of business. But if the credit insurers turn out to have had inadequate reserves, what are we to make of the credit default swap market? Mr. Seides calls it "an insurance market with no loss reserves," and points out that $45 trillion in such swaps are now outstanding. That is, he notes, almost five times the United States national debt.

Many of those swaps cancel each other out— or will if everyone meets their obligations. The big banks say they run balanced books, in which they sell insurance to one customer and buy insurance on the same borrower from another customer [[Gee, just like my old bookie! : normxxx]]. But if some customers cannot pay what they owe, this could be another shock for bank investors. As it is, financial stocks have underperformed other stocks by record amounts this year.

One of the more remarkable facts about the subprime crisis is that total losses to the financial system may be about equal to the amount of subprime loans that were issued. On the face of it, that appears absurd, since many such loans will be paid off, and those that default will not be total losses. But, as Mr. Seides said in an interview, "the financial leverage placed on the underlying assets was so high" that the losses multiplied, even as the profits did when times were good. "When there is more leverage" and things go wrong, he said, "the losses are far greater."

The corporate credit market is vastly larger than the subprime market, and there are plenty of dubious loans outstanding that probably could not be refinanced in the current market. If some of those companies run into problems, defaults could soar and fears about C.L.O. valuations and C.D.S. defaults could spread long before there are large actual losses on loans. There are other areas of potential weakness in 2008. Commercial real estate is one area where some see disaster looming. Others worry that some emerging markets could run into big problems because many borrowers there have taken out loans denominated in foreign currency and could be devastated if local currencies lose value.

It was the greatest credit party in history, made possible by a new financial architecture that moved much of the activities out of regulated institutions and into financial instruments that emphasized leverage over safety. The next year may be the one when we learn whether the subprime crisis was a relatively isolated problem in that system, or just the first indication of a [more general] systemic crisis.


More Rate Pressure As New Mortgage Figures Plunge
November UK Mortgage Approvals Slump More Than 40% To The Lowest Since July 2005 Amid New Forecasts Of House Price Drop

By Miles Costello, London Times | 1 January 2008

The Bank of England came under mounting pressure today to cut interest rates as early as next month as official figures from Britain's high street banks showed that new mortgage lending dropped by 43.5 per cent last month compared with last November.

The British Bankers Association revealed that banks lent just £4.3 billion to homebuyers last month, £500 million less than October, more than £1 billion below the average over the previous six months and the second successive monthly slide. Banks approved only 44,811 mortgage loans in November, marginally higher than October but still the second-lowest level since records began. The figures provided the latest evidence of a marked slowdown in the UK housing market amid signs of a sharp slowdown in consumer confidence. The BBA's bleak assessment of the mortgage market sent economists scrambling to predict fresh falls in house prices next year and shorten the odds on the Bank cutting interest rates in January, which would be the second cut in as many months.

Howard Archer, chief UK and European economist at Global Insight, said he now predicted that house prices would fall 3 per cent next year and would remain in the doldrums well into 2009. Before the BBA's data was published today, Mr Archer had expected house prices to stay flat in 2008. Mr Archer said: "The weak mortgage data for November provides yet further evidence that housing market activity is now slowing markedly in the face of stretched affordability as well as the tightening lending practices resulting from the credit crunch." He added that house prices in London could be particularly hard-hit, if the City [London's Financial and Legal district] unleashes a wave of job cuts as predicted this year. A slump in bonus payments would also act to provide an effective cap on prices.

Despite a rush to the retailers' sales during the past two days, household finances have been stretched to the limit this year, as the cost of borrowing continued to rise and the high oil price saw utility bills rocket. Homebuyers, particularly those seeking a first rung on the housing ladder, have also come under further pressure as mortgage lenders have tightened up their criteria in the wake of the credit crunch.

The BoE was unanimous in its decision to cut interest rates by 0.25 per cent to 5.5 per cent last month. Some leading economists are predicting it will cut rates by a total of 1 per cent next year, returning borrowing costs to the 4.5 per cent level they stood at before the Bank began increasing rates last year.



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