A different kind of credit cycle

Back in June, the following comment(slightly edited by me) was posted to a thread at Calculated Risk:

“A tougher market for LBO bonds/CLO's means less bank capacity(investment or commercial?) for additional lending, which means less deals. All this should remind us why this cycle is so different: the marginal dollar of credit is coming from levered lenders with concentrated portfolios and unstable sources of funding, or from "non-natural" buyers such as the hand-over-fist Chinese buying of Agencies. The nature of these creditors is that their provision of credit is a) correlated with one another and b) highly variable.

And yet we continue to compare this cycle to 2001, 1998, 1991, and 1981.

They are as different from today as chalk and cheese. It’s not about assets, it’s about how they are funded. We should prepare to see a different type of credit cycle, perhaps more similar to the "Golden Age" late 1800's downturns we experienced before the advent of regulated financial institutions.” David Pearson | 06.27.07 - 1:44 pm | #

I agree with Pearson’s conclusion that this credit cycle will be different than any in the US since the establishment of the Federal Reserve system. None of the crises that Pearson mentions were brought about by asset overvaluations based on issuance of CDOs. According to the July 2007 issue of Bloomberg magazine, “Worldwide sales of CDOs—which are packages of securities backed by bonds, mortgages and other loans—have soared since 2003, reaching $503 billion last year, a fivefold increase in four years..” One aspect of CDO issuance is that these securities were designed so that illiquidity and low transparency were selling points; i.e. the risk due to those two factors implied that yields would naturally be higher than traditional asset classes. Given that in the post dot com bust recovery most asset classes were providing relatively low yields, the popularity of CDOs is not surprising. Of course, very few were paying much attention to what might happen should these investments run into trouble. People were ignoring the risk side of the risk-return equation.

Pearson comments a couple of days later at Calculated Risk along these lines…

”I believe the opacity is very much by design, and that these securities are a direct analog to Enron's opaque "Special-Purpose Entities". The hedgies need securities which they can "mark to model" (again like Enron) so as to support claims of huge short-term profits from which to take their 20% cut.”

I don’t think there is any question that hedge funds have been a primary target market for securitizers. However, I believe that just about every type of investment vehicle out there has purchased some type of CDO during this boom.

To elaborate on Pearson’s comment above that this credit cycle will be similar to those that occurred pre-Federal Reserve, there is no regulatory agency in the US with the specific ability to manage debt securitization activity. One of the Fed’s purposes was to reduce the volatility of business cycles by regulating the creation of credit. Now that a major portion of credit creation has been occurring outside the control of the Fed, we have seen a massive explosion of credit and are likely to now see a massive implosion of credit.

A quick look at who could lose big due to CDO problems

Jim Jubak of MSN wrote Deepening Debt Crisis providing an estimate of who is at risk(my highlights):

"First, the investors who elected to buy the equity tranche (which are the riskiest debts), attracted by the possibility of an equitylike return on a fixed-income investment, get killed...

Hedge funds bought about 10% of equity tranches in 2006, according to Bear Stearns. But pension funds bought more -- 18%. Insurance companies bought even more -- 19%. And asset managers bought even more -- 22%. When pension funds take big losses, parent companies have to make up the loss or workers have to take smaller pensions. When insurance companies take the loss, insurance rates go up. When asset managers take the loss, well, we all cry when we open our monthly mutual-fund statements.

It's hard to get a complete list of who owns equity-tranche CDOs. But some names that come up include the California Public Employees' Retirement System ($140 million), the Teachers Retirement System of Texas ($63 million), French financial giant AXA and the New Mexico State Investment Council ($223 million)"...

Blackstone IPO a smashing success

Reuters reports today that

"Private equity firm Blackstone Group's initial public offering was about seven times subscribed, boosted by demand from Asia, the Middle East and Europe, the Financial Times reported on Thursday...The flotation on the New York Stock Exchange, worth up to $4.75 billion and underwritten by Morgan Stanley and Citigroup, is set to be priced later on Thursday. Blackstone earlier said it expects to sell 133.3 million common units at $29 to $31 each. The banks will be permitted to sell an additional 20 million shares to meet excess demand"...

I think that purchasing shares of Blackstone would be very unwise...here is one reason why:

Interest Rate Roundup posted back in November of last year that

"I wondered out loud the other day about whether Sam Zell's deal to sell Equity Office Properties to private equity buyer Blackstone Group was the mother of all bells signaling a top for REIT shares. Lo and behold, the iShares Dow Jones U.S. Real Estate Index Fund (IYR) closed down 2.59% today. That's the worst one-day percentage decline going all the way back to August 2005, and twice the decline in the Dow. Maybe investors are slowly regaining their sanity ... or maybe it's just a blip. You never know. What I BELIEVE, however, is that ...

* Real Estate Investment Trusts are wildly overvalued by a wide variety of measures (including price-to-earnings and price-to-Funds From Operations (FFO) ratios)

* A weaker economy will crimp rent growth in the office and retail markets. And in the apartment market, you have a very large (and growing) supply of "shadow rentals" from stuck house flippers who can't sell and are trying to rent instead. That will likely throttle down the rent growth we've seen at key apartment REITs.

* Lastly, REIT yields are far below what you can earn on risk-free Treasuries, much less other fixed income investments. The IYR has an indicated yield of a whopping 3.38%, for instance, versus 5.13% on a 6-month T-bill"...

and then Interest Rate Roundup posted today that

"I have gone on record in numerous venues (here's a post from May 2 ... and here's a longer story from around that same time) claiming that commercial REITs could be in trouble. I pointed out that valuations were extremely stretched, that tighter credit conditions and rising interest rates could cause them problems, and that the apartment sector in particular faced significant headwinds due to the supply overhang of former-flips-turned-rentals.

Today, the Dow Jones U.S. Real Estate Index Fund is breaking down from critical support, continuing a sell-off that has stretched back several weeks. Yep -- looks like Sam Zell sold out at the top to the geniuses at the Blackstone Group, as I mused back in November"...

In any case what you would be buying is essentially a chance get some of the lucrative fees that the firm's management charge to investors for managing "private equity" investments. But by going public, I would think that would put some limitations on what a private equity firm could do relative to non-public private equity firms due to SEC/Sarbanes-Oxley reporting requirements. So it looks to me like Blackstone's people are thinking that their returns are going to shrink so they get some extra cash now by selling shares to offset what they expect their shrinkage in future fees will be.

The high demand for the shares indicates to me that they are literally capitalizing on their brand name...

Unwinding of mortgage backed securities positions

Bloomberg is reporting in "Bear Stearns's Attempt to Save Hedge Funds May Falter" this morning that "creditor Merrill Lynch & Co. decided to seize and sell $800 million of bonds held as collateral for loans to the funds"...referring to a couple of funds in trouble due to bad mortage loans...the bigger issue is as Greg Newton describes it here that "what happens when the whole world reprices its CDO and RMBS (residential mortgage-backed securities) [on the] basis [of] forced liquidation"...other commenters raise the same issue, specifically in the Bloomberg article of this morning as follows:

"The real fear has to do with just how many other funds and warehouses could be in trouble,'' said Jeremy Shor, who oversees about $3 billion in asset-backed bonds as a portfolio manager at Brown Brothers Harriman & Co. in New York", and " Asset sales could force the banks to reduce the value of their own investments and loans they made to other funds, said Josh Rosner, managing director at New York-based investment- research firm Graham Fisher & Co."...

The Bloomberg piece also states that

"As defaults rise, bondholders stand to lose as much as $75 billion subprime-mortgage securities, according to an April estimate from Pacific Investment Management Co., manager of the world's largest bond fund. Investors in all mortgage bonds will probably take about $100 billion in losses, according to a March report from Citigroup Inc. bond analysts"...

Also referenced is the bailout "of Long-Term Capital Management LP, which lost $4.6 billion, in 1998, he said. At the time, lenders met and agreed to slowly liquidate the fund's assets to limit the impact of its collapse"...a quick unwinding at any time would likely result in greater repricing to the downside than a more measured, gradual recognition that the mortgage-backed securities and associated derivatives are worth far less than what the owners have them valued on their books currently. Recognizing the $100 billion in losses mentioned above in a short time period would likely cause a lot of fear-driven market activity that might be avoided by the more measured workout.

One hedge fund takes it in the shorts

According to Business Week,

“Investors in a 10-month-old Bear Stearns (BSC) hedge fund are learning the hard way the danger of investing in risky bonds with borrowed money. The investment firm’s High-Grade Structured Credit Strategies Enhanced Leverage Fund, as of Apr. 30, was down a whopping 23% for the year.”

“The situation is so bleak that Bear Stearns’ asset management group is suspending redemptions at the onetime $642 million fund—meaning investors have no choice but to sit on their losses. And that’s got some hopping mad.”

“‘At the end of the day, I’d like someone to be honest with me about what’s going on,’ says one investor in the hedge fund, which bet heavily on bonds backed by subprime mortgages.”

“An investor in Europe, who didn’t want to be identified, says he’s been trying to get his money out of the hedge fund since February.”

“In a June 7 letter to investors, Bear Stearns says it’s suspending redemptions because the ‘investment manager believes the company will not have sufficient liquid assets to pay investors.’”

Hey, that's what happens sometimes to risky investments...

Hedge funds as a group and the S&P 500 correlate closely

Per a number of studies referenced by Christopher Holt, who mentions that " Bridgewater CEO Ray Dalio was in the news again last week with this New York Times story on his concerns over the “high correlation” between hedge funds and the S&P 500 during the past few years"...

It would seem that the S & P 500 is a pretty good index, after all. If after all the scrounging for opportunities done by all of the hedge funds, they come up with returns similar to the S & P, that says to me that the index is a pretty good proxy for the market as a whole.

Holy smokes!

Charles Hugh Smith's weblog today talks about hedge funds and who actually gets the profits from their activities. There is one mind-blowing statistic that he offers up:

Here is the top 10 hedge fund managers' income: The full top 10 list of hedge fund earners according to Trader Monthly includes:

1. T. Boone Pickens - estimated 2005 earnings $1.5bn +
2. Steven A. Cohen, SAC Capital Advisers - $1bn +
3. James H. Simons, Renaissance Technologies Corp. - $900m - $1bn
4. Paul Tudor Jones, Tudor Investment Corp. - $800m - $900m
5. Stephen Feinberg, Cerberus Capital Management - $500 - $600m
6. Bruce Kovner, Caxton Associates - $500m - $600m
7. Eddie Lampert, ESL Investments - $500m - $600m
8. David Shaw, D.E. Shaw & Co - $400m - $500m
9. Jeffrey Gendell, Tontine Partners - $300m - $400m
10. Louis Bacon, Moore Capital Management - $300m - $350m
10. Stephen Mandel, Lone Pine Capital - $300m - $350m

I thought it was pretty crazy when the White House released Vice President Cheney's tax return a few years ago and his adjusted gross income was $36 million!