Valuations are undergoing a dramatic re-think in the US subprime market. Exactly what is going on in the subprime market in America, and what will the spillover effect be here in Australia?
The answer to the second question comes first but, it's brief. A slow-motion subprime meltdown in the States will raise global bond yields and could take the pressure off the Reserve Bank to raise rates. The market could do that work by itself. And stocks? Expect some sympathetic selling in the short-term. In the longer-term, we expect a decoupling of Australian stock valuations from the fluctuations from the housing-dominated, consumer-dependent US market.
But returning to that US market for a moment, the latest drama comes from Bear Stearns (NYSE:BSC) and two of its wonderfully named hedge funds, the "High Grade Structured Credit Strategies Enhanced Leverage Fund" and the "High Grade Structured Credit Strategies Fund."
The only difference between the two funds, so far as we can tell, is the "enhanced leverage" in one. But what they have in common is more important than what makes them different. And what they have in common is that both lenders and investors have serious doubts about the quality of the assets the funds own, or have used as collateral for loans.
The trouble is that the rolling collapse of the American subprime market is roiling the balance sheets of hedge funds, most notably each time interest rates move up. The Journal reports that, "Last month, Enhanced Leverage reported that its value fell 6.75% in April after the fund's bets on the mortgage market went wrong. Two weeks later, it put the loss at 18%, spooking already-nervous investors and creditors and sending many of them running for the exits."
Bear is now in the uncomfortable position of having to sell assets to pay off creditors as the value of its capital is reduced. What a mess, especially when the fund didn't have that much "capital" to begin with.
"As of March 31, the Enhanced Leverage fund had $638 million in investor capital and at least $6 billion in borrowings," the Journal reports. "It used the money to make $11.5 billion in bullish bets and $4.5 billion in bearish bets...Its sister fund had $925 million in investor money, and made $9.7 billion in bullish bets and $4 billion in bearish bets."
Now that the bets have gone wrong, Bear has to pay back its lenders. But the trouble is that the assets it bought - collateralised debt and mortgage bonds - aren't worth what it thought they were worth. Oops.
Bear's peers on Wall Street appear to be revelling in its misery. Merrill Lynch (NYSE:MER), one of Bear's creditors, says it intends to seize about US$850 million worth of Bear's collateral assets and sell them for whatever price the market will bear. If it does that, it could be bad news for anyone else who owns subprime bonds. Why?
Well, the bonds just aren't worth what most people are carrying them on their balance sheet for. If Merrill sells, it's admitting whole huge chunks of mortgage-backed assets should be revalued to reflect market pricing. "No one in the subprime business wants to ask the question of whether they need to re-mark all the assets. That would open the floodgates," says Janet Tavakoli in the Journal article. "Everyone is trying to stop the problem, but they should face up to it. The assets may all be mispriced."
Yep. Each tick higher on bond yields in the US prolongs the summer of mortgage pain for owners of adjustable rate mortgages set to reset this year. And it's not just homeowners...it's all those hedge funds, pension funds, insurance companies, and foreign central banks that intentionally or inadvertently own a piece of mortgage-backed debt.
At some price, it might make sense to buy a bundle of mortgage-backed bonds, assuming you - or someone smart - could vouch for their credit quality. But can anyone do that these days? Alan Greenspan celebrated the re-packaging of risk into a million little pieces because it "dis- aggregated" the risk among many players in the market instead of concentrating in the hands of a few.
The trouble with that, as the subprime slow-mo meltdown is showing, is that a small chunk of bad debt can infect an entire portfolio, the way small bacteria can screw up your entire gastrointestinal system. We're not saying it's a CMO, MBS-led pandemic. There is a much simpler explanation, with fewer acronyms. "The value that assets are being carried at may well be proved to be far above what they're really worth," says Josh Rosner of Graham-Fisher in New York.
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About the Author
Dan Denning is the author of 2005's best-selling The Bull Hunter (John Wiley & Sons). He began his financial publishing career in 1997 and has covered financial markets form Baltimore, Paris, London and, beginning in 2005 Melbourne. He’s the editor of The Daily Reckoning Australia and the Publisher of Port Phillip Publishing.