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Markets: Toxic Debt
New York: July 09, 2007
By Markets: Toxic Debt

"All truth passes through three stages. First, it is ridiculed. Second, it is violently opposed. Third, it is accepted as being self-evident."

--Arthur Schopenhauer, (1788-1860)

Just as we were settling down to a long quiet summer, it had to happen — a blow-up in the bond market. All of a sudden, risk is being re-priced with some painful consequences, in part, because of the troubles of two hedge funds run by Bear Stearns.

Fixed income investors are acting skittish. Once content to clip coupons, investors are demanding more compensation (yield) for taking on additional risk. Companies that have relied on the debt markets to fund their growth have had to withdraw or re-price their new debt issuances to make them more appetizing to an increasingly queasy investor base. US Foodservice, an American wholesaler, has delayed plans to raise nearly $2 billion in the debt markets and Arcelor-Mittal, the world's largest steelmaker, has also decided to delay a planned debt offering.

Fidelity Investments and Lehman Brothers Asset Management are staying clear of debt linked to leverage buyouts. Jim Rogers, author of Investment Biker and former co-founder of the Quantum fund, is on record as saying "financial companies, stock brokers, investment banks — I am short." Seemingly overnight, investors have become aware of the risks in the world's financial markets. But why now?

Blame it on creative finance and savvy marketing. For a long while, the gold standard in judging corporate debt was an AAA credit rating from one of the big rating agencies (e.g. Standard and Poors). In fact, in 2005 there were only nine companies including GE and Berkshire Hathaway, that qualified for such a distinction. The AAA rating was investors' assurance that the likelihood of default as assessed by these rating agencies was extremely low. As a result, companies, which possessed such a coveted rating, were able to borrow almost as cheaply as the federal government.

But that was then. Today, investors have been clamoring for yield, fueled in part by pension funds that were looking to support their aging demographic in retirement. That was also before the wizards of Wall Street realized that risky loans could be repackaged in such a way as to qualify for a coveted AAA rating from the various agencies.

In the U.S., some 25% of mortgages on new homes are known as subprime mortgages. These are mortgages that are issued to people who wouldn't normally qualify for a traditional mortgage. But with loose lending practices, unscrupulous lenders would eagerly lend to individuals that traditional lenders wouldn't touch with a ten-foot pole. None of that seemed to matter as long as interest rates remained low and the incidents of default were low, everyone benefited — at least in the short-term.

That was also before the wizards of Wall Street realized that they could turn lead into gold. In order to do that, investment banks trotted out a new toy to investors, a Residential Mortgage Backed Security ("RMBS"). Investment banks found that by packaging up all these individual mortgages and turning them into a pool, lead could become gold. By creatively packaging pools of these mortgages they were able to obtain a coveted AAA rating for over 80% of the mortgages that were securitized in this way. In fact, by tranching (slicing) the subprime mortgage pie in this way, only 4% of the subprime loans outstanding were rated below investment grade. Lead had become investment gold.

Not content to sit on their laurels, investment banks took the remaining four percent slice of these mortgage pools and turned them into a product called a Collateralized Debt Obligation ("CDO"). According to the rating agencies, a pool of these mortgages is less risky than an individual subprime mortgage. Accordingly, rating agencies decided that in 87% of the cases these sub-investment grade pools were now investment grade. So creative was the packaging that of the original pool of mortgages, more than 99% had been transformed into investment grade paper that hedge funds and pension funds eager for yield could buy. And so they did.

That was the magic of modern finance. By pooling large numbers of weak credits, a series of products was created that in over 99% of the cases appeared to be safe bets. Of course, they weren't and the rating agencies should have known this. They probably did. But, when fees are enormous and the market is expanding at a fast clip, why take yourself out of the game by unilaterally disarming. So, they kept quiet.

Interest rates and default rates weren't complicit in the scheme. As rates on mortgages started going up, many homeowners found it difficult to keep up with the payments. Default rates started to climb and property values in many parts of the country faltered and fell. Some research even indicates that as many as 20% of these subprime mortgages issued in 2005 and 2006 are going to default. That's bad news for not only homeowners, but also for investors.

Already the casualty count is climbing. This month, two high profile funds (the High Grade Structured Credit Enhanced Leverage Fund and the High Grade Structured Credit Strategies Fund) both managed by Bear Stearns have blown up. Both funds employed tremendous leverage.

In the case of the Enhanced Leverage Fund, they took $638 million of capital and borrowed at least $6 billion to invest $11.5 billion on the long side (bull side) and $4.5 billion on the short side (bear side) of the subprime mortgage market. That's about ten times leverage if you assume that their long and short positions are truly hedged.

Those are big assumptions and big bets. They only make sense and money if you are right. For many of these leveraged funds the getting couldn't have been easier. Borrow massive amounts of money at LIBOR (today around 5.36%) and invest in a pool of subprime mortgages that are yielding 8 percent. With ten times leverage you can turn 8% yield into 23% returns before fees — so long as nothing goes wrong.

As long as no one defaults and the collateral stays solid, this type of trade is a no-brainer. But what happens if the collateral in the underlying pool of mortgages drops by just 2 percent? You are in trouble. That's because you've got ten times the leverage applied to your investment which turns a 2% drop into a 20% loss. Ouch.

Magnify this problem across the lending spectrum and you can begin to see the size of the issue. Repackaging of subprime loans and greedy investors are only part of the problem though. Another potential problem for our financial institutions is in the form of a widely used form of insurance called Credit Default Swaps ("CDS"). The CDS market is a market that has been growing dramatically recently. The way it works is simple. If you are a bank or financial institution, you can sell the returns and the risk of a loan or loans to the CDS market. If you a have a bunch of loans that you are concerned about, the solution is simple. Find someone who will take this risk off your hands for a price. That's the CDS market and it's huge, by some estimates as big as hundreds of trillions of dollars in size.

On General Motors Corporation alone, there are some $1 trillion of CDSs for an underlying $20 billion in GM debt. There are even firms that buy and sell these CDSs securities for a profit. As long as the collateral is there the game continues and no one loses. Right? Unfortunately, there is no oversight of this market, so if a default occurs which triggers a chain reaction the problem with too many bets on too weak securities might get a whole lot worse.

That has savvy investors running scared. Jim Rogers is one who is betting with his feet by speculating that some of the major investment banks are going to post some pretty poor financial results in the years to come as these problems come home to roost.

Already, the stock market is beginning to catch on. In the U.S., the major investment banks are trading at P/E ratios of around 10, as compared to regional banks with no exposure to either the CDS or subprime markets that are trading in the range of 20 times.

For our money, the risk just isn't worth the reward. For a while, bonds will not be the place to be, as the specter of rising interest rates will likely quell returns in the debt markets. Not only that, but the subprime mess, hedge fund blow-ups and the contagion effects will make this some tough sledding for the foreseeable future. Major money center banks, investment banks and asset managers are another investment category to be avoided, at least until the dust settles on this toxic debt.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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