Credit crunch creep - liquidity alarm bells sound
The third Bear Stearns fund to get into difficulties borrowed no capital and had only limited exposure to subprime mortgages. The ordinary sounding mutal fund run by Macquarie, which this week warned it could lose 25 per cent of its money, was a retail fund and hadn’t been anywhere near the US subprime mortgage market.
So what, in the case of Macquarie, was causing the “supply demand imbalances” in the market, ask the FT’s capital markets team, also translating this into plain language - lots more needing to sell than wanting to buy.
Opinions differ on how and why the problems in subprime mortgages spill over into other types of credit, and into equities.
Gary Vaughan-Smith, a partner at fund of hedge funds manager SilverStreet Capital, says the most important transmission mechanism is the so-called “common holder” problem - where investors are forced to sell more liquid assets to cover losses in assets that are difficult, or impossible, to sell, such as stricken mortgage-backed securities, or collateralised debt obligations built out of these.
But hedge funds involved in CDOs of ABS – the worst-hit area of the structured credit markets – are relatively few and highly specialist. The two collapsed Bear Stearns funds and Australia’s Basis Capital were dedicated to this kind of product.
Others argue that the primary transmission mechanism is the margin calls or haircuts imposed on levered investors by their banks.
“Haircuts are increasing because investment banks generally are uncomfortably long credit risk – through bridge loans to private equity buy-outs, repo financing to hedge funds and warehouses for CDO managers,” Matt King, analyst at Citigroup, says.
With the valuation of mortgage-backed and CDO-types investments uncertain, and only recalculated on a monthly basis, the banks means of control of risk expsorue is through the adjustment of margin requirements.
The ‘credit creep’ is moving in other directions as well. There are now clear signs that the problems in subprime are spreading to higher-quality mortagages, the so-called Alt-A loans. The third Bear Stearns fund to encounter difficulties was invested in these and prime mortgages. Alt-A lending represent a further $500bn to $1,000bn of the US residential mortgage market, on top of the estimated $1,300bn of subprime loans.
The big question though, asks Lex, is whether the next creep will be back from the financial markets into the real economy.
House prices are likely to come under more pressure. That could be a drag on consumption and further damp US growth. It is probably manageable, with companies well-financed overall and the global economy still buoyant. But it does not leave much margin for error if the long-stable US employment picture finally starts to worsen. |
