I have a monthly Friday lunch with some pals, and received the following as homework for today's meal ... I have not digested it for myself yet, so, just is as is.
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A Hedge of Thorns
by Sean Corrigan
August 1, 2001
Sean Corrigan is publisher of The Capital Letter available from Capital Insight, www.capitalinsight.co.uk
Hedge funds have reportedly been selling Japanese stocks in recent weeks, seemingly on the premise that either Koizumi will not be able to push a credible reform programme through in the face of stiffening opposition from
the LDP faction heads and equities will suffer as hope is stillborn, or that if he does prevail, the prospect of a big bank, a large retailer, or a major construction company being sacrificed pour encourager les autres, will knock the Nikkei lower, regardless. However, those hedge funds had
better give a thought to their wider positions if recent BIS statistics are any guide. European pension managers would do well not to be overly smug about the upheavals either. This is a very interconnected world - and even
good old Argentina might have a role, however, peripheral - to play in the scenario we will elaborate below.
Firstly, lets look at the hedge fund universe. Already this year, the ranks of Wall St and City thirty-somethings have been rapidly thinned, but not by more Baby Bezos' aiming to milk the VC universe of Dot.com Dollars. Now that the decimal place has moved a long way to the left, so we have
Zero.dotcoms these days, these enterprising types have been setting up in their droves to run hedge funds instead. Moreover, given the demise of the macro fund - with Tiger no more than a stuffed rug, Quantum lost to the uncertainty principal and even the mighty Moore making Less of a splash, at least - the penchant has been rather for rocket science ( a wonderfully apt metaphor since a working definition of rocket science might be:- launched
with a billion-dollar bang, landed with a splash and very little salvageable afterwards).
Explicitly, the new wave has largely been about two things - convertible bonds and structured product. Indeed, the wave has been cresting so high, that the SEC Director of Investment Management, Paul Roye has been quoted warning us to be cautious about the hedge-fund "craze", going on to say, "New funds have sprouted in the United States and Europe, run by managers with little experience, raising questions about capacity to handle the billions of dollars flowing into these funds," and arguing that they may be
the next "trendy investment bubble to burst."
The same press reports had Roye citing TASS Research to the effect that the first quarter of 2001 saw about $6.9 billion invested in hedge funds - almost as much as in all of 2000. At least 100 new hedge funds have started
since January and in the year to March, Hennessee Group of New York, a hedge-fund adviser, estimated that hedge-fund assets had risen 26 percent to $408 billion and the number of funds had grown 20 percent to 4,800 in the previous 12 months.
So here we have a classic instance of too much liquidity finding ? as water is ever likely to - the lowest level, late in the day, and we have thus spawned a miniboom of tyros keen to cut their teeth and impress us with their acumen in what is one of the most challenging fundamental
environments since the 1930s. How many of their models do you think cope with current conditions?
McLuhan may famously have intoned that the medium is the message, but Meriwether clearly demonstrated - somewhat more expensively - that the model is not the market. Convertibles we can deal with swiftly. This week
will see last year's US annual total - then a record - of $61 billion surpassed. Much of recent issuance has been complicated in structure (after all, we wouldn't want all those derivative geniuses to feel left out, would
we?) and nearly half have been zero-coupon - meaning no income to cushion against future downgrades or defaults.
And why have these wrinkles, often prohibitive to traditional buy-siders, been included? Because they appeal to hedge funds. Because these mathematical adepts like to arbitrage the embedded options in the convertibles - something which may be a factor adding to the 20% increase
in short interest in the NYSE and Nasdaq this year.
OK - but here's another rub. Moody's, in a study going back to 1970, found the default rate on convertible bonds was 1.47%, compared with 1.06% for all corporate bonds - a statistically significant difference. Moreover, TMT
companies with their voracious appetite for capital consumption have accounted for roughly half of all the convertible bonds issued during the past five years. As Moody's put it, "High-risk issuers who couldn't get
financing anywhere else were drawn to the convertible market."
The next little beauty is the collateralized debt obligation, or CDO, market - where there is something of a European passion for liabilities which are simply bundles of rob-Peter-to-pay-Paul synthetics crafted by carving up other debt issues into slices of varying quality and risk. The only problem has been the hedge fund thirst in Europe has meant demand has outstripped supply - a clear sign of overly lax monetary policy. Thus issuers of Euro CDOs - already over-weighted to Telcos - have attempted to
satisfy the hunger by swapping US paper into the pools, just in time for US corporate revenues to plummet and credit quality to follow it down the gurgler. Not that this has deterred anyone Stateside either. More than $15
billion of new junk-bond CDOs have been issued in the first half of 2001, nearly the pace of last year's total of $36 billion. The market here is estimated to be around $400 billion in size and 40% of that has been issued
during the Bubble Years. Indeed, our friends from LTCM are still exerting a malign influence on world capital today. You remember how, in the run-up to the Russian default, their particular alchemy was so efficient at managing risk and volatility (!) that they managed to gear every spread
down to unheard of lows?
Those bonds are the ones now causing the biggest headache to CDO-owners. Issued when default rates were around 2%, they are now failing at an 8% pace and the 1997-8 vintage is an especially fruitful one here.
Next comes CMBS - the commercial mortgage-backed market. Another game for the big boys, this has just been given an untimely boost by the relaxation of a potentially stultifying FASB rule relating to the FDIC's primacy of
claim on the underlying assets in a pool which commercial banks wish to securitize, effectively giving the green light to the Street to clear their decks of these commitments at an accelerating pace.
In the first six months of this year, issuance has run to $40 billion - a full third faster than in 2000 and on pace to beat the record year of - you guessed it - 1998.
Now this is all well and good, but bear in mind that Fannie, Freddie and the FHLB have yet to persuade Congress that they should also be allowed to monetize debt in this sector. Thus, CMBS have to function in the absence of
any bootstrapping, John Law-type effects of a torrent of liquidity on prices of a particular physical asset class, like their residential MBS cousins enjoy. (It's still easier for those three little GSE pigs to make a
house of paper than it is for home-builders to construct one out of timber or brick, which is why prices and turnover are still rising).
By contrast, commercial property has to depend upon - well, commerce, actually - and commerce is not such a hot ticket these days, as we know to our cost. Notwithstanding the boom in issuance, look at the property market underlying all these obligations. Colliers International of Boston produced a report last week which shows that with 6.4 million square feet of new space coming on stream and a 183% jump in sublease space in 15 major downtown office markets in just six months, vacancy rates are climbing.
They are up fivefold in Boston, they have doubled in NYC, and tripled in San Fran and Seattle already. Rents are beginning to drop as a result and rents are the grist to the CMBS payment mill. Not surprisingly delinquency
rates are climbing here, too, hitting 1.08% in Q2, an 8% increase in a quarter, with the real estate-owned (effectively foreclosed properties) segment up a whopping 45% increase to stand at the highest dollar amount since S&P started monitoring the business. Caveat emptor!
Now we started with hedge funds and the Japanese, so how do we get back there after this little review of the some of the hotspots burning in the global capital market? The answer is simple, really - fuel. As of the end of March, the BIS reported that Japanese banks had more funds
lent to the Caribbean - a massive $115 billion - than they had out to the UK, or to Germany and France combined. Indeed, only the United States accounted for a bigger proportion of their cross-border assets. Of the $271
billion total worldwide claims reported against the Cayman Islands alone, fully $86 billion - or 30% - were Japanese in origin. Moreover, as the BIS pointed out, local dollar lending in the US was a rapid $200 billion in Q1
and Japanese banks again were responsible for the bulk of the lending. In the cross border component, Japanese bank lending to the US since the Bust began in QIV has been an inordinate $49 billion - a 30% annualized rate of
increase.
Much of this was driven by the demand for funds from non-banks frozen out by stricter US lending standards, though some undoubtedly indirectly helped provide the cash for repos with Caribbean hedge funds - US claims on Cayman
went up $9.5 billion or 140% annualized simultaneously.
However ineffective ZIRP has been at stimulating the Japanese economy, the BoJ has certainly helped provide parachutes for the US as it deals with its very own asset bust. So what happens now if Koizumi forces banks to
accelerate bad loan write-offs? Write-offs imply either a smaller rate of capital increase (fewer retained earnings) or an actual reduction in equity. The first means fewer new loans, the second implies smaller balance sheets are required above and beyond the number of loans directly removed. This means that resources will be much more focused on core activities.
In their desire for assistance with the unwind of cross-shareholdings and bolstered by their potential need for the injection of public funds, we would suggest that the moral impetus, if not the commercial one, will be for the surviving Japanese banks to concentrate on the home market. The BoJ might even tie any reserve additions it undertakes in a crisis to an increase in domestic, rather than international assets.
Imagine if hedge funds had a chunk of their liquidity withdrawn as a result of this contraction and when they came to liquidate their own holdings, they found that the dearth of Japanese-sourced liquidity in the domestic
market was tightening the squeeze on the very highly-specialized assets which they wanted to unload.
Imagine if this then led to bigger, Amex-style mark-to-market losses for US lenders and so on round to another wave of credit tightenings? Moreover, consider that Japan will want to ease its inevitable labour market adjustments, while keeping its budget from deteriorating further, as
promised. Might it look to that great, inert stockpile of $362 billion (Y45 trillion) in forex reserves? It would surely be tempting to use it to boost its own financial system rather than continuing to help the GSE's reap
monopolist profits in the US, wouldn't it ? The problem with Japan, some superior US & UK analysts have sneered, is that it doesn't have a single functional bank. Be that as it may, even in their dysfunction they have been helping to hide a multitude of very deep pitfalls in the US and UK
financial landscape. That camouflage may be about to be torn away.
Finally, for those of you who believe the 'no contagion line' on Latam, just imagine what happens to the now legally-liable brokers, who have stuffed Japanese retail buyers with the reams of EM and lower-quality Samurai bonds issued of late, when Argentina eventually goes bust.
Wonder if the hedge funds own any of these, too?
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