Institutional Investor's Alpha Magazine - October 2007 - (Page 88)

Unhedged Commentary Crisis? by Garth Friesen What Crisis? ucts posed virtually no default risk — they were considered “money good.” However, if an entity is ten times levered and the asset price falls ﬁve points in value, there is a serious mark-to-market problem. The assets that are held may be money good, but the lenders that supply the leverage don’t really care. The collateral that backs their loans has fallen by 50 percent. They need to adjust their loan to value, which forces selling of the underlying assets. The result is a massive deleveraging. This deleveraging exposed the counterparty risk resulting from the banks’ shift to act as intermediaries rather than as lenders. So while the banks replaced the inherent investment risk with counterparty risk by selling the assets, much of the recent spread widening was caused by those very same banks and brokerages taking steps to hedge or reduce the newly acquired counterparty risk, either by buying credit-default swap protection or by selling the seized assets. Again,there was a great deal of fear that further mark-to-market losses would lead to more counterparty defaults. Consequently, as repo collateral was seized and SIV backup liquidity agreements were invoked, many of the assets were put back to the banks that supplied the leverage in the first place. Almost instantly, banks were again in the business of holding assets, unable to pawn them off to the leveraged buyer who could no longer get any leverage. Investor appetite for collateralized debt and loan obligations evaporated overnight. Even the soothsayers who predicted an end to the compressed credit spread environment were surprised by how quickly the market unraveled and mark-to-market losses mounted. Ten years ago the primary concern of credit managers was that increased defaults would lead to negative performance; the mark-to-market volatility of positions was secondary to picking the right money-good credits. In the new world of credit derivatives, where managers can bifurcate default risk and spread risk — and take that risk in highly leveraged structures — there needs to be increased respect for mark-to-market losses stemming from spread widening, which may or may not be accompanied by defaults. Clearly, as we’ve seen, you don’t need defaults to have a credit crisis. Garth Friesen is a principal and head of the credit strategies team at III Associates, a Boca Raton, Florida–based registered investment adviser that manages more than $4 billion in ﬁxed-income and credit funds. or the past two months, the media have heralded the subprime credit crisis, pointing to actions by central banks around the world — and losses by some of the firms they regulate — as proof of the potential spillover into the broader economy. Although plenty of indicators signal a credit crisis, where are the defaults? Historically, defaults have increased across most sectors of the market as a precursor to, and a warning of, an impending crisis, as they did at the bottom of the credit cycles in the 1980s and ’90s. Now, except for the residential real estate sector, defaults and delinquencies are at or near their cyclical lows for just about all types of borrowers in the U.S. and other developed markets. So what’s different this time? Credit derivatives have mushThanks to the roomed from less than $1 trillion at the end of 2000 to more than growth in credit $40 trillion when this year began. This new product has allowed derivatives, there banks to shift large amounts of no longer needs to credit risk to leveraged institutions like hedge funds, structured investbe a sharp rise in ment vehicles (SIVs) and monoline insurance companies. Banks deterdefault rates to have mined that they could earn higher returns on equity if they focused on a credit crisis. the origination, intermediation and securitization of credit risk rather than the warehousing of that risk. This strategy shift has had two profound effects. First, the risk holder has changed from one that is relatively insensitive to mark-to-market ﬂuctuations to one that is often highly sensitive to them. Second, the credit risk of the asset has been exchanged for the counterparty risk of the entity to which it was transferred. When this summer began, the amount of leverage that was being deployed was at an extreme, owing to a prolonged period of tight credit spreads and lax lending standards. Once subprime spreads started to widen, many hedge funds, SIVs and conduits with long exposures needed to reduce leverage to meet margin calls. Position liquidations led to further declines in prices, which led to additional mark-to-market losses — and thus to more unwinds. As liquidity started to dry up, many credit portfolio managers were forced to sell whatever positions they could, unwinding triple-A-rated assets in lieu of lowertier, less-liquid instruments. Many of these triple-A prod- F 88 • INSTITUTIONAL INVESTOR’S ALPHA • OCTOBER 2007

Table of Contents Feed for the Digital Edition of Institutional Investor's Alpha Magazine - October 2007

Institutional Investor's Alpha Magazine - October 2007 Contents Letter from the Editor Longs & Shorts Pension Corner: Applied Knowledge The Good Guys: Autism Advocate Interview: Nerves of Steel Cover Story: Ivy League Education Alpha Awards: Top Service Providers: Trying Times Strategies: Passage to India Profile: The Oracle of Irvine Alpha Bytes: Futurama Research Center: Funds of Funds 50 Unhedged: Commentary: Crisis? What Crisis?

Institutional Investor's Alpha Magazine - October 2007

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