The market situation now seems to be more about nerves than fundamentals. Stay tuned.
The banker’s view of the market jitters
It is too early to know whether the reported $2 billion Reserve Bank intervention in financial markets last week relieved a nasty case of indigestion, or whether in fact it was no more than whistling into the hurricane of our next recession.
Where to from here? The situation appears to be more about nerves than fundamentals, so how this unfolds depends on whether there is any more bad news on the way.
The good news is Australian banks are in good shape because they don’t hold risky loans – but that doesn’t mean their share prices won’t bounce around. Interest rates seem likely to rise again – but it’s too early to tell by how much, and for how long.
Corporate profits may be affected by rate rises – which will also roll through to share prices. Risk margins on bank loans will probably rise. And over the next 12 months, the mums and dads of Australia will learn just how much of their superannuation was invested in CDO funds.
CDO funds I hear you ask? CDO stands for collateralised debt obligations (is that clearer?). Let me explain the madness of the CDO investment vehicle and the concept of securitisation.
Securitisation describes the process of packaging up loans and selling them to investors. Lenders do this because it provides them with a cheaper source of finance, but it has the handy side effect of passing the risk on to someone else.
Although the majority of securitisation involves home loans, many large corporates have likewise used securitisation, and for exactly the same reasons.
Who buys the securitised loans? Well, prime quality securitised assets are an appropriate and sensible investment for life companies, cash management trusts and central banks, among others.
More recently, CDO funds entered the fray. CDO funds typically borrow money to buy securitised assets, making their profit on the difference between their cost of funds and their return.
Typical of the financial engineer’s lust for complexity, CDOs borrow money in several “tranches” or levels. Think of a borrower with nine mortgages (yes: nine) and you’ll understand the situation. The first mortgagee is first to be repaid and last to feel the impact of non-payment. The ninth mortgagee is last to be repaid and first to feel the pain of non-repayment.
Someone lending money with only a ninth mortgage as security requires a premium for the risk they are taking on – and some of the CDOs were paying their bottom-tier lenders a hefty 10% over and above the base cost of funds.
With a high cost of funds on the lower tranches, the CDOs had to chase high returns. As return always follows risk, that means taking on more risk, such as the “ninja” loans that your correspondent learnt of last week – which are loans to US borrowers with no income, job or assets (self-fulfilling prophecy, anyone?). The net result was bottom-tranche investors with a structurally leveraged exposure to high risk borrowers – a ticking time bomb in my book.
(In point of fact, it was better than that: major Australian lenders were offering margin lending so that investors could gear their investment into hedge funds that were internally gearing into the bottom tranche of CDOs – external leverage upon internal leverage upon structural leverage!)
With house prices stalling in the US – preventing knife-edge borrowers from refinancing – some defaulted. The concentration of risk in the bottom tranches meant that some of those investments were completely wiped out.
The story from here on is about mob psychology. Highly visible losses in the bottom tranches reminded investors in higher tranches that there was some inherent risk. Many of them decided that safe was better than sorry and sought to exit their investments.
Liquidity is king to the traders. They don’t want to get into a position that they can’t get out of, so even though there is some intrinsic value in those investments, there were no buyers. With lots of sellers and no buyers, the market price of those CDO funds is zero.
For the moment, it appears that markets have decided that they have underpriced risk across the whole market – and are making up for it with a vengeance. On one interpretation, the Reserve Bank intervention on Friday was necessary because the market simply did not work.