MoneyMorning.com 7/30/07 - by Martin Hutchinson
Just how bad is the “credit crunch?”
When Daimler Chrysler AG (NYSE: DCX) last week found that the collapse of the debt market was threatening the sale of its Chrysler Corp. carmaking unit, the German automaker and buyer Cerberus Capital Management announced they would put up $2 billion of their own money to make sure the deal gets done.
The “credit crunch” that started on Main Street with the U.S. housing market has now spread to Wall Street. But the next question is how bad this liquidity squeeze will get: At it worst, it could terminate the buyout wave that’s been a big part of the reason U.S. stock prices have achieved record highs this summer – sending U.S. shares into a tailspin. And that, in turn, would turn into a bear-market contagion that spreads to international market.
To understand just how bad things could get, it’s important for us to look at how this liquidity squeeze got started, and then to see how it could affect the corporate debt market – for that will help determine the ultimate affect on the buyout market, and then stock prices.
The so-called “Sub prime” mortgages had a separate crunch in February, but now the mainstream corporate debt market – where exciting mega-billion-dollar deals were being sketched out on back of restaurant envelopes – has become extra wary of assuming anymore acquisition-related debt. That’s not great news for Wall Street bonuses; and it likely also spells trouble ahead for the rest of us.
Back in 1999 and the first part of 2000, high-tech stocks soared far beyond any rational calculation of their value. Today, the yields of risky bonds have fallen (and their prices risen) to levels that can’t possibly reflect their likelihood of default.
In short, if you are receiving only a 1% spread above risk free Treasury bonds on a conventional bond, you must be confident that in each year of that bond’s life, the chance of it defaulting and losing all value is less than 1%. If you think that, even in a default, you’ll get half your money back, you can afford a default risk of 2% for each year of the bond’s life. If it’s a 10-year bond, and the chance of default is more than 20% over that period, you shouldn’t buy it unless it yields much more than 1% above a 10-year Treasury (much more, not just more; you need to be paid for taking the risk and making the intellectual effort to assess the thing.)
Hedge funds love this kind of risk: For them, it’s more fun than playing Russian roulette. They load up on risky bonds, borrowing the money to buy them, and then keep their fingers crossed. While the bonds pay off, the intrepid hedge-fund operators make the spread between the bond’s yield and their borrowing cost, multiplied by the number of times they’re leveraged: So if they borrow 90% of the value of the total bond portfolio, they make 10 times the spread on their 10% capital. The hedge-fund manager pockets 20% of this, without taking significant risk of their own.
The mass buying by hedge funds, with purchasing power a large multiple of their capital, has pushed down spreads. So long as the Fed keeps printing money, and doesn’t raise interest rates too much, the bond borrowers will stay solvent, and the hedge funds and their management will make good money. Once the market cracks, and defaults appear, the hedge funds and probably those who have lent to them will have losses. However the hedge fund management doesn’t have to pay the 20% back, so walks away from the wreckage unharmed to find another scam.
Cracks are already appearing. In the home mortgage market, high-risk mortgages were also a happy haven for hedge-fund investments, so when the subprime mortgage market dried up in February, hedge fund losses began to appear. The $4 billion in losses announced by investment bank Bear Stearns in two of its hedge funds are just the tip of the iceberg, and that illustrates just how big an iceberg we’re dealing with.
Moody’s Investors Service downgraded another $5.2 billion of mortgage-backed higher-than-expected delinquencies, and essentially conceded that the rating agency had underestimated the risks involved.
Of course, as mortgage financing has become harder to obtain, the housing market has nosedived, and speculators who bought property and financed the deals with floating-rate mortgaged, are now in trouble. It is now pretty clear that the U.S. housing market is just one enormous train wreck, albeit one that’s unfolding in very slow motion. The upshot: It will be a year or two before we see the full damage.
Housing’s not going away, but house prices can drop, and that drop will cause painful losses for homeowners and mortgage lenders, probably stretching into the trillions of dollars.
A similar scenario now seems likely to play out in corporate bonds. A number of leveraged acquisition deals have fallen apart because they couldn’t get financing, and investors are particularly wary of “covenant-lite” and “payment-in-kind” bonds – the riskiest-such securities.
It all makes sense Just as a hiccup in the housing market led to defaults in sub prime mortgages, so, too, will a hiccup in the corporate loan market likely to lead to junk bond defaults, as borrowers find themselves unable to conclude deals they had counted on.
A decline in the corporate bond market would, at first sight, be almost good news for real people. After all, if the Wall Street predator can’t buy your company, you probably get to keep your job.
At least for now.
With the U.S. economy growing at 1% per year on average, and corporate profits growing slowly, too, it’s likely that the recent manic deal flow is all that’s propped up share prices, sending the key indices to record highs (one recent record close was achieved almost solely because of an announced $44 billion deal for Alcan Inc. (NYSE: AL), for instance).
The bottom line: If corporate-bond defaults escalate in frequency, and the deal flow slows, Wall Street bonuses won’t be the only casualty – the U.S. stock market will drop and the entire U.S. economy will take a big bath. Even in corporate bond markets, what goes up must come down. Only the hedge fund guys who inflated the bubble will get to keep their 20% “carry” on the profits that have vanished.
http://www.moneymorning.com/2007/07/30/creditcrunch/
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