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SubPrime Mess Explained

Its been a busy two weeks given the melt down in the credit markets. The catalyst was the unwinding of the SubPrime Lending market, but it transitioned into a full blown credit crunch. I’ve been researching and analyzing what happened (many thanks to David Merkel and Doug Kass for their source materials and news reporting from their own blog posts ) in order to put things into a historical context and to look to the future for the impact on our portfolios. In doing this, the analysis below will hopefully give you some perspective on what is happening.

Greed drives normally sane investors to seek outsized returns that have no true investment basis, rather they are engineered from derivative securities. The demand for these derivative securities drives up the compensation for the investment professionals who can utilize the derivative securities in a manner to achieve (albeit for a short period of time) the outsized returns. The increased compensation morphs into unjustified rewards which drive investment professionals to accept unjustified levels of risk in search of more reward, for their clients and for themselves.

The current crisis in the financial markets stems from both of these situations. Hedge fund providers are paid huge fees to provide above average investment returns and for short periods of time, investors see these and invest ever-increasing amounts of money in these hedge funds. Here is a short step-by-step discussion of how the search for outsized returns and the incentive to provide them worked relative to the hedge funds that bought the subprime paper:

  • Hedge “fund-of-funds” demand smooth returns that are higher than what a moderate quality short-term fixed-income fund can deliver. Fund-of-fund managers are paid an annual management fee plus an large incentive fee if the return exceeds a target level
  • This leads to the creation of hedge funds that seek yield through arbitrage strategies.
  • And the creation of hedge funds that seek yield through buying risky debts, without the use of leverage.
  • And the creation of hedge funds that seek yield through buying less risky debts, using leverage.
  • And the creation of hedge funds that seek yield through buying risky debts, using leverage.

In the short run, yield-seeking strategies work. If a lot of players pursue them, they work extra-well for a time, as late entrants to the trade push up the returns for early entrants. Increasingly greater demand for scarce, illiquid securities with extra yield make current holdings of them more valuable, providing ever greater incentive for hedge fund managers to obtain more of them.

These illiquid securities have no discernible market so they are priced off computer models using pricing grids. The pressure of demand for more of these illiquid securities raises the value not only of the securities being bought, but also of those securities already owned. If more of these securities are being bought, the computer models price them ever higher.

The problem that we have now is that since there is no secondary market to sell them. When the funds try to liquidate them in private transactions in order to meet client redemption requests, they are being offered 20 cents on the dollar. The assets, if sold at that price, are not adequate to pay off the debt incurred by the fund during the leveraging process — let alone enough to fund the client redemption requests — and the fund folds (just as Bear Sterns folded three of their funds).

Over the years, there have been various crises in the financial markets related to leverage and derivative securities. It is not unlike a game of musical chairs when the music stops and all the players are searching for a safe place to land. Something shifts at the back of the chain of related events which forces every asset in the category to reprice. For example:

  • 1989-1994: After the real estate boom of the mid-1980s, many banks, savings & loans and insurance companies get loose in their lending standards and real estate investment, leading to a crisis when rent growth can’t keep up with financing terms; defaults ensue, killing off a great number of S&Ls, some major insurance companies and a passel of medium and small banks.

  • Late 1991-early 1993: The adjustable-rate mortgage market, fueled by demand from ARM funds, overbids for ARMs in an effort to provide a high floating rate yield. As the FOMC loosens monetary policy, higher than expected prepayments force losses onto the ARM funds

  • Late 1993-late 1994: The FOMC threatens to, and does, start raising interest rates, which throws the residential mortgage-backed market into crisis. Pre-payments on mortgage pools dropped and the computer models that predicted the returns on derivative instruments were found to be erroneous. Many holders who purchased mid-tranche bonds and who planned on a certain average life actually ended up holding the bonds significantly longer.

  • Mid-1998-mid-1999: Long Term Capital Management blows up, forcing all manner of exotic asset-backed securities (ABS), residential-backed securities (RMBS) and commercial mortgage-backed securities (CMBS) into the market for bids. The bids back up, until the entire market reprices downward and the holders of other similar securities see the values of their holdings tumble. Funds that had significant leverage fold.
  • 1998-1999: Home equity ABS blow up, as defaults threaten to, and then do, emerge at levels far higher than anticipated. Almost no originators survive.
  • 1999-2001: Cruddy high-yield bonds reveal their true value as defaults threaten to, and then do, emerge.
  • 2002-2003: The manufactured-housing ABS market blows up, as originators don’t take initial losses but roll borrowers over into new loans that reduce payments and extend payment terms, technically keeping the loans current. The system collapses when the buildup of bad debts and repossessed homes becomes too great to roll over.

Of the existing large securitization markets, only the CMBS market so far has not faced a real crisis, partly due to the influence of the B-piece buyers cartel: six or so firms that buy the junk-rated debt of deals and enforce credit quality standards on the individual loans by kicking out poorly underwritten loans.

In each of these situations, there was a boom-bust cycle. The markets did not adjust slowly and evenly to changing conditions; the transitions between “boom” pricing and “bust” pricing were swift. This is the nature of markets, particularly when enough debt is employed to amplify the process – in the case of the Bear Sterns funds, they were levered 15-to-1. That situation mirrors what we are seeing today in the subprime market.

There is no conspiracy necessary to make the shift happen even though often the media or the government will make it seem like there was one – remember it was simply greed that caused it.

The bubble pops when the credit market dries up and financing is not available to carry the assets. The assets reprice downward and no longer adequately secure the value of the loans obtained in the leveraging process. After the bubble pops, it becomes a question of what the underlying assets can be liquidated for, allocating losses mercilessly according to the loan documents and bankruptcy priority. Nothing is left over for the investors who were searching for the outsized returns.

Today’s crises are in the areas of (a) nonprime lending, (b) leveraged buyouts and other high-yield debt, and (c) over-leverage in the collateralized debt obligations (CDO) market. These problems will get worked out, as all other crises have, handing losses to those who speculated unwisely. Those fund managers who financed properly or who acted opportunistically buying the high quality assets from the failing hedge funds end up prospering once the crisis has passed (the high quality assets have to be liquidated along with the illiquid assets in the unwinding process).

The next shoe to drop will be with the management of money market mutual funds. We are already starting to see a number of money market funds disclose that they invested in subprime paper in order to increase money fund yields. In their grasping for yield, many money market funds — including BlackRock , Charles Schwab and Fidelity — attempted to enhance their investment returns by purchasing low-quality debt instruments (collateralized debt obligations, continuous linked settlements, mortgage-backed securities, etc.).

Many of those money market funds — like the hedge funds that invest in them (particularly futures funds, which typically keep large cash positions) — have yet to mark to market, or if they have, in certain cases have halted redemptions. This is likely the first time that many investors will hear that their money market mutual funds can lose money or that they cannot access their funds when they need the money. Depending upon how widespread this becomes, and whether Schwab and Fidelity infuse their own capital to make their funds whole, it will likely impact a lot of unsuspecting investors.

As with past crises, we will get past it, but not before a lot of pain is felt by investors who were either not paying attention to what they bought or by investors who greedily bought investments for outsized returns without understanding that with reward always comes risk.

As the stock and bond market has been tumbling downward, we have been buying shares of the companies in sectors that will continue to have strong earnings: energy, metals, Ag, defense and infrastructure. These commodity and economically cyclical names have been sold off because of two situations: (1) certain investors (hedge funds and mutual funds) are being forced to sell good companies because the bad investments they hold – subprime bonds – cannot get a bid at a time when shareholder redemptions are requiring them to raise cash; (2) some investors believe that we are at the beginning of a global slowdown and the commodity and cyclical names will have reduced earnings.

Situation (1) above is a temporary phenomenon that gives us buying opportunities. Situation (2) above is a point worth debating. If these investors are right, then selling these companies is a better move than buying them.

At this time, there is no evidence that we will see a slowing of people moving into the middle class in China and India. All of the numbers continue to show that millions are moving each year out of poverty into the middle class as their job situations improve. This means that the demand for all of products in our preferred sectors will continue and the earnings for the companies in those sectors will continue to grow. Could the GDP growth slow in China and India from double digit levels to high single digits? Absolutely. But to think that this will derail this investment theme makes no sense. On a comparative basis, if the companies in these sectors continue to grow earnings at a greater pace than companies in other sectors, this is still the preferred investment.

At this time, we will continue to follow our strategy and opportunistically make purchases in these sectors for the long-term outperformance of our client’s portfolios.