US sub-prime debt

SHANE OLIVER goes back to the scene of the crime and uncovers the damning caveats

THE last month or so has seen big swings in markets on the back of the turmoil in credit markets. By and large though, most investors should have come through reasonably unscathed. However, some would not have been so lucky. Funds reported to have had the greatest losses seem to fall into three categories - funds with a heavy direct and geared exposure to US sub-prime debt, some of which have seen 80 per cent to 100 per cent of their capital wiped out; funds with a geared exposure to corporate debt which has been caught up in the fallout from the subprime problems; and quantitative equity hedge funds which have been caught out by the volatility in investment markets.

While conceding that the period of share market weakness and credit turmoil ‘ain’t necessarily over yet’, and without getting into the surrounding economic issues and the outlook going forward (which I have covered in previous reports), the blow-up in credit markets provides a number of lessons for investors. Specifically, these relate to financial engineering, diversification, gearing, the fact that there is no such thing as a free lunch and the need to invest in only what you understand.

Lesson 1: Beware of financial engineering

Financial engineering is at the centre of the storm now engulfing credit markets. Mortgages to very low quality borrowers (sub-prime mortgage borrowers) were packaged up into securities (collateralised debt obligations, or CDOs) which were sold off in various parcels, some of which came with high risk like equity but some of which came with AAA credit ratings (the highest possible credit rating).

So, due to the magic of modern finance, a portion of something which was regarded as high risk was able to be marketed as low risk. Hence it was always an artificial construct. And more fundamentally, because of a limited track record (usually just covering the last few years of relatively favourable conditions) risk was dramatically underestimated. Risk was underestimated both in terms of the performance of the underlying sub-prime mortgages and how the securities themselves would behave in times of market stress and poor liquidity (like we have seen over the last few months).

What’s more, this re-packaging and underestimation of risk arguably made the whole situation worse. By encouraging demand for the securities more money became available for lending to sub-prime borrowers which meant that lending standards became ever more lax. Such complex arrangements also led to a poor alignment of interests. Everyone was paid up front - the mortgage originators, the banks underwriting the securities, the ratings agencies, the CDO managers - except the end-investor who held all the risk. And mortgage originators had an incentive to write loans regardless of the quality of the borrowers. On top of all this, these complex securities were poorly understood and irregularly traded, adding to the difficulties involved in undertaking a decent risk analysis.

So when all is going well, there are no problems. But once the underlying investment (ie, mortgages to borrowers with poor credit histories) started to turn sour, the credit ratings proved unreliable. The securities proved impossible to sell because they were so complex and no one really understood them, let alone knew their true worth. And everyone ran for the exits at once.

The key lesson for investors from all this is to be sceptical of investments which rely heavily on financial engineering to meet their objectives, particularly if they haven’t been tested in both good and bad times. Such constructs often have a poor alignment of interests, the true risks may be poorly understood or hidden and, because so many parties are involved, the underlying fees may be excessive.

Lesson 2: Gearing is great - till it isn’t

We all know the benefits of gearing. Investing $1 of borrowed capital for every $1 of your own capital can turn a 10 per cent gross return into a 20 per cent gross return. But of course when returns are negative it can go badly wrong. In fact, very high gearing (eg 5 to 10 times) was at the centre of most of the big fund losses announced recently. For example, if debt is running at five times capital then just a 5 per cent drop in the value of the underlying investments will lead to a 30 per cent drop in the value of the fund for investors, viz: If initial capital in a fund from investors is $1 million and $5 million is borrowed, then the fund’s total investment is $6 million. If the underlying investments fall in value by 5 per cent to $5.7 million the lenders to the fund are still owed $5 million, but the investor’s capital in the fund drops to $0.7 million, or a 30 per cent decline.

Excessive gearing on top of the losses in the underlying securities explains why some funds with direct exposure to sub-prime debt have seen all or most of their value wiped out. It also explains the severity of the decline in value for some funds which were not directly invested in sub-prime related investments, but may have had an exposure to high yield corporate debt, where the decline in value has been modest.

A high level of gearing of this nature can also make the problem a lot worse. An ungeared fund might (depending on the ‘patience’ of its investors and whether it can freeze fund withdrawals if they are not patient) be able to ride out any market turmoil until pricing improves or the underlying securities simply mature by which time any actual losses (eg. owing to mortgage defaults) may be far less than current market conditions imply. But when gearing is huge, the fund’s creditors may seize the assets and sell them into weak markets pushing down their value even further (the equivalent of margin calls). Such fire sales only lock in the losses for investors.

It should also be noted that not only were the funds investing in sub-prime related securities geared, but there was additional gearing in the securities themselves. For example, CDOs that contain sub-prime debt could be up to 25 times geared. In this context it only takes a small increase in mortgage defaults to start causing big losses. As a result, there was effectively gearing on top of gearing.

So be wary of investments that rely on excessive gearing, both at the fund level and in the underlying investments.

Lesson 3: Diversification is good

Many of the funds at the centre of the recent storm appear to have been poorly diversified (particularly those with an excessive exposure to sub-prime related debt) and this has only magnified their losses. More diversified credit focused funds have held up much better.

Similarly, the events of the past month or so have also highlighted the downside of concentrated exposure to hedge funds. Some hedge funds, particularly quantitative long/short equity funds, had a particularly rough month with losses of around 30 per cent being reported at one point.

However, well-constructed funds-of-hedge-funds have generally come through in far better shape.

The point is that investors are always wise to make sure that funds they invest in are well diversified and not overly reliant on a particular type of investment or investment strategy.

Lesson 4: There is no such thing as a free lunch

Investor interest in credit investments and more recently in highly complex yield-based securities has its origin in the long-term decline in interest rates and bond yields on the back of the shift to low inflation over the last two decades.

Somehow, getting a 6 per cent return from government bonds in a world of 2.5 per cent inflation doesn’t sound quite as good as getting a 12 per cent return from bonds in a world of 8.5 per cent inflation (the 1980s). So investors with a desire for a high income flow, such as self-funded retirees, have been prepared to go in search of higher returns moving from government bonds into corporate debt. This was probably all fine because most corporate debt has a long history and so the risk involved can be reliably estimated and managed. In recent years though this has started to morph into funds investing in highly complex securities such as CDOs where risk was less well known.

However, while risk may remain dormant for many years leading investors to forget about it, the events of the past few months highlight that higher returns also come with higher risk. In other words, there is no such thing as a free lunch. The trick for investors is to make sure that they are aware of the extra risk they are taking on and to then make sure that it is managed appropriately in terms of diversification and gearing levels.

Lesson 5: Only invest in what you understand

A key lesson for investors from the events of the last few months is to only invest in what you understand. Modern credit instruments are incredibly complex and it would appear that many (including market participants) did not understand the nature of the investments being undertaken. Until recently most investors would not have known what a sub-prime mortgage was and most would have thought that a CDO was just another acronym for a senior company executive.

The writer is head of investment strategy and chief economist at AMP Capital Investors



Source: Business Times 12 Sept 07