Sub-prime fallout: Lessons of the market seizure

THE SENIOR CREDIT strategist at one of the biggest banks in the US, has been much in demand. In August, hedge fund and other clients are calling constantly for updates and insights on the turmoil in credit markets, where fast rising short-term spreads and underperformance of high-quality credit is threatening to inflict horrible losses. The only way to speak to them all is to stick strictly to 15-minute slots arranged back to back. Time is precious.

One of the bank’s traders appears at the strategist’s elbow, an individual used to positioning all the derivatives on the new credit indices, well versed in the credit curve steepener, the ABX tranches and mezzanine ABS CDOs. He asks if the senior man, when he has a minute, can explain something that’s troubling him.

Sure. What is it that he doesn’t quite get? The trader wants to know: "How do we fund the financial system? Where do the banks get all their money from?"

Deep breath. The strategist sits down in front of a screen and pulls up a bank’s financials. These, over on this side, are the assets and over here, look, are the liabilities and right there, that’s the capital. The trader blinks. "Wow, these are really leveraged institutions," he says.

In every financial market crisis, members of the old guard shake their heads wisely and point out, usually with considerable relish, that those youngsters out on the trading floor who have never seen a market downturn won’t know what’s hit them.

This time, nobody seems to know what has hit them.

The banker says: "When I think back to the crisis of 1994 [when interest rate hikes sparked a rout in fixed-income markets] and all the debate then about leverage concealed within the system, I just think how quaint markets were. Innovation has proceeded at such a pace since 2002 that we really do, right now, have a generation of traders with no wider or historical context."

One of the consequences seems to be that to the most basic of questions – where are the risks, how bad could it get, who might get hit? – no one has an answer.

In London, a week later, Patrick O’Brien, head of investment grade DCM for Europe at UBS, reflects on how the new fixed-income, credit and structured credit markets have fared in their first big stress test. Although he doesn’t say so himself, it’s hard to conclude anything other than failure. "The machinery of fixed income is broken," he says. "There is a complete absence of bid-offer spreads in very large asset classes. There is disruption to bank-to-bank liquidity, overnight funding and commercial paper, and huge suspicion hangs over structured credit and mortgage-related asset classes in their entirety."

This comes, he says, after a golden era when recruiting the brightest young talents to the fixed-income and credit world, once the poor relations of equity and M&A, was suddenly easy. "Our pitch was that fixed income was changing faster and more dramatically than any other business in the history of investment banking and that recruits would be there at the birth of entire new markets." And indeed they were.

It’s just a shame no one remembered to tell them what a bank is or how the financial system works.

When the once-in-three-hundred years volatility – which breaks out every four years or so – inevitably struck, few senior managers, investors, analysts, had any deep instinctive feel for the new credit markets – for the CDO squareds, for correlation desks and their synthetic CDO positions, or even for single-name CDS flow desks. In such circumstances, opportunities for misunderstanding abound.

A week before our strategist’s little tutorial with the credit trader, and two weeks before Euromoney meets O’Brien, UBS had invited investors to a conference call with its credit strategists and experts on the structured credit derivatives markets, to discuss risks embedded in synthetic credit structures. The firm’s own bank credit analysts joined the call, admitting they themselves had been scrambling up a steep learning curve in trying to understand these markets and the potential impact on banks from their dislocation.

It becomes one of those classic calls – there have been so many in recent weeks – designed to calm investors’ nerves but which succeeds only in achieving the exact opposite. The UBS analyst is keen to point out the immense strength of protection against losses from underlying credit defaults to holders of the super-senior tranches now in the headlines. Defaults remain low and for these holders to be hit, defaults would have to rise to undreamt of levels.

Investors have learnt, though, that fixating on default protection might give a false sense of comfort. What about mark-to-market losses from positions that had been put on with huge leverage at historical credit spread tights: does UBS know of any structures reaching the point of forced or even voluntary unwind?