Liquidity is never there when you need it most
In recent years success in the financial services industry has been predicated on two main strategies: first, taking on significant if not massive proprietary risk, a strategy as old as the hills; second, underwriting risk positions and using the capital markets to exit. This is an even more well-established feature of the most successful investment banking operations.
The most important asset class in driving global underwriting volumes forward has surely been mortgages. Originating and securitizing residential mortgages has been a key foundation for any decent fixed-income franchise in the US and latterly Europe. Many of the leading investment banks have replicated this model by establishing commercial property mortgage loan conduits – on both sides of the Atlantic.
Other areas where banks undertake extensive risk until there is a capital market exit include LBOs, whole-business securitizations and infrastructure financing. Of these it is the LBO market that most closely mirrors the sub-prime mortgage sector. CLOs have become the ultimate underwriters of leveraged buyouts in the same way that cash ABS CDOs largely own the riskiest parts of the sub-prime market.
Most estimates suggest that something like 70% to 80% of senior secured loans are bought by CLOs.
They also buy products such as PIK notes that appear to be a bull market innovation; and these are just as opportunistic as the rise of affordability products that are now causing so many problems for sub-prime borrowers that are being forced to refinance. The effect of poor origination standards on sub-prime borrowers was a predictable outcome once house prices stopped rising rapidly and interest rates rose.
The most obvious threat to the benevolent economic and market backdrop that has driven investment banking profits comes from higher delinquencies in the US residential market. If the sub-prime woes extend to the supposedly better quality Alt-A residential mortgage sector, the US economy will rely on the Federal Reserve cutting rates soon. However, the Fed still worries about core inflation. The discussions in monetary policy circles must be anguished right now.
But a tough question needs to be answered: how much of the US economy’s 2006 soft landing was a result of soft underwriting standards in sub-prime lending? If it played a substantial part, then the Fed’s shift to a neutral policy stance might be too little to late.
Everyone is searching for signs of contagion but on the surface the problem of the sub-prime market seems contained (although the sub-prime contagion could spread to Europe – see Guilty by association). Optimists argue that over the past 10 years the global financial infrastructure has grown far more robust and the risk is contained. Early signs of some fallout in the CMBS sector – where tenants were involved in the sub-prime mortgage business – should not be too much of a concern.
And yet it will be no surprise if equity and subordinated CLO spreads start to move in sympathy with cash ABS CDOs. Relative-value players might well think it appropriate to re-rate triple-B CLO risk given the current level of triple-B ABS CDO spreads. The holders of the most risky CLO tranches should also be thinking carefully about the possible impact of a weaker economy on corporates.
There is little evidence so far that the huge pipeline of CLOs is becoming more credit sensitive. Demand far outweighs supply, especially for newer managers who do not have the relationships to get allocations of the best deals. This technical feature of the market remains a huge positive for LBO arrangers. But it is still worth wondering what will happen if it proves temporary.
The sub-prime woes have proven that exposure to the capital markets comes with risk attached. With CDOs not buying any more ABS, volumes have fallen dramatically. That is because the ultimate owners of these various risks are mark-to-market-driven entities. There remains a significant backlog of sub-prime mortgages that no one wants to buy. And one can only pity those who have recently increased exposure to sub-prime originators, as volumes and margins are not going to be attractive for some time yet.
When an adjustment happens, it happens fast. The liquidity, or the perception of liquidity, on the loan side could evaporate within a month or two. Watch the refinancing risk – because if this market shuts it is going to shut pretty damn fast.