The WSJ reveals this morning that Merrill Lynch has been using hedge funds to temporarily hide its exposure to the subprime mess:
Merril Lynch & Co., in a bid to slash its exposure to risky mortgage-backed securities, has engaged in deals with hedge funds that may have been designed to delay the day of reckoning on losses, people close to the situation said.
More on this, and on the underlying panic in the credit markets, below the fold.
From the European Tribune
In one deal, a hedge fund bought $1 billion in commercial paper issued by a Merrill-related entity containing mortgages, a person close to the situation said. In exchange, the hedge fund had the right to sell back the commercial paper to Merrill itself after one year for a guaranteed minimum return, this person said.
So Merrill Lynch is buying time, putting its own money on the line via the guarantee to repurchase after a year in exchange for a deal that allows it to lower its apparent exposure to subprime mortgages - or to create for them an artifical transactional value which it can use to value favorably the rest of the paper it still holds. This suggests that neither Merrill (which needs to resort to tricks to find a market value for its assets) nor the hedge funds (which require a guarantee) are confident that the underlying value is anywhere near what they claim it is. And it explains why banks are increasingly wary of one another.
The Financial Times has a scary article this morning, describing some og what's going on behind the scenes in the credit markets right now , and it's worth looking at in more detail:
Prepare for the credit drama sequel
This week, a banking friend made a startling confession. In recent weeks he has been furtively unwinding some large investment portfolios linked to subprime securities.
But as he has embarked on this sordid task, he has discovered that the only effective way to get rid of these distressed assets is to avoid putting any tangible price on the trade.
Again, the same underlying points: worries about the value of subprime securities have not abated, and everybody is trying to get rid of them in any way they can. But, and this is very important, nobody wants an actual formal price to be put on any transaction, because that would force such prices in the open, causing the need to use such 'official' market prices to value other similar assets held by banks and investors on their balance sheets or portfolios, under current "mark to market" rules (ie you're supposed to provide on a regular basis a value of your portfolio at its market value, and not at what it cost to purchase. It's only when there is no market that you can use acqusition price or, on occasion 'mark to model' - fancy estimates of what you think it's worth).
Instead, he has resorted to using a tactic more normally associated with third world markets than the supposedly sophisticated arena of high finance: barter.
“Barter is the only thing that works right,” he chuckles grimly. “It is like the Dark Ages.”
I daresay this is an extreme example. But it nevertheless reveals a crucial point: namely that while this summer’s credit turmoil is already several months past, parts of the credit world remain plagued by strikingly high levels of fear and mistrust.
Barter is highly inconvenient compared to using money: you need to have assets of similar value to trade, and both sides must want what the other is 'selling'. Resorting to barter is an extraordinary sign that either (i) money is no longer trusted or (ii) bringing out the subprime mess in the open would be a catastrophe. As we're not yet under option (i), it just goes to show (like in the Merrill example I used in the introduction) the extremes that banks will use not to have to give an accounting of what they hold.
Indeed, in some arenas, such as mortgage-linked securities, sentiment now seems to be getting worse, not better. And that raises the prospect that we are now moving into an entire new phase of this year’s credit squeeze.
Take the ABX index, the basket of derivatives linked to subprime securities. As financial tools go, this index is far from perfect, since it is barely two years old, and tends to be thinly traded.
But right now it has the unfortunate distinction of being the only tool easily available to measure sentiment in the opaque subprime securities world. And in the past couple of weeks, the message emerging from this measure has started to look utterly dire.
All the indices and ancillary info can be found at this link: ABX Indices
Never mind the fact that the risky tranches of subprime-linked debt (the so-called BBB ABX series) have fallen 80 per cent since the start of the year; in a sense, such declines are only natural for risky assets in a credit storm.
Just as a note here: a BBB rating is an investment grade rating, ie a rating that pension funds are, by public regulation, allowed to trust in invest in freely (the distinction between "investment grade" and "junk bonds" (or "high yield debt") is precisely that those above the cut are allowable for investment by regulated investors, while those below are not). So we're talking about instruments that, in absolute terms, should carry only a little bit of risk.
An article in Bloomberg that i already quoted several times (and which provided some excellent background on the coming crisis back in July)noted:
Corporate bonds rated Baa, the lowest Moody's investment rating, had an average 2.2 percent default rate over five-year periods from 1983 to 2005, according to Moody's. From 1993 to 2005, CDOs with the same Baa grade suffered five-year default rates of 24 percent, Moody's found.
Moody's Baa rating is equivalent to S&P's BBB-, ie it's one level lower, or riskier. Thus BBB rated paper should, in theory, have a probability of default under 2%. And now the ABX index is telling us that these papers are valued at 20% of their face value, i.e. buyers expect that they will get only one fifth of the theoretical financial streams they are purchasing. One fifth.
But that's understandable, we are told, because these were the risky bits... But, remember, they have the "investment grade" stamp nad have thus certianly been purchased by the managers of pension funds and other supposedly safe funds all over the world.
But back to the Ft article:
Instead, what is really alarming is that the assets which were supposed to be ultra-safe – namely AAA and AA rated tranches of debt – have collapsed in value by 20 per cent and 50 per cent odd respectively.
This is dangerous, given that financial institutions of all stripes have been merrily leveraging up AAA and AA paper in recent years, precisely because it was supposed to be ultra-safe and thus, er, never lose value.
Here's the graph showing the evolution of the price of these two indexes (from the ABX page linked to above):
AAA graph
AA graph
The prices reached in August were already seen as extraordinarily worrying: 10% discounts on AAA paper was, quite frankly, completely unheard of, and smacked of panic and/or desperation. AAA is the rating that the best sovereign governments (but not all - Japan is not rated AAA, for instance) and a very small number of corporations manage to get. It's the safest kind of paper you get - and you get paid very low remunerations because of the low risk. And now we're talking about 20% discounts! And AA is still an excellent rating - typically that of the best rated banks on the market, something that gets you a remuneration a few tenth of a percentage higher than the no-risk AAA. And they've lost half their value?!
And remember - this is the only visible price we have for these financial assets, given how most banks and investors are desperately scrambling NOT to get them valued, so that they don't have to go through their balance sheet to "mark them to market" and revels bigger losses than theye already have.
But the trend also has crucial significance for investment banks. Until quite recently, many Wall Street banks tended to value their subprime linked holdings using models, because they (and their auditors) knew it was hard to get prices for these opaque instruments through real market trades. But I am told that this autumn some banks’ auditors have started to crack down on this approach, particularly in the US, owing to the so-called “Enron factor”.
More specifically, the experience of living through the Enron scandals earlier this decade means that the audit industry is now terrified that it could face lawsuits if it is perceived to be too lax towards its clients. So some now appear to be demanding that their banking clients reprice their mortgage assets according to the only visible market tool – namely the ABX. It is thus little wonder that some banks have suddenly been forced to increase their writedowns in recent weeks. Indeed, I would wager that the pernicious combination of ABX and the “Enron factor” is a key reason for the recent shocks emanating from Merrill Lynch.
This is ironic, but it touches upon one of the hard truth of the subprime mess: it's Enron, write large. First, it does show that regulation-by-precedent at least ensures that the errors of the past are no longer made: at least this time the big accountancy firms are not going to be complicit of attempts to hide the mess. But, secondly, it does flag that, at heart, the mess is not that different from what Enron did. Enron's modis operandi was to create semi-artificial future financial streams, book their equivalent value as profit today, and dump the liability on outside vehicles so they would not be visible on their accounts. The line between outright crime (completely fictional streams) and creative finance (real streams, whose full value was non-fictional only under highly favorable hypotheses) is hard to place...
However, the rub is that while auditors at some Wall Street banks are becoming quasi-evangelical about the need to reprice subprime assets, there are still other, vast swathes of the financial system which have not been touched by the full blast of transparency yet. Moreover, many financiers outside the world of Wall Street banks remain very wary of rewriting their mortgage assets to current ABX price levels, due to a lingering hope that the recent ABX slump will remain temporary.
Titanic ... iceberg ... chairs on the deck ...
No wonder that my banking friend is now furtively resorting to barter, to unwind his clients’ investment portfolio. And no wonder that investors are currently so suspicious about the health of financial entities – and so nervous about the potential for secondary shocks. This new wave of fear is unlikely to vanish quickly. Call it, if you like, The 2007 Credit Crunch Story, Part II.
And remember, this is all happening in an economy which is supposedly growing nicely... What will happen when the inevitable recession hits?