Consumers paying for the implosion of dumped risk

July 22nd, 2007

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In our previous article, How to dump risk to consumers: securitisation, we said that:

With the recent financial ?innovation? of debt securitisation, lenders can now aggregate their loans, and through dicing, slicing, splicing and divesting, repackage it into an ?investment? product.

These ?investment? products are then sold to retail investors (i.e. consumers) directly and indirectly (through their retirement funds). As with all financial products, these ?investment? products come with ?management? fees.

Today, we are seeing the implosion of such ?investment? products due to the sub-prime crisis in the US (see How did the US sub-prime lenders get into trouble?):

  1. Bear Stearns’s two hedge funds has collapsed and are not worth a combined 9 cents to the dollar (i.e. value fell by 91%).
  2. Basis Capital, an Australian hedge fund manager, has two of its hedge funds in crisis: Basis Yield Fund and the Aus-Rim Dividend Fund. Both of which were exposed to the sub-prime market.

According to the ?cockroach theory,? if you see one cockroach in the kitchen, then there must more of them somewhere else. In the same way, if we see some of these crises in hedge funds coming to light, then there must be more of such rot somewhere else. In one of the news article, Warnings over hedge fund crisis, it was reported that (in the context of Basis Capital’s crisis):

… fallout was the first instance of ripple effects from the implosion of the US sub-prime market reaching these shores.

… the situation was “serious already”, but difficult to accurately assess because “opaque” secondary credit markets made it hard to track risk. “From a systemic point of view, though, the problems are quite manageable so far,” he said.

There are two main causes of the turmoil in the sub-prime market, and its increasing relevance for local investors.

First, poor lending standards resulted in mortgage lending to risky customers with only a limited capacity to repay.

Second, and most important for Australians exposed to the crisis, the loans were repackaged through securitisation and sold throughout the world, finding their way into the portfolios of largely unsuspecting investors, according to Schroders.

This led to a complete disconnect between the originators of the loans and the eventual holders of the risk.

The disconnect was further enhanced by complex structuring mechanisms, transposing the loan parcels into CDOs.

Mr Hodgson linked the cascading effect of turmoil in the sub-prime market to the wider debt market, particularly highly leveraged private equity deals.

“Leverage is always the first thing that catches a cold first, and there’s probably been some pretty toppy multiples paid for some of those businesses,” he said.

“With a rising interest rate environment and toppy multiples, it’s going to be tough for some of those deals.”

Mr Hooper said it was going to be difficult to get a handle on the depth of the sub-prime problem, and where the impact would be most seriously felt, because of the opacity of the secondary credit market.

“The first question is whether or not this is the tip of the iceberg in sub-prime, and we have (US Federal Reserve chairman) Ben Bernanke saying this is a fairly major credit problem,” Mr Hooper said.

“But the second issue is where – and the extent to which – this will work its way through the securitisation and collateralised loan market.

“It’s a bit difficult to call at this stage on both counts.”

Foreign banks, including Lehman Brothers, Merrill Lynch, Citigroup, JP Morgan and Morgan Stanley, have the biggest exposure to Basis Capital.

Mr Hooper said the banks’ right to sell assets quickly would be at the expense of investors’ interests.

“It’s the glory of leverage in reverse,” he said.

We warned our readers before in Spectre of deflation and Liquidity?Global Markets Face `Severe Correction,? Faber Says, and our suspicion is that in the months and years ahead, we will see a rising trend of such collapses.

 Investors beware!