Subprime for a Long Time (by Mauldin)

Back to 1998

Let's get in the Wayback Machine and revisit 1998. (For reference for my foreign readers, the "Wayback Machine" originally referred to a fictional machine from a segment of the cartoon The Rocky and Bullwinkle Show used to transport Mr. Peabody and Sherman back in time.)

First, there was the Asian currency crisis and then Russia looked like it would default on its debt, causing a crisis in the credit markets. A hedge fund called Long Term Capital Management had leveraged their bond positions about 80 to 1 based upon the relationship between certain types of bonds always, emphasize always, converging upon a certain price. They diversified on bonds throughout the world as an "extra" protection.

Except that the markets in the fall of 1998 were not acting as they had in the past. The relationships changed just a very small amount, but if you are leveraged 80 to 1, then small is enough to wipe you out. The Nobel Prize winners who designed the system overlooked the possibility that the market could become irrational.

Fast forward to 2007. Again, the credit markets are in turmoil, and the subprime mortgage problems are spreading, as predicted here last January. Let's look at some things that are similar to 1998.

First, normal relationships between certain types of bonds have been turned on their head. For many companies who go into the credit markets, there are different types of debt they sell. Certain types of bonds or loans are considered "senior" because in the event of the company going bankrupt, they get paid first. Then debt that is subordinated to the senior debt gets paid, and lastly the shareholders get to split what is left over, if anything.

So, clearly, it stands to reason that senior debt is more valuable than subordinated debt. Why would you pay more for the riskier debt? So, if you want to put on a hedge, you can "go long" the senior debt and "go short" the subordinated debt. And in the past, that works.

Except not this time. There are a number of funds that are having real problems and are being met with high redemptions because they are exposed to the subprime markets. But no one is buying the subprime debt, so they have to sell what they can to meet redemptions. And what sells? The quality senior debt. At a discount, of course.

So, if you are another fund holding that debt instrument that just traded down, you just saw the value of your high quality loan or bond drop. But because the subordinated debt you sold as a hedge is not trading, there is not a price for it, so you can't show the profit there should be on the pair trade. Your fund is down for the month. Bummer.

Now, if you are not over-leveraged and forced to sell, you can wait a few weeks or a month and the normal relationship will come back. And you may even benefit as quality will rise even as the riskier instruments fall. But until there is a price made on your hedges, you cannot just make up a price based upon normal rational markets.

And if you are in the lucky position of having cash, you can go in and buy very good debt at a fire sale price today. There are a lot of debt instruments of very good and profitable companies that is on the market for much less than what it will be in a few months when things get back to normal. And if you are a company with cash, you may be able to go back in and buy your debt at a discount.

The End of the Quantitative World

I should first note that the average hedge fund made money in July, and some did quite well. There are a number of hedge fund strategies that have the potential to benefit in this type of environment. That being said, if a fund has invested in the subprime mortgage space (unless they are short), they are losing money. It is easy to see the relationship between the subprime mess and the funds that invested in it. But there are other funds which are losing money, and the connection to the subprime markets is less clear.

There are any number of statistical relationships which have simply not functioned as they have in the past. Large quantitative hedge funds that employ teams of mathematicians and physicists to develop complex "black box" trading programs to computer trade on these relationships are finding themselves losing money. As Spencer Jakab writes:

"Quantitative hedge funds running 'black box' models are primarily market neutral, seeking to exploit small inefficiencies in valuations and historical volatility between similar securities. A period like the last few weeks would have typically seen such funds outperform most of their peers in the hedge-fund community, but they have instead shocked investors with steep losses.

"Because risk managers were able to demonstrate that they were less risky, on paper at least, they were allowed to use far more borrowed money than other leading hedge fund strategies. Some are clearly overextended. 'The inherent leverage is killing them,' said a broker at a major investment bank who deals with hedge funds."

"Analyst Matthew Rothman of Lehman Brothers wrote that the models are working in exactly the opposite way they should to protect a black box fund in an up or down market. 'It is not just that most factors are not working but rather they are working in a perverse manner,' wrote Rothman. 'The names that are short are outperforming, often notably, while the names that are long are underperforming, although less severely.'"

Goldman's Global Alpha, which has been losing money for two years, is down 26% for the year and down almost 40% since the end of July. It is not surprising they are being hit with redemptions. And that forces them to sell. Many of the largest hedge funds are the very quantitative funds that are being forced to sell, putting pressure on the markets.

In 1998 problems in Asia and Russia spread to the rest of the markets, affecting Norwegian bonds and US stocks. It took a few months to sort out, and a lot of people lost money. Today, problems in the subprime mortgage markets spread to other credit markets and the affect is spilling over into stock markets.

But there is a difference. Today, instead of one fund that was at the epicenter of the problem, the problems are spread around the world among scores of funds and permeate the largest institutional and pension funds. While that means the losses are spread among thousands of investors, it also means that central banks can't bring everyone to the table to "fix" the problem.

The problem of the last two days was triggered by BNP Paribas telling investors in three of their funds that they would not be allowed to redeem. This simply froze the European markets. The European Central Bank has injected $211 billion into their system. Central banks have put $339 billion into the world system in the last 48 hours. And you should be very glad they did, by the way.

I heard on TV that some are saying the Fed is bailing out banks. Not they way I read it. They are simply taking short term "repo" paper for a few days to inject liquidity. If you are going to have a central bank, then this is a proper action. The fact that the excess liquidity which produced the bubbles can be laid at the Greenspan Federal Reserve's feet is a topic for another day.

And while we are on the topic, I think BNP Paribas probably did the right thing. They have funds which have invested in all sorts of credit vehicles. Nothing is trading, so if they tried to meet redemptions, they would have to sell assets at much distressed prices, and then guess at what prices the other assets should be valued at in the absence of a market price. If they guessed to little, then those exiting would lose too much, notice their losses were too high and sue. If they guessed too high, then those remaining would notice that they lost more than they should have and then sue. BNP was in a no win situation. To be fair to all investors, they have to wait until the market prices the assets in their portfolio.

They have not said what those assets are. If they are not US mortgage related it is likely they will turn out ok. If there is subprime in the mix, they will take significant losses.

Subprime for a Long Time

And one last difference between 1998 and today. Back then, the problems in the markets became known and were priced into the markets in relatively short order. It is going to be several years before we know the extent of the subprime losses. Remember the table that I used last week which showed the bulk of subprime mortgage interest rate resets was not until the first half of 2008. It is going to take years for the markets to know what the losses on the subprime will actually be.

And it is not as if it should be a total surprise. Any investor can go to their Bloomberg and pull up a listing of subprime Residential Mortgage Backed Securities. There are 2,512 of them. If you sort by the ones with the most loans over 60 days past due, you find that the average RMBS has 12.39% of their mortgages over 60 days, and 2.39% have already been repossessed (REO in the next table), with almost 5% in foreclosure.

The table below shows the RMBS with the highest level of 60 day past due (or worse) mortgages in them. Yes, the worst two offenders are the 2006 vintage of RMBS. But notice that a lot are from 2000, 2001, 2003 and earlier, well before the supposedly lax standards of the past few years. The third listed RMBS, the INHEL 2001-B is selling at 18 cents on the dollar (you can't see this from the table), and has been dropping since 2003. Over 25% of the mortgages in that portfolio have already been repossessed or are in foreclosure, with another 25% past due for over 60 days. Can you say ugly?

But you can also find paper from 2001 that is not doing badly. It should be clear to anybody who did a little due diligence a few years ago that there were problems in the subprime RMBS markets. There was a great deal of difference in the quality of various offerings. So it paid you to do some homework. If you could not get transparency, then you were taking a gamble.

That being said, many of the European and Asian institutions who bought this paper relied on the credit rating agencies. They relied on the models built by the investment banks that put this paper together. As I have written, they sold their AAA rating but put legal language buried in the documents that basically said, "OK, this is not what we mean by AAA in our other ratings." The document for the RMBS mentioned above was 300 pages of fine print. I will bet you that the vast majority of people buying this paper did not read it or understand what they were reading if they did.

You can bet lawyers all over the world will look at this same screen I show below. They are then going to ask the bankers and credit agencies how they could put such a high rating on the paper seeing the problems in these securities? "Really, you didn't look at the lending standards?" It's all hindsight, of course. But that's what lawyers do. And in front of a jury, it will be a tough day for the banks and credit agencies.