Friday, February 23, 2007

Debt-market bomb : tick, tick, tick, baby.

Debt-market bomb could hurt us all

The greatest economic threat today isn't deflation in the housing market. A bigger worry is that a meltdown in the debt markets could force the global economy into a credit squeeze and recession.

By Jim Jubak

File this under strange but true: Insurance encourages risk-taking behavior, and ultimately, it increases the size of a disaster when it finally strikes.

That is bad news, really bad news, for the debt markets. So bad, in fact, that if you're worried about a financial-market meltdown, you should be watching the debt markets and not the stock market.

The problem is what I call the insurance effect. Make it possible for homeowners to get flood insurance, and more people will build in flood-prone areas. Sell hurricane insurance, and more people build in areas at risk of getting hit by a hurricane.

The result is logical, if perverse. The insurance policies haven't reduced the risk of floods or hurricanes, but they have shifted part of the risk from the homeowner to the insurance company. The homeowner with insurance, as a result, has less financial motivation to avoid the risk of floods or hurricanes.

Increasingly risky business

Investors aren't any different. For example, look at the buyers of mortgages, securities based on pools of mortgages, corporate loans, and corporate and government bonds. If you offer them insurance against the risk that a borrower will default on paying what's owed, those investors will be more comfortable buying riskier debt from borrowers more likely to default. Why not? Part of the risk has been passed along to those who sell the insurance. In the debt market that insurance goes by names such as "credit default swaps" and "collateralized debt obligation."

When the inevitable flood or storm or debt-market meltdown does finally take place, of course, since there are more homes in the flood plain, more buildings in the hurricane zone, more shaky credits in portfolios, the size and cost of the disaster is much larger. In fact, if the flood, hurricane or market meltdown is big enough, the costs of the disaster can overwhelm the ability of insurance providers to pay. The availability of insurance has created a feeling of safety that has encouraged so much risk-taking behavior that the insurance safety net itself can fail, leaving homeowners or investors fully exposed to the risks of their behavior.

I think that's where we are in the debt markets right now. The financial engineers of Wall Street have promised that the sophisticated financial instruments they've invented make it safe to buy riskier types of debt. The result has been a predictably large increase in risk-taking behavior.

Certainty and vulnerability

All this has left the debt markets vulnerable to a storm -- an economic slowdown -- big enough to test Wall Street's promise. I think it's almost certain that these insurance instruments will fail the test. The biggest risk in the financial markets today isn't that a deflating housing market will trigger a stock-market bust but that the huge expansion of risk-taking -- of which the problems in the market for the riskiest of home mortgages is just one part -- will overwhelm the debt markets, creating a quick reduction in the amount of money available to borrow and forcing the global economy into a credit squeeze and recession.

You can better grasp how the financial markets have gotten themselves -- and us -- into this fix by understanding exactly why investors in the various shapes and sizes of debt were so eager to believe Wall Street's promises. Interest rates around the globe are low, extremely low, in historical terms. That's great for borrowers and has fueled economic booms that stretch from Beijing to New York City to Bangalore to Ho Chi Minh City. But it's not so great for investors in debt. When 10-year U.S. Treasury bonds are yielding just 4.7% -- that's about 2% to 2.5% after inflation -- investors are constantly scouring the globe for better returns.

Piling on the risk

Traditional wisdom says that there's no free lunch, however. To get higher yields, you have to take on more risk. For example:
  • Buying bundles of mortgages held by homeowners with shaky credit ratings will net you an extra 2 to 3 percentage points over the yield of mortgages for the most creditworthy homebuyers.
  • Buying the newly issued bonds of financially challenged telecom Level 3 Communications (LVLT, news, msgs) yield 8.75% versus the yield of 5.57% you'll get by buying the AAA-rated bonds of the GE Capital, the financial arm of General Electric (GE, news, msgs).
  • Buying 10-year Peruvian government bonds, yielding 5.88%, will give you a small edge over 10-year German bonds yielding 4.07%.

Each of these attempts to get a higher yield or to leverage the return on your investment carries enough risk to make a debt investor hesitate before pulling the trigger. About 10% of subprime mortgages are now delinquent by 90 days, according to investment bank Friedman, Billings, Ramsey (FBR, news, msgs).

That's above the peak in the 2000-01 economic downturn. Level 3 has narrowly skirted bankruptcy in the past. And Peru, well, it's not exactly a model of economic stability.

Packaging to appeal to investors

This is where Wall Street steps in to whisper, "Have I got a deal for you." By bundling risky credits together, Wall Street can create a pool of debt that is more diversified and therefore less likely to go into default than the debt of any single issuer. Then, by slicing that bundle into different pieces, called tranches, Wall Street can spread the risk around, so that investors less inclined to take on risk can get still receive a higher yield but without taking on the full risk of the total bundle of debt.

According to Satyajit Das' book "Traders, Guns & Money," it might work like this: A bank makes $1 billion in loans and then sells the risk -- but not the loans -- in the form of a derivative, a synthetic asset derived from the original loans, to what's called a "special-purpose vehicle," a kind of minibank. That minibank, in return for a fee, guarantees to insure the bank from any losses on those loans. The special-purpose vehicle then sells senior bonds, mezzanine bonds and stock -- backed by the synthetic asset purchased from the bank -- to investors who receive both interest and risk.

In the original pool of loans, risk and reward were spread evenly throughout the pool, but the derivative slices and dices risk and reward. Senior bond investors get paid first, for example, while the stock investors take the first losses, and mezzanine investors get hit if the losses exceed the investment by stock investors. Returns are allocated in proportion to risk with stock investors getting a higher return for their higher exposure and senior bondholders getting a lower return because they own a safer "investment."

Investors flock to the market

This structure allows Wall Street to manufacture a steady supply of AAA-rated credits at a time when few countries or companies earn this top rating for safety. Because the senior bonds have been shielded from risk by the equity and mezzanine tranches, these bonds have a good chance of earning the AAA rating -- the highest ranking -- even if the original loans were to much less creditworthy individuals, companies or countries.

Yield-hungry but risk-averse investors have flocked to the market encouraged by financial engineering like this. Total issuance of collateralized debt obligations, or CDOs, a major type of derivative used in the kind of risk reduction that I've described above, came to $503 billion globally in 2006, up $64 billion in 2005, according to JPMorgan Chase. Add in private CDO deals and CDOs based on one index or another, and the figure climbs to $2.8 trillion in 2006, estimates the Financial Times, three times the issuance in 2005.

Fallout in debt markets

Two peculiar things have happened to the debt markets as the amount of money flowing into risk-controlled synthetic debt has zoomed.

First, the credit rating on actual debt has continued to decline. Almost 16% of the junk bonds on the U.S. market were rated CCC -- that's the grade reserved for bonds with the highest risk of default -- at the end of 2006, up from 13.5% at the end of 2005, according to Merrill Lynch. But, of course, since you can manufacture an AAA rating out of a CCC by pooling and then slicing the risk, it really doesn't matter right?

Second, the premium for taking on more risk has shrunk. Consider this telling example: Level 3 Communications, which still has a junk-bond rating, was able to raise money recently at 8.75% to refinance its previous generation of junk bonds, which had paid a coupon yield of 11% to 12.875%.

Much of the decline in risk premium is a result of confidence that this new generation of synthetic debt instruments has reduced risk in the debt markets, especially for the riskiest credits. There is good reason to believe that confidence is misplaced.

Setting up for a major bust

We've been here before. Every time the economy has turned in a long run of good times, defaults on mortgages and loans drop to exceedingly low levels. Lenders almost always become convinced that this isn't a result of the business and credit cycle -- good times -- but of some improvement in the way that lenders manage risk. The belief that it's different this time always leads to an expansion of lending and a relaxation of lending standards that sets up the debt markets for a major bust when the economy turns. As it always does.

For example, when the economy went into a slump in 2000-01, the CDO market hit the wall, generating huge losses. Defaults wiped out equity and mezzanine tranches, and then, because the senior bonds were now exposed to losses, they received credit-rating downgrades that sent the price of these bonds tumbling.

Worse shape this time around

But because of the insurance effect -- remember, an ability to buy insurance, even if it's ineffective, increases risking-taking behavior -- we're in much worse shape this time. Going into the 1990 recession, most-likely-to-fail CCC-rated companies made up just 2% of the junk-bond market, says Martin Fridson, the publisher of Leverage World and formerly Merrill Lynch's junk-bond guru. In February 2007, the figure is 17%.

On these numbers, the debt markets are just one recession away from disaster. So much, it seems, hinges on the Federal Reserve's ability to get the economy just right.

... How's that working for ya?