Right now Z is trading occasionally with the aim of supplementing his ‘day-job’ income. His current trading strategy means he tries to:
a) trade just one market (the FTSE)
b) make relatively few trades
c) make lower-risk trades
d) not let the sleep-loss caused by his new baby girl trash his judgement
Subprime 2: Crunch Time?
Folks one and all, hope you are having a fun time playing in the markets.
It has been 7 trading days since sub-prime market issues sparked a slump in the equity markets and, slightly weirdly, we seem not much closer to knowing whether there is more ‘correction’ to come or not.
Last Monday FT wrote a great post explaining what a ‘sub-prime mortgage’ is, how these mortgages get lumped together and traded as packages (sometimes called CDOs) and why we should give a damn. If you haven’t read it recently I’d strongly suggest grabbing yourself a reminder.
However that was a stuff-load to cover in one post. So I’m gonna ruminate, elucidate and hopefully illuminate a few more of the reasons why investors are losing sleep and spread bettors looking to go short are drooling with anticipation. On the way I’ll hopefully be explaining (or re-capping) on a few of the bits of jargon that are being bandied about, including PIKs, Credit Crunches and our starter for 10: LBOs
WAVY LINES ON SCREEN - CUE FLASHBACK
A great example of an LBO (standing for leveraged buy-out) was the takeover of Manchester United back in 2005. To make a long story short Mr Malcolm Glazier found a company (Man-Yoo) that had fabulous assets (brand, stadium, history, poncy Portuguese winger etc.), great earnings potential (as long as aforementioned Portugese and his overpaid brethren keep finding the net) and very little debt.
Now most people would say that not having much debt would make a company stronger. AHA - not in this case. In this case it allowed Mr G. to go out to the bond markets and say “Hey guys, look at all these lovely assets. Check out the brand, the stadium and the finely chiselled features of this fleet-footed Portuguese f…f…footballer. If you lend me some money, using these super assets as security, I could buy this company.” And the bond markets said yes.
The irony here is that if Man Yoo had, for example, already borrowed lots of money against their assets there was no way the Glaziers could have pulled it off.
But Malcolm had another trick up his sleeve. He said “Hey guys, you know what? I’m borrowing a lot of money here and it may take a while for these lovely assets (brand, stadium, history, Portugese) to generate lots of lovely cash. So how would it be if, instead of paying all of you interest in cash, I paid some of that interest with IOUs.” And the bond markets said … yes.
By the way, the proper term for Bonds with interest paid in IOUs is actually Payment In Kind Bonds or PIK Bonds. They are a highly risky because there is no cash paid until the end of their life – which means if the company issuing them goes bust the bond holder receives diddley squat.
LBOs and PIKs are nifty tricks if you can get away with them. How did the Malcolm get away with it? Three reasons come to mind:
- The man has abnormally large ‘cojones’ (which may make buying underwear a challenge but I guess when you are that rich getting tailor-made y-fronts ain’t a problem).
- 2005 was a year of rapid growth for hedge funds. Hedge funds, I should explain, are funds that aren’t sold to members of the public which means they get a lot of leeway in choosing their investments. Some hedge funds seek out quite high levels of risk – and PIKs were made for that type of fund.
- In 2005 Interest rates were low and the corporate scene looked as peachy as American pie. Which meant that normal corporate bonds weren’t paying much interest; hence riskier investors (such as hedge funds) were on the look out for higher-paying assets.
BANKS CAUGHT OUT
A quick fast forward to today, and it ain’t just the Glazier’s that have been indulging in LBO-ing. Private equity houses such as Blackstone and KKR have been buying up companies faster than a dog can pick up fleas. However the recent problems in the sub-prime market very few investors want to buy debt. Which means:
Firstly there will probably be less Mergers & Acquisitions (M&A) activity in the near future. As M&A has been on of the things pushing share prices up in the last few years, for people to go long this is not a good thing.
Secondly hedge funds holding riskier debt instruments like PIKs may find them worthless. In order to meet their financial requirements these hedge funds might find themselves selling other assets, including less risky corporate debt or shares. Again not good for the bulls.
Finally the thing to note is that banks often sell bonds by first guaranteeing to lend the money, then sell the debt to ‘investors’ soon after. However if investors decide they no longer want to buy PIKs and the riskier types of corporate debt (check out the problems banks are having in shifting the debt KKR needs to buy Boots) the banks get landed with loans that they cannot sell and that have a high risk of never being paid off. No-one knows how much that is going to cost but late last week the FT reckoned there were US$300bn of LBO loans sitting on banks books for which they hadn’t yet sold debt.
Hmmm … no wonder bank share prices have been going south since the whole of the sub-prime thing started.
CRUNCH TIME?
I hope you’re all still hanging in there, ‘cos banks and hedge funds losing money is not the really big worry here. In the short term that might depress share prices. However the big worry is that we hit a credit crunch, meaning banks – and investors – have been so badly burnt by sub-prime mortgage losses that they simply stop lending. They might stop lending mortgages to home-buyers or they might stop lending capital to businesses … or both. In Western economies borrowing is the petrol that makes the engine go round. And while I’m not normally a doom monger even I would have to admit that any significant reduction in lending could quite conceivably bring about a recession.
That’s the doom and gloom view. Every cloud has a silver lining: this one is that while the Bank Of England has been busy putting up their interest rates to dampen inflation, the sub-prime debacle might have pushed up corporate interest rates enough to have done the work for them!
P.S. Anyone really wanting the chapter and verse on how the sub-prime thing arose need look no further than here.
P.P.S. If you were wondering how the current market is affecting Man Yoo Know Who, check out this article. And begrudingingly I must admit that, no matter what Eamonn Dunphy thinks, the poncy Portugese is still Man Yoo’s best asset.
Enjoyed this post?
August 8th, 2007 at 9:09 am
There are no articles linked to?
August 8th, 2007 at 12:27 pm
Minor technical hitch JM - hopefully all OK now.
November 7th, 2007 at 1:30 pm
Amazing that this was posted so long ago and yet it is still all relevant. I wonder what the impact on bank profits will be from a lack of M&A activity?