After years of confidence, could defaults in the american sub-prime mortgage sector mean an end to easy credit?
By Giles Parkinson
As the implications of the US sub-prime lending crisis were beginning to unfold in July, the head of research for an Australian investment bank was overheard fretting about the gloomy nature of the reports he was receiving from the firm's New York analysts. 'They keep on talking about contagion,' he lamented.
Analysts are not paid just to turn a positive spin on markets or securities, and are usually happy to slap a 'sell' recommendation when the situation is warranted.
Contagion, however, is an altogether different concept. The dreaded c-word doesn't allow for normal patterns of market behaviour to be observed. Its effect is viral and its course impossible to predict. The research head was worried. After years of confidence, and even greed, now he could smell the fear in the market.
These sub-prime mortgages are offered to customers with a poor credit history or those deemed to be at a higher risk of defaulting, and therefore not touched by traditional and more conservative institutions.
The flow-through impact of these sub-prime mortgages has also impacted the CDOs (collaterised debt obligations).
It seemed to be only weeks earlier that bankers and deal makers had been trumpeting the continuing emergence of another c-word: 'covenant lite'. This is when banks competing for business strip their loan covenants down to next to nothing - imagine dancers in an MTV music video - to capture the attention of the private equity firms who had come to rule the M&A market, and to satisfy their seemingly insatiable demand for new funding.
In the US, some US$24 billion of loans had been made in this way, and the practice was slated to make major inroads in significant deals in Australia. But that was about to change. In a matter of weeks, the tap was turned off as the knock-on effects of defaults in the US sub-prime mortgage sector began to flow through the market.
The problem the world faced was that private equity money had also been pooled in the same manner - by some estimates around two-thirds of the US$300bn that had been lent to private equity investors over previous years. When the sub-prime mortgage offerings began to default, the banks rushed to take cover, and to surround themselves with as many covenants as they could find - if they agreed to lend the money at all.
And so, after a boom cycle that witnessed an unprecedented flow of liquidity into financial markets - fuelled by strong economic growth, the explosion of alternative investment vehicles, the accumulation of petro-dollars and bulging central bank reserves - another era of easy money was about to close. And in the most dramatic fashion.
Nowhere was this felt more keenly than in the bidding war for Coles Group - the biggest corporate auction ever undertaken in Australia. Private equity firms were again at the door.
One banker involved in the auction, who declined to be named, says the PE firms were forced to beat a hasty retreat when their line of credit tightened, and then all but evaporated. 'It was amazing to see the depth and pace of change though the process,' he says.
The banker noted that over a period of just two months, banks were no longer offering the same amount of debt, and were tightening up on the terms. 'It was quite extraordinary,' he notes. 'We went from a lot of debt being offered on good terms, to a lot less debt being offered on almost no terms. It's certainly hard to see that coming back very quickly.'
Credit crises are not new. But this one has many worried, particularly as the contagion flows through to mortgage lenders in other countries, and to the hedge funds and investment firms that bought up their offerings.
First, there is concern that no one really understands exactly where the financial system lies exposed, nor how one weakness can lead to another. Already, the failure of a few obscure sub-prime funds in the US have sent enough shock waves around the world. It has put stock markets into a spin, and caused so much panic in credit markets that banks are scared to lend to one another. It has also caused the collapse of several hedge funds, and as rumour has added to the climate of fear, it's provoked runs on lending institutions.
Secondly, notes Jeremy Reid, the founder and CEO of Everest Babcock & Brown, a Sydney-based hedge fund investor, what makes this crisis different is that it is sourced primarily from defaults caused by consumer excess rather than a corporate binge. 'If you look back to 1987, the crisis was produced by high interest rates and highly leveraged corporates,' he says. 'This time, it's the individuals who are highly leveraged, while the corporates are in good shape.'
But that's not necessarily good news. Consumers, of course, drive consumption and demand for goods. 'The big risk is that this can flow into the economy a lot easier [leading to] reduced demand for consumer loans and retail products,' Reid says. This could lead to a recession, just as other crises have following the bursting of an asset bubble.
It is this fear that is driving central banks to consider what measures they can take to ensure liquidity in global markets, and whether they should cut interest rates to ease the burden on struggling borrowers.
Reid notes that there are two schools of thought on how they should act. 'Should they [US Federal Reserve and other central banks] step in to ensure that the economy is right, or should they let it work through the system? Their job is to make sure that the financial system works,' he explains. 'But it is not necessarily their job to bail people out.'
While every market dislocation creates grief in one sector of the economy, it usually poses opportunity elsewhere. Just as Wesfarmers was able to take advantage of the retreat of private equity firms and make a bold move for Coles, so other corporates are expected to be in a position to take advantage of what they would see as a more level playing field.
Citi says adequately capitalised companies might be well placed to use their strong balance sheets to push their expansion plans - both organically and through acquisition.
'Some corporates may previously have been hesitant to make a move on a prospective target if they felt that such a move would simply start a bidding war that private equity would end,' says Mark Reade, a credit sector specialist with Citi. 'Now they have a window when private equity will find it more difficult to compete for these assets, which could trigger more trade M&A activity.'
Everest's Reid says private equity will be hamstrung while the world's banking system works through the estimated US$300bn of loans that have yet to be syndicated. 'The days of easy credit for an LBO (leveraged buyout) are long gone,' he says.
Citi's Reade suggests that corporates can potentially fund M&A via their own cash flow, accessing investment-grade debt markets - where there have been fewer liquidity concerns - or through equity markets, which still offer a relatively cheap option for some corporates given their continuing strength through the recent volatility.
He notes that Rio Tinto's ability to syndicate its US$40bn facility for the purchase of US aluminium giant Alcan bodes well for the corporate sector. 'While pricing may have increased slightly, it shows that there is still funding available for solid investment-grade corporations,' he says.
Indeed, he notes, one other effect might be a reduction in the number of aggressive buybacks, special dividends and capital returns, which have been a feature of global markets in recent times as corporations sought to ward off the threat of the marauding private equity groups. 'The need for capital management as a defence mechanism is no longer as critical as it once was,' Reade says
There will be opportunities in individual sectors as well. Banking is an obvious one, highlighted by the problems faced by some smaller lending institutions in both Australia and the UK.
Westpac CEO David Morgan recently outlined numerous medium-term opportunities that were being presented by the widespread re-pricing of risk, the existence of wider credit spreads and a general flight to quality. Westpac expected that non-bank lenders and regional banks could come under pressure. This could result in less competition for the major banks and improved trading opportunities. Westpac and NAB are considered to be possible buyers of smaller lending institutions that are currently facing liquidity problems.
Citi advises that most companies need to be proactive in aligning their corporate finance strategies to the changing credit market conditions. This might include leverage ratios, lengthening the maturity on debt obligations, locking in interest rates or repurchasing debt, and a renewed focus on risk management.
Hybrid securities, mandatory convertible and common stock instruments should be considered as part of the suite of financing options to preserve ratings. Citi says emerging market countries have seen the least dislocation in credit markets, creating an opportunity for companies to fund their needs through their local subsidiaries in those emerging markets.
Citi also argues that while structuring issues in the sub-prime and leveraged finance markets (rather than fundamental economic concerns) have caused a liquidity crunch, the overall dynamics of the market have changed. The global economy is no longer so dependent on the US market, and the longer-term sources of liquidity, boosted by the growing reserves of the central banks in emerging markets, will provide a major countervailing influence.
Everest Babcock & Brown, meanwhile, sees opportunities in its own sphere of influence, and is taking advantage of the fact that its managers saw the signs of this crisis early in the piece. 'The huge amounts of excess leverage had started to make a few of our managers nervous,' Reid says. 'We saw a bit of a shakeout in February, and that gave people an opportunity to reposition themselves. Our managers saw that and managed to stay ahead of the curve.'
Everest Babcock & Brown has even opened its income fund for further subscriptions, believing that the current investment environment - and the reduction in asset prices, less aggressively structured deals and widening interest rate spreads, is providing a number of highly attractive investment opportunities.
'As a consequence we are now actively seeking to raise capital in order to take advantage of [this],' Reid says, adding that the group is evaluating a number of transactions for the fund, which specialises in high-yielding, reasonably predictable, income-producing investments and securities.
There may be widespread fear, but obviously not everybody is worried.
