FYI | Jul 18 2007
By Greg Peel
As news broke of Bear Stearns declaring its two troubled CDO hedge funds as worthless, little attention was being paid to the latest TIC flow data from the US, which was released last night. Treasury International Capital flows provide an insight as to whether foreign central banks and private investors are buying or selling US debt.
The latest news is good, with a net positive result of US$112.6 billion across long maturity securities. Net buying of corporate bonds saw the biggest increase, more than doubling from the previous month to US$72.6 billion. The International Herald Tribune reports one Lehman Bros economist as suggesting the jump in stock and corporate bonds indicated a bit more “risk seeking” on the part of foreign buyers. There may have been some concern, however, in China (one of the US’ greatest financiers) having reduced its net holding of US Treasuries from US$414.0 billion to US$407.4 billion – the second consecutive month of net sales.
Reading these figures one could be forgiven for thinking everything was indeed rosy in the risk market but there is one small problem. Due to the length of time it takes for the data to be collected, these latest figures are only for the month of May. Debt markets were were a happy place to be in May as the February-March subprime crisis had proven to be just a blip. Many hedge funds had jumped in to buy what were perceived to be oversold and thus cheap debt securities. Among those funds were two belonging to Bear Stearns.
The riskier fund, which Bear Stearns had declared in March to be worth US$638 million after sustaining heavy losses, now has no value. The second fund (US$925m) has lost 91% of its value. The second wave of the US subprime crisis began in June when Merrill Lynch, one of the funds’ financiers, attempted in vain to offload its share of the mortgage collateral. Bear Stearns was then forced to declare it would spend US$1.6 billion to bail out the second fund. According to a letter sent to investors this morning, about US$1.4 billion remains outstanding.
In the letter, Bear Stearns noted that the fund’s “performance, in part, reflects the unprecedented declines in the valuation of a number of highly rated securities” and that it “has taken action to restore investor confidence”, the International Herald Tribune reports. “In light of these returns, we will seek an orderly wind-down of the funds over time. This is a difficult development for investors in these funds, and it is certainly uncharacteristic of Bear Stearns Asset Management overall strong record of performance.”
James Cayne, Bear’s long time chief executive, has said the bailout would not have “any material adverse effect” on the company’s business. There are, however, already whispers of legal action by investors. While sophisticated investors would meet a “caveat emptor” wall if trying to retrieve funds, there is a suggestion Bear Stearns may have implored investors not to exit after the March crisis as increased value was expected ahead. Bear Stearns stock fell at least 4% in the after-market.
As the “worthless” news was breaking after market in the US, credit ratings agency Moody’s announced it had placed under review for possible downgrade the credit ratings 13 tranches of Bear Stearns CDOs which are part of 8 deals issued over “first lien, fixed and adjustable rate, alt-A mortgage loans”, CNN reports. Alt-A loans are what Australians know as “lo-docs” or “no-docs”, issued to borrowers with low credit worthiness. Despite being of low quality, such mortgages are actually of a higher quality than “subprime” mortgages.
Moody’s does not place such securities under review due to news or rumours. It will only do so when the rate of delinquency of the underlying mortgages passes a rate higher than anticipated. The greatest fear among those on Wall Street with a bearish view (ie the minority if the stock market is any gauge) is that the subprime crisis will spread deeper into the higher quality mortgage market, and that contagion will have ramifications for all forms of debt.
On that note, it was revealed last week that Wall Street debt underwriters are holding a growing tally of unsold corporate bonds and loans on their books, estimated to be as high as US$11 billion. These “junk” bonds are residual from private equity leveraged buyout deals conducted over past months. According to (of all people) Bear Stearns, the nine-month backlog of financings for LBOs now includes about US$90 billion of bonds and US$200 billion of loans. Those underwriters now stuck with debt they can’t sell include Goldman Sachs, JP Morgan Chase and Wachovia. Were the investment banks to hit the bids on such debt, all of Wall Street banks would take a material hit to their capital.
It is not the environment to be selling low quality debt, as potential buyers have fled and are hiding under rocks. The investment banks will now need to finance the debt themselves rather than sell into a panicked market.
“Bankers, who just a few months ago boasted that demand for high-yield assets was so great they would have no problem raising debt for a [US]$100bn-LBO, are now paying for their overconfidence”, says Bloomberg. The cost of tying up their own capital may curb earnings and stem the flood of LBOs, which generated a record US$8.4bn in fees in the 2007 first half, Brad Hintz, former chief financial officer at Lehman Brothers, told Bloomberg.
In one example, last month, Goldman, Citigroup, Lehman and Wachovia had to buy US$725m of bonds that Tennessee-based Dollar General was selling to finance KKR’s US$6.9bn purchase of the company. Acquisitions by private equity firms such as KKR and Blackstone Group helped push sales of high-yield bonds and loans worldwide up more than 70% in the first half of this year to a record US$708bn, according to Bloomberg data.
Reuters reports at least six US junk bond issues have been pulled in recent weeks as investment banks baulked at increasingly loose terms and higher leverage in many deals. One flow-on of the subprime crisis is that corporate takeover activity will undoubtedly slow from its earlier frenzy. The tougher financing conditions reputedly led to a group of private equity firms abandoning a planned US$25 billion buyout of student loan specialist SLM Corp this week.