Who is next to catch subprime flu?

Who is next to catch subprime flu?

http://www.ft.com/cms/s/1968ee7e-46ab-11dc-a3be-0000779fd2ac.html

By Paul J Davies

Published: August 9 2007 21:00 | Last updated: August 9 2007 21:00

BNP Paribas’s decision to freeze withdrawals by investors on three investment funds on Thursday showed once again just how far have the US subprime mortgage crisis has spread.

The difficulty of valuing credit assets of many stripes in this sudden drought of liquidity has caused problems at fund managers as far away as Luxembourg and Australia.


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Meanwhile, banks from Singapore to Switzerland are rushing to either protest their lack of exposure or warn shareholders that they are facing losses.

After German banks were forced to bail out their local peer, IKB, and a number of other lenders have confessed to heavy exposures, the question increasingly in Europe is: who will be next to come down with the subprime flu?

“There’s all sorts of rumours swirling around the market about who will be next into the lifeboat,” says one London-based banks analyst. “It looks like its going to be a hot sweaty summer for some.”

German officials seem particularly concerned and there is talk that more bad news in that market could come soon if they really are telling local institutions that it is time to show their cards.

“We suspect the Bundesbank is going round all of the German institutions telling them to put everything related to subprime problems on to the table, in addition to orchestrating the rescue package for IKB,” says Marc Ostwald, fixed income strategist at Insinger de Beaufort in London.

The big question for those outside the cut and thrust of the financial system is how have the profligate ways of ambitious homebuyers in US towns such as Paris, Texas, come to threaten the savings and pensions of people in Paris, France? And just as importantly: why now?

In the years since the dotcom crash and the September 11 terrorist attacks, the economies of the US and Europe have lived with historically low interest rates.

This has had two primary effects that are important in understanding how the worldwide debt bubble has reached such a troublesome point.

The first is that low rates have encouraged ordinary people and businesses owned by private equity to borrow ever-greater amounts of money at evermore exuberant ratios to their available cash flows and the value of their assets.

This has been possible in part because of the second effect, which has seen pension funds, insurers and other asset managers struggling to make the kinds of returns they need to cover their future liabilities.

Low interest rates have propelled such investors into riskier and more complex securities that pay a higher yield.

Through the medium of the rating agencies and their models predicting probabilities of default among borrowers, this demand has enabled banks to offload ever riskier loans in structured, asset-backed bonds.

The value of US subprime-backed bonds has been heading south since at least the turn of the year, when many hedge funds were already using a specialist derivatives index to bet against borrowers’ ability to pay back their debt.

The fall in this index has gathered pace throughout the year, occasionally also helping to cause correctional ticks in other markets for debt and equities.

But it was not until mid-June when it emerged that two hedge funds run by Bear Stearns Asset Management were in serious trouble that the extent of the problems in global credit markets began to be revealed.

The crucial element was that the funds were invested mainly in highly-rated structured bonds, which meant a large amount of doubt was cast over the many similar investments that investors around the world held.

Since then, banks have increasingly realised they are uncomfortably exposed to all forms of credit markets.

As they have rushed to cut these exposures – and as some investors have faced real losses from some badly performing holdings – liquidity has vanished, effecting not only riskier bonds but their highly-rated cousins.

Jonathan Asquith, deputy chairman of UK fund manager Schroders and head of its fixed income business, insists his business is not exposed to subprime, but says the issue has “more than one layer”.

Organisations with a lot of exposure have been selling investment-grade bonds to reduce their exposure to credit across the board.

“Liquidity in higher grade securities is beginning to suffer and that is an issue for the broader market and for those running higher-grade portfolios who can’t get sensible prices,” he says.

In a market as low on confidence as it is on people during the summer break, the machinery of modern finance has simply seized up.

“You have to differentiate between those vehicles that are invested purely in subprime related bonds and those properly diversified vehicles,” says Robert McAdie, global head of credit strategy at Barclays Capital.

“This is an environment where there has been a big loss in confidence and nobody is distinguishing between oranges and apples.”