How masters of the universe got burnt

It's a familiar story: market exuberance leads to hubris as players begin to believe that the laws of risk and the cycles of boom and bust no longer apply.

by BusinessWeek
Last Updated: 23 Jul 2013

In recent years the titans of home loans boasted they now had software that could provide calibrated interest rates and fee structures for even the least credit-worthy of borrowers.

The same went for private equity deals funded through debt - the algorithms would magically remove the normal burdens of risk because private equity buyouts were ‘different'.

Hedge funds leveraged to the hilt to finance the housing and equity booms. Securitization of dodgy loans made big money for hedge fund managers who devoured securities conjured up by investment banks. The claim was that the obvious dangers of lending to people who were likely to default on their debt could be greatly reduced by spreading the risk through securitisation.

By June the chickens had come home to roost as credit markets seized up and hedge funds saw losses piling up. Dozens of high-profile buyouts stalled.

How did this happen? By creating layers and layers of leverage, mortgage lenders abandoned minimum underwriting standards. Then hedge funds borrowed some more using the same securitised loans, and used these same loans to launch spectacular buyouts.

Mortgage lenders in recent years claimed they had created the perfect system of underwriting using huge consumer databases. Rather like a secret recipe, some of these systems were proprietary, such as the one created by the country's largest mortgage lender Countrywide Financial Corp.

But the claims for the algorithms that assessed the risk on loans were based on assumptions and guidelines that were, inevitably, fallible. For a start, there was insufficient historical data to allow for reliable prediction. Once some lenders began lowering underwriting standards, the temptation for others to do the same became overwhelming. Lenders then sold off the loans to big investors in the form of innovative securities, such as CDOs - collateralized debt obligations.

A painful adjustment has now begun, and old standards are being reinstated. However $750 billion of adjustable mortgages are due to reset over the next year, meaning more defaults and foreclosures are inevitable.

In private equity buyouts, loan securitisation also fuelled ever bolder, more risky debt financing. Private equity firms bid up prices for ever larger leveraged buyouts. The ratio of debt divided by a company's operating earnings, a key measure of leverage, rose from 4.7 in 2004 to 7.0 in the second quarter of 2007, according to Standard & Poor's. From a record of $254 billion in buyouts in the three months to the end of July, the market for leveraged buyout finance has dried up, deals have stalled, although none have yet collapsed.

One of the problems has been the lack of transparency around the debt financing techniques of hedge funds and private equity firms that have fuelled this credit boom. No one really knows where the bad debts are.

In the end banks withdrew lines of credit and forced investment funds to stump up the full value of their leveraged assets. As credit lines closed, many funds had to sell off better performing assets to find the money, causing the stock market to fall.

The 2007 crisis is the equivalent of the run on short-term bank deposits that happened in the 1930s. This time it is mortgage lenders and other players that are in danger of failing because they are losing their source of funds: short-term IOUs, known as asset-backed commercial paper, which include significant but unknown quantities of subprime mortgages.

However the crisis resolves itself, it may be that in future banks, hedge funds and others will have to disclose more about their holdings, either voluntarily or because they have to by law.

Source:
Not so smart
Roben Farzad, Matthew Goldstein, David Henry and Christopher Palmeri
Business Week, September 3

Review by Joe Gill

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