What has suddenly changed is the market's collective attitude toward risk -- we basically had what physicists call a phase transition from historically low risk premia to more normal risk premia. I'd guess most of the hedge funds that have lost money recently weren't entirely stupid -- they were expecting spreads to widen, but they bet on correlations that have yet to be realized in the first indiscriminate reaction of the market. Nevertheless, they should have remembered how "contagion" works in financial markets. Those that can weather the storm may be ok in the end; the rest will end up like LTCM.
SUDDENLY it’s not so easy to borrow.
Only two months ago, it seemed as if almost any company could borrow money at low interest rates. Now loans seem to be drying up everywhere.
What had seemed like a contained problem, involving home loans to people with poor credit, has suddenly mushroomed into a rout that threatens to make life difficult for everyone who needs to borrow money.
Home buyers are likely to pay more for mortgages, and some with less-than-pristine credit or an inability to come up with a down payment may find they no longer can borrow at all.
A German bank had to be rescued by other banks last week, because it had speculated in securities backed by American mortgages. One of the biggest mortgage lenders in the United States collapsed, and another said it would drastically scale back its lending because it cannot find investors willing to finance the loans it makes.
The volume of new high-yield bonds — also known as junk bonds — fell by 89 percent in July. The market for loans to highly leveraged companies has almost dried up. Standard & Poor’s counts $35 billion in corporate loans that have been delayed or canceled, including loans to finance the leveraged buyout of Chrysler.
The Chrysler deal will go through, because banks had promised to lend the money if others would not take the loans. But from now on there are likely to be fewer corporate takeovers, and those that do take place are likely to be at lower prices. “This is a classic credit correction,” said Jack Malvey, the chief global fixed income strategist for Lehman Brothers. “The magnitude of risk was significantly underappreciated.”
Mutual fund investors have been pulling back rapidly, with more than $1.3 billion coming out of funds that invest in leveraged loans during recent weeks, and $2.7 billion leaving funds that buy high-yield bonds, according to AMG Data Services.
Hedge funds, which had been major buyers of complicated securities that financed leveraged loans and mortgages, have also pulled back. Some investors have tried to pull money out of such hedge funds, leading Bear Stearns to stop investors from making withdrawals from three of its funds.
“That is the core of a financial crisis, when too many people head to the exits simultaneously,” said Robert Bruner, the dean of the business school at the University of Virginia.
Mr. Bruner is the co-author of a book on the Panic of 1907, to be published next month, and he sees similarities between then and now. “It was a time marked by the rise of new financial institutions and new financial instruments,” he said. “It marked the end of a period of extraordinary growth, from 1895 to 1907.”
The credit market has changed drastically in recent years, as banks grew far less important and credit rating agencies like Standard & Poor’s and Moody’s became the essential players in the new financial architecture.
Many loans, whether mortgages or loans to corporations, were financed by selling securities. It was the credit agency ratings that determined if those securities could be sold, and deals were structured to meet the criteria set by the agencies.
Those criteria turned out to be very generous. The agencies figured that even very risky loans were unlikely to cause big losses, and so most of the securities backed by loans to poor credit risks could get AAA ratings — the highest available — as long as those securities had first claim on loan payments. Investors bought the securities thinking they were completely safe, and some did so with borrowed money.
Now, however, there is fear even about those securities. The rating agencies are changing their criteria for the loans, and many investors no longer trust the ratings.
The markets are “very panicked and illiquid,” said Mike Perry, the chief executive of IndyMac Bank, the ninth largest mortgage lender in the first half of this year, as he announced plans last week to curtail lending sharply. It is very difficult, he said, to find buyers even for the AAA securities.
All this has happened with few defaults. Mortgage delinquencies are up, particularly on loans made in 2006 when credit standards were very low, but the real problem is that lenders and investors fear things will get much worse.“This is what we would characterize as the first correction of the modern neo-credit market,” said Mr. Malvey of Lehman Brothers. “We’ve never had a correction with these types of institutions and these types of instruments.”
It now seems likely that the rating agencies, and investors, were lured into a false sense of security by the lack of defaults. With the value of homes, and companies, rising, it was usually possible for a borrower in trouble to refinance the debt or, at worst, sell the home or business. Either way, lenders got paid.
Now, there is less confidence that rising prices will bail out lenders, and there is doubt not only about the quality of old loans but also about important parts of the new financial system.
“The markets seem to be expressing concern about the performance and the stability of hedge funds and, to a lesser extent, private equity funds,” said Mr. Bruner.
The credit squeeze is coming at a time when the American economy seems to be growing, despite problems in the housing market, and the world economy is strong. “The underlying economy is very healthy,” said Henry Paulson, the Treasury secretary, as he visited China last week. But a good economy in no way precludes credit problems. In fact, it is during good economic times that credit standards are most likely to be so lax that bad loans are made.
“Financial panics don’t happen during depressions,” said James Grant, the editor of Grant’s Interest Rate Observer. “They happen on the brink of depressions. The claim the world is prosperous is beside the point.”
Not all panics lead to economic downturns, of course, and if this one continues pressure will grow on the Fed and other central banks to lower the short-term interest rates they control and thus stimulate the economy.
But central banks do not always determine what happens in credit markets.
“The Fed tightened in 2005 and 2006, but creative financing on Wall Street blunted the impact,” said Robert Barbera, the chief economist of ITG, a research firm. “The collapse of that option in the last 90 days means the entirety of that tightening is arriving now, and there is a violent tightening going on.”
Of course, this phase will pass. The insurance companies and pension funds that are the traditional buyers of bonds always have money coming in, from interest payments and bond maturities, as well as from new business, and they will have to put it to work.
“The history is that lenders move in great caravans between two extreme points, which we can call stringency and accommodation,” said Mr. Grant, recalling how hard it was for companies to get loans as recently as 2002.
Lenders will move back to accommodation one day, he said, but for now it appears that risky borrowers,whether of the corporate or individual variety, will discover that it’s much more difficult to find someone to lend money to them.