This summer’s nasty new guessing game is “spotting where the subprime bodies lie”, writes the FT’s capital markets editor Gillian Tett, in Monday’s FT. For even as the financial world reels from the credit storm, the list of potentially affected companies is widening well beyond the usual suspects, she notes.
True, some hedge funds have blown up – and more are bound to follow, Tett notes, citing Moody’s warning last week that it now sees a 50-50 chance of an implosion at a big fund soon.
“But don’t be fooled into thinking that this summer’s turmoil is a direct replay of the events of August 1998 — or, at least not in the sense that it can be blamed on the dénouement of just one big victim (as with LTCM in 1998),” she says.
This time, by contrast, “the losses are potentially widely scattered about,” notes Tett: “There are rumours, for example, that some bank proprietary trading desks are nursing pain. Some specialist debt vehicles, such as collateralised debt managers, have probably taken hits too. So have investment units that are partly attached to banks, conduits or specialised investment vehicles. On Friday night, for example, Germany staged its second bank rescue in as many weeks when SachsenLB was sunk by problems in a conduit, echoing earlier woes at IKB.”
However, as the rumour mill goes into overdrive another category of companies is also being scrutinised — the so-called monoline insurers, or those financial companies such as MBIA or Ambac that insure securities, says Tett.
“In normal, quieter times these companies receive very little attention, since they inhabit a particularly slow-moving, obscure niche of the financial jungle. But the sector is a veritable behemoth: though Ambac and MBIA first sprang up in the 1970s to insure American municipal bonds, they have since moved into the structured finance world, covering tranches of collateralised debt obligations (CDOs), for example. As a result, the sector insured $3,300bn worth of paper last year.”
The monolines have always prided themselves on operating in an ultra-conservative manner, and that has hitherto enabled them to produce steady earnings, and maintain the all-important AAA credit rating, explains Tett. The problem, however, is that investors have now suddenly remembered that as the monolines have moved into the CDO world, “they have also started handling securities related to — yes, you guessed it — subprime debt.”
The monolines vehemently deny this will cause them any problems, notes Tett. “After all, subprime assets represent just a tiny part of their book (reportedly less than 4 per cent of exposures)”. But this doesn’t placate some observers, concerned that monolines typically use high leverage (insuring, for example, assets 150 times the value of their capital base), she adds. “Thus, the share price of the monolines has recently tumbled, exacerbated by the fact that some hedge funds, such as Pershing Square, are gleefully shorting the sector.”
Tett has no way of telling whether these concerns are “poppycock or not”, she says. But that very uncertainty “is the biggest issue of all,” she adds. For the current “climate of confusion is so high that nobody quite knows what to believe anymore — in respect to the monolines, or anything else”. The reason for such uncertainty is that this decade’s frenetic financial innovation “has scattered subprime losses around the financial system to a degree never seen before”.
In theory, this structural change should not have surprised anybody, says Tett. But in this disorientated climate, “banks are cutting off other banks and investors are shunning entire asset classes — sometimes to a completely irrational degree. No wonder the monolines are suffering under the curse of subprime contamination too”, says Tett.
Presumably, this panic will eventually die down, as investors slowly adjust to this new risk-dispersed financial world, concludes Tett.
Credit officers, in other words, will find a new compass. At some point we may even discover where those subprime bodies truly lie. But don’t bet on that happening soon — or particularly smoothly. Thus for the foreseeable future, the monoline insurers have a nasty investor relations challenge on their hands. The only possible comfort is that in this respect, the monolines now find themselves in a very large financial club.