The global credit squeeze has affected banks and fund managers differently, especially in Asia, argue Christian Stauffer from Eurofin Asia and Esfandiar Sorouchyari from Pensofinance.
The last few months have been a challenging period for fund managers and especially for ones focusing on alternative strategies. It started as it usually starts by concerns over equity-related strategies back in February 2007 when the Asian markets were shaken down. This is always the case since their long-short equity universe covers probably 70-80% of the hedge fund population, and in Asia it is probably as high as 90%.
The fears of investors were mostly driven by the volatility and the old adage ‘what goes up must come down’. The fact was that at that time, pretty much everything was up and giving no signs of turning south, while some were thinking about the possibilities of an apocalyptic scenario.
It is interesting to note that at the time the problems of sub-prime mortgages in the US was already known and determined and the markets did not overreact.
As mid-year arrived (and summers always have their fair share of surprises), the markets started their rollercoaster pattern; so did currencies. Everyone started to wake up to the call of the real extent of the sub-prime mortgage chain reaction.
Newspapers and magazines started educating the public on strange ‘animals” like CDOs, structured products, and so on – a tough education if there’s a hard landing coming for some. The worm was already in the fruit.
Bundled products with multiple tier assets of the ‘same’s family were infected and their performance impacted by a series of defaults on borrowers of poor quality without proper collateral – the classic unstructured high yield/high return asset that boosts overall performance of products while keeping an overall very good rating.
This is now combined with the fact that some fund managers were highly geared and needed to liquidate some positions to satisfy their lenders while clients were redeeming in fear of the product content. This is a catastrophic scenario that has pushed some hedge funds and/or their administrators to stop redeeming their shares; claiming valuation problems or lack of liquidity of the assets and driving a strong market lack of confidence.
The snowball effect does not stop here: it is now extended to the main holders of CDO large positions.
This has created quite an unprecedented systemic crisis in the inter-bank borrowing market with spreads as high as 100bp over the base rate, meaning that banks are reluctant to lend money to their peers for fear of finding some unpredicted skeleton in the cabinet.
These fears have put the credit market in a wait-and-see mode that can take a few months at least to get back to normal. It is clear that additional or new borrowings will be penalised and this could trigger a real slowdown on an even bigger picture.
How does that impact Asia and trade finance assets
- Not so badly. One major safety belt to observe is that – contrary to European and US markets that are driven by more sophisticated lending products, not so transparent and mostly priced on ratings – Asia is very much based on old, traditional lending.This is even truer after the 1997-98 crises where banks were highly affected by the clean corporate lending more than anything else. Asian borrowers are still less sophisticated and more disciplined to asset-backed credit where various tangible collateral is given in guarantee of lending.
Structured product lending will be less transparent and more aggressive in discounting future cashflows and using a more quantitative approach trying to maximise credit spreads between intangible credit assets. Structured trade finance assets are less sensitive to this kind of credit crunch and we see very little reason apart from panic from banks that will affect this particular class of assets.
On the contrary, with the existing credit squeeze and banks hesitating to lend to other banks, it will have negative consequences on the on-lending to customers and could generate spread increases and market opportunities in the classic secured (collateralised) debt lending area.
This is a role that could and must be played by trade finance funds that are geographically well positioned to capture these opportunities. Nonetheless it will still be very important to monitor closely the impact the environment has on corporates; a credit squeeze at the wrong time can bring down even a very good and sound company.
Was this predictable
- Who knows
- But it has the merit to bring people back to fundamentals. Higher returns always derive from higher risks – or nowadays belong to niches that can never exist very long.Investment policies must be tested in a downturned market to really appreciate their stress resistance. In our structured trade finance sector we could see that something was wrong in light of investors’s reactions. It was no more than six months ago that a true ABL model with a performance of 10% per annum and low volatility would have been considered ‘not very interesting’s or ‘not very exciting’s – probably true when the Chinese equity market was flying at 300% performance. But the real question is not that comparison, but more: why are people looking for excitement in ABL products
- Why are investors pushing managers to over-perform in a class of assets that are, in nature, not part of the racing crowd
- More generally, in a thunderstorm, each cloud and lightning bolt is unique.However, the physical phenomena generating thunderstorms is always the same. Predicting a financial crisis, its timing and precise manifestations, is impossible. Yet, reckoning some of the financial environment conditions that breed instability is the noble challenge of investors and economists.
Don’t blame sub-prime
One can diagnose the sub-prime crisis as the proximate cause of the present financial turmoil. From another point of view however, this crisis can be considered as a consequence of developments underway for many months. A simple inspection of the history of the Federal Reserve interest rate cycle reveals the simple truth that each time the Fed Funds rate is at its highest level over at least few months, a financial crisis has occured.
Naturally, each occurrence has had different consequences and promoted different names into the collective memory of investors. Let us evoke simply the recent ones: Orange County/Mexican crisis in 1994, the Asian and Russian crises to the LTCM debacle in 1998, the tech wreck in 2000.
The expression and circumstance of each crisis has obviously been unique but the internal mechanisms which generated them were similar. They have been formalised by the economist Hyman Minsky (1919-96).
A ‘feel good’s environment and low interest rates create a higher appetite for risk and dramatically reduce risk premiums. In face of good financial performances, the need of meeting more ambitious performance targets encourages speculative leverage practices.
Tighter monetary policy signals the end of the party for the weakest – and more exposed – participants and generates a crisis which always plays out the same way: normalising the price of risk back to reasonable levels.
Practically, this means equity markets decline, credit spreads widen, and easy money for private equity and LBO financing dries up. Lenders, so enthusiastic a few months ago, are of course now becoming over-restrictive.
In this situation, the main role of central banks is showing up. They are wisely signalling themselves as lenders of last resort moderating the liquidity unease presently underway.
One can observe the current situation either as a crisis with unpleasant consequences such as increased volatility and difficulties generated in the markets, or view this period as a natural episode of the economical cycle. The second alternative allows access to interesting investment opportunities.