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There has always been something special about the number three. In many religions, the digit transcends its secular meaning. Philosophers speak of the body, mind, and soul. In discussing the human psyche, Freud referred to the id, the ego, and the superego. Air, water, and food are often listed as mankind's most basic survival needs and time is a tri-part continuum. It's as easy, people like to say, as one, two, and three.

With that in mind, today's post includes three recent articles that paint a powerful picture of the extraordinary financial disaster that lies ahead of us.

In the first, "Junk Bonds May Repeat Crash of 2002 on LBO Credits," Bloomberg reports on one especially dangerous corner of the fixed-income universe.

Never have so many made so much money from junk bonds, and that worries Dan Fuss.

Fuss, whose $10.7 billion Loomis Sayles Bond Fund has been the best performer among its peers over the last 10 years, says that high-yield, high-risk securities are showing unmistakable signs of a bubble. Yields are near record lows relative to government securities even though sales of the riskiest bonds increased 39 percent from last year, debt has grown faster than earnings and the economy is expanding at the slowest pace in five years.

"I haven't felt this nervous about a market ever," said Fuss, vice chairman of Loomis Sayles & Co. in Boston, who's been working in the banking and securities industries since he joined Wauwatosa State Bank in Wisconsin in 1958. His fund has returned an average 9.91 percent a year for the last decade, and is the best of 45 funds with similar investment rules, according to Lipper, the mutual fund research firm.

Martin Fridson, head of high-yield research firm FridsonVision LLC, and Mariarosa Verde, and managing director of credit market research at Fitch Ratings, say that sales of junk bonds and the record $366 billion of leveraged buyouts may lead to the worst bear market for bondholders.

The last time junk bonds tumbled was in 2002, when companies defaulted on $166 billion of its securities, according to Moody's Investors Service. Merrill Lynch & Co.'s High Yield Master II Index fell about 2 percent that year as yields on the securities rose to a record 11.2 percentage points over Treasuries. Speculative grade, or junk, bonds are rated below Baa3 by Moody's and BBB- by Standard & Poor's .

Severe Downside

"The downside is likely to be very severe," said Fridson, who led Merrill's high-yield strategy group until he left in 2003 to start his own firm, in an interview from his office in New York.

Fridson predicts that in the next few years the default rate may reach or surpass the 2002 level, when WorldCom Inc. in Jackson, Mississippi, and Adelphia Communications Corp., then based in Coudersport, Pennsylvania, filed for bankruptcy.

About 1.5 percent of junk-rated companies have defaulted on their debt this year, which is near the lowest number in almost a decade, Moody's says.

"Defaults are almost non-existent today and, well, we know that doesn't hold forever," said Thomas Lee, who stepped down last year from Thomas H. Lee Partners LP, the Boston-based takeover firm he founded 32 years ago.

"When the economy goes bad, defaults will spike up from 1 percent into the 9 percent level," Lee said at the Milken Institute Global Conference in Los Angeles on April 25. "If that happens then the financing part grinds to a halt" for LBOs, he said.

About $366 billion of LBOs have been announced this year, a rate that may eclipse last year's record of $701.5 billion, according to data compiled by Bloomberg.

'Fantasy Land'

More than half of the junk bonds sold this year were used to pay for leveraged buyouts and mergers and acquisitions, according to Barclays Capital. Money is so easy to come by that for the first time some investors agreed to let borrowers choose to make interest payments in cash or in additional bonds.

"This is a fantasy land for corporate treasurers," said Edward Altman, a professor of finance at New York University's Stern School of Business. In 1968 Altman, created the Z-score, a mathematical formula that measures a company's bankruptcy risk. They "are smiling like Cheshire cats" and borrowing conditions in order to "entice them to increase their leverage."

In some parts of the financial world, the endgame has already started. Only a few years ago, company management and analysts, intoxicated by the essence of their own excrement, were applauding HSBC's bold acquisition of lender-to-the-downtrodden-masses. Household Finance, was harping on about the long-term benefits of geographic diversification, among other things. Unfortunately, while the British-based lender didn't quite ring the bell at the top of the credit cycle, its has already been gonged hard by its recent reversal.

In "Bad U.S. Loans Plague HSBC," the Wall Street Journal reports on the latest developments stemming from the bank's unfortunate foray into the credit market gutter.

HSBC Holdings PLC (HBC) has taken steps to clean up its troubled U.S. mortgage loans, but the big British bank still faces challenges, including mortgage-delinquency ratios that continue to rise, according to a new securities filing.

In the first quarter, the delinquency ratio for its U.S. mortgage-services business rose to 5.26% from 4.76% in the fourth quarter, according to a filing made on Tuesday with the U.S. Securities and Exchange Commission. That rate is nearly double HSBC's rate in the first quarter of 2006.

The bank cited a declining balance of customer borrowings as one reason for the higher delinquency ratio. Its mortgage-services customer loans and advances stood at $46.6 billion in the first quarter, compared with $49.5 billion in the fourth quarter. The bank said it had increased its collections business, which led to reduced mortgage-services loan balances.

The filing also showed a large book of adjustable-rate mortgages, whose interest rates will climb this year and add to pressure on borrowers to meet payments.

The bank was one of the first financial companies this year to acknowledge problems in the U.S. sub prime mortgage-loan business. This year, HSBC added nearly $2 billion to its funds set aside to cover loans that became delinquent in 2006.

HSBC has tightened its lending policies and shuffled its leadership. Executives at HSBC and U.S. consumer-finance business, HSBC Finance Corp. briefed investors on Tuesday about these results.

For the first quarter, HSBC Finance reported a net income of $541 million, compared with $888 million in the same period a year ago. Provisions for credit losses doubled to $1.7 billion in the first quarter, compared with $866 million in the year-ago period. HSBC Finance's business includes mortgages, auto loans and credit cards.

The consumer-finance business is the outgrowth of HSBC's 2003 purchase of Household International Inc., a U.S. lender that specialized in sub prime loans, or loans to people with spotty credit records.

This year, HSBC Finance's adjustable-rate mortgage portfolio of $27.8 billion includes $9 billion worth of loans whose rates will be reset higher, according to Monday's securities filing. The bank has been contacting customers hardest hit by the higher rates to assess their ability to pay. According to the filing, the bank said it's willing to modify the loans if appropriate.

Not everyone will be caught as unawares as the "world's local bank." A few seasoned Wall Street operators already know, in fact, just how badly it is all going to turn out in the end. They are taking steps now to prepare for the inevitable deluge, as this post from the FT Alphaville blog, "Lex, Death and the Credit Cycle," makes clear.

Lex in theatrical mode reminds us that Hamlet said: “If it be not now, yet it will come: the readiness is all.” The tragic prince was of course talking about death. But the same is true in today’s apparently benign credit markets, says Lex.

Everywhere, financiers are holding their collective breath, waiting for the dreaded turn in the cycle. Even bank bosses are becoming more and more candid about the dangers. Bank of America’s Ken Lewis, talking about private equity, last week called for “a little more sanity in a period in which everyone feels invincible.”

So how are banks and broker-dealers readying themselves? Broker-dealers have less capital to play with than the big banks, and lack deposits to fall back on if they suddenly need more liquidity. If the credit markets seize up, their funding is at greater risk, warns Lex.

It is worth noting, therefore, that Morgan Stanley (MS) and Goldman Sachs (GS) have both upped their excess liquidity “pot” to record highs of $52bn and $55bn respectively for the latest quarter. This cushion allows the broker-dealers to fund cash outflows in crisis without having to sell off assets, and would cover things such as client commitments, the principle and interest on unsecured debt, and any extra collateral that might be required. Such an “insurance policy” does not come cheap: probably several hundred million dollars of margins are now foregone. “But it’s worth it to those bosses still scarred by the memory of 1998,” says Lex.

They can also extend the average life of long-term unsecured debt – as Goldman has done – or buy more credit protection in the derivatives market. JPMorgan Chase (JPM), for instance, has gone from $18.9bn of protection purchased in 2005 to $41.5bn in its latest quarter.

The problem with credit default swaps, however, is that they are of limited use to protect against really scary loan commitments, such as leveraged loans to fund big private equity deals, while the deal is not yet public.

Indeed, concludes Lex: Mr Lewis echoed the secret wishes of many, when he said: “We need a deal to go bad as long as we’re not in it.”

In the end, though, many of the preparations will be for naught. When the the credit bubble bursts wide open, no small number of individuals and firms will quickly discover that they've been doing nothing more than moving deck chairs around on the Titanic.

Source: Three Views on Whether Financial Disaster Lies Ahead for the U.S.