The Consequences of Chasing The Fast $?

Most are now aware of the subprime mortgage mess. Our take is that at the core of the issue was the urge to make a fast buck. Investment bankers, their clients, mortgage brokers, real estate speculators, and unqualified homeowners were a few of the cast of characters in this international drama. What we do believe is that there are possibly similar scenarios unfolding in other credit creation arenas that most investors are unaware of.

The first arena we want to discuss is the Credit Default Swap (CDS) market. This is an agreement between two parties that one will receive a periodic premium to insure against a negative credit event such as a bankruptcy, default, or reorganization. Essentially it is an insurance contract between two parties, one laying off risk and one taking on risk. According to Ted Seides, Director of Investments at Protégé Partners, the major players on the insuring end of these contracts are banks and hedge funds. The possible fly in the ointment is that these entities do not have to set aside reserves to cover the potential defaults. They collect the premiums and hope for no negative events regarding the promises they have made. The company that insures your car, house, life, etc. has to have reserves to cover their potential liabilities. The outstanding credits have grown nine-fold in the last three years.

The second arena is the High Yield Bond market also known as junk bonds. These are bonds issued by companies with less than investment grade ratings, BB and below. Bonds with more credit risk pay higher yields to offset the weaker standing of the issuer. When the economy is humming along these can be great investments as the strong economy keeps even the weaker companies afloat. As an economy slows the risk of default rises and HY bonds prices tend to fall.

The potential problem with these two areas is that the standards of creating these credit vehicles may have been lowered similarly to the mortgage industry. The rush to create product and the fees associated with those products may have take priority over assessing the risks from a more traditionally prudent standpoint. Similar to no doc loans, 100%+ financing, low teaser rates, etc. in the mortgage world, these lax standards may create the next domino in the financial world. Everything is fine when the economy is surging, a recession would probably create a number of defaults surrounding these credits compounding the woes of the already wounded.

There is no guarantee that this unfolds badly, but it does give me a reason to be vigilant. Look at what the subprime issue did to our financial institution and markets. One sentence in a paper Mr. Seides wrote stood out to us, “Never before have we entered a downturn of an economic cycle with so much paper riding on the fortunes of companies known to have such poor credit quality.”

The action in the stock market the last few weeks seems to be indicating to me that there is more downside ahead. We are also sensing that there may be an event that triggers the slide and maybe it is tied to these areas. With the uncertainty in the air surrounding these financial instruments and the leverage the holders have employed, this is a good time to be vigilant with investments.