Fast, Loose Credit Scares Even the Buyout Gurus

Mark Gilbert

By Mark Gilbert

May 3 (Bloomberg) -- Central bankers aren't the only people distressed by lax lending standards. Even the dealmakers who depend on cheap finance with few strings attached are complaining that finance is too cheap and there aren't enough strings.

``There's too much liquidity in the system,'' Philip Yea, chief executive officer of 3i Group Plc, Europe's largest publicly traded venture-capital and buyout firm, said last month. ``There's too much debt available.''

Too much debt available? That's tantamount to Kate Moss complaining that her photo is in too many magazines, Steve Jobs moaning about iPod ubiquity or Madonna criticizing African nations for not having more stringent child-adoption policies.

So what's going on here? Why, in the fastest, loosest credit markets seen since a tulip bulb was worth as much as a house, are the supposed beneficiaries of loan largess bleating about easy money and the boom in global liquidity from Texas to Tokyo?

Is it because cut-price loans are propping open the mergers- and-acquisitions door for interlopers? Are existing leveraged- buyout specialists concerned about new entrants pushing up prices, and exacerbating the risk that a big deal will sour and attract the unwelcome attention of regulators?

Steve Rattner, co-founder of buyout firm Quadrangle Group LLC, told Bloomberg reporter Edward Evans in January that ``the world isn't pricing risk appropriately. Investors are simply not being paid for the risks they're taking.''

Ninja Loans

You might have expected renewed caution among lenders after the willingness of some U.S. mortgage companies to grant so- called Ninja loans -- No Income, No Job or Assets -- triggered the collapse of the U.S. subprime mortgage market and helped sink an armada of companies.

Larry Fink, CEO of BlackRock Inc., says the subprime debacle has had a domino effect on the rest of the credit market -- just not the one you might have expected.

``We're seeing fewer investments in subprime, but that money needs to be put to work so they're going into other credit markets,'' Fink said in an interview published by the Financial Times newspaper last week. ``Historically, when we've seen one problem, we've seen an adjustment throughout the marketplace. We've seen no indication of that yet. We've seen the actual opposite.''

While liquidity is notoriously hard to define, the Bank of England took a stab at quantifying it last month in its Financial Stability Report. The central bank combined some key market measures -- the gaps between bid and offer prices on bonds, currencies and stocks, the ratio of market returns to trading volumes, and spreads in the credit market -- to produce an index showing that financial-market liquidity is at its highest level since at least 1992, and has doubled in the past four years.

Loaded With Debt

``Markets are currently very liquid and have been so over the past few years,'' the central bank wrote in the report. ``Maximum debt levels for European LBOs are now consistently above seven or eight times earnings, whereas the maximum was around six times earnings a year ago.''

While that extra leverage makes deals more risky, it isn't deterring newcomers from getting in on the action. ``There's a lot of money in the Middle East that the private-equity companies can now access,'' said Colin McKay, the New York-based head of PricewaterhouseCoopers LLP's private-equity division in March. ``The force that hasn't even entered yet into the private-equity market to any degree is the trade surplus in China and where that's going to be invested.''

`Capital Everywhere'

Investment banks used to be content to take a fee for advising on takeovers; now they can demand equity participation, boosting the pool of capital available to get deals done.

``There's capital everywhere,'' buyout doyen Henry Kravis of Kohlberg, Kravis, Roberts & Co. said at a New York conference last week. ``It's very smart of these firms to be in it. I just wish they wouldn't compete with us, but they do.''

In the U.S., the California Public Employees' Retirement System, the nation's biggest public pension fund, is allocating more money to private-equity firms. In Canada, the Canada Pension Plan Investment Board, the Public Sector Pension Investment Board and the Ontario Teachers Pension Plan have all said they might bid for BCE Inc., the country's biggest telephone services provider. In the U.K., the Wellcome Trust Ltd. charity is part of a group trying to buy drugstore company Alliance Boots Plc.

As more buyers enter the fray, prices for doing deals rise, eroding the internal rate of return on transactions. In a low- yield environment, however, even a slowing bandwagon can be an attractive investment vehicle for latecomers.

Settling for Less

``Inevitably, returns can't be as good as they've been,'' David Rubenstein, co-founder of Carlyle Group, said last week. ``The returns that people will be able to get are better than anything else they can do with their money, at least that's legal.''

The biggest worry that the LBO community has, though, is that an overpriced, overleveraged deal will collapse. ``Some of these deals will go bad,'' Quadrangle's Rattner said in January.

When you borrowed from a bank, there was room to negotiate a rescue when the business plan melted. When your lender is a hedge fund trying to deliver monthly returns, the ear may not be anywhere near as sympathetic.

(Mark Gilbert is a Bloomberg News columnist. The opinions expressed are his own.)

To contact the writer of this column: Mark Gilbert in London at magilbert@bloomberg.net

Last Updated: May 2, 2007 19:16 EDT

Housing Crisis Knocks Loudly in Michigan

Credit Markets
Why Soft Landings are Impossible in Property Booms
The Ultimate Subprime Lender
---
Foreclosures Hit Record Numbers as Region Continues to Lose Jobs

By Dina ElBoghdady
Washington Post Staff Writer
Saturday, March 31, 2007; A01

DEARBORN HEIGHTS, Mich. -- Janet Laitis leaned on a chain-link fence in her front yard, dragged on a cigarette and pointed to the homes on her block that lenders have seized in just the past two weeks.

"There. There. There," said Laitis, 70, pointing across the street, down the street and then to the modest ranch house next door. "This neighborhood is deteriorating before my eyes."

Within a square mile of Laitis's house in this bedroom community outside Detroit, more than half the 96 homes on the market are foreclosed properties. The situation is not uncommon in pockets of the industrial Midwest, where a record number of people are missing their mortgage payments and losing their homes.

While lax lending policies have been blamed for the unfolding home-mortgage crisis across the country, the distress in the Midwest has been exacerbated by fundamental problems with the economy. The region has been devastated by a severe drop in manufacturing jobs as the U.S. automobile industry shrinks.

"There's a structural shift going on that's undermining the unionized, industrialized states, and Michigan is leading the way," said Donald Grimes, a senior research specialist at the University of Michigan. "When you talk to people in Michigan, you can tell from their voice and their demeanor that they are just depressed."

The housing bubble of recent years has burst and home prices are under pressure in many parts of the country. How far they fall will be determined in large measure by the strength of the economy, experts say, since job and income growth ultimately determine how much people can pay for housing. The U.S. economy is growing, but the pace of growth has slowed markedly of late.

States like Michigan and Ohio, struggling with their particular economic problems, illustrate just how bad things could get in the housing sector if the national economy falls into a recession. They are, moreover, politically important swing states; rising anger there over the housing situation could help determine the outcome of the 2008 presidential election.

Michigan has lost 305,000 jobs since 2001. Economists estimate that 40 percent of the cuts came from automakers and their suppliers, who have shed jobs each of the past six years as they have tried to regain their competitive edge.

About 65,000 people moved out of Michigan from July 2005 to July 2006, the U.S. Census Bureau reported. The migration eroded already weak demand for houses, which in turn hurt prices. In the last three months of 2006, Michigan was the only state in the nation where home prices fell, dropping 0.4 percent from the same time in 2005.

Even during the first half of the decade, when home prices jumped in most of the country, Michigan's stagnated. Dana Johnson, chief economist at Comerica Bank, said home prices typically outpaced income in most of the nation during the housing boom. But in Michigan, income plummeted and dragged housing down with it.

Cash-strapped homeowners could no longer sell their homes or refinance their way out of trouble. Many got stuck with adjustable-rate mortgages offering low teaser rates that spiked in later years. Now many borrowers are struggling.

"It's been a spillover from the weak economy to the housing sector," Johnson said. "What we've seen here is a one-state recession."

Losing Jobs and Value

Brian Minjares, 40, is living that recession first-hand. His story is proof that no one in Michigan is immune to the state's financial woes.

Three years ago, he left his job at a financial services firm to start his own practice with a partner in the Detroit suburb of Southfield. Minjares took out a home equity line of credit to finance the business. At the time, his house was appraised at $350,000 and he owed $275,000, he said. The bank gave him a loan equal to 100 percent of his equity.

As the housing crisis worsened, the value of his home dropped to $260,000. Minjares could not afford to sell it because he owed more than it was worth. He could not afford to keep it because, as the rates on his loans adjusted, his monthly payments jumped to $3,000 from $2,100.

Meanwhile, his client roster was drying up. With the auto industry in decline, many of his customers' businesses crumbled. "So they had no money to give me to invest for them," Minjares said. He coped by running up credit-card debt.

But he fell behind on his payments and the bank foreclosed on his Colonial in Flat Rock, not far from Detroit. Minjares shut down his business and now sells cleaning products. He rents a condominium from his brother.

"You just have to cut your losses and run," Minjares said. "You have to take into consideration your marriage and your health and you say to yourself: 'It's just a house.' "

Ralph Newkirk, an agent with the Michigan brokerage Real Estate One, hears similar stories every day. The foreclosure situation is so extreme that his firm created a division two years ago with 25 agents who sell only foreclosed homes; Newkirk heads it.

Back then, the average sales price on foreclosed homes was about $70,000. Since then, the price has more than doubled, suggesting the problem is no longer confined to low-income neighborhoods in Detroit. "The problem is moving out to the suburbs," Newkirk said. "It's spreading like a cancer."

A Tangible Form of Pain

Michigan's strong tie to the auto sector has been a source of pain before. Strikes damaged its economy in 1967 and high oil prices crippled Detroit in the 1980s.

But Michigan's most recent trouble is "the most severe crisis in the state's existence," defying the pattern of past economic cycles, when Michigan bounced back quickly, said David Littmann, senior economist at the Michigan's Mackinac Center for Public Policy.

This time, the rest of the country recovered from the 2001 recession, but Michigan's per capita income remains 7 percent below the national average, Littmann said. For the first time since the Great Depression, Michigan is a poor state relative to the rest of the nation.

"This is not a cyclical problem anymore, and housing is the most tangible form of the pain," Littmann said.

For most of the past year, Michigan has ranked among the three states with the highest percentage of late mortgage payments and foreclosures, surveys by the Mortgage Bankers Association show. In the fourth quarter, it came in third, behind Ohio and Indiana, with 2.39 percent of its loans in foreclosure.

Many economists say, and union officers agree, that those hardest hit are not auto workers who lost jobs. Many received buyouts that should keep them afloat for a while. And because they tend to be older, some have paid off their mortgages.

Those feeling the worst squeeze, rather, are workers at the auto supply companies, such as Max, 44, an engineer who spoke on condition that his last name not be used because he is embarrassed by his situation.

Max bought a condominium in the Detroit suburb of Plymouth using a traditional fixed-rate mortgage more than five years ago. But three years later, his firm took away company cars from its workers, hiked insurance premiums and cut raises and bonuses -- raising Max's monthly living expenses and reducing his pay.

Max responded by refinancing his condo twice. Though he did not realize it then, the second loan was adjustable. Over time, his monthly payments rose from $1,500 to $1,800 to $1,950.

"I wasn't even reading the paperwork," said Max, who makes $106,000 a year.

Weeks ago, Max turned in his keys to his lender. The bank paid him $500 and took possession of the condo earlier than it otherwise could under Michigan law.

In fact, across the country, official foreclosure numbers do not capture the full scope of the mortgage problem, since many people are doing what Max did. Others are signing over their deeds to the bank in lieu of foreclosure to lessen the damage to their credit records. Some have been granted permission from their lenders to sell the property for less than they owe on the loan.

Signs of Trouble

As the problems grow, at least one type of business is booming in Michigan -- those that help manage foreclosed property. Take the case of Property Maintenance Inc., which changes keys, mows lawns, shovels snow and repairs foreclosed-upon homes in Michigan so that they are ready for sale.

Deanna Simmons, who created the company in 2002, said the revenue of her six-employee firm shot up from $20,000 in the first year to $1.6 million last year.

Driving through the streets of a working-class neighborhood in Dearborn Heights, Simmons points out the tell-tale signs of a foreclosed house: mail boxes overflowing, fliers piling up, shades drawn.

Once inside, she can tell which people left angry. They're the ones who leave all the water faucets running or take the door knobs with them. "They do anything they can to make it difficult for the mortgage companies, like they're trying to get back at them," she said.

Simmons spots the home next door to Laitis, the Dearborn Heights resident alarmed by the foreclosures on her street. The white ranch house is not for sale yet, but the tell-tale signs are there.

Laitis said her neighbors, a couple in their 40s, left recently after they learned their house would be foreclosed upon. The husband, a carpenter, had lost his job. The wife did not work. They crammed what they could into their white Bonneville and drove off without saying goodbye.

Laitis said the house was paid for at some point but the couple took out a $75,000 home equity line of credit to buy a car and build a garage, now half-finished.

Lots of people can't afford their mortgage or can't afford rising property taxes, Laitis said. For her, the taxes have become onerous. She wondered aloud if she could lose her house for failure to pay them. She could.

"Maybe I'm going to be the next one out of here," she said.

Subprime and the biggest risk of all

Following the US subprime mortgage alarm, some investors have been reassured by rebounding indices and optimistic pundits. But the biggest risk of all lies in thinking that risk has been conquered. It has not - it merely slumbers, so long as massive quantities of cheap credit allow the roll-over financing of future rounds of debt. If this slows sharply, the subprime housing turmoil is the tip of the iceberg.

Mar 28, 2007

By Max Fraad Wolff

The subprime mortgage market is in a state of flux. Risk reduction and risk sharing financial products are being stress-tested and the results are unclear.

Recent announcements by HSBC, New Century and others have rattled volatility-complacent investors. Rapid downward repricing has occurred and global contagion has emerged. A few weeks out, some smiles are evident as indices have whipsawed and jawboning has reassured investors. Others see catastrophe on the horizon. We are in neither camp.

Estimates are that there is about US$1.5 trillion in subprime housing loans in the US market. Slowing house-price appreciation calls into question repayment on some of these loans. The greater risks and lessons are symbolic. The subprime boom and the risks from a rapid deterioration in the market are much bigger than subprime. Questionable loans and the misallocating credit models that generated them are everywhere. Trillions of dollars in managed speculative wealth seeks returns greater than traditional low-risk assets offer.

Global deregulation and consolidation of banks and financial intermediaries creates a world of opportunity. New risk and asset securitization innovations enable products to arise to meet the ravenous hunger that fuels a global credit boom. Risk redistribution and repricing derivatives proliferate to "offset" and safeguard the rising exposure required. We may be on the brink of testing our new portfolio and solvency safety equipment.

Lehman Brothers and Bear Stearns base cases call for subprime national defaults of $200 billion to $250 billion over the next two years. This would translate into 1 million to 2 million residential-unit defaults. The next 22 months will see nearly $1 trillion in adjustable-rate mortgages resetting, with $650 billion in subprime. Industry base cases assume average house prices will be flat to 2% down across the next two years. Given the scope and size of recent house-price appreciation, the projected housing-market correction is very modest. Confidence derives from many questionable assumptions. Default risk and hedging products must turn in stellar performances, fear must not grip markets, and contagion must be limited. This is possible and has happened before. This best case requires us to thread the needle.

Risks must be measured against private US housing stock valued at $20.6 trillion on January 1 and total mortgage debt of $9.7 trillion on the same date. The sheer size and recent growth of household net worth is constantly and impressively invoked to sooth. Household real-estate assets increased by 50%, or $6.857 trillion, from 2002-07. During the same period, the Federal Reserve Z1 Flow of Funds records an increase of $3.708 trillion, 62%, in mortgage liability. Disposable personal income increased by $1.851 trillion or 24% over the period. Net worth grew by $16.829 trillion, or 43%. It has been a crazy few years. All this growth of wealth and debt amid asset inflation is made possible by new markets, methods and innovation in risk hedging and sharing.

The rise of collateralized debt obligations, credit-linked notes, over-the-counter finance and custom derivative products are the enablers. The subprime situation, credit quality, hedging techniques and products must all be considered together. Across the past three years there has been a steady decline in the quality of mortgages written and creditworthiness generally in the system. Credit-default protection has been extended to lower credit-quality-rated debt.

Massive international capital flows and global financial deregulation have grown exponentially over the past decade. Cross-border capital movements have increased more than threefold to more than $7 trillion since 1996. This has made far more credit available at much lower cost. For riskier borrowers - subprime - this has meant a maiden voyage deep into debt. The securitization and sharing of default risk has allowed issuers to share loss risk and markets to grow.

The sheer mass of managed wealth has reduced the returns to traditional safe investment grade assets. Thus supply and demand are generated by the same forces. These forces include rising risk/return appetite, global upward distribution of wealth, financial deregulation and financial innovation. Risk-management products have been inexpensive and the hunt for yield intense. There is more capital chasing riskier assets to gain acceptable returns. Lower-quality loans are made, hedged, bundled and sold. The serious systemic risk associated with the recent subprime episode stems from the prospect that the new financial architecture is less robust and more highly correlated than assumed. The rising cost of hedging debt positions and greater fear of lending to riskier borrowers is far more worrisome to us than the US subprime market.

New risk product and the rapid growth of established hedging and sharing contracts and trading techniques have boomed. From a systemic perspective, this does not reduce total default or shock exposure. Redistribution and repricing of risk occur. This is valuable and acts as a shock absorber for intermediaries that would otherwise have to restrict activity or ride unsound direct loss exposure. As higher risk assets are sold or hedged, there has been a tendency to use the raised cash to purchase other risky assets in the hunt for yield.

A prime example comes from the CDO (collateralized debt obligation)/mortgage-securitization process. As banks issue mortgages they assume a first loss position (FLP) to be able to sell off the loans for securitization. If we assume a fully funded standard contract, the banks pass the loans to a special purpose entity/vehicle (SPV) that sells the loans and assumes the loss position. Losses from "unlikely" system shocks are partially passed to the buyers of the securitized loan bundle, but that first loss position means the banks still bear risk. In addition, the total reduction in risk achieved hangs heavily on what is done with bank proceeds generated by this process. You guessed it, the evidence is that banks make further loans and repeat the process. The good news is that banks have a more diversified, riskier portfolio. The bad news is that risk exposure does not fall, it rises. The total risk in the system rises and is diversified and more broadly shared. This is the good news and the bad, out of our brave new era.

We see subprime as risk and valuable lesson. This market is in for a rough run. There are sweet dreams of containment; they defy reality. There is no such thing as a subprime neighborhood. Subprime is concentrated more heavily in some areas than others; it is everywhere. Thus broader housing-weakness questions are when and how bad, not if. Hundreds of billions of dollars in loans were made to people who clearly could not repay, absent significant annual house-price appreciation and cash-out refinancing. This means that we made housing loans to create housing-price appreciation on which loan repayment was predicated. Sometimes we are tempted to think that this credit boom has gotten a bit out of control. There is no long-run safe substitute for earnings, savings and income growth when increasing credit. This is not to say there cannot be a lot of money made, valuable financial innovation and long periods of great returns.

The other vital lesson involves our brave world of fully managed risk and nearly perfectly hedged positions. Have other markets and asset classes become dependent on credit growth to drive up asset prices to allow further credit growth? A huge Maginot Line of default defense has been erected to keep loss exposure out. Many valuable and potent new risk-management techniques and products have been developed. Riskier borrowers remain risky to all the various parties that extend credit to them. This showed up fast and furious as the cost of credit-default protection shot up and interest-rate premiums snapped into correlated action with every increase in subprime stress.

The greatest risk may be in thinking that risk has been conquered. It cannot be. It has not been. Risk has simply been redistributed and repriced, downward. As perceived risk fell and sharing grew, new monies were freed up for riskier lending and new, riskier projects. Loans went through and new projects were launched. Default risk continued/continues to grow as credit grows and allocations hunt for return. There is no innovating around this basic reality of financial gravity.

We are looking for periods of contagious fear in credit-risk-reduction markets feeding back and forth with particularly risky asset markets. The real danger slumbers - we hope - so long as massive quantities of cheap credit allow the roll-over financing of future rounds of debt. If this slows sharply, or runs in reverse, US subprime housing turmoil is the tip of the iceberg. There has been a lot of subprime allocation of capital and risk across the past few years. Subprime will either become a heeded warning shot across the bow, or a prelude to violent repricings to come.

Max Fraad Wolff is a doctoral candidate in economics at the University of Massachusetts, Amherst, and editor of the website GlobalMacroScope.

(Copyright 2007 Max Fraad Wolff.)

Giant credit bubble behind yen slide: if it bursts, could destabilise the global financial system

Financial News
Sunday February 11, 05:14 AM

Giant credit bubble behind yen slide: analysts

TOKYO (AFP) - The recent sharp depreciation of the yen is believed by economists to be the result of a giant credit bubble which, if it bursts, could destabilise the global financial system.

The bubble is the result, they say, of the gap between Japan's super-low interest rates of 0.25 percent and those in the United States and the eurozone, which encourages investors to borrow cheaply in yen to invest overseas.

This practice, known as 'carry trade', means that speculators exchange yen into other, higher yielding currencies, driving the weakness of the Japanese currency, which was a hot topic at a weekend meeting of world finance chiefs.

The Swiss franc has also been affected by carry trade -- though to a lesser degree -- due to relatively low Swiss interest rates of 2.0 percent.

The more the carry trade succeeds, the more people it attracts, said Noriko Hama, an economics professor at Doshisha University in Kyoto.

"It tends to feed the depreciation" of the yen, she added.

No one knows the exact magnitude of the yen carry trade. Conservative estimates put its value at upwards of 200 billion dollars.

Some others estimate it to be much higher. Tim Lee of the US research firm Pi Economics reckons that the true size could be in excess of one trillion dollars -- equivalent to the annual national output of Canada.

He believes the yen is 29 percent undervalued against the dollar.

"The yen is a foolproof indicator that we are in the midst of a gigantic bubble. The yen has been falling persistently despite being undervalued and despite Japan having zero inflation," he wrote in a recent study.

"The yen carry trade is ballooning as never before and is now larger than ever. There is no doubt whatsoever that this credit bubble will end extremely badly," he warned.

Analysts say it is very hard to estimate the exact extent of the phenomenon.

"It is very difficult to come to grips with the depth of the carry trades," said Markus Krygier, the head of forex strategy at the German investment bank Dresdner Kleinwort.

However, he predicted that carry trade would start shrinking if the US Federal Reserve moves to cut interest rates by the end of the year as he expects.

Many economists expect the Bank of Japan meanwhile to raise its interest rates again at some point this year, reducing the appeal of carry trade.

"To deflate a bubble orderly has a lot to do with luck. It is something that is very difficult to engineer, particularly if the bubble has been inflated" for quite a long time, said Krygier.

He said that the current situation has echoes of 1998 when the yen shot up almost 20 percent in just three days as the Russian financial crisis and prospects of a Japanese interest rate rise triggered a reverse in carry trades.

Krygier expects the dollar to finish 2007 at 100 yen, down from about 121 now. Lee at Pi Economics goes even further, predicting the dollar will sink to 70 yen over the next year.

"As long as the credit bubble goes on the yen will be weak. When the credit bubble turns to bust the yen will be extremely strong," he wrote.

Such a sharp appreciation of the yen would pose a serious threat to Japanese exports and the overall economy, analysts said.

"If you start to see an appreciation of the yen, then the carry trade unwinds very quickly, the rush for the exit gathers momentum, and not everyone can get out to the door," said John Shepperd, another economist at Dresdner Kleinwort.

"In terms of the global economy, we will see a massive withdrawal of liquidity," he said, adding that there could be a "sharp setback in equity markets" in the United States and Europe.

For analysts at the investment bank Barclays Capital, it would be risky for global monetary authorities to try to deflate the credit bubble.

"Carry trades are a function of the low volatility environment in financial markets, which is partly due to G7 (the Group of Seven rich nations) central bankers' success in maintaining low and stable inflation," they argued.

"Policy coordination against carry trades would only fuel a sharp unwinding of those trades and pose the very risks to financial market stability that G7 officials seek to avoid," they wrote in a note to clients.