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Subprime Tsunami: Spreads Kill You, Not Defaults
April 10, 2007

Subprime Tsunami: Spreads Kill You, Not Defaults

"The unwinding of the US housing bubble is like a train wreck in slow motion. As the first wagons crumple, a picture of serenity depicts the trailing cars. However, their fate is sealed. The same is occurring in the US housing market. As the sub-prime market implodes, the situation is calm in the higher-quality segments�with prices still rising in some up-scale markets. Yet, it is only a matter of time until the damage spreads."

Walter Molano
BCP Securities

Last week, one long-time reader of The IRA, a senior equity derivatives maven with one of the bulge bracket Sell Side shops, scolded us for spending too much time pondering the affect on bank safety and soundness of rising loan default rates:

"Everyone focuses on 'defaults', but the risk, in my opinion, is in the 'spreads'. People have levered up on the super-senior tranches as a safe way of chasing yield. Sure the distance to default for this paper may be large, and the principal safe for many who can hold to maturity, but that doesn't mean that the paper wont be repriced at a (substantial?) discount between now and maturity. And everyone I talk to, unfortunately, is using fairly modest assumptions of spread-widening. Therein lies the real problem, short-term memory."

We did not remind our colleague, who spends the day on a trading floor taking incoming fire, that we obsess about spreads all the time. Indeed, the magnitude to which cash and derivative spreads remain extremely narrow vs. the underlying risks is one of the key ingredients of our ongoing angst. But we appreciate the comment and the insights.

While spreads on subprime paper have indeed widened in the past couple months, spreads in other sectors remain very tight, this even with happy predictions of generalized deflation from all sorts of observers. At the wide, premiums on credit default swaps ("CDS") for collateralized debt obligations ("CDOs"), the vast majority of which contain subprime paper, traded at perhaps half the underlying default rate on that collateral, raising questions about the rationality of market participants as well as about their short-term memory.

Part of the explanation, of course, is that the flow of funds into just about any sort of asset class is so strong that cautionary statements and pessimistic data go almost unremarked. When you see private equity funds going public, you know it is time to start hitting the bid.

Last week, we read that hedge funds and other non-bank investors now account for three quarters of all loans made to junk-rated companies. No wonder defaults are so low. According to Standard and Poor's, there is "a new marketplace of borrowers," including private-equity groups, which prefers loans to bonds. These same funds are also buying subprime bonds, partly in the hope of scoring a bonanza on somebody else's mistake, often in competition with CDOs, which were the main buyers of such collateral last year.

The entry of all manner of funds into the junk and subprime loan universe has driven spreads down to silly levels, thus the rant from our equity derivative maven. And of course the warning is well-considered, but spreads have been so tight for so long that most people simply don't care. The reality of tight spreads, far below the true economic risk character of a given asset, is now part of the financial landscape, meaning that spread risk is entirely pervasive.

Consider a sample from the banking world, taking a bank-only rollup of Bank of America (NYSE:BAC) and its peers as a surrogate for the price of spreads in the financial markets generally. In the early 1990s, BAC earned a gross lending yield over 1,100 basis points, nearly 50% above current levels. Did this mean, as it would today, that BAC was a subprime lender? No, but it does suggest that this key indicator of bank profitability was considerably fatter in the early 1990s than it is today.

2006 2001 1997 1991 1990
Bank of America 709 841 806 983 1,040
Peer Avg 661 758 824 994 1,097
Source: FDIC/IRA Bank Monitor

A decade ago, a subprime asset would have been trading in the 2,500bp or 25% yield range, what in those days was seen as the minimum return for a group of assets rated in the B/CCC categories. Today assets with similar credit default probability profiles trade at half that spread or less. Indeed, before the big media grabbed onto the subprime phenomenon, some subprime deals and derivatives were trading at just a tenth of where similar assets would have traded a decade ago. This raises a couple of issues in our minds:

First, does the apparent fact of pervasive spread risk among and within US market participants mean that financial institutions and investors are headed for a macro event, a one-time outward shift in spread pricing that exceeds the mean assumptions employed today in most risk models?

Second, does the possibility of such a "spread tsunami" imply that the market for banks, broker-dealers and hedge funds is going to see a wave of forced mergers and consolidations, this when smaller boats are swamped by the flood of red ink? Will the already tight profitability of US banks, funds and BDs be squeezed further when credit and market spreads revert to the mean?

So long as the deal flow remained strong and the hedge funds remained numerous, all was well. But if one morning Mr. Hedge Fund wakes up to the fact that his CDS of CDO portfolio, which covers collateral that conservatively will throw off 20-30% defaults over a three year time horizon, is trading at well less than a 10% spread, then look out.

Or as the equity derivatives maven told The IRA: "Spreads kill you. By the time the paper actually defaults, you'll be long gone and, hopefully, working at another shop."

Questions? Comments? [email protected]

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