The recent troubles of the Bear Stearns Asset Management Funds, the halt on redemptions at United Capital Asset Management and the shutdown of a hedge fund at Braddock Financial might only be the first of many market rumbles to clock in on the RMBS Richter scale. However, market experts say their broader market effect may not be as widespread as some have expected.
For the past several months, market players have speculated that these firms are just the beginning of a grander chain reaction setting off other market lockdowns. While further subprime-related meltdowns are expected, it may not be enough to shake bordering markets, sources say, noting that other hedge funds may be forced to mark down their own holdings, especially because of the end of June and the conclusion of the second quarter.
"The data we are getting anecdotally make us believe that there will be more casualties to come and they will play out over the next few weeks," said Ajay Rajadhyaksha, co-head of U.S. fixed-income strategy at Barclays Capital, on a recent conference call.
That said, however, the bank does not see a broader market risk in the expected liquidations. While other sectors should have been affected by systemic risk - mainly the credit markets - these other sectors were far less worried than the rates markets, Rajadhyaksha said. He noted that, while the hedge fund crisis played out over this period, rate volatility spiked to a much greater extent than credit volatility did. And while systemic risk usually has investors turning to higher-quality assets at the expense of the riskier bets, emerging market debt, which is normally one of the first asset classes to get hit, appears to be at ease, a Barclays report said.
And spread widening has affected only U.S. MBS products, while other pools of collateral, such as autos, CLOs and credit cards, have remained largely unaffected, according to a research report from Credit Suisse. The investment bank's U.S. CDO team estimated that the current volume of outstanding U.S. CDOs is $900 billion, with 21% in high-grade ABS CDOs and 17% in mezz ABS CDOs, totaling more than $200 billion of exposure to the U.S. home equity sector and the highest risk, BBB' or below, is estimated at roughly $130 billion. Nevertheless, the bank said, losses would not be significantly widespread. "Tens of billions of dollars are clearly a huge problem, but we do not think that they are a systemic one," the bank said.
The top 10 global investment banks currently hold $513 billion of equity capital, which should, even in the worst case, be sufficient since the losses are unlikely to be confined just to the investment banks but will include commercial and mortgage banks in the U.S., as well as investors in home equity paper, Credit Suisse said. Hedging activity will also spread the potential losses more thinly across the financial system, reducing the risk of a systemic issue, the bank added.
The investor side was a bit more skeptical about the overall effects of the hedge fund crisis. What happened at Bear Stearns was a result of the classic late-cycle liquidity phenomenon, said participants at SCM Advisors conference call held last Tuesday. The call included High Grade Strategist Robert Bishop, Chief Strategist Max Bublitz and High Yield Portfolio Manager Al Alaimo. "We think [the hedge fund crisis] is far more correlated with a global liquidity contraction; the $64,000 question is how far does that contraction go? And we are not entirely clear," Bishop said.
Currently, liquidity concerns have begun to put pressure on the leveraged finance markets with bank financing drying up. This has left private equity to try to force leveraged buyouts into a somewhat dysfunctional market, Bishop said. In fact, early this month, Memphis-based outsourcing services provider ServiceMaster pulled a $1.15 billion issuance structured in two $575 million tranches made up of PIK toggle notes and senior notes. Proceeds were slated to fund the company's $5.2 billion buyout by Clayton, Dubilier & Rice. And just last week, Swift & Co., a Greeley, Colo.-based beef and pork provider, pulled $600 million in high-yield bonds, which were to help pay for Swift's acquisition of Brazil's J&F Participacoes, majority owner of Latin America's largest beef producer, JBS.
SCM added that the ability to transact and actually have decent bids and offers in the market, which also defines liquidity, is currently being tested with these events. "Liquidity is just another word for confidence, and confidence in that portion of the market is struggling right now," SCM said.
However, investor hesitation is a healthy adjustment before market stress is apparent, said Mark Howard, managing director of Barclays Capital and co-head of research, at the bank's global outlook meeting last Wednesday morning. He noted that, while further unwinds in the ABS CDO market could undermine the markets in the short term, longer term, their effect will actually be stabilizing. - GS
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