Who's afraid of the sub-prime wolf?

News analysis

By Charlie Corbett
Wed, 01 Aug 2007

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Investment guru Warren Buffett once said that when the tide goes out you can see who has been swimming naked. In the case of this year's fiasco in the United States sub-prime mortgage market, never have truer words been uttered.

In the wake of what some commentators have called a meltdown in the American sub-prime market, a number of hedge funds have been left high and dry without a stitch on.

Australia's very own Basis Capital, which has won multiple awards in the past for its strategies, is one example splashed across the news pages recently. Steve Howell and Stuart Fowler's fund last month came clean on its exposure to sub-prime loans.

In a letter sent to investors in July, the firm said its investments in collateralised debt obligations, or CDOs, had been tarnished by guilt by association. Less than a week later, the fund, which had $1 billion under management in May, admitted its two funds lost 9 per cent and 14 per cent in June.

Basis Capital is just one of a series of victims of the sub-prime mortgage rout.

US investment bank Bear Stearns last month told clients their money in two hedge funds that invested in sub-prime mortgage was basically gone.

It admitted one of its funds was worthless and the other one was worth less than 10 per cent of its value.

And in London too, investors felt the sub-prime pain. Caliber Global Investment and Queen's Walk Investment were stung. Caliber Global, with US$900 million, closed after losing US$8.8 million. Queen's Walk reported a US$91 million loss.

The market, however, remains uncertain about what kind of impact the recent events will have on the wider credit market. Investors are asking themselves whether this is the beginning of the end or merely a salutary warning of what could lie ahead if loose lending gets out of control?

"It is close to the time when we'll look back and say we did stupid things," fixed income shop Vianova's chief investment officer, Michael Schneider, told an investment briefing in Sydney late last month.

"There has been a change in the liquidity conditions. US$2 trillion worth of so-called honeymoon mortgage rates are starting to re-price. That represents about 20 per cent of the US GDP. It's liquidity happening in reverse."

Who's afraid of the sub-prime wolf?

News analysis

By Charlie Corbett

Page 2 of 2

Schneider is one of many fixed income investors that fear the impact of the sub-prime rout could spread to the wider fixed income markets.

"All of a sudden we are seeing deals that are not going through. This is something we haven't seen for many, many years," he said.

Toby Nangle, a fixed income investment manager at Baring Asset Management in London, agreed. "We are starting to see some signs of credit rationing for the riskier deals and have counted 28 corporate bond or loan deals representing around US$17 billion that have been pulled since June 22. We didn't count a single pulled deal in the previous year," Nangle said.

Schneider and Nangle, however, do not feel wider credit markets have too much to fear, provided some sense returns to risk and return strategies.

"Greater credit risk aversion is appearing in developed markets as investors realise that fixed income is not as defensive as they once thought," Schneider said.

"The price of risk is still not adequately reflecting market conditions . it's time to play defence, not offence, in terms of fixed interest investing."

The impact of the sub-prime meltdown on the pricing of corporate credit markets more generally had so far been limited, according to Nangle.

"Corporate bond and loan spreads have ticked up a little, and investors who have been lending with their eyes closed have begun to complain about pricing becoming slightly less expensive, but over any medium-term horizon the spread movement to date has looked modest," he said.

Ultimately the sub-prime mortgage fallout is a sober reminder to our debt-ridden, consumer-driven society that houses built on sandy foundations have a habit of falling down.