Roundtable: Sounding out the buy side

With the markets still reeling from the liquidity crisis, Credit gathered together three luminaries from the buy side to discuss the effects of the summer slowdown and, more importantly, how things will pan out over the next few months

Matthew Attwood, editor, Credit magazine: Given the problems we have seen in the credit markets over recent months, when can you see hedge funds coming back?

Jonathan Laredo, partner, Solent Capital: If by coming back you mean acting as an alternative lender to the banking system, I'd say a long time. You'd be looking at 12 months, at least.

MA: And what will have to happen before they do?

JL: Well, credit-based hedge funds will continue to trade, but I don't think they will play the role of an alternative source of finance except in seriously distressed positions.

Kevin Colglazier, chief investment officer, Standard Asset Management: I think the question you've posed - 'when will people come back?' - assumes that the previous period was normal and now is an abnormality.

JL: Exactly. This is more normal.

KC: The point we're missing is that they're looking at the April to May period and saying that's normality, and that this June, July, August period was a horrible aberration. What we have to realise is that the credit cycle's turned. We've had central bank tightenings over the past five years. I think people have forgotten that central banks basically tighten monetary policy until something breaks. So people are not going to come back in the same magnitude they were in March to May because that represented a peak.

MA: So prior to the summer the markets were an aberration then ...

JL: Two things have happened between the last time we had a liquidity crisis - 1998 - and today. Firstly, banks have changed their role: nowadays they are largely warehouses. They take risk on, they repackage risk, they distribute it, and they have larger derivatives operations. Secondly, over the last six or seven years there's been a massive growth in investors who buy credit based mainly on ratings. We've seen huge increases in leverage, and as leverage increases people hunt for yield; and as they hunt for yield both spreads and credit standards fall.

What we've seen over the last few months is a very rapid de-leveraging, principally in the commercial paper market. Asset-backed CP fell by about 20-25% in a month or so. At the same time, the banks that had huge leveraged loan commitments got caught with that risk on their books. Now it's been repriced, and it's going to take them the best part of six months to work it off their books. One of the consequences of this has been a very rapid tightening of credit standards which will make access to credit more difficult across the board.

KC: You also have to look at the role of the rating agencies. After the Asian crisis there was an uproar about the rating agencies: how could you rate South Korea from double-A at its peak to triple-B? You could buy KDB distressed in Christmas 1997 at about 1000 over. This criticism cropped up again after Enron and WorldCom. But it's interesting how ratings have been relied upon again in 2005/2006.

MA: There seems to be pressure building for regulatory action against the rating agencies. Do you think that is necessary?

KC: Government intervention in rating agencies would be a disaster; it completely misses the point of what the rating agencies are there to do. They are there to provide an opinion. Not a fact, but an opinion. The blame for poor performance should lay with the individuals who bought the securities. When you get the Moody's, S&P or Fitch report handed across your desk, you don't have to buy the product, no one's holding a gun to your head. There seems to be a view that the rating agencies should foresee all this stuff. That's just nonsense.

MA: Do you think we will see certain structures not getting done in the future?

JL: It's hard to look more than six months forward. If you're asking about types of structured products, my own view is there will be less issuance next year than this year. But I wouldn't hazard a guess that this will be the end of the structured product market. What we are going to see is the onset of a corporate bear market in terms of defaults. Specifically, in high yield.

MA: With the Northern Rock crisis there has been a lot of criticism of the tripartite model of regulation in the UK. Do you have a view on that, Simon?

Simon Thorp, chief investment officer, Ilex Asset Management: From what I know of the situation, it might have been prudent to have tried to line up a potential suitor during August or early September to stop the situation getting into the public domain.

JL: They could have tried what happened in the US. The Fed opened the discount window in New York and said you can effectively put structured assets on repo. Given the Rock's books, it could have accessed that window fairly inconspicuously as opposed to borrowing last-minute as a distressed debtor, which was what started the run. Looking at it from the outside, the Bank of England didn't seem to be aware of the extent of the liquidity crisis. Or if they were aware, they appear to have changed their policy mid-stream.

ST: I know the Bank of England from a previous life and I understand what they were trying to do, but it's been made to look even worse. No doubt there will be changes in the way the bank operates going forward.

MA: Is there a disconnect between the way people are approaching equity and credit markets?

JL: If you do the analysis on investment-grade credit, especially large international corporates, the story still looks really good. If you do the same analysis on large-cap equity, the same seems true. I'm less convinced that speculative equity makes any real sense at the moment, but that's why I'm not in equity.

ST: I think it's more psychological. Fixed-income credit people tend to be naturally cynical and negative, always looking to see the problem. Credit is an asymmetric risk instrument and equity isn't. To really maximise your returns in equities, you've got to be looking for the growth side of the story. We know that in this stage of the economic cycle, it's often the case that equity outperforms fixed income for a period of time, until such time maybe when the writing's much more clearly on the wall.

I think we're in the last part of this credit bull run, where the market begins to seriously look at the differences between credits that are delivering and credits that aren't, and you can begin to deliver returns from both sides of the balance sheet for the first time since 2002. And that's the precursor to a broader sell-off. But I don't think we're quite there yet.

MA: There's been some criticism of so-called vulture funds or 'special situations' funds. Are they looking for discounts that are too deep?

JL: How can they be asking for discounts that are too deep? If somebody's prepared to sell and the price they're prepared to sell at is low ...

MA: Well, in mid-September the Financial Times posed the question of whether banks would accept the prices being demanded by these funds.

JL: But why should there be any sympathy? Look at the investment banks' profits over the last five or six years. If, for example, Merrill really have got $30 billion of assets on their books marked at 60%, let's say they clear them at 20%. They're still profitable over the last five or six years. If you start pointing your finger at the vulture funds, I think you're missing the point.

KC: You need to remember that the market clearing price is simple supply and demand. You can't moan about a poor price when six months ago people were giving you a really good price. Everybody in the City who's got a bit of cash left and has got the ability to play it is obviously looking for distressed stuff, whether that's investment grade that's trading 50 wider than it was last month or EM that's trading at 70 cents on the dollar. But you've got vast swathes of the previous investment community that are not participating. The German Landesbanks, who were big buyers of structured credit - that's a pretty dry market right now. The next trade will be to repackage the assets and sell them aggressively.

JL: Distressed prices are no bad thing for a while; they've been high for a long time. You can trade long/short in credit for the first time in years, whereas if you had been trading short for the past five years it would have been pretty painful.

ST: We operate more in leveraged loans and raise money for the same sort of idea. At the moment there seems to be this Mexican standoff between buyers who want to pay low to mid-90 cents on the dollar for senior loans and the banks who have run the market up a bit. The clock's ticking because the investment banking year ends at the end of November and the clearing banks at the end of December, which might shake one or two of them out.

JL: They're trying to sell for 96 cents and change really, when they need to clear at 92 or 93 cents. I think the banks hope the Fed cuts will give investors more confidence but I think that's unlikely to happen. The Fed might cut but whether investors will get more confident or not is another issue.

MA: Do you give it six months?

JL: Once we get to the end of the year, banks start again at zero. So assets that haven't yet been written down to sale prices are going to be written down soon otherwise you're risking next year's bonus pool. That doesn't even start to address structured assets - loans are easier to understand than ABS and CDOs. I think that in December you're going to see a lot of books being written down. That will help the banks liquidate their balance sheet, but it won't necessarily solve their problems.

ST: They'll also be keen to clean out their balance sheets so that they can begin work on some new deals and start to generate some new fees early in 2008.

MA: Do you think having more granular information on the underlying loan pools would have prevented the subprime crisis?

JL: I don't think that would have made any difference. It's not a question of getting access to more granular information, it's a question of knowing what it means. If you look at an ABS transaction, you're looking at 4,000-plus individual loans, each of which has 10 or 11 bits of critical information. Who is going to trawl through all that information in order to prove the rating agencies were incorrect? For an investor to be prepared to do that analysis themselves, how many assets do you need to buy to make the analysis worthwhile? You'd have to pay two or three analysts plus half a million dollars a year in systems and information, and what are you going to do? Buy $10 million of paper that gives you Libor plus 30? The numbers just don't stack up.

The macro issues are pretty clear: you saw in financial terms a feeding frenzy as people wanted assets and the structured market kept bidding down spreads. Spreads collapsed, and naturally the originators of assets dropped their credit standards. But giving people more data doesn't change the macro issue: you've still got to make your own decision about when to stop playing the market.

KC: There's no lack of data. In the subprime market the trigger was the tightening of monetary policy because of adjustable-rate mortgages. Everybody knew exactly how many adjustable-rate mortgages were written, everybody knew the terms. There were forecasts just two years ago of the hump that was coming in 2006, 2007, 2008 in the resets - it's all simple stuff, initiation date plus three years or so. So you could see it coming.

ST: I think a lot of investors arguably bought instruments that they didn't fully understand. In a sense they hid behind the rating agencies, used them as an excuse for not really wanting to understand the instruments.

JL: For me the critical issue is liquidity. You can spend a huge amount of time doing fundamental research and a huge amount of time looking at fundamental assets but if trades get crowded, if there is no liquidity, you get massive volatility. If you look at the equity markets in August, some very good equities sold off very rapidly as the arbitrage guys started selling their positions, and investment-grade credit performed worse than sub-investment-grade credit on a relative basis. Why? Because people holding those positions who were leveraged had to sell their best positions, so they sold their most liquid assets.

MA: So are we moving into an environment where underwriting standards and prices have become untenable? Are we seeing a market backdrop that's simply more reasonable?

JL: We've come out of an extended bull run. We've had increasing use of structures, increasing use of leverage and what triggered the end of that process was loss of confidence by the commercial paper market as much as anything else. I've been calling the end of the bull market - probably prematurely - for 18 months. I just didn't see how defaults could stay so low. Well, one of the reasons they did was because people had easy access to credit. Now that easy access to credit has gone, more speculative-grade companies will default, and we'll move into the beginnings of a bear market in default terms.

ST: The weakening of covenants has been a problem. The early-warning indicators have gone so companies are going to be in a far worse position by the time people realise it is too late than in previous cycles.

JL: And where you see defaults, you'll also see lower recoveries. That'll be a surprise to many people, because some market participants seem to persist with the notion that recoveries are always at 70% or 80%. The company in the LCDX that defaulted - Movie Gallery - when they restructured, their mezz got turned into equity. Which suggests that senior recovery is going to be very good and mezz is going to be close to zero.

ST: Absolutely.

JL: And given that mezz has been trading at a 40/50 recovery and senior at 70 or so, it's a pretty horrible position for somebody.

MA: Thank you all for your time.