October 2007

Derisking trend

During recent months global markets have been experiencing levels of volatility unseen since the beginning of 2003. Primarily, this has been caused by renewed fears over the deteriorating outlook for the sub-prime US mortgage and lending market, which in turn, has led to a broader reassessment of credit risk, mounting concerns surrounding the potentially detrimental effect it could have upon the financial system and concern over the wider economic impact of a 'credit crunch'. Corporate bond markets came under serious pressure, with moves in credit derivatives making daily headlines with spreads on these products literally going through the roof (credit default swap spreads more than doubled in July), as holders of the underlying physical debt rushed to hedge their positions for fear of default.

Volatility within the credit markets has inevitably spilled over into the equity markets as investment banks struggle to sell bonds to finance high profile private equity deals which, over the past few years have been the main driver of equity returns through merger and acquisition activity.

However, outside of the players participating in the credit markets, the term sub-prime lending had been relatively unknown. So in order for us to understand what is happening in the financial world at the moment, we need to know what is at the root of the trouble.

Subprime lending offers an opportunity for borrowers with a less than ideal credit record to gain access to credit in which to purchase a home, or in the case of a cash out refinance, finance other forms of spending such as purchasing a car, paying for living expenses, home renovations, or even re-paying on a high interest credit or store cards. In return for allowing this certain pocket of borrowers access to this type of facility, the interest rates applied to such loans are typically higher. To put it simply, the companies lending require higher interest payment to offset the risk of borrowers not being able to pay loans back.

The various types of loans are then securitised and packaged together by the lending companies and sold into the credit markets via investment banks and traded, and indeed rated by the various credit ratings agencies (S&P, Moodys etc) in a similar way to other bond instruments.

During the early part of this century when the US Federal Reserve (Fed) had an extremely accommodative interest rate policy (in June 2003 the key funds rate was a mere 1%) which clearly enabled sub-prime borrowers to enter into loan obligations with very affordable re-payment amounts. More recently, as the economy has blossomed and with inflation fears increasing the Fed has raised rates on 17 consecutive occasions. As a result of these rate rises re-payments on non-fixed rate loans has increased and caused many sub-prime borrowers to default. The knock on has caused the credit market to re-price risk to more sensible levels during which time investment banks are failing to lend to each other as counterparty risk is perceived to have increased therefore driving up short term rates within the money markets.

At Origen, we believe that it is extremely difficult to ascertain how long this period of de-risking will last. Therefore we are remaining cautious over the remaining months of 2007.

John Monaghan
Investment Manager
Origen