KEY POINTS:
Apparently one of the key benefits of the new global credit derivatives market is that the cost of credit is lowered as risk is spread more widely among investors. Small investors who have lost part of their savings through investing in managed funds with holdings in dodgy US residential mortgages, to earn an extra couple of percentage points of interest, might have quite another view.
Critics of collateralised debt obligations (CDOs) and structured credit instruments believe that it is more difficult to see who has been left with exposure to the bad debt.
It also seems that right now markets in credit derivatives and CDOs are highly volatile, so much so that it's hard even for professional investors to know what the things are worth.
In fact, earlier this month two European banks were forced to disclose that funds through which they had invested in US CDOs had taken nasty writedowns, despite earlier assuring investors that they had minimal exposure.
In one extraordinary move a large French bank decided to invest its own money in two ostensibly low-risk money market funds owned by clients to prop up their position following a 21 per cent fall in price as a result of bad investments in subprime mortgages.
Some estimates of the extent of the subprime/CDO losses are as high as US$240 billion but even that could be conservative as it assumes that problems don't spread to other junk bond categories.
In the US housing market things are getting worse not better: mortgage interest rates are rising so affordability is falling and home prices are declining so loan-to-value ratios are increasing. One thing that is clear at this early stage is that some of these losses are now turning up in the fixed-interest portfolios of small investors in New Zealand. If we just look at the more popular listed and unlisted vehicles which have previously admitted exposure to CDOs and credit-linked instruments the reduction in value since May 31 adds up to $140 million. Not quite as bad as Bridgecorp but still an awful lot of money. For many of the listed products there is simply no stock bid for, meaning shareholders cannot sell even if they wanted to.
These figures, while alarming, could conceivably get worse. Tim Bond of Barclays Capital in a note to clients neatly summarises the crisis in credit as follows: "The problematic securities are a particular vintage of mortgages whose prospects the market is having immense difficulty in valuing, largely because participants no longer trust historical parallels.
"In the absence of collective assessments based on historical averages, the analysis now needs to be done from bottom up, an immensely complicated and time-consuming task given the vast number of underlying individual loans. "Compounding the problem is the complexity of the vehicles that hold the problem securities and the further losses inflicted by falls in corporate credit instruments.
"The broad point is that the original mode of analysis underpinning mortgage asset-backed securities and related investment vehicles has been discredited by events and the markets have not been able to substitute an alternative analytical paradigm."
Some local fund management firms with big CDO exposures are extremely defensive and will not even disclose the size of their funds, let alone the nature of any problems.
Three related factors may combine to make the current problems in CDOs a "creeping credit crisis".
Firstly the market in some of the specialist CDO structures is described as being highly illiquid, which in reality means that no one wants to buy them, thus a little bit of selling pressure can push prices down a long way. When the creditors of two Bear Stearns funds tried to liquidate their positions they quickly realised this wasn't a good option.
The second factor is that small investors owning local unit trusts, which hold the illiquid CDOs which can't be sold can, in theory anyway, demand their money back immediately. This of course unfortunately means selling that which can't be sold, ie the underlying portfolio of bonds/CDOs.
Investors with long memories will recall that this same dilemma impacted the Australian unlisted real estate markets and a local small companies fund in NZ in the early 1990s when investors panicked, demanded their money back and the fund managers couldn't deliver because they were not able to sell the underlying assets, not at the then current prices anyway.
This prompted one critic to label the theoretical right to redeem an open-ended fund holding illiquid assets as being "an umbrella which you can only use until it starts raining".
Where it gets quite messy is that at the early stages of a crisis open-ended fund managers don't want to cause a panic by suspending redemptions so, to fund unit holders who want out, they sell the things which they can sell which in this case might mean hanging on to high-risk CDO tranches for which there is no bid.
Unit-holders who didn't panic and sell could get left with the dodgy securities. The third factor, according to the Financial Times, is that price discovery in many CDO instruments is imprecise to say the least in that rather than prices "being what you can sell the product for" it seems that frequently the price is "what the computer model of the bank that sold you the product says it's worth".
These two figures may be difficult to reconcile. For example in a Stock Exchange announcement the manager of the listed Credit Sales notes said that: "The estimated worth of the notes had been calculated using estimates provided by investment managers and where estimates could not be obtained the value included assumptions made by the investment manager on the performance of some underlying funds.
"Actual performance of those funds could be different from that contemplated by the estimated value."
The credit crash, while being bad news for many New Zealand investors, also has its fair share of ironies: it's ironic that when everybody was worried about a stockmarket crash ostensibly "safe" bond investments have done as bad and in many cases worse than equities, especially in New Zealand dollar terms.
It's ironic that the really big losers in the shakeout so far are professional investors: hedge funds managed by the likes of Goldman Sachs and Bear Stearns who are so clever they can charge a 2 per cent annual fee and 20 per cent of profits but so silly that they can get totally wiped out. It's ironic that in NZ and overseas many low risk fixed interest funds, designed to return a couple of per cent above 90-day bills, are taking losses of 20pc and more.
The current uncertainty is just what small investors don't need when they thought they were taking only a small risk to increase their interest income. No doubt many investors are now coming to the conclusion that the potential extra return of credit structured notes in no way justifies the additional risk.
If the credit problems get much worse we may yet see accusations of misselling from aggrieved parties who might claim they weren't properly advised of the risks of CDOs.
But it isn't all doom and gloom. At the AGM of local stamp dealer Mowbray Collectible, managing director John Mowbray told shareholders the global jitters weren't affecting stamp collecting. That's a relief.
* Brent Sheather is a Whakatane-based investment adviser.
