Three separate pieces of news, and three letters did it. The end result, markets in the US fell 226 points, London saw a rout, and fears grew that markets may have peaked.
First there was Countrywide, the largest US mortgage lender, saying it won’t be until 2009 before the US housing market starts seeing growth again. The giant lender had announced a 33 per cent drop in Q2 profits, and it seemed like the company was trying to get all the bad news out of the way in one go. Its boss compared the US housing market to a warship and said, “It just takes a long time to turn a battleship around.” He added that his gut feel told him it would take “the balance of this year to get this thing to look like it’s slowing down (and) 2009 to head into the other direction.”
Then there was JP Morgan and those three letters. CDOs, or collateralized debt obligations, have been a key financial instrument of the last few years. They are a little like those complete meals you can pick up in Tesco. Just like the Tesco product they re-package different products and combine them into one. But whereas Tesco might combine potatoes, beef and a couple of vegetables, CDOs will combine different types of debt, investment grade debt, for example, or perhaps high yielding bonds.
It’s a market that has enjoyed outstanding growth. According to the Securities Industry and Financial Markets Association, aggregate global CDO issuance totalled USD $157 billion in 2004, USD $249 billion in 2005, and USD $489 billion in 2006.
But yesterday came news from JP Morgan that CDOs seem to be coming out of fashion fast. In June $50.6 billion worth of CDOs were sold, but apparently so far this month sales have reached a mere $19.9 billion.
Now analysts are panicking that the banks will find themselves with debt on their hands that they don’t want. Instead of selling the debt on, reducing their exposure, they are suddenly finding that they have got to take responsibility for their own lending, and suffer the full consequences if some of their loans go bad. They won’t like that, and it’s feared lending could plummet as a result.
Finally, there’s Bill Gross. Mr Gross is one the great gurus of US investing. He is the manager of the $103.1 billion PIMCO Total Return Bond Fund. Earlier this year he called the top of the bond market, and it was his words that initially sparked off the fall in the price of bonds.
Yesterday his wise words had the market running for cover.
This is what he told CBS: “There’s no doubt this recent upward movement in yields justifies a 5-10 per cent correction in stock markets.”
Mr Gross cited the private equity buy-out of Chrysler from the Daimler Chrysler Group. It’s being bought by Cerberus Capital Management. Mr Gross says that he has heard the private equity company is being forced to pay out debt equating to a 9 per cent interest rate, and even higher for parts of the debt whereas, when the deal was first agreed, it was expecting to offer interest payments of around 7.5 per cent.
Mr Gross said “So times have changed in a period of two months. At the same time, investors have focused on sub-prime markets. But they haven’t really seemed to notice the dramatic move in high-yield markets#133;.Investors have basically been the willing servants of private equity and hedge-fund managers who are willing to take advantage of them#133; but investors no longer trust the rating services to adequately and fairly rate the bonds they’re buying#133;. basically, bond buyers have become frozen in place.”
So, what does all this mean? It would appear that the rise in yields witnessed over the last few months, initially caused perhaps by the US sub-prime crisis which saw the collapse of mortgage lender New Century and the near collapse of two Bears Stearns’ funds, is spilling over.
The last few years’ cheap credit hasn’t just propped up house prices, it has funded the mergers and acquisitions boom. And now, it would appear, the show is close to ending.
But, it may be worth putting this into perspective. Considering Mr Gross’s comments, even a 10 per cent fall on the Dow would merely see the index return to the level seen at the end of March. A five per cent fall, and the index would fall to the level seen at the end of April.
And while the FTSE also fell sharply yesterday, no one is yet calling the peak in the London markets.
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