Goodbye risk, hello volatility

Call it a 'reality check', a 'warning shot', a 'pull back' '¦ call it whatever you want: The markets are bracing for a correction. Earlier today the ASX fell 2.8% after an overnight drop of 2.3% on the Dow. And it's clear we're in for a rocky ride over the new few weeks as investors re-rate risk and a predictable flight to quality assets gets under way.

How rocky that ride will be become will depend firstly on how the troubles in the US credit markets play out – particularly whether the weakness in housing-related CDO (Collateralised Debt Obligation) markets spill across to the corporate debt market – a development that would immediately hamstring merger and acquisition activity, which has been driving equity markets higher for many months.

Analysts are split over how hard the global sharemarket will be hit by ruction in the credit market; economist Gerard Minack argues that at the very least the crisis means 'supportive flows' for takeovers will dry up (To read Minack click here).

Nigel Douglas, a senior analyst at Van Eyk Fixed Interest is a 'man in the middle' of these related events. As a key executive at the ratings group he has been in the thick of our local hedge fund crisis with Van Eyk, a rating agency consultant in Basis Capital and Absolute Capital.

Douglas says Van Eyk blew the whistle on Basis Capital last year. He also says the ratings group had 'concerns' over liquidity levels at Absolute Capital the second hedge fund to freeze redemptions in the Australian market.

According to Douglas, the pullback in the credit markets over the past fortnight, and the associated drop in US and now Australian stockmarkets, is the beginning of a predictable correction that has been building all year.

Will it get worse? Douglas says investors should be reassured by the absence of defaults in the corporate credit market the market where risk of contagion from the US housing debt crisis is at its most acute. He is also comfortable the markets can accommodate this correction. As he suggests, it may well be positive for pricing risk in the future after a period of 'excessive bullishness'.

The interview

Michael Pascoe: You downgraded Basis Capital more than a year ago but Van Eyk still got caught with a little bit of it. How did that happen?

Nigel Douglas: Well, there was a regulated exit to the fund. We actually did downgrade it in May 2006 and the fund had regulations on the speed of exit and that’s really '¦ we were left with a residual holding over a year later.

So you were within a month of having none?

Exactly.

Your job of rating both Basis Capital and Absolute Capital meant neither of them was investment grade. Why not?

Well it’s really several factors. Primarily we adopt a very rigorous process – people process and business management for all funds – that we analyse and rate, and these two funds already failed the grade. Basis had become riskier in the sort of CDOs in which it was investing. Its level of disclosure was below standard. We need very high levels of disclosure for these types of investments and key-person risk could actually increase in the fund and there’d been people turnover.

So the Basis Capital in trouble is not the Basis that you originally rated and invested in?

They changed their investment strategy to become more aggressive, investing in low-grade tranches, equity tranches. Those are the higher return / higher volatile tranches, so we took that into account in coming out with the rating.

But Van Eyk’s fund of funds, Blueprints, still got left with some Basis Capital. How much?

Overall in terms of the fund, which is over a billion dollars, it’s very close to zero and in the alternative fund, which is a unit of that fund, it’s just under 1%. So very small numbers indeed.

But where does Absolute Capital fit in?

Absolute Capital is a more conservative investment. They’re not leveraged like Basis. They invest in less risky tranches and different types of CDOs in structured credit, but we’ve had concerns about the organisation for different reasons and that fund has always been B rated. We have been concerned about the liquidity in that fund and just recently they have announced temporary closure of the fund, given the stresses we’ve seen in the market, so that’s really confirmed our original views on that fund.

So Van Eyk took a dim view of CDOs and funds that invest in CDOs, more than a year ago. Why?

Overall we saw CDOs'¦ it’s a good technology in the sense it out [reallocates] credit risk in the sense that interest rates [falsely] allocate interest rate risk, but we saw them being used at this stage of the market cycle, the credit cycle, as a form of leveraged investment and that’s very negative when combined with funds that are relaxing their constraints on their investing and that comment really more relates to Basis than to Absolute.

Do CDOs have a role in super funds?

It depends on the type of CDO that we’re talking about. What we did see was CDOs coming out that were very highly leveraged. CDO squared, CDO cubed. There’s all types of CDOs, and they do have a role; however we only think because of the losses to principal that can occur, we think that investors need to be fully aware of those risks. It’s not a set and forget investment.

Where do you think credit markets are going next? There’s certainly plenty of turmoil.

Well just going back to our original reason to downgrade the funds. We saw that Basis was a fund you shouldn’t invest in and we said that at the time when you thought there were going to be periods of credit stress – and basically we’ve seen a big bull market in credit since 2001 and the market had got very over-extended – so what we’re seeing now is a pull back that was quite foreseeable.

The problems really came from clearly a deterioration in credit quality in the US housing sector, which was rolling over the same way the housing sector had rolled over in other countries such as Australia. So we do think this was foreseeable and some correction in credit markets was going to occur and CDOs were likely to be hit given they were leveraged into that situation.

Now we’re not totally negative on the situation now because the global economy’s pretty healthy. Inflation’s still low. Interest rates are rising, but gradually, and company balance sheets are still in pretty good shape. There is leveraging occurring through leveraged buyout transactions and they have been hit right now by this fall out in the credit derivatives market, but we do think that confidence is likely to be restored and there may be a tentative recovery. Longer term, credit spreads were likely to be in a rising trend but that’s going to require increases in company defaults which are now at historically extremely low levels. So to see that happen we would need to see the global economy weaken significantly in terms of growth and interest rates rise significantly.

And there’s no sign of major company defaults yet, are there?

No. I mean we haven’t seen mainstream corporate company defaults occurring globally. This year there’s hardly any that have occurred this year. The default rate’s around 1% historically in high yield. They seem to average around 4–5% so if we say there’s going to be a mean reverse in the future we’d expect defaults to rise and credit spreads to widen. Everyone’s been anticipating that. They’ve been forecasting it for the past three years and it hasn’t happened and when it does happen we would expect the credit squeeze to widen. So this is a reminder to people or a reality check, I think I heard someone describe it as, for the credit market which has really got excessively bullish.

So this could actually be a healthy thing without doing any real damage to the economy or to underlying corporate health. There is a warning shot here about remembering to price in risk?

Yes it could be a healthy thing because there have been lenders out there and hedge funds involved in assets that are essentially where credit quality has slipped and they haven’t really priced the risk properly. So this will force banks and other organisations to more properly assess risk on a longer-term basis and hopefully that is going to be positive for pricing risk in the future.