Serial crunching
Credit problems refuse to go away


Nov 22nd 2007 From The Economist print edition

NO LONGER can the credit crunch be dismissed as a blip or an isolated phenomenon. Every other financial wobble since 2003 has lasted just a few weeks. This time, even two rate cuts by the Federal Reserve have failed to do the trick.

Indeed on some indicators, things now look even worse than they did in August. The desire for safety has driven the yield on ten-year Treasury bonds below 4% for the first time since 2005. The gap between the three-month dollar London Interbank-Offered Rate (which banks use to borrow from each other) and the federal funds rate has reached half a percentage point, higher than it was in the summer. According to Manoj Pradhan of Morgan Stanley, two-year swap spreads, another measure of risk aversion, are significantly higher than they were three months ago.

In part, this gap is based on a belief, bolstered by the minutes of the Fed's recent deliberations, that a weakening economy will force it to cut rates again in December. It also reflects concern that banks have yet more bad news to reveal.

But it is not just the banks. Investors are trying to guess where the credit crunch will have the greatest knock-on effect. George Cooper, a strategist at JPMorgan, says: “It seems quite clear that the credit problem is becoming systemic.” For a while investors thought the credit markets were ignoring the reality of strong economic growth; in fact, that growth was the result of previous credit excesses. Now the economy will have to deal with the consequences of tighter lending standards; the subprime effect is starting to be replicated in car loans and may soon crop up in credit cards.

What is a problem for banks today, Mr Cooper believes, will eventually become a problem for governments, as they are forced to mount rescues (as the Bank of England did with Northern Rock, a battered mortgage firm). Eventually investors will start to worry about the health of government finances.

Another knock-on effect may be felt in hedge funds, which have slipped out of the limelight in recent months. Back in July and August, with the collapse of two Bear Stearns hedge funds, the industry was perceived to be at the heart of the crisis. Industry data, however, suggest that hedge funds have long put the crunch behind them. The average loss in August was only around 2% or so, and funds more than made up for that in September. According to Hedge Fund Research, the average fund returned 3.2% in October, bringing the return for the year so far to 12.3%.

Of course, the hedge-fund industry invests in a wider range of assets than subprime mortgages; most funds are involved in the stockmarket, where conditions have been mostly positive this year (the average emerging-market hedge fund, for example, has returned 26.6%). But even those funds that specialise in fixed income have not been slaughtered; according to Hedge Fund Research, the average 2007 return, at the end of October, was 3.3%.

But do these figures represent the true scale of the problem? After all, every week seems to bring news of a write-down of assets at a leading financial firm: among the latest is Swiss Re, the reinsurance giant. Surely, some hedge funds have made similar mistakes.

It is hard to tell. The suspicion is that some credit-related funds have been valuing their assets on the basis of prices derived from models, rather than real markets. “The mathematical models people have been using to value credit derivatives have been very naive,” says Paul Wilmott, a financial consultant. The bad news may not be revealed until the positions have to be sold.

When might that be? One prominent investor is worried about the outlook for December, on the grounds that hedge funds will then have to meet the redemption demands put in by clients back in August and September (many hedge funds have three-month notice periods for those seeking to get back their money).

The danger is that the crunch may be aggravated if hedge funds are forced to sell assets into an illiquid market at fire-sale prices. If funds then do have to mark down their portfolios further, that could trigger a further wave of redemptions. “There will be probably be funds that will not survive the recent market volatility. Those with mediocre records will be more harshly dealt with by investors,” says Gunner Burkhart of Lehman Brothers.

Do not overestimate the damage. Plenty of hedge funds are immune to the credit crunch and a few have profited handsomely out of it. On the other hand, do not assume they have all been clever enough to trade their way around it. Some may simply have been cleverer at hiding their losses.