Sunday, September 28, 2008 0 comments ++[ CLICK TO COMMENT ]++

Financial Equityholders Started Sufferring First...Bondholders Likely To Be Next

There are some dark clouds gathering in the debt markets. The clouds have been building for a while now but the final fate may be near. The storms will be threatening...

So far, the losers in the credit crisis that was started by the subprime virus have been shareholders. Many have suffered monumental losses, including yours truly, not to mention such illustrious ones as Hank Greenberg of AIG, who lost almost his entire net-worth of $3 billion. Not complaining here; it's the nature of markets and there is a reason we invest in equity.

Bondholders of financials, in contrast, have sailed smoothly, albeit in rocky seas, for the most part. However, that is in the process of changing and it will have massive ramifications for the investing world. Credit markets--the bond prices, as well as CDS on those bonds--have been signalling losses but it never really happened on a large scale until recently. The collapse of Lehman Brothers was perhaps the first sign that bondholders are at real risk of loss (do note that companies go bankrupt literally every week, with bondholders taking huge losses, but I'm talking about large scale losses.) However, the real big historic loss would be from Washington Mutual. It looks like bondholders of Washington Mutual will end up losing everything.

If bonds of financial companies start defaulting, it will have two big effects. It will weaken confidence in an already-doubtful marketplace. This essentially means cost of debt financing will increase. It's also not clear who owns these bonds. I think foreign central banks are primarily invested in low-risk bonds of the US government or its agencies (eg. Fannie Mae, Freddie Mac, Farmer Mac, etc.) So these bonds are likely owned by retail investors, mutual funds, hedge funds, or corporations. Some of these entities may start posting big losses on bonds of financial firms (default rates are also projected to increase for other industries but I don't see similar damage as with financials.)

The other result is that there is likely to be huge CDS payments for the defaulted bonds. Since financial companies often had high ratings, it would not surprise me if the CDS contracts were underpriced (think of what the monoline bond insurers did with mortgage bonds and replace it with corporate bonds of banks.) This could rock the CDS marketplace. There was some concern after Lehman Brothers went down but I suspect very few would have considered an investment bank to be as safe as a commercial bank.

To me, it is almost inevitable that bondholders would take losses. So far, the government has bailed out some key players (Bear Stearns, AIG, Fannie and Freddie) but if more banks fail--some expect a great number of regional bank failures--then the government may not be able to bail out all the bondholders. Some commentators such as John Hussman argue that bondholders should not be bailed out (read the portion in the middle). It is not only prudent but it seems inevitable in my eyes. The core problem is not simply that there are real estate losses; rather, most of the firms in question have high leverage. Once the equity is wiped out, bondholders will have to pay the price--unless the government bails them out.

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