Global Investing

from Funds Hub:

Batten down the hatches

It's fashionable now for leading economists and financial wizards to claim that they saw the credit crunch coming and the kind of dislocation it would create. But how many have predicted where the next implosion will occur?

bad-building1Dr Andrew Lo, founder of hedge fund firm AlphaSimplex, and director of the MIT laboratory for financial engineering, has spent his career studying market behaviour, publishing papers examining why quant funds imploded in August 2007, and trying to reconcile behavioural economics with efficient market theory.

He sees the next big meltdown in commercial mortgages, but this time it's pensions funds that will bear the brunt of the losses rather than banks. Lo points out that commercial mortgages have been packed and sold in the same way as residential mortgages - different levels of risk exposure sliced and diced and wrapped up together in one package with a triple A rating slapped on top.

But commercial mortgage backed securities (CMBS) are facing the same liquidity problems as RMBS following the sub-prime meltdown. When mortgages start to reset at higher rates this year the defaults will pile up and the losses will hit the end-investor - in this case, large pension funds in the US, Europe and Japan, says Lo.

"We are likely to see a number of pension funds having a hard time meeting their liabilities, and the government may have to step in and help out some of these insolvent funds," he says.

Hobson’s choice

Imagine you’re an institutional investor holding a great deal more illiquid, price-impaired assets than you’re comfortable with. Do you a) hold on to them and pray that the price rebounds, or b) sell now and take a loss, before things get even worse?

This is the dilemma facing institutional investors who went just that little bit too far out along the risk curve in search of extra yield. According to Tom Graf, who heads BNY Mellon’s global workout solutions business, clients have to-date largely preferred to wait for markets to rebound, and in some cases this could well make sense.

The workout unit seeks to establish an intrinsic fair value for those assets that have lost their lustre since the sub-prime implosion in 2007. Graf says the illiquid assets most commonly found in institutional portfolios are non-agency “Alt-A” mortgages, which sold like hot cakes during the US property boom. Non-agency means anything not secured through friendly government-backed Fannie Mae and Freddie Mac, whilst Alt-A mortgages require less documentation than traditional loans, allowing borrowers to inflate their income and assets.