Gearing up for ever higher leverage

Rising leverage in the global system coupled with fears for the accuracy of credit risk pricing dominated discussion at the World Economic Forum in Davos this year. But not everyone is downbeat, as Matthew Attwood finds out

Central banks and regulators are looking at the global credit markets and they do not like what they see. Spreads are unintelligibly low, there are high and opaque levels of leverage, and the unstoppable growth in derivatives and structured credit has distorted perceptions of risk and an understanding of where it now lies.

"There is now such creativity of new and sophisticated financial instruments ... that we don't know fully where the risks are located," said president of the European Central Bank, Jean-Claude Trichet, speaking at the World Economic Forum in Davos in January. "We are trying to understand what is going on but it is a big, big challenge."

Trichet's concerns, and those of other central bankers at Davos, where credit risk took centre stage, echoed another warning issued by the UK's Financial Services Authority. "Financial markets have become increasingly complex in recent years, which implies that transmission mechanisms for shocks have also become more complicated," notes its Financial Risk Outlook for 2007.

Correlations between asset price movements and investment strategies have risen, increasing the inaccuracy of risk management models and changing the valuation of financial instruments that factor correlation risk into their pricing models. "The combination of low volatility, high correlation and a historically low level of risk premia brings an inherently high likelihood of a major shock, especially if an event were to occur that triggered a significant deterioration in market sentiment."

So should credit investors be worried? It's not unusual for central bankers and regulators to sound the warning bell about market risk and leverage; it's their job. But how justified do these fears sound to the experts who build, rate and invest in complex credit risk products?

Poorly rewarded

Central to the discussion is the phenomenon of low risk premia: many believe that spreads are unnaturally low, and are not sufficiently rewarding investors for the credit risk they're taking on. Global high-yield spreads, for example, were at a new low in January 2007, at 267 basis points, says Deutsche Bank. During the height of the telecoms crisis in 2002, when the high-yield default rate was in double figures, spreads reached a high of 1,132. But does this mean risk is being mispriced? Not necessarily.

The fact is that default rates remain stubbornly low: at 0.54% in 2006 for all corporate issuers, according to Moody's, and 1.57% for high yield - the fifth consecutive annual decline in that sector. The technical bid from the insatiable demands of structured credit is keeping spreads tight.

"The market would certainly be under pressure if defaults reached 5%, but at the moment banks are flush with cash and want to lend: recovery rates are going up, not down," says Tim Frost, a director at London hedge fund Cairn Capital.

"Defaults are where they are because there is a lot of money chasing opportunities to lend: banks are happy to waive loan covenants and inject cash into struggling companies."

Jonathan Laredo, a partner at another credit specialist hedge fund in London, Solent Capital, says it's all about liquidity and the low cost of borrowing. "The real issue is the amount of liquidity in the market, not leverage," says Laredo. "The credit markets are expanding because people want to buy assets, and people want to buy assets because money is cheap. If the ECB is concerned about leverage, all it has to do is make money more expensive, in the same way that the Federal Reserve has intervened to make dollar borrowing more expensive. One can see the effect that has had on the speculative bubble in the US housing market."

One concern is that the record tight spreads, against a background of seemingly low risk, are pushing investors into increasingly leveraged products in order to see some return. "Until systemic risk rises, leverage will increase as no one wants to buy a single-A credit at 10 basis points over when they could earn 70 to 170 basis points from a collateralised debt obligation," says Laredo.

That means there are more investors who may not understand the risks associated with derivatives and structured credit now holding those assets.

"Low default rates have contributed to huge demand for leveraged assets, but there are concerns that a minority of investors may not be aware of those assets' true risk profile. Some may be attracted to yield without fully thinking about risk," says Richard Barnes, a credit analyst at Standard & Poor's in London and author of Outlook for Banks' Leveraged Finance Revenues and Risks. "One of our focuses for this year is to improve understanding of how leveraged finance risk is dispersed and managed. Credit fundamentals won't remain at current levels, and recent trends in leverage ratios and covenant breaches point to problems ahead."

There are also indications that banks are not going out of their way to educate investors about the risks of complex products and give them the right information for them to perform adequate risk analysis. "When I look to buy specific tranches of CDOs (collateralised debt obligations), dealers do not speak about the underlying credits in the portfolio; they only enquire about my return target," says Jim Kauffmann, head of fixed income at ING Investment Management in Atlanta.

"The prevailing view is that with varying degrees of leverage, any return target can be met," he adds. "This behaviour will continue until a few defaults wipe out the equity and subordinated tranches of a number of deals. At that point you will see a fundamental repricing of credit risk."

With the right amount of credit analysis, and due attention to risk management, however, leverage is not a problem per se. "Leverage in itself is not new," says Peter Meijer, co-head of JPMorgan's CDO structuring team in London. "Any corporation or private individual is leveraged, with people choosing the point in the capital structure they want to inhabit."

Equity tranches are more risky than mezzanine and senior debt, but the trade-off - 15% to 20% returns - is good if the investment is driven by the right economic decision, he says. "Investors taking that approach should have confidence in the underlying companies. If you like the default risk, go for equity. At the higher end of the capital structure, investors need to take a view on spread risk. If you want to take advantage of a temporary arbitrage, you need to look at the technicals and have a full entry and exit strategy. For a good credit investment, you need to do the same, as well as keeping an eye on the fundamentals."

In addition to doing the requisite research, investors must stress-test portfolios - and not just to the levels of the current rosy default environment, says David Lofts, head of high yield and special situations sales at Royal Bank of Scotland in London. "As long as investors stress-test their portfolios, the risks resulting from increasing leverage levels can be better understood, analysed and controlled. They must ensure that their stress test scenarios are realistic and not just coloured by current low default rates. Stress tests should go to 6% default territory, not just the 0% to 2% we have seen in the last couple of years," he says.

CDOs: The next generation

One cause for optimism about the structured credit market may lie in the new wave of CDOs. Although they do have higher levels of leverage than previous structures, they may still prove less risky, argue some investors.

For example, there is a clear trend in CDOs away from default exposure towards market value: the biggest indication of that being the expansion of the leveraged super senior sector over the past two years. "This trend is consistent with new products such as constant proportion debt obligations (CPDOs), where the index roll mechanic all but limits default exposure and creates an exposure akin to total return product," says Brent Canada, senior strategist at Barclays Global Investors in San Francisco. "Clearly both of these products are highly leveraged, but I would argue that CPDOs are less exposed to default than traditional CDOs."

Canada is not alone in pointing to the importance of the shift from static synthetic CDOs to managed synthetic CDOs. Managers optimise the structural integrity of a deal, focusing on loss avoidance and rating stability, which makes leverage more acceptable than in the static sector, where dealers maximise arbitrage potential.

The question is what will happen to all these products when the market turns. The likely result, says Canada, will be the tiering of transactions. "The old assumption that one triple-A CDO is equivalent to another will not hold. If there is a significant turn in the credit cycle, I expect static synthetic CDOs to be the first to be downgraded. From there, managed products may also be affected, but the extent of this will rely heavily on the skill of the manager and the structure and strategy employed."

Some believe that the degree of leverage in the system means that contagion is almost inevitable. "If it all blows, there is only so much that fund managers can do, as all asset classes are affected," says Karl Bergqwist, head of credit research at Gartmore Investment Management.

The average European corporate used to have a single- or double-A rating, but now the norm is triple-B. Consequently there is more leverage in the kind of companies in which structured vehicles take on leveraged exposure, with hedge funds investing in the equity tranches.

"No one has a handle on the amount of leverage that exists," says Bergqwist. "If rising volatility precipitates a forced unwind, widening spreads could trigger events in products outside the structured arena and a hedge fund could fail as a result. The fundamental problem is the amount of cheap money bidding up prices in search of yield combined with a blase attitude to risk caused by record low levels of volatility in both credit and equity."

Tipping point

Some believe investor enthusiasm unalloyed with due consideration of risk could even provoke a turn in the cycle. They point to the late 1990s, when technology companies and competitive local exchange carriers (CLECs) issued debt in the US.

"Default cycles are started when companies that should either not be funded at all or, if funded, should be done so by venture capital firms, are allowed access to the corporate bond market. Generally it takes two or three years for these companies to hit the wall," says Kauffmann at ING. "There are a number of factors besides declining nominal GDP that can lead to a turning of the credit cycle. Marginal deals in the form of risky capital structures, excessive prices paid for acquisition targets and companies that should properly seek equity financing electing to tap the debt market are three common causes."

The unknown factor is that markets now have a very different structure than the last time there was a credit risk crisis, not least because of the growth of credit derivatives and market leverage. While this unknown quantity is undoubtedly a cause for concern, it could also mitigate contagion.

Optimists point to the example of the limited fallout from the collapse of hedge fund Amaranth, which lost $6 billion from trading natural gas last year. "There was no question of systemic risk because credit risk management had significantly improved," says Sunil Hirani, co-founder of New York brokerage Creditex.

That was very different to the wake of 1998's Long-Term Capital Management (LTCM) crisis, which required the intervention of the Federal Reserve and a $3.5 billion creditor rescue package.

The argument goes that because derivatives spread risk across a wider range of market participants, losses will be less dramatic, but will be felt across a much more diverse range of investors than before. "Investors are not complacent, but it is possible that structured credit products could lead to a smoothing of the cycle," says one hedge fund manager in London.

Structured credit experts add a word of caution to the risk dispersal argument. While the European credit market is big, the pool of underlying assets is limited, so while risk is dispersed over many structures, many of these reference the same assets.

According to Stefan Bund, a managing director at Derivative Fitch in London: "An investor buying several structured products could be buying an overlap in terms of the underlying credits, so while the impact of a downturn on individual investments might be minimal, it could severely affect the investor's portfolio. Investors must keep a close eye on the composition of each investment."

What's more, models used to assess correlation remain untested in the credit markets. CDOs are essentially a rating agency arbitrage, says Kauffmann at ING. Managers are looking for the highest credit spread per rating, leading to a focus on companies where the rating lags the market view. Once the CDO is structured the rating agencies apply a rating based on their correlation models. "These models are loaded with assumptions like normal distribution of default risk, continuous smooth pricing curves and diversification benefits, some of which will work with interest rate derivatives but are untested in the credit markets, where default risk is binary," says Kauffmann.

It's clear there is little consensus over whether perceptions and understanding of leverage and credit risk are worse or better than ever before. But as one hedge fund manager speculates, perhaps the market's focus on leverage is the wrong issue entirely. "An equally pertinent question to the one being asked about leverage by regulators and central banks is: what happens if spreads continue to tighten?"

That prospect was looking increasingly unlikely as this magazine went to press at the end of February, and global markets turmoil sent credit derivatives spreads hurtling wider. But should that prove to be a temporary blip: continuing spread tightening would bring other challenges that are less well understood, cautions this anonymous hedge fund executive. "As with the spectre of deflation a few years ago, we spent decades worrying about a possible resurgence of inflation only to realise we were in a deflationary environment."