Investor debts worsen financial market spiral

Lenders issue margin calls, deepening the credit crunch despite falling interest rates.

Go to Original
By tom.petruno@latimes.com

The credit crunch is showing signs of worsening, defying efforts by the Federal Reserve to restore confidence in the financial system.

Bond and stock markets were rocked Thursday by mounting credit woes of hedge funds and other investment firms that bought securities with borrowed money.

Some of those firms now are facing demands by their lenders to put up more capital against the falling value of their investments -- which in some cases are high-quality securities, not the low-quality mortgage debt at the heart of the housing crisis.

Despite the Fed's deep cuts in short-term interest rates in recent months, "what the market is telling you is that there isn't any credit available," said Christopher Whalen, an analyst at Hawthorne-based research firm Institutional Risk Analytics, which analyzes risk for financial firms.

Further strain on borrowers could weaken the already fragile economy.

Late Wednesday, Carlyle Capital Corp., a $21-billion European investment fund that had borrowed heavily to buy high-quality mortgage-backed bonds, said it was unable to satisfy all of the lender demands, known as margin calls, that it received in recent days. The firm, a unit of private-equity firm Carlyle Group, said one lender had served it with a notice of default.

Another home-loan investor, Santa Fe, N.M.-based Thornburg Mortgage Inc., also said it couldn't meet margin calls. Its shares plunged $1.75 to $1.65 on worries that it might file for bankruptcy protection from creditors.

Fear of spreading margin calls hammered shares of other mortgage investment companies that had survived the industry shakeout of the last year. Annaly Capital Management in New York dived $3.47 to $15.81; Santa Monica-based Anworth Mortgage Asset Corp. sank $2.62 to $6.23.

Wall Street, facing another round of turmoil rooted in the housing market debacle, drove share prices down across the board. The Dow Jones industrial average tumbled 214.60 points, or 1.8%, to 12,040.39, its lowest since Jan. 22.

What has unnerved some investors is that the margin calls this week have stemmed in part from a drop in the prices of mortgage bonds issued by Freddie Mac and Fannie Mae, the two government-sponsored home loan finance giants.

As mortgage defaults continue to surge, investors' concerns about the financial health of the two companies have been evident in the deep declines in their stock prices. Shares of Fannie plummeted $2.57 to $21.70 on Thursday and are down 22% for the week; Freddie's shares slid $1.50 to $20.14 on Thursday and are down 20% for the week.

Some investors also have been dumping the companies' bonds despite their top-rank credit ratings. That has pushed down prices of the bonds and boosted their yields.

The falling value of the bonds has in turn triggered margin calls by nervous lenders who financed investment funds' purchases of the securities. The funds used leverage to juice their bets, but in a falling market that debt magnifies the funds' losses.

"The whole leverage game is unwinding," Whalen of Institutional Risk Analytics said.

As lenders pull back, they are fueling a vicious circle: Leveraged investment funds facing margin calls are forced to dump securities they bought on credit, which further drives down the value of the securities in the market, in turn triggering margin calls against other funds.

For the financial system, "margin calls can metastasize the problem" of credit-market woes, said T.J. Marta, fixed income strategist at RBC Capital Markets in New York.

Last week the normally low-key municipal bond market was upended by margin calls against some hedge funds that had bought the tax-free securities with borrowed money. Forced selling helped to drive yields on long-term muni bonds to their highest levels in nearly six years.

That spike helped to attract new investors, however. The result: Muni yields have edged lower this week, and the state of California's sale of $1.75 billion in general obligation bonds on Monday and Tuesday attracted record demand.

But troubles have persisted this week in other corners of the credit markets. The average yield on an index of 100 corporate junk bonds reached 9.74% on Tuesday, its highest level since 2003.

And in Europe rates have been rising on large loans that banks make to each other.

The three-month LIBOR, or London Interbank Offered Rate, on euro-currency loans was at 4.43% on Thursday, up from 4.39% on Wednesday and the highest since Jan. 17.

Higher LIBOR rates signal continued nervousness among banks about extending credit, analysts said.

Likewise, in the market for so-called credit default swaps -- contracts that allow investors to insure against default on corporate and other debt -- the cost of such insurance has rocketed in recent weeks, indicating investors are more fearful of worse to come.

Although the Federal Reserve's interest-rate cuts so far haven't calmed the credit markets, the central bank has no choice but to keep lowering rates, analysts say.

The Fed is expected to drop its key rate, now 3%, to 2.5% or 2.25% at its March 18 meeting.

"There is plenty of cash in the world, but you can't finance a thing" because investors and lenders remain on edge, said James Kauffman, who manages $80 billion at ING Investment Management in Atlanta. But at some point, he said, paltry short-term rates should give investors more incentive to pump money into higher-yielding long-term assets.