Bear Stears catches subprime cough, Australian corporate bonds get a cold

Over the past few months, we’ve attempted to share with you plenty of facts and perspectives surrounding what we feared could be the interplay between U.S. subprime mortgages and the broader corporate debt market. The constant focus on this stuff might have been a trifle boring to our equity friends, but as you saw yesterday, the equity market cares what is afoot in the debt market.

Here are some excerpts from our post “US mortgage liquidity crisis at hand“, March 14, 2007:

According to the CEO of Countrywide Financial Corp., the problems in the subprime market have already started to spill over into the mainstream mortgage sector.

There is a warning in this retail subprime mortgage episode for corporate borrowers, however. For those would-be borrowers that are turning to private debt funds (or hedge funds playing the lender role) that rely on substantial amounts of leverage from third party banks, watch out. If those banks (primarily U.S.-based) that specialize in lending to finance companies begin to cut back on the credit they provide to your prospective lender, which in turn provided that credit to your company (backed by a bit of their own equity), you can imagine how fast your credit facility will get called in that scenario.

Never hurts to do due diligence on anybody whose financials are private, just as your lender does on you. And if you think the liquidity crisis in a sector of a foreign economy unrelated to your business won’t effect your business, just ask CIBC’s shareholders how distant it all is: the Commerce’s (CM-TSX) market cap shed $350 million yesterday alone. Their exposure to US subprime? Rounding error. But trouble in the credit markets causes tightening at the rest of the sector as well, and earnings can’t grow if credit doesn’t continue to flow/grow at the chartered banks.

And here is the Bloomberg story, confirming the fears:

Australian Corporate Bond Risk Rises on Bear Stearns Concerns

By Laura Cochrane

June 26 (Bloomberg) — The perceived risk of owning Australian dollar corporate bonds rose as losses at two hedge funds run by Bear Stearns Cos. raised concerns that the creditworthiness of other U.S. securities firms which sell debt in Australia may be hurt.

Credit-default swaps based on $10 million of debt in the iTraxx Australia Series 7 Index of 25 companies rose $330 to a six-week high of $27,000 at 2 p.m. in Sydney, according to ABN Amro Holding NV. An increase in the five-year contracts, used to speculate on the ability of bond sellers to repay debt, typically suggests deteriorating credit quality.

Australian-dollar bonds sold by U.S. securities firms account for more than 12 percent of outstanding corporate debt in Australia, according to National Australia Bank Ltd. Investors are concerned a near-collapse of two funds of New York-based may be a precursor of losses at other hedge funds and the banks that finance them.

“No one is really sure how much of an impact this will have and whether it will be limited to the Bear Stearns hedge funds or others will fall as well,” said Stuart Gray, portfolio manager at Aberdeen Asset Management PLC, which manages A$1.2 billion ($1.01 billion) of investments.

Bear Stearns, the second-largest U.S. underwriter of mortgage bonds, may put up $1.6 billion to rescue one of its money-losing hedge funds, half as much as it offered last week, according to two people with knowledge of the situation. The firm said June 22 it would assume $3.2 billion of loans to prevent lenders from liquidating assets, after the funds’ bets on collateralized debt obligations backfired.

`Next Wobble’

Investors are looking for the “next wobble” and losses at Bear Stearns reverberated in local markets because investors hold a large amount of Australian dollar-denominated bank debt, said Sarah-Percy Dove, head of credit research at Australia & New Zealand Banking Group in Sydney.

Credit-default swaps based on $10 million of Bear Stearns bonds jumped $8,530 to $56,530 at 2 p.m. in Sydney, according to National Australia Bank.

Credit-default swaps were conceived to protect bondholders against default and pay the buyer face value in exchange for the underlying securities or the cash equivalent should the company fail to keep its debt agreements.

CDOs are pools of bonds, loans, credit-default swaps and even other CDOs that sell notes backed by the payments received on those debts. Sales skyrocketed last year to $560 million, according to estimates from Morgan Stanley.

“If the whole CDO product hits the skids and everybody stops buying, it’s not just Bear Stearns’ earnings that will be affected,” Michael Bush, head of fixed interest credit research in Melbourne, said. “The earning streams of any bank that originates those sorts of deals will also be hit.”

MRM