Subprime woes: The butterfly market

Chaos theory imperils a mega-billion-dollar deal.

Edward Lorenz, a father of chaos theory, famously posited that a butterfly flapping its wings in Brazil could set off a tornado in Texas. But the weather isn’t the only complex system where small causes can have large effects. The currents that carry capital and information through global financial markets are as intricately woven as any. And so a homeowner defaulting in Iowa can derail the largest leveraged buyout the world has ever seen. This is not science fiction, however much investors may wish it were.

The chain goes something like this. It’s 2005, and the Joneses in Des Moines want to buy a house. They’ve got a less-than-perfect credit history (falling into the now-notorious “subprime” space). But their bank is willing, in fact eager, to get them into this new 2/28 ARM mortgage product (where rates are fixed for two years, often at special introductory levels, then float with market rates for the remainder of the loan’s 30 years). The Joneses take the money and buy their home.

The bank then sells the Joneses’ mortgage on to another institution, which packages it up with thousands like it into a mortgage-backed security (MBS). That security may then be offered as is, or further pooled into a collateralized debt obligation (a CDO, which is essentially just a security backed by other securities). Either way, the financial institution pays for a debt rating agency to assign the security a rating (AAA on down), reflecting the default risk of the paper. The rated securities are then sold in chunks to end investors like pension and hedge funds. The Joneses now essentially owe a bit of money to hundreds of different creditors whom they’ll never know, and who will never know them.

Fast-forward two years later. The 2/28 mortgage resets at higher rates, which the Joneses can’t afford to pay. Nor do they necessarily want to, with the busting housing market having wiped out their home equity. They default. Of course, the investors to whom the Joneses’ ultimately owe the money have no idea. But the rating agencies do, and can see that the Joneses aren’t alone. As payments dry up and the value of collateral drops, they downgrade the securities. The investors who bought them take a hit.

Of course, those investors know that some loans do inevitably go bad. Asset management is about risk. But now it looks likemany of these securities carried a lot more risk than rating agencies thought they did, or than the buyers were compensated for. Once bitten, twice shy, those investors get more cautious, demanding greater compensation from borrowers in the form of higher interest rates (more properly, higher spreads above risk-free rates)—if indeed they’re willing to lend to less-than-perfect credits at all.

Private equity generally specializes in turning companies into less-than-perfect credits. PE firms look to load under-levered companies up with debt, to enhance returns and motivate management. But the investors they need to buy that debt are the same ones still smarting from their experience with the Joneses (and more importantly with the rating agencies and securitizers), and those lenders aren’t exactly lining up to provide their capital. And without access to the “L” in LBO, takeovers founder.

This is all happening right now. Fed chairman Ben Bernanke said a couple of weeks ago that subprime mortgage losses could reach $100 billion. The same day, rating agency Standard & Poor’s downgraded a further 418 mortgage-backed securities, some of which are trading below 50¢ on the dollar. And reeling investors are looking more suspiciously at credits of all stripes. High-yield debt spreads have widened 150 bps since mid-July, erasing two years of improvement. But investors aren’t biting even at those juicier spreads, reportedly leaving investment banks with about $40 billion in unwanted LBO debt on their books, and nearly $300 billion in further commitments apparently beyond that, including the biggest deal of all: the buyout of a certain Canadian phone company.

Thus does default in Des Moines threaten morass in Montreal—and in Canadian financial markets more generally.