Credit Market Cycles and Investment Implications

“Doubt is not a pleasant condition, but certainty is absurd.” Voltaire

Uncertainty amidst a Credit Crisis

The “R” word is now being mentioned for 2008. Luminaries, such as Alan Greenspan, are now more emphatic that a recession is more likely to occur due to the credit markets’ seizure. The credit crisis has thus far cost Bear Stearns, Citicorp, and Merrill Lynch their CEO’s, forced multiple financial institutions to seek capital contributions, and contributed to the decline in US home prices. We’ll attempt to explain briefly what’s going on here and draw lessons for clients on how to react within a strategic investment framework.

Figure 1

The direct effects of the housing bubble do not necessarily imply a US recession in 2008. Residential construction activity has decreased US real GDP by 1% over the last several quarters. Recent decreases in home values have reduced consumers’ ability to finance consumption. Still, consumption rose at an annualized 3% rate for the 3^rd quarter. While we are concerned that mortgage defaults will rise from resetting adjustable rate mortgages (ARM’s), we note that the potential impact upon consumption from households likely to be affected by future foreclosures is estimated to be only 0.3% of real GDP.1

Despite that, we are concerned about the credit crisis fall-out, the lack of asset pricing transparency and absence of timely valuation disclosures. High inter-bank lending rates demonstrate that banks are reluctant to lend money to each other. Credit spreads, measuring the compensation required for  accepting credit risk, have risen substantially and could climb further in 2008.  While monetary authorities worldwide may work to provide liquidity, banks with impaired capital levels and uncertain outlooks may nevertheless remain reluctant to extend credit.

What’s an Investor to do with Uncertainty All Around?

We answer that question, in part, by framing portfolio management within a long-term strategic context: asset allocations and investment strategies are selected with expected after-tax returns and volatilities to be realized over long horizons. We do not pursue momentum investing, tactical allocation shifts, or, especially, product strategies having poor disclosures and opaque price discovery.

The current environment reinforces our confidence in our core investment philosophies and of the subsidiary managers we employ for our clients.  It also reminds us of the wisdom of a skeptical stance.  We insist that our subsidiary managers: 

• Understand return implications from using leverage.
• Use leverage prudently and only within established long-term strategic limits.
• Carefully control, and if warranted, avoid allocations to securities having inefficient price discovery.   
• Maintain skepticism of high credit ratings for structured products.
• Recognize that some money market and “low” duration debt funds may have substantial credit exposures, resulting possibly in significant and surprising price volatilities.2 
• Seek diversification in credit-sensitive sectors, targeting mostly the higher credit grades within a sector.
• Diversify asset class holdings across broad geographies.     

Credit Cycle Behavior:  Present and Prior Profiles

Credit cycles vary in length and severity and reflect the proverbial “greed” and “fear”, characteristics that describe the extremes in investor risk preferences. As with many forms of human behavior, history repeats itself in the capital markets. During a crisis, investors quickly abandon specific markets but then subsequently return.

Most credit crises manifest themselves in credit premiums3 increasing substantially and in a volatile manner. From May 2007 through November 2007, the yield spread of the Lehman US Corporate High Yield (HY) Index rose from 2.38% to 5.56%. Figure 2 below traces the spreads of different HY credit grades over the last 20 years. Credit premium levels last peaked during the 2001 US recession and did not decline meaningfully until 2003 when US economic growth had resumed.

Figure 2

A byproduct of a credit crisis is the scramble for high quality, liquid debt. This strong preference for low-risk assets results in yields on such paper falling dramatically relative to other debt. From May 2007 through November 2007, intermediate yield spreads over similar maturity Treasuries rose by 45 to 50 bps for composite US AAA debt and by 80 to 90 bps for composite US AA debt.4 This crowding into liquid, shorter-term paper is evidenced by 2-year Treasury yields dropping to 3.00% by the end of November, representing a yield decline of 190 bps from May 2007.

Most credit crises have been precipitated by rising private sector and emerging country defaults. In contrast, this current crisis has some unique characteristics: 

• Corporate credit defaults5 have remained relatively low, although they are projected to increase over 2008.
• Emerging market debt performed well in 2007.6
• Several money market funds7 suffered principal losses and essentially “broke the buck.”
• Structured products (collateralized debt obligations, “CDO’s”), and structured investment vehicles (“SIV’s”) have generated most of the losses reported by financial institutions.
• The majority of credit impairments has involved US-originated debt but numerous non-US investors have suffered extensive losses.
• Hedge funds have become much larger players8 in structured debt and credit-sensitive markets, providing liquidity but also inducing potentially more price volatility.

Mortgage Meltdown: Poor Underwriting, Too Much Leverage, and Asset Price Disconnect

Sub-prime and alternative-A9 mortgages had been originated in large volumes as recently as 2006.10 Sub-prime mortgages are estimated to represent 12% of the present US mortgage market of $10 trillion. Approximately 70% of sub-prime mortgages are held in structured securities. The sub-prime market started to take off substantially in 2004 due to rising home prices, ample liquidity manifested in low funding costs, and relaxed lending standards.

Using cheap funding and rising home prices (prices nearly doubled in the seven years to September 2006), Wall Street ramped up issuance of structured mortgages. Some more recent vintages have experienced the highest past due frequencies. While home prices began to drop in 2006, Wall Street continued to package poorly underwritten mortgages in securities with minimal restraint through mid-2007.

The sub-prime mortgage collapse was triggered by the unwinding in July 2007 of two Bear Stearns leveraged mortgage funds, costing investors $1.6 B in losses. As the Bear Stearns funds suffered redemptions and collateral calls, the falling CDO prices underscored the disconnect between market-based prices and recorded fair book values. CDO pricing is made even more complicated by the presence of multiple tranches.

We expect the mortgage market to suffer further in 2008 as Lehman Brothers projects that 2.8 million mortgages will reset in 2008 with 3.6 million more mortgages resetting during 2009. With falling home prices, some estimate11 that more than 10% of all mortgages have zero or negative equity backing in the related home values.

The capital markets generally allow issuers and investors to interact effectively in allocating risk capital. However, occasionally informational diseconomies result in mis-allocated capital.  Here the rating agencies were in part to blame by assigning too-high ratings to the asset-based commercial paper inssued by SIV’s.

Assessing the Fall-out from the Credit Crisis

It will take time to determine accurately the ultimate losses…and losers…from mortgage holdings. As of mid-December 2007, financial firms had announced over $80 billion in losses from mortgage-related investments. We expect that financial institutions will incur more losses in 2008 and many will be required to raise capital to maintain credit ratings and appropriate risk-based capital ratios. Some of the reported capital raising thus far is shown in the table below.

The capital raised by financial institutions relates both to on-balance sheet and off-balance sheet assets. There had been a push by Citibank, JP Morgan and Bank of America, encouraged by the Treasury Dept. to create a “credit superfund” to take higher quality assets from bank-sponsored SIV’s into an independent funding vehicle. This industry-sponsored initiative ultimately was not consummated as the larger banks assumed direct responsibilities for their SIV holdings by taking such investments directly onto their balance sheets.

Fiscal and Monetary Responses

The Fed moved initially in mid-August to lower the borrowing rate for financial institutions. The Fed subsequently has encouraged banks to borrow over longer periods and has expanded the set of permissible collateral backing borrowings. The Fed acted in December in concert with the Bank of England and the European Central Bank to assure an ample supply of liquidity to international financial markets and to make available US dollar-based assets to overseas investors.

Federal agencies have encouraged Congress to consider legislation or have used moral suasion to have mortgage investors and servicers offer low fixed rates to qualifying homeowners whose ARMs may be resetting over the next several quarters. These targeted homeowners are only a limited subset of ARM holders: mortgages originated over the last two years; borrowers current on payments; and borrowers who are likely to default under higher reset rates.  The Federal Home Loan Banks (FHLB) have stepped into the void and increased their short-term note fundings by approximately $160 billion from August through October 2007. In particular, Countrywide (CFC) borrowed $51 billion through the Atlanta FHLB. Some of the regional FHLBs also have begun to offer longer-term loans, allowing borrowers to defer principal payments for up to 5 years.

Ultimately, federal agencies and Congress will have to decide what levels of moral hazard to accept for past investor behavior. The Fed through its active supply of liquidity in reacting to the 2001 US recession and its concern over declining price levels helped shelter the economy from the dot.com and tech bust and help prevent the evils of disinflation (remember that?). But it also helped supply the liquidity that fueled the explosion of mortgage products. Easy money, low qualification standards, and documentation fraud contributed to overinvestment in the real estate sector. A concern of many market participants is that continuing government intervention in the capital markets to dampen the fall-out from investor speculation and Wall Street origination sins will create similar expectations for government aid in the future. The fear is that similar cycles of excess investment and subsequent government action could create one-sided call options for investors and originators, who are then incented to assume more risk against expectations that the Federal Reserve or the federal government will come to the rescue. Imprudent risk-taking and successive asset bubbles would likely result.

Rich Palmer, Los Angeles