Our Thoughts on the Recent Market Volatility
It is impossible to watch the news, read the paper or listen to the radio without some discussion on the collapsing real estate and sub-prime lending markets. More importantly, in the past few weeks you can barely open the paper and not read about the stock market moving triple digits that day. How volatile have the financial markets been? The Dow Industrial average has moved over 100 points twelve out of the past fifteen days. The Dow has moved over 200 points eight days in the past month. And there is an entire category of mortgage backed bonds that you can’t even get a price on because no one is willing to touch them.
So what is driving this? The answer is uncertain debt backed by uncertain assets. However, we feel that the majority of the market participants are trading more on fear than substance and thus it is important for us to address the fundamentals of how these events will really affect our clients.
The Credit Markets
First and foremost, what is really driving the volatility that we have seen lately (both in stocks and bonds) are credit concerns. While most of these credit concerns revolve around the mortgage market, the real problems are larger in scope. Ultra-low interest rates over the previous few years and massive amounts of global liquidity have led many commercial and retail lenders to greatly relax their credit standards for borrowers. As lenders struggled to maintain their profitability and compete with one another for loan and investment banking business, they have resorted to lending money for more and more speculative purposes. To make matters worse, the structures of these loans have also become more confusing. Ultra-low interest rates have also led buyers of interest baring securities to invest in increasingly speculative issues, seeking yield.
In the mortgage market these lax lending standards can be seen by the explosion of ARM, interest-only, balloon, no equity, etc. loans being underwritten relative to the conventional fixed rate mortgages that we are all used to. In the commercial market, these questionable loans have been used to underwrite such things as leveraged buyouts, share buybacks and to leverage up hedge fund portfolios.
It is important to understand that the credit market is much larger than the equity market. While there may only be around ten thousand stocks actively traded in this country, there are infinitely more bonds issued and held at any given time. And while many of these bonds are direct debt of the issuer, the largest percentage of these bonds are pass-through instruments that are actually backed by pools of smaller loans such as mortgages.
With over $5 trillion worth of mortgage bonds outstanding, the mortgage bond market today is a complex ecosystem of issuers, each with different characteristics and financial structures. At the top of the heap are Agency MBS, bonds guaranteed by a government-sponsored enterprise such as Fannie Mae or Freddie Mac. These securities offer outstanding liquidity, relative predictability and as a result, low yields. At the opposite end of the spectrum are Non Agency MBS and ABS, bonds with no guarantee other than the creditworthiness of the loans that comprise them, and any structural credit protection provided by the terms of the bond itself. These securities are less liquid and less predictable.
If you’ve ever wondered where all the money comes from to fund the housing market, it is the bond market. Home owners don’t actually owe money to the bank they originated their loan from. They really owe the money to the bond holders of the pool that their mortgage was sold into. The same holds true for most auto loans and even credit card debt.
With much of this MBS and ABS debt trading with shaky collateral backing it, it was only a matter of time before the underpinnings began to erode. The catalyst for the collapsing collateral has been twofold. First was the steep rise in interest rates that we saw earlier this year and second was the real estate bubble bursting in the priciest markets in the country.
On the interest rate front, the yield on the benchmark ten year Treasury bond rose dramatically at the beginning of this year. As the yield curve steepened and rates went up, many of those speculative loans’ rates reset higher. Combine this with a topping out of the real estate market and borrowers were stuck with the higher payments and no way out. Eventually the defaults began to mount. As the defaults mounted so did the concerns. As the concerns mounted the market for this sub-prime debt evaporated and prices dropped precipitously.
This has led to a cascade of events that has driven the incredibly high level of volatility that we’re now seeing. At first hedge funds that held much of this high yield debt were forced to liquidate their positions at huge losses. Some big funds found themselves illiquid when the value of their investments dropped below their debt level. The resulting margin calls shut them down. Their lenders were then stuck with the bad debt and so on.
One of the more interesting characteristics of bonds is that because they don’t actively trade over an exchange like stocks do, their quoted price is only an estimate as opposed to an actual bid. This works fine in a normal market for normal bonds but it doesn’t work well in this environment for high yield debt. This has added greatly to the already nervous financial markets because no one actually knows what these securities are worth. This is the real key. In recent weeks the models that have been used to price these securities have been proven wrong. This lack of transparency means that no one knows what the paper is worth. No one knows what the derivatives supporting this paper are worth and no one knows what the collateral backing this debt is worth.
This has been obvious to the funds that have tried to unwind their positions recently and un-lever their portfolios. What they have found is that these bonds that they’ve been holding on the books at 80 are really selling for 20. This has forced everyone to take a hard look at their portfolios. The word on the street now is that there are a lot of financial institutions out there that really don’t know what they own. There are surely other financial institutions hiding substantial sub-prime losses.
The feeling now is that no one knows were the risk is. It’s like these financial institutions are in the middle of a mine field and everyone is afraid to move. There is plenty of liquidity in the financial markets but no one wants to commit it. This is where the broader problem is coming from and is driving the losses in the whole market place. Companies, consumers, and home owners depend on credit. That credit supply has evaporated literally overnight. Firms that have been negotiating the buy or sale of businesses are now uncertain as to how much the financing is going to cost them. Stock tender offers are being repriced because of the cost of capital. Hedge funds that depend on lines of credit to manage their portfolios are finding themselves cut off.
This week we’ve learned that much of this debt is held by international banks. Apparently, one of our major exports recently has been sub-prime debt. The fallout intensified yesterday when BHP Paribas froze three investment funds once worth a combined 2.17 billion dollars because of losses related to U.S. housing loans. This sent short-term rates higher in Europe and around the world. Central banks have now started aggressively injecting cash into money markets to bring rates back down. The Fed also announced that it would enter into repurchase agreements worth almost $70b specifically targeted at mortgages.
The broader fear is that the credit markets will shut down for everyone. Central banks can partially control this contagion by making credit easier (i.e. lower short-term rates). However, Central bankers have generally felt lenders had become complacent about risk, and a return to more-normal standards would be healthy. ECB President Jean-Claude Trichet on Aug. 2 described market gyrations as a "normalization of the assessment and pricing of risks." And Bank of England Gov. Mervyn King this week said, "Interest rates aren't a policy instrument to protect unwise lenders from the consequences of their unwise decisions".
Yesterday's developments, however, underscored the worry that markets may rapidly go from being excessively lax with lending to excessively tight. Until yesterday, lenders were primarily avoiding borrowers whose ability to repay was clearly questionable, such as sub-prime borrowers. The new development consists of signs that market participants may be hesitating to lend to each other because they don't know where the losses are going to be. The balancing act that central bankers must now walk is to insulate credit worthy lenders and borrowers from tight credit conditions while at the same time letting the market forces punish the “unwise”.
The effect on the equity market has been wide spread. The Dow Industrial average has been down as much as 1000 points. Year to date gains in all the major averages have been cut at least in half. As imagined, the financial sector has born the brunt of this decline. Here is a brief list of the casualties:
Sub-Prime Mortgage Lenders - Many have already become insolvent. Source of capital to lend has all but gone away. Many debt holders are now seeking recourse against the loan originators.
Traditional Mortgage Lenders - No one wants to touch anything with the term “mortgage” in it. Countrywide announced that it is experiencing an “unprecedented disruption” in the availability of credit.
Commercial Banks - Almost all commercial banks hold sub-prime debt in their own portfolios. No one knows the degree that these securities will begin to default. No buyers of this debt means they’re stuck with it for a while.
Investment Banks - In addition to holding this debt directly on their trading desk, these firms run many of the hedge funds in question. The hedge fund collapses are just beginning. No one knows where the end is.
Insurance Co. - Same as the commercial banks. Although their investment portfolios are more diverse and thus have a lower overall percentage exposure to the sub-prime market.
Non-Financial Related Firms - Tight credit is hampering business activity, M&A deals and other capital structure reorganizations.
The Bottom Line
While there is no doubt that these events are serious, it is important to realize that as in all crises’, this too shall pass. The long-term implications are clearly for the good. What we are witnessing is the market place cleaning house. Just as in the Japanese Banking crisis in the 80’s or the collapse of Long Term Capital, major events force others to take a hard look at their own business practices. This scrutiny always results in better and healthier markets. When inefficiencies and irresponsible activities are allowed to continue, the problems become systemic and far reaching. This is why the Fed will not, nor should they, move to bailout the sub-prime mortgage and bond business. If the stock market is higher simply because hedge funds bid it up using leverage then it should not have traded at those levels and will eventually come down to its appropriate long-term value.
The backdrop to this news is that earnings continue to be strong, employment is strong, inflation is well contained, interest rates remain low and GDP is healthy. For these reasons we believe stock prices will finish the year in fine shape. However, as the worries compound in the credit markets over the coming months, as we’re sure they will, expect to see continued volatility across all markets. In the mean time there are some enticing investment opportunities in the financial sector as “the baby is thrown out with the bathwater”. For example, the income potential we’re now seeing is very compelling with dividend yields on many banks in the 4.5 – 5% range. In the alternative fixed income area we’re now seeing yields well above 8%. Finally investors are being paid for their risk.
At Alder Financial we believe that a disciplined investment strategy will allow our clients to capitalize on the long-term opportunities that these volatile times can present. One reason that we have always believed a portfolio’s cash flow is important is because it allows the investor to continue profiting while riding out the inevitable periodic corrections.
