Market News

The Third Rewrite

It seems that every time we’ve tried to get our newsletter out this month we’ve had to rewrite it because there has been yet another major event to rattle the markets. Although these events have involved different institutions and markets, they’ve all been rooted in the subprime mortgage crisis that began this summer. If nothing else, these past few months have been an important lesson in the interdependency of the global financial markets. From a broad perspective, the scenario playing out right now looks like this:

The real estate markets soften, putting pressure on property owners who can’t afford the mortgage payments long-term and were hoping to flip their property in the shot-term.
Rising foreclosures and higher interest rates further depress housing prices, making it increasingly difficult for property owners to escape from the high debt load.

More and more people are forced or willing to walk away from their properties, leading to alarmingly high default rates in the mortgage backed bonds that now own these loans.
As the losses mount, bondholders become aware of the disturbingly high number of bad loans wrapped inside their bonds due to appallingly poor underwriting practices that have been prevalent in the mortgage industry for several years.

Unable to ascertain the magnitude of this problem, buyers of private-label mortgage backed bonds or anything associated with them vanish from the market in a matter of weeks. Prices of these securities plummet.

Owners of these securities that have used them to collateralize loans get margin calls as the much lower bond process no longer supports the debt levels. Hedge funds are the first to get hit.

Forced liquidations from margin calls further drive prices of these securities down, creating a cycle of more margin calls.

The Fed, European Central Bank, fund sponsors and money center banks have to step in and act as counterparty for the forced sales of these securities.

Commercial and investment banks make huge write-downs in the value of their portfolios to reflect the lower prices of their own securities as well as the massive amount of capital contributions made to their leveraged subsidiaries.

Shocked by their loss of capital and the known losses of their peers, financial institutions severely cut back on their lending activities, curtailing economic activity.
Additionally, consumers’ lack of available credit further pressures GDP down. Unemployment rises as a result of this slowdown.

The Fed steps in and lowers short-term interest rates hoping to keep the economy from slipping into a recession. The value of the dollar against other currencies drops due to our lower rates. Oil gets more expensive in dollar terms.

The Fed is slow to aggressively lower rates because of the inflation fears brought on by the already weak dollar.

Recession fears are magnified by the Fed’s slow response and seemingly unending data showing a slowing economy. The stock market drops 10-12% in the first 3 weeks this year.
Counterparties to credit default swaps are finding it difficult to fulfill their contractual obligations due to higher than anticipated default rates.

Major monoline insurers Ambac and MBIA have trouble raising needed capital to shore up their balance sheets leaving in question the quality of their bond insurance contracts.

That’s “B” as in Billion

On the surface, it’s hard to believe that the residential mortgage market could lead to a recession in an economy our size or the global liquidity squeeze we saw this fall. But these are really big numbers we’re dealing with here. To be sure, the bond market is by far the largest financial market in the world and the mortgage market comprises roughly 60% of the U.S. credit market. Furthermore, according to the FDIC, real estate related holdings for U.S. banks accounted for 58% of total assets. This is up from 45% in 2000.

Since May, specific losses reported by the world's biggest banks have climbed to more than $100 billion as a result of U.S. subprime mortgages. Hardest hit, Citigroup Inc. posted its largest loss in the bank's 196-year history this past week, driven by $18 billion of write-downs on its mortgage and other fixed-income investments. On the brokerage side, Merrill Lynch had write-downs of $14 billion.

It’s still uncertain if the worst of the write-downs are over. Citigroup, for example, ended the fourth quarter still exposed to $37 billion of subprime mortgages, and $43 billion of corporate-loan commitments for leveraged buyouts remain on its balance sheet. Still, losses from the current credit crunch (nearly equivalent to 0.7% of U.S. gross domestic product) haven't reached the level seen in the savings-and-loan collapse in the late 1980s, when losses reached $189 billion, or 3.2% of average GDP.

Globally, foreign banks have been hit by these write-downs as well. Analysts estimate that state-owned Bank of China, traditionally the most international of the country's big banks, may have to write off a fourth of the nearly $8 billion it holds in securities backed by U.S. subprime mortgages.

Similar situations have been seen across the European Union banking sector. German bank IKE Deutsche Industriebank nearly collapsed in August under the weight of its subprime investments. Multibillion Euro write-downs have been taken by French and British banks as well.

The “R” Word

The credit crunch that was sparked by problems with residential mortgages is spreading to the broader economy with banks making it harder and more expensive for some small and midsize businesses to borrow.

While companies with strong balance sheets still can borrow what they need at good rates, others are beginning to feel the chill. In particular, start-up and smaller companies are finding that banks are setting higher rates, seeking more collateral or lending smaller amounts.

This is the way it often unfolds when there is a squeeze on lending. The last significant credit crunch, which ran from about 1989 to 1992, began with a pullback on lending for commercial real estate that then spread to business lending. This time, the problems spread from residential real estate and are being felt by everyone from commercial farmers to makers of heavy machinery.

With other indicators pointing toward a possible recession (including falling stock prices and rising unemployment,) a widening credit crunch doesn't bode well for the economy. Start-ups and small businesses are generally the companies that create jobs in a downturn. But tighter credit could curb business investment and hiring as companies recalculate the costs of investing in new machines, marketing campaigns or ventures. This could magnify the current slowdown in growth.

These scenarios have a wider economic implication than just in the United States. Because the U.S. comprises over a fifth of world-wide GDP, a meaningful slump in growth domestically would surely be felt around the globe.

Equity prices are already pricing in the expectation of slow or negative growth around the world. In addition to U.S. stock prices being down somewhere in the neighborhood of 15% in a few short weeks, European and Asian markets are down significantly as well. This pessimistic outlook is being echoed in the bond market too. While the risk spreads have increased the yields on many corporate issues, the core risk free rate has declined, reflecting the view of slower growth going forward. The ten year treasury yield is now down over 50 basis points since this summer.

Looking Forward

It seems unavoidable that this is going to be a rocky road for all financial markets for, at least, the first half of the year. Stocks will have to mount a healthy rebound to overcome January’s double digit declines. That would be difficult, to say the least, in an unhealthy economy.

In our opinion, the biggest impediment to any recovery is the continued default worry in the credit market. The most recent scare and possibly hardest to quantify is in the credit-default swap market. These are complex financial arrangements where one entity contractually sheds its portfolio default risk to someone else for a fee. This is essentially buying default insurance for particular securities in a portfolio.

Many financial institutions have been using these contracts to hedge much of the risk in their portfolios. Now, due to the elevated default rates, the ability of these counterparties to actually make good on these swaps have come into question.

This month, bond insurer ACA Capital Holdings requested a one month grace period to unwind $60b of credit-default swap contracts it can’t pay. Standard & Poor’s cut ACA’s rate 12 levels to CCC, casting doubts on the company’s guarantees. ACA is an important case to follow because it shows how the banks react to fast-deteriorating counterparty creditworthiness.

Because most of those guarantees are in the form of derivatives, these contracts are required to be valued at market rates. Those valuations are now highly suspect and may require further write-down’s in the banking industry, further depressing earnings and capital.

These problems will get sorted out. It’s just a matter of how long and at what price. In the meantime, the question remains as to where to hide. U.S. stocks clearly aren’t the place. International equities offer no relief. Last year every category of bonds posted negative returns except treasuries. There were even worries with money market funds.

Short of liquidating everything in your portfolio and putting the cash in treasuries, there is probably little that can be done to sidestep the expected price volatility. That being said, there is a saying that in crisis there is opportunity. We believe the opportunity in this market is income.

Through all of this, yields on dividends and interest have risen considerably. We now have the opportunity to pick up as much as 2% higher income returns than we’ve seen as recently as last summer. Our focus now is to lock in these higher long-term yields. In addition, U.S. Based firms with large international revenues will greatly benefit from the weak dollar. We just need to keep an eye on their credit worthiness.

Market Flash Commentary

Perspective on the Last Few Trading Days

The nation's stock market did an amazing 600 point about-face, rising from its morning low to finish deep in positive territory yesterday. The rally, which followed two days in which anxious investors drove stocks sharply lower around the globe, culminated in a 30-minute buying frenzy that left the Dow Jones Industrial Average at 12,270.17, up 298.98 points. The Dow's 631.86 point intraday swing was its biggest since July 2002, one of the low points of the last bear market. There have been just nine days with 500-plus point swings since 1995, many of which occurred at major market turning points.

Yesterday’s trading was important not just because of the point gains but because of the reason for these gains. The rally was supercharged late in the day by news that insurance regulators met with major Wall Street firms to discuss ways to stabilize and potentially bail out big bond insurers. These insurers have taken a hit because of their exposure to securities tied to subprime mortgages, and their instability threatens the wider financial system because they insure tens of billions of dollars in bonds, many of them held by Wall Street firms. Together, this insurer bailout, talk in Washington of creating a fund to buy troubled mortgages, and the hope for continuing Federal Reserve interest-rate cuts was the perfect combination to address the largest concerns in the market.

Understanding Credit Default Swaps

Credit default swaps (CDS) have become an increasingly popular way for financial institutions to insure potential default losses in their portfolios. Speculators such as hedge funds use CDS’s to potentially profit from the changing credit outlook in the economy. The technical definition of a CDS is a bilateral contract under which two counterparties agree to isolate and separately trade the credit risk of at least one third-party reference entity. Under a credit default swap agreement, a protection buyer pays a periodic fee to a protection seller in exchange for a contingent payment by the seller upon a credit event (such as a default or failure to pay) happening in the reference entity. When a credit event is triggered, the protection seller either takes delivery of the defaulted bond for the par value (physical settlement) or pays the protection buyer the difference between the par value and recovery value of the bond (cash settlement).

The popularity of CDS’s has leaded them to become the most widely traded credit derivative in the international financial marketplace. Outstanding CDS’s totaled $28.8 trillion in December 2006, up 107% from the year before. The market for credit derivatives is now so large that in many instances the amount of credit derivatives outstanding for an individual name are vastly greater than the bonds outstanding. For instance, company X may have $1 billion of outstanding debt and $10 billion of CDS contracts outstanding. If such a company was to default, and recovery is 40 cents on the dollar, then the loss to investors holding the bonds would be $600 million. However the loss to credit default swap sellers would be $6 billion. In addition to spreading risk, credit derivatives in this case also amplify it considerably. This is a huge and meaningful market. As such, more and more entities are becoming involved in trading these securities.

With any CDS there are two parties. The buyer wishes to reduce his exposure to risk and the seller who is willing to increase his exposure to risk for a fee. The buyers are typically banks, pension funds, insurance companies and the like. The sellers have traditionally been speculators such as hedge funds. However, bond insurers like Ambac and MBIA have become increasingly active in this market place over the last few years. This is at the heart of the credit crisis today.
Because mortgage backed bonds comprise approximately 60% of the bond markets, it is easy to see how the CDS market has been impacted by the massive default rate of sub-prime loans, and thus sellers of these derivatives have experienced loss rates that had never been imagined.
One of the biggest criticisms of the CDS market is that these contracts are not collateralized. Their ultimate value depends on the creditworthiness of the counterparty. This counterparty risk is at the core of the latest round of fear that has struck the financial markets and was partially addressed yesterday.

A recent survey found that 26% of investors were worried about counterparty risk. These fears are not unfounded. Two days ago ACA Financial Guaranty Corp. asked its trading partners for more time as it scrambles to unwind more than $60 billion of swaps it sold but can’t fully pay off. The contracts were intended to protect Wall Street firms from losses on mortgage securities and other debt they own. As a result, Merrill Lynch had to write down $3.1 billion on debt securities it hedged through ACA. Citigroup has set aside $935 million to cover the likelihood that trading partners won't make good on trades in this market. These write-downs are in addition to the actual un-hedged losses that these banks have already taken. This has been taking place all over Wall Street.

Wider Implications

What happens when your insurance company goes broke? That’s what many have been asking themselves about Ambac and MBIA. These two monoline insurers are by far the largest insurers of municipal bonds. Most municipal bonds that trade today carry the highest credit rating of AAA. In a great many cases, that rating has been granted based on the bond insurance issued by one of these two firms. In fact, most small municipal governments have no credit rating at all. They find it cheaper to buy the insurance than pay to have a full audit performed and rating assigned.

Thanks to the huge losses incurred at Ambac and MBIA on their CDS business, their capital base has dwindled dangerously low. Forced to raise capital, MBIA issued $1 billion in bonds to shore up its balance sheet. To attract buyers, these bonds had to carry a 14% coupon. Even so, a week later these bonds were trading down 10-15%. Keep in mind that a typical investment grade bond (BBB or higher) would trade in the mid-5%. Not only was the 14% coupon indicative of a junk bond rate, but the fact that they traded so much lower immediately after issuance says that the marketplace feels bankruptcy is extremely likely. The next week, Ambac followed up with attempting to float its own issue. With the MBIA issuance fresh in investor’s minds, they had no takers. That day, credit agencies cut Ambac’s rating to AA (still very generous in our opinion) and stocks in both companies tanked.

The obvious question to ask is how can all of these bond issues trade with AAA ratings if the underlying insurance is perceived as no good? Shouldn’t the value of these bonds be marked down as well to reflect the riskier nature of their credit? How does this impact the cost of borrowing for municipalities that depend on those ratings? The cascading effect of this becomes obvious. Further write-downs lead to a further reduction in portfolio values which in turn puts more pressure on required capital levels which then limits banks’ ability to lend.

Pending Recession

Financial institutions, especially in the U.S. but also globally, have lost a tremendous amount of capital in the last few months. Faced with the prospects of another wave of write-downs that could be larger than the first, it’s apparent how economic growth is threatened. Modern economies run on credit. Whether it be consumer credit or business liquidity needs, access to capital is essential. The current situation is that most banks are either limited or unwilling to make major loan commitments at this time. All of the current data clearly points to a slowing economy and stock prices have come down to reflect this. There are only two events that will bring us out of this downturn, which are a stabilization of asset values and a massive injection of liquidity into the economy.

The Fed’s Role

Tuesday morning we were greeted by a surprise announcement that the Fed was cutting a key interest rate by 75 basis points. The size and timing of this announcement was a complete surprise that helped stem massive losses in stocks. The Fed’s move helped pair the opening declines on the Dow by roughly 350 points. The next day we were told that a bailout of the bond insurers was being orchestrated, which fueled a 600 point rally. It’s clear what the financial markets perceive as important. This is beginning to resemble the Fed’s orchestrated bailout of Long Term Capital Management in 1998. That too was centered on counterparty risk that threatened capital liquidity. We’re hopeful that all the cards are on the table now and it’s just a matter of accounting for all the losses.