Understanding the Dangers of Riding Without a Helmet
During my teen rebel years, my friends and I took to the streets on our motorcycles—without helmets. We never believed this was risky, and dismissed the constant warnings from the older "un-cool" generation. We wanted the freedom and communication that could only exist without wearing helmets. And of course, riding with a helmet did nothing to help our efforts to attract members of the opposite sex and impress them with our carefree ways!
For a few years, we defied the advice and pleading of our parents to wear helmets. The more we rode, the more resistant we became. We told our un-cool parents that we understood the risks and could handle them, as our few years in the saddle proved. We explained our prowess in riding, citing the accidents we avoided or survived with minor injuries.
The defiance lasted until one of my friends collided with the bumper of a 1967 Impala. He survived, but suffered permanent brain damage. Since five of us rode with him that night and witnessed the accident, we all understood how difficult it was to predict the accident. My friend would most likely have avoided serious injury if he were wearing a helmet. Guess how many of us purchased helmets the next day? Guided by our sudden understanding of risk, we were all willing to pay for quality and passed by the cheapest helmets.
Many participants in the credit markets have been riding without helmets, driving faster and attempting more death-defying activities. The narrow credit spreads and large liquidity flows, combined with more exotic lending in a bubble housing market, have created a crisis in the credit markets that will play out over the next few months, but should have lingering effects for many years to come. The near-historic low credit spreads virtually eliminated the margin of safety in low-grade debt and produced a very marginal risk/reward tradeoff.
Capitalism is often painful and it is said that capitalism goes through phases of creative destruction. For markets to operate properly, some injection of pain is necessary because it helps to correct for illegal or incompetent behavior, or even just for poor judgment. The cleansing cycle we are experiencing in the credit markets over the past few months will likely last many more months. It will expose some aggressive and even stupid behavior that looked like prowess and experience only a few months ago.
Assessing the Consequences
Investors in high-risk mortgage credit and lenders in this marketplace should be most concerned. Liquidity has ceased to exist in the high-risk credit mortgage market. There has been some impact on all high-risk credits despite ample cash and liquidity in many other markets.
We expect to see other painful—but normal—outcomes as risk is re-priced. First, the housing market and residential real-estate cycle may take longer to work out than many previously thought. Second, the market is aware of risk again and high-yield bonds will actually pay high yields. Of course, the high yields themselves imply that companies who need capital and are not of the highest credit quality (most of the companies in the world) will have to pay more for the debt capital they raise. In our world, this means the cost of capital is rising while the return on capital is not, creating a negative impact to economic valuation and wealth destruction.
At this point, we believe the equity markets are adjusting to the credit risk (higher cost) adjustment. We do not believe the equity markets are signaling a recession. In fact, using our economic intrinsic value analysis model and adjusting for the increased cost of capital (as a result of the increase in spreads) for the average business, we estimated the market should decline 8% to 10% from the peak. As of today, the Russell 3000® Index is down -9.90% from its peak of around 900. We believe the large-cap biased S&P 500 Index should be on the lower side of the 8% to 10% range since many of the large, better-capitalized companies will not be as significantly impacted by the credit squeeze.
It is anyone's guess as to the impact of the credit squeeze on the economy, but we believe the de-leveraging of hedge funds and the complexity of many derivatives is magnifying the impact in the credit markets. If further de-leveraging or credit damages occur, the impact on the equity markets could be magnified. The volatility in the markets is a function of the leverage in the markets, the complexity of the derivative structures and of who has the credit exposure. When you're leveraged six-to-one or seven-to-one, and the market moves against you, many options go out the door and survival mode sets in. A somewhat "hyper" state results and leads to the type of volatility the markets are experiencing.
The risk-management systems in place today—such as value at risk (VAR) and forms of portfolio insurance and hedging—often exacerbate rather than alleviate the problems in market corrections. VAR models generally estimate the amount of risk exposure that banks, trading desks, hedge funds and insurance companies take by estimating correlation of various asset classes and the standard deviation of assets. During a correction like this, the standard deviation of assets increases. This, in turn, indicates risk is high and that assets should be sold and leverage reduced. At the same time, the correlation of assets increases, further adding to risk and forcing additional selling. This is very similar to the portfolio insurance programs that perpetuated the 1987 stock market crash.
After the accident, it is too late to put on your helmet
In many cases, the performance of mutual fund portfolios today is a result of positioning decisions made over the last few years. Those who misunderstood or overlooked the risk of lower-quality mortgage investments are likely paying a steep price today.
We believe the Calamos portfolios are positioned well for the current market turmoil. Our focus has been on the next 12 to 18 months, not the next week. We have very limited exposure to home-building or mortgage-related investments. Principal loss risk in the portfolios is not a concern at this point. Most of the adjustments in values in our strategies have been related to the market, and not to individual credit risk. In fact, as credit spreads become more rational, we expect to see many more opportunities, not only in the low-grade debt markets, but also in equities and through other strategies.
The central banks have acted prudently by injecting some liquidity to stem the tide. They have sent a signal that they are aware of the credit crisis and that they can help. On the other hand, they have been careful not to bail out the high-risk players and create a moral hazard on the scale of the S&L crisis that taxpayers are on the hook for.
The re-pricing of risk should be played out in the near term with some reverberations for the next year. It is our opinion that the economy can absorb the wealth destruction and continue to expand. The impact today is globally dispersed. In decades past, the U.S. banks would have had to weather the storm and most lending would grind to a halt. Today, the credit event has hit hedge funds around the world, global banks, investment banks and private equity. Also, many large pools of capital should act to stabilize prices as valuations reach levels that price in all the risk and some extra return for going against the tide. As the credit markets clear and liquidity seeps back into the mortgage markets and high-risk lending, the markets will actually have moved back to a more normal credit spread for risk capital.
The markets may not be out of the woods, and a recession is still possible should further weakness occur in the lending environment. But the game is still being played. We are riding with our helmets on and watching the road ahead for possible risks. We believe there are plenty of opportunities for investors to enjoy the ride.