"We believe the bond market has gotten it more right than wrong with its recent re-pricing."
The Credit Crunch and Beyond
The fixed income markets had an eventful summer, to say the least. Highlights on the calendar of summer fun included the near run on the bank at Countrywide Financial in the United States and at Northern Rock in the United Kingdom, the German government intervention to support two Landesbanks near collapse, and the general freezing up of money markets as banks hoarded cash and central bankers lost control of overnight interest rates. The resulting impact has been dramatic: the Fed funds rate was slashed to 4.75% from 5.25%, the U.S. Treasury yield curve steepened and moved markedly lower, credit risk premiums increased significantly and the U.S. dollar continued to drop in value.
The fixed income markets are now in the midst of a de-leveraging trade. This process is likely to play out over multiple quarters, rather than multiple days or weeks. In order to understand where we are in this process, we need to have a firm grasp on the underlying sources of the problem.
The main casualties in this cycle have been: 1) the U.S. housing market and the market for sub-prime loans and 2) the securitized debt market, including the environment for collateralized debt obligations (CDOs) and structured investment vehicles (SIVs).* As is nearly always the case, the problems these markets are experiencing can be viewed as the payback for prior excesses.
Source: Bloomberg LP
Source: Lehman Brothers, Bloomberg LP
The U.S. Housing Market
The United States was far from alone in experiencing strong gains in housing prices over the past 10 years. What sets the country apart from the rest of the world are the abuses that occurred in mortgage lending. These abuses came in the form of sub-prime loans made with little regard to the borrower's ability to make payments and option adjustable-rate mortgage (option-ARM) loans that allowed many borrowers to buy homes they could not afford after the teaser rate was reset. The resulting increase in demand for housing helped fuel a speculative frenzy and provided incentive for homebuilders to build ever more inventory.
Now we are witnessing a natural correction in home prices to account for the inventory overhang created by overbuilding. Further, much stricter mortgage loan underwriting standards have increased the effective cost of purchasing a home. The scope of this problem is large and will take some time to work out. While securities markets can correct quickly for extended periods of past abuses, the correction underway in the housing market is much more likely to play out in a far more methodical fashion. This is because the vast majority of homeowners do not need to sell their homes; those who would prefer to sell would be unlikely to do so if they were forced to crystallize a loss. Homeowners forced to sell will suffer losses, and the implied values of their neighbors' homes will fall in kind. Afterwards, home prices will likely stabilize and then tread water for a number of years while the economy grows into the previously inflated prices. This process will represent a drag on economic growth due to lower home construction activity and the negative wealth effect on the U.S. consumer because of falling home prices.
Securitized Debt Markets
However much the outlook for economic growth has been subdued because of the fallout from the housing market correction, recent market dislocations have been driven by the fear and uncertainly surrounding which institutions stand to lose money through their holdings in these now toxic sub-prime mortgage loans. Lending standards plummeted because of: (1) The lack of discipline in the fast-growing mortgage securitization arena and (2) the fact that numerous agents (the originator, the servicer, the arranger, the rating agencies, and the bond mortgage insurers) in the securitization process had a vested interest in producing ever-more product.
The last line of defense in this game is the end investor. In the case of sub-prime securitizations, end investors were more than willing to rely upon the overly optimistic assessments of rating agencies when assessing the inherent risk of these mortgage pools. To make the matter worse, many of these highly rated sub-prime backed securities made their way into other securitized investment vehicles, namely CDOs and SIVs. CDOs and SIVs found subprime mortgage-backed securities to be particularly attractive as they provided the two things such vehicles crave most: a high yield and a pristine rating from the rating agencies. Given the apparently high quality of the assets underlying these CDOs and SIVs, the rating agencies were willing to assign very high ratings to the financial instruments then issued to fund the CDOs and SIVs. In short, it was ratings arbitrage nirvana and the managers of CDOs and SIVs couldn't buy enough!
Financial Market Fallout
Earlier in the crisis, the assumption was that the scale of the sub-prime market was not sufficient to cause lasting financial damage. What happened next left the global financial system on the brink of a major run on the bank. As concerns surfaced about the increasing delinquency and default rates on sub-prime securitizations, the already sparse secondary market for such securities evaporated. There were no observable markets to use as a base for mark-to-market pricing and "mark-to-model" prices increasingly were viewed as "mark-to-myth" pricing; after all, these very models had misjudged the risk embedded in these securities in the first place. The market quickly seized up and prices fell—but by an unknown amount. With little or no ability to know which institutions were left holding the risk, banks and investors began to hoard capital. A classic credit squeeze ensued.
To make matters worse, banks that had provided back-stop liquidity facilities to asset-backed commercial paper programs and SIVs were asked to provide liquidity. This effectively brought back onto the banks' balance sheets the very risks the securitization process was meant to disperse. Compounding this even further, these same financial institutions are now sitting on massive piles of hung LBO bridge loans—loans that the holders desperately want to sell on to the credit market or to renegotiate with their private equity "partners."
This confluence of events led to a dramatic increase in the risk premiums associated with all kinds of borrowing, and to a seizing up of the credit markets to an extent that threatened the financial viability even of innocent bystanders. There are encouraging signs the market is methodically working through this mess, which likely will be substantially worked out in a matter of quarters as opposed to years. The higher financing cost through this period will have a negative impact on economic growth. Unfortunately, normality can be quite underwhelming when one has grown accustomed to excess.
Looking Beyond
Against the backdrop detailed above, we view the Federal Reserve's recent half-percentage-point interest rate cut as being an appropriate first step. The move should help stabilize financial markets by lessening the immediate impact of higher credit spreads and by helping to restore investor confidence in the financial system overall. As confidence slowly rebuilds, credit conditions will begin to normalize and the fear of a systemic meltdown will gently drift away. What will not quickly drift away is the hangover resulting from the prior period of excess credit creation and excess consumer consumption.
What does this all mean for the current state of the fixed income markets? We believe the bond market has gotten it more right than wrong with its recent re-pricing. With an estimated neutral Fed funds rate of 4.25%, the market's expectation for 50 to 75 basis points of further interest rate cuts looks reasonable. On this basis, the recent rally in the Treasury curve is well supported. The recent spread widening in residential mortgage-backed bonds is easily justified by the increased volatility in interest rates and in the underlying value of the homes backing these mortgages. The mortgage market appears to have further volatility ahead.
We are more constructive on the corporate bond market. Credit quality still is strong and earnings are likely to be resilient, thanks to the weakening U.S. dollar and to the supportive back-drop of global growth. With the recent move higher in corporate bond yields relative to Treasuries, valuations are now much more attractive. The most important lingering concern at this point is the fear that the combination of lower interest rates and the significantly lower value of the U.S. dollar will lead to a resurgence of inflation. However, inflationary pressures—most importantly wage pressures—appear well enough contained to not represent a significant risk to the bond market or to the near-term economic outlook. This constructive outlook for inflation should allow the Federal Reserve to take the steps necessary to ensure that the economy and the markets have sufficient time to recover from the recent summer of discontent.