Interview: Master of the Debt Universe

At the beginning of 2007, savvy investors were watching the credit markets with candles and penlights. As the credit markets expressed signs of a bubble, flashlights replaced our trusty wicks and pocket tools. Since August the savviest investors have turned on their dusty floodlights (which have been in storage since exposing issues with tech stocks in 2000).

Although 2008 should see the credit industry come under lights as powerful as Fenway Park’s, SGS tapped our trusted contacts in the credit market to help our readers and community get ahead of the curve and make winning trades (due to firm restrictions, our Master of the Debt Universe must remain anonymous.)

1) Tell us a bit about your hedge fund and job.

I am a corporate credit analyst and trader at a relative value and special situations hedge fund.

2) What does it look like on your turf in the trenches of the debt world?

Things are still pretty ugly. Liquidity is extremely poor and credit spreads are near all-time wides. With spreads where they are, issuing debt is very expensive for companies. Many financial corporations were able to fund themselves by paying as low as 50 basis points above Treasuries for issuing 10-year paper. These same companies are now forced to pay 3-5 times as much. For example, in mid 2006 Wachovia (WB) was able to issue 10-year senior bonds at Treasuries plus 70 bps. Now they would have to pay Treasuries plus 170 bps or more depending on where credit protection [CDS] is trading. And Wachovia is one of the better names. Bear Stearns (BSC), Merrill Lynch (MER) and Countrywide (CFC) — just to name a few — have to issue much much wider [i.e., more expensive debt].

Basically, it comes down to where CDS is trading on the Street. Companies must issue their debt at a similar spread to this credit protection, otherwise many funds would just choose to sell protection rather than buy the debt.

3) How will the current conditions in the debt markets affect the broader economy? Some traders in the debt markets believe we are heading toward a recession. Do you agree?

The current situations in the fixed income world lead me to believe we are heading into recession. Too much money was lent to too many people who do not possess the ability to pay it back. Significant losses are pouring through Wall Street. Due to the securitization and leverage of all these bad loans, the losses keep multiplying. There have already been huge job cuts throughout the Street and it is starting to hit the rest of the country. Many people will lose their homes and those that are able to refinance will most likely lose wealth.

4) A lot of doom and gloomers are coming out of the woodwork to prophesize payment to the piper in the form of a rough recession/depression. Do you agree with this thinking or will the recession be short lived?

This is a tough question and I never try to time anything. There are many guys also coming out now saying we can fight off the recession, but I am still not a believer. I think that a recession will last until we find some sort of new equilibrium between supply and demand in housing. There are many factors involved here, but I know that wages will have to rise at some point to keep up and exceed the devaluation of our currency. The easing of rates has already begun to combat these issues as well, so we will see what happens. There are too many unknown factors out there now to determine how long or how severe the hit will be, but I wouldn’t think more than a few years at most. We dug ourselves a nice big hole and now it’s up to us to find a safe way out.

5) Can the Fed save us from ourselves?

As far as the Fed bailing everyone out, these actions have large ramifications. The more money the Fed dumps into the system, the less each individual dollar is worth and, in essence, the bubbles get re-inflated.

In order for the housing market to correct itself, prices will have to fall and rent will have to increase in the areas that have been affected most (Florida, California, Nevada, etc.). Renting is way too cheap right now, and a significant number of homeowners cannot afford to pay their mortgages [a few days after this interview, the Wall Street Journal wrote an article supporting this exact thesis: “Home Prices Must Fall Far To Be In Sync With Rents.”] I think the losses will start to seep into the broader economy and credit cards may be the next to take a hit as people max out their cards.

6) What key events should investors look for to know things are improving?

I think everything comes down to housing. Once more people start buying homes again and the foreclosures start to decrease, everything should get better. Right now prices are being redefined across the map. So, once they seem to reach some sort of stability or floor, hopefully buyers will come out of the closet. Right now there is simply much more supply than demand.

7) What would signal things are getting worse?

If credit markets continue to deteriorate and spreads continue to widen, liquidity will get even worse than it is now and you will witness extreme turmoil and volatility in the capital markets. Should this happen, I am quite sure you will see some defaults among some of the bigger players such as mortgage insurers, monolines, possibly even some smaller banks and lenders. Take a look at how the credit crunch is affecting MBIA (MBI), Ambac Financial Group (ABK), Financial Guarantee Insurance Corp [FGIC], Financial Security Assurance [FSA], XL Capital Ltd (XL), and Assured Guarantee Ltd (AGO).

8 ) Do you think the credit crunch is spreading? If so, which industries do you believe will be next to slow or blow up?

The credit crunch has spread through much of the investment grade names. It is much more costly for companies to issue debt, and risk is being repriced across the board. This is strictly speculative, but as I mentioned earlier, I believe credit cards may be the next to take big hits.

9) In general, what indicators do you use to assess the economy and markets?

We use many indicators. We look at all the economic data that comes out each morning (everything from GDP to Housing Starts). We also follow corporate and asset back fixed income markets very closely.

10) The web has increased access to analysts who are very skeptical of government economic data. Are you skeptical? If so, which data sets do you think need to be changed, and in what ways?

I am skeptical of government data and think much of it is skewed and biased. After all, it’s the government. Not only do they have a vested interest in making things look better than they are, but there is just way too much information needed to accurately compute this data. They take whatever they deem necessary and spit out the numbers. They also throw out a lot of stuff. For instance when measuring inflation, they take a basket of goods and services not including food and energy. However, those are the first two things I look at when trying to measure inflation.

Master of the Debt Universe, thank you for your time and insights. We wish you the best with your trading in 2008 and look forward to asking you some more questions as the credit markets move into a new identifiable phase.

Comments

[Josie Wales:]

I am uncertain the person you interviewed is a Master of the Debt Universe. If he was, he would warn about hyper growth in credit card debt outstandings will be highly probable as well as his prediction of growing defaults in 2008. The outstanding commitments are well over $2 Trillion with only $900 + Billion in outstanding balances in 2007. Also, 20% to 40% of the $11.5 Trillion in MBS is at risk of high default rates since 80% was originated in since 2002 with approx $2.5 Trillion refinanced out during this period further stimulating the economy. Without the refinancing out of home equity, 08 and 09 looks bleak for the world economy. Expect the deflation of home prices to go lower than rent equivalents for up to two years given that rents will become unstable in a recession and will probably drop due to complications of higher unit turnover and increased multi-family foreclosures. The $3.2 Trillion in Commercial RE debt looks no better than the MBS. About 25% of the $760 Billion in CMBS is at risk of loss given the over 50% portfolio composition of interest only loans with unsustainable high leverage and non-recourse liability. In a recession, look at high default rates in the CRE debt markets as well given that there are at least 35% of the CMBS portfolio, I would catagorize, as subprime. We are already seeing CMBS credit quality issues. Being a Master of the Debt Universe would be appropriate if he focused not so much about observing the debt trade market trends in a deductive manner but understanding where are the debt market risks and its level of magnitude. If you interviewed someone who would tell me something I don't know, I might accept the title of the person you interviewed as a Competent Debt Market Participant.

2008 Jan 06 12:13 PM

[SmartGuySto...:]

Josie,

Great points. However, my guest said credit cards were next, and they were. I don't understand the whole first part of your comment given that this was discussed.
Second, we did consider exploring CMBS, but the problems there are very small at the moment, and I was looking to give people a view at what is happening NOW in the pits, not create a comprehensive list of all the possible things that could go wrong (and Portfolio already had a CMBS article the same week).

I am sorry you already knew everything in the interview. We happened to receive a large amount of emails thanking us for the insights because most people are not as educated as you.

We can't please everyone, and we are not an academic site. But we will keep your criticism in mind for our upcoming interviews.

2008 Jan 12 03:05 PM