Just Another Credit Crunch?

Many investors are beginning to think that income investing is every bit as risky as equity investing, but nothing has really changed in the relationship between these two basic building blocks of corporate finance. What has changed in recent years is the nature of the derivative products created by the wizards of Wall Street to deliver both forms of securities to investors. The most popular form of equity delivery today is the three-levels-of-speculation Index Fund. New ETFs are birthed every day and, in total, have become as common as common stocks. Have you noticed that regulators always strive to prevent financial disasters from happening... again?

But, in the meantime, the forever-sacred bond market has become the hysteria arena of the moment in media, country clubs, neighborhood pubs, and retirement villages. Does my nest egg have a crack in it? No, not really.

Stories abound concerning the sub-prime mortgages that financed the recent bubble in real estate prices. Many people, who couldn't afford to purchase homes at any price, were able to obtain financing with no-documentation-required mortgages. Many loans had sub-prime, short-term teaser rates that would adjust to above market levels too quickly. Many borrowers weren't concerned because they never intended to occupy the properties... speculators attempting to flip the properties quickly in a much too hot real estate market. Predatory lenders and some greedy realtors exacerbated the problem. Lenders didn't care because the bad loans and higher risks were gobbled up by Wall Street institutions to be sliced, diced, seasoned, and syndicated into CMOs, CDOs, and SIVs of all imaginable shapes and risk levels.

Rating agencies gave the products AAA status because they were guaranteed. Insurers guaranteed the derivatives because they were AAA rated. Investment bankers underwrote and syndicated the products because of their high quality ratings and their banker friends made markets for them through their trading desks. It was party time on Wall Street, as it always is before such MLMesque schemes unravel. Have you noticed that regulators always strive to prevent financial disasters from happening... again? You can bet that attorneys have.

So when over-the-top real estate prices began to settle and the flippers were hooked with homes that began to smell fishy, the houses-of-cards began to tumble, bursting bubbles and drowning speculators as they fell. Borrowers with adjustable rate mortgages had to face new financial realities, but contrary to the picture painted by the media, most homeowners are making their payments right on schedule. Speculators should expect losses, but should financial institutions encourage the speculators? Welcome to Las Vegas east.

It is practically impossible to determine how many and precisely which mortgages within the CDOs and SIVs are in or near default. As a result, the market value of these products has fallen to levels that unrealistically presume a major default experience. The fact that Wall Street leveraged some of the products excessively has made a bad situation worse, and banks worldwide have written down billions on mortgage portfolios that contain an unknown number of potential defaults. But regardless of the financial reality, the market value reality of having no buyers for these securities has caused a global panic and spiraling illiquidity in the financial markets. So, as a result of their self-inflicted capital-raising problems, the banks have become risk averse with everyone. Aren't banking and mortgage lending regulated industries? Is it time to change the way banking institutions assess the value of their debt investments?

Individual investors have always relied upon fixed income obligations to fund everything from college to retirement. Historically, the default rate on corporate bonds has been low, and that on Municipal bonds approaches zero. Dot-com debt was added to the markets in the later half of the 1990s, and the 8% leveraged-corporate-bond default rate in that era helped cause recession a few years later. But corporate balance sheets were far less liquid than they are today, and by early 2004 the default rate was under 1%. In late 2005 there was a short-term spike to 2%, but since then the default rate has dropped to a recent historic low of 1/4 of 1%. There does not seem to be a major quality issue within corporate debt right now, but fearful investors have abandoned all but treasury securities... finding even the commodity markets more of a safe haven than Municipals. Boy, are they in for a surprise. The fear of a routine cyclical economic slowdown and the credit crunch has caused massive selling of income securities while the default rate has not increased at all.

Corporate and municipal closed end funds have not responded normally to recent reductions in interest rates because of the general problems plaguing the industry and, additionally, because of questions about the Auction Rate Preferred Stock [APS] they use to finance short-term borrowing. (Keep in mind that nearly all corporations and municipalities use debt financing and that such financing is not, in and of itself, a bad thing.) APS in effect resets the interest rate the borrower pays every seven to twenty-eight days. The preferreds are mostly purchased by banks, but may also be sold to individual investors. The credit crunch that originated with the sub-prime problem has spread to the APS market as well. Consequently, CEF managements now have a higher cost-of-carry on short-term borrowing.

APS issues include maximum interest rates that are generally well below the amounts the funds receive from their holdings, and all Closed End Funds can raise new capital by selling additional shares of stock. As long as the earnings generated by the assets in the portfolio continue to exceed the costs of the APS financing, such financing is beneficial to the shareholders. Should the cost approach the revenue, the manager can simply redeem the APS and reduce the holdings in the portfolio.

To alleviate the problems, central banks worldwide have injected billions to help ease tight credit conditions. Ours has slashed the Fed Funds rate to lower borrowing costs and to ease general credit conditions; more rate cuts are expected. Unlike the quality issues in the sub-prime mortgage market, the weakness in the corporate and municipal CEF markets is a more solvable liquidity problem. Historically, the easing of interest rates and injection of reserves into the system eventually move credit markets toward normal conditions. The Fed Funds rate now stands at 3%, down from 5.25% a few months ago. In 2003, the rate moved to 1% as the Fed liquefied the credit markets after 911; there is still a lot of rate cutting room in the system.

Investors would fare better if they could learn to think long-term in the face of short-term problems. This is not the first, and certainly not the last, dislocation in the financial markets. The Treasury Secretary and the Federal Reserve Chairman have testified that they expect economic growth to resume during the second half of 2008. The congressional stimulus package will be implemented quickly. The Fed stands ready with rate cuts and will inject additional reserves if needed. Typically, credit crunches with or without stock market corrections have proven to be investment opportunities. This one will be no different.

Comments

[markg]

Re: the last paragraph in the article...so we are supposed to believe that the same federal reserve chairman, who said in 2005 that we are not in a housing bubble, is supposed to ride to the rescue? At the time, that sounded like more of Clinton's "this is the new economy.."

And we still have room to drop rates? So far this has been highly inflationary, and mortgage rates have been rising, which is the opposite effect of the intention. Bernanke is supposed to be the smartest guy in the room, but he sure hasn't shown it so far.

[Pent updemand]

One has to love the newspeak: "central banks have injected billions"; in the old days we would say that they're running the printing presses full bore. Oh, right, the bankers have to present "collateral" for these injections. But we've redefined collateral to mean anything up to and including shiny rocks found on a recent trip to the shore.

[Hellacious]

The Fed is sacrificing not just savers, the responsible investors, but also business, the real economy, with its rate cuts and resulting inflation. It is doing this mainly to protect asset prices for irresponsible investors.

Inflation is bad for businesses, some more than others. If a business can't recover its increasing costs, it has to cut back, and that means layoffs.

Look for massive layoffs soon - a key effect of the interest rate cuts. Unemployment: always the main show in a bad recession.

[Fat Arby]

CORRECTION
mortgage rates have not been rising in the past 6 months, just lately, this year, due to tightening of lending standards.
If you have a lot of dough, a good credit rating, you can refinance and save even more money. But if you don't it doesn't matter to you because your credit cards and other loans won't drop. These discount rate cuts are meant to stimulate the economny long-term; trickle down...

[Fat Arby]

You're overlooking something. When a bank has , say, 100 dollars, it only needs to keep , say, 20 dollars cash and can loan out the other 80 bucks. So, it keeps loaning and loaning and so then a whole lot of money is going out. If, say, that 100 is not 100 but 100 billion, they've loaned out 80 billion. Out of that, they also take out DEBT, redeposit it, and then loan out another 80percent of that debt, say 40 BILLION. cAN you see the path?
When their collateral fails, that being mortgages, they're bound by the terms of that debt, ie, collateral. They still have to pay it, so what they do is take it off the books. It doesn't matter that 90% of the money is still coming in; what matters is that that 10% has grown to to 40% of a certain CDO or whatnot. See? this is our 'credit creation machine'. It has taken down markets in the past and will likely take this one down too.

[Fat Arby]

Typically, maybe, but once in a blue moon it goes ka-boom!
This year we had 2 lunar eclipses- red moon.

Personally, I want to see a big correction. why? I want wealth! Once upon a time I had plenty of it but it was yanked from me. Now, I want it back. It's my birthright.

[Fat Arby]

You really are way off in your calculations. If I've taken out loans, I have to repay them, one way or another. These things don't just disappear. Do you really understand leverage? Think about options.
I buy a contract, cost one hundred. The underlying security goes down 10 percent - and doesn't come back. As time passes, I'm down 20 30 40 50 percent, and then, one fine day, voosh! 100 percent loss.
This is LEVERAGE. BAnks are overly LEVERAGED and it's JUST BEGINNING to become apparent. So, please, do a little research into the credit equation. Don't mean to be mean but it's a mean market. Lots of mean people.

[starder]

This article has as much water as the "injected billions" - quite on par with Bernanke's drivel. The Fed’s inflationary financing bluff has been called by the markets long ago. Producers and traders of raw materials are raising prices in advance, because they don't trust the "Fed". All attempts to catch up by spinning the printing press faster will only cause additional panic. The combination of high inflation and even more inflated material prices can make the Great Depression look pretty. The "Fed" should stop fiddling with rates and allow the government do he right thing - use tax incentives, tariffs, etc to spur domestic production. There is no credit crunch, there is purchasing power slump coupled with harmful for the US structural imbalances. The economy is way over-leveraged and more "credit" will only tip it over the inflation edge. Let’s not forget that big chunks of the “credit” and “stimulus” end up overseas where the inflation is rising even faster than here. In due course it will be imported along with the poisoned foods and such.