Are We There Yet?

by: David Merkel, CFA

With trends, I often try to answer the question, “Has the goat reached the end of the snake yet?”  (I got that phrase from a Canadian Investment Actuary with a quirky sense of humor.)  Another more common metaphor would be “What inning of the baseball game are we in?”  I’ll stick with the goat for now — but what I am considering is how far are we into the negative phase of the credit cycle, where:

  1. bad debts develop
  2. are realized
  3. written off
  4. new capital raised
  5. capital calls fail at a few financial entities, leading to bankruptcies
  6. contagion/ systemic risk worries multiply
  7. moderate-to-weak capital structures come into question, perhaps a few fail…
  8. increasingly, as failures happen, and marginal entities dilute the equity and raise capital, the number of zombie debts starts to decline
  9. when the amount of zombie debts drop below a threshold, the credit markets realize that the rest is solvable, and the bull phase starts, usually with a roar.

Nine points?  Maybe I should get rid of the goat, and bring back the baseball analogy.  The nine points aren’t perfectly linear, though, and portfolio managers, both equity and debt, operate in a fog.  In 2002, when I was a corporate bond manager, I would sometimes take my head in my hands at the end of the day and say to the more-experienced high yield manager who sat next to me, “This can’t go on much longer.”  When I would get that feeling, we were usually near a turning point.  The high yield manager would usually encourage me and tell me it was the nature of the market, and things change.

Part of the challenge is identifying the drivers of the credit bear market.  Is it the technology/CDO bubble (2000)?  LTCM (1998)?  Commercial real estate (1989)?  Here are two posts from the RealMoney CC:

     
Analogies for the Current Market Environment
3/9/2007 10:13 AM EST
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When I think of the current market environment, I don’t think analogies to Autumn 1987, Autumn 1998, or 2000-2002 are proper yet.

What do I think are reasonable analogies? Mexico/bonds in 1994, Cash flow Collateralized Debt Obligations [CDOs] 1999-2001, Manufactured Housing Asset-backed securities [ABS] 2002-2004, and the GM/Ford downgrade to junk crisis in May 2005 when the correlation trade went wrong.

All of these were large enough in their own right to be minor crises, and they sent measures of systemic risk up for a while, but ultimately, they were self contained, because market players with strong balance sheets picked up the pieces from failed players, and earned a reasonable return off them after buying up the “toxic waste” at fire sale prices. What was a horrible idea buying at par ($100), can be an excellent idea buying at $30.

In general, my systemic risk proxies are falling. There is still systemic risk out there, a lot of it, but it will take a bigger crisis than Shanghai/subprime to unleash that. Just be careful; watch your balance sheets and your valuations — for long-term investors, that will reduce your losses in a crisis.


 
Gradualism
1/31/2006 1:38 PM EST
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One more note: I believe gradualism is almost required in Fed tightening cycles in the present environment — a lot more lending, financing, and derivatives trading gears off of short rates like three-month LIBOR, which correlates tightly with fed funds. To move the rate rapidly invites dislocating the markets, which the FOMC has shown itself capable of in the past. For example:

  • 2000 — Nasdaq
  • 1997-98 — Asia/Russia/LTCM, though that was a small move for the Fed
  • 1994 — Mortgages/Mexico
  • 1989 — Banks/Commercial Real Estate
  • 1987 — Stock Market
  • 1984 — Continental Illinois
  • Early ’80s — LDC debt crisis

    So it moves in baby steps, wondering if the next straw will break some camel’s back where lending has been going on terms that were too favorable. The odds of this 1/4% move creating such a nonlinear change is small, but not zero.

    But on the bright side, the odds of a 50 basis point tightening at any point in the next year are even smaller. The markets can’t afford it. 

  • Click to enlarge

    Add in the housing bubble, lousy credit quality in high yield issuance 2004-2008, mismarking of derivative books at investment banks, the troubles with CDOs, and growing problems in commercial real estate, and you have the main elements of the current financial crisis.  This crisis is broader than the previous crises.  Many players played it to the wire in a wide number of areas.

    In this environment, the continuing fall of residential housing prices another 10-15% will lead to more bank failures, and failure of a few related institutions.  Commercial real estate has far to fall, and there is no telling what it might do to financial institutions.

    So, we’re still in the middle innings.  The goat has only eaten one-third to one-half of the snake.  What this means to investors is to be careful of credit risk.  Avoid entities that need credit risk to improve for now.  And pray that we don’t get a negative self-reinforcing scenario where financial failures lead to more failures.

    Be wary of credit risk, particularly among financial stocks.