Indigestion and the Right Medicine

As the de-leveraging story unfolds, the market is throwing up some significant opportunities for the patient investor. The credit markets have been dominated by a relatively new type of investor who bought anything with a rating and then stuffed it into structures that could be levered and sold on. There is no need to go into the detail again; suffice to say that, as these structures are unwound, their bond inventory is released back onto the markets. One of the main buyers of these bonds has now turned into a forced seller just at a time when banks and their hedge fund friends are also reducing their appetite. It makes for a classic case of bond market indigestion and difficult trading activity, with large parts of the market moving sharply away from fair value. This is an opportunity for investors looking for income, and perhaps capital gains, and no margin is required to achieve it.

Meanwhile, the US housing market continues to infect the rest of the US economy and the debate has moved on from 'is the economy in recession?' to 'how long will it stay there?'. Weak economic growth leads to rising default rates, which are as bad for credit markets as inflation is for government bond markets. A combination of deteriorating economic conditions and the de-leveraging of credit structures has left us with some extreme valuation levels. The chart below shows the extent of the moves compared to the last credit crisis in 1999/2003 (when Enron and then WorldCom went bust).

The relevance of using this period relates to the response from the US central bank at the time. Official rates were pushed down to 1% to help alleviate the economic problems and to offset a fear of deflation. Although inflation seems more of a concern right now, the underlying economy and the credit crisis is arguably in a worse state. Hence the markets believe that we are on a path towards a 1% Fed Funds Rate by the summer. If not, how else would you make money in a US 2-year bond that yields 1.3%? In most cases, the yield spread (over an underlying government bond) is now wider than it was at the highest point during the 2001/3 period.

How can this indigestion be cured? As with previous bubble bursting periods, there is usually not one thing but a series and also it takes time. One could argue that, if the Federal Reserve had moved to 1% rates almost immediately (say in August last year), then we wouldn't be in this mess; but the credit bubble probably would have re-expanded and made a bigger mess when it eventually imploded. The housing market is seen as the starting point for the whole problem and therefore this is where we need to look for things to turn around. Getting official rates down to extremely low levels only helps if the rest of the interest rate market follows. Owing to the uncertainty in the credit markets, this has not happened and recent attempts by central banks have been focussed on adding liquidity in the right places. House prices are only down 9% year on year, which only offsets some of the rapid growth we have seen since the Savings and Loan Crisis in the late 1980s. Some commentators are suggesting that a 30% decline is needed to bring the market back to the long-term average. A move of that magnitude is being priced in by credit markets, but the reality will prompt a bigger response from the authorities.

The issues holding back intervention by the authorities are being overcome: "moral hazard" - the situation is bad enough that there is significant wealth destruction to overcome this concern (ask Bear Stearns or Northern Rock shareholders); and wasting tax-payers money, but one could argue that they would be buying cheap assets and should come out with a profit on the other side.

What is the right medicine to apply? Here are a few suggestions gleaned from the past:-

Get interest rates down low and ensure the cash market is working. The Federal Reserve could cut rates to 1%, which is priced in by the treasury market. It can also provide sufficient liquidity in the repurchase ("repo") markets. In addition to the Term Auction Facility, the Fed has announced a new ($200bn.) initiative called the Term Securities Lending Facility.

Government support - Bush plans to give taxpayers $150bn. worth of cheques (to be received in May). So far, there have been numerous ideas to help home owners in difficulty, but none have taken off. The latest plan being discussed is to allow the Federal Housing Administration to use $300bn. to help refinance homeowners with greater than 40% mortgage-to-income ratios. This could be the most significant step and may help work through the problem.

These initiatives may not be enough on their own and we may require more. One thing is for certain; there needs to be an appropriate amount of time before the full negative effects of the credit crunch are felt in the economy and then the appropriate bandage or bandages can be applied. The timing of a turnaround still seems a way off, but meanwhile there are opportunities to spot assets that have moved to a point where they offer significant value.

The healing process requires an effective banking system, without which the medicine cannot be applied in the right areas. With the Fed Funds Rate at 1% and long rates down at close to 4%, the banks have a positively-shaped yield curve which will enable them to go back to their old business of borrowing short and lending long, thereby making money without the need to apply excessive leverage. For the economy, the recovery is still far away, but for the banks the positive yield curve can help to offset the losses elsewhere. Bonds issued by banks have been the hardest hit because of their exposure to each of the shoes that have dropped over the last year. Cutting dividends and raising capital will still hurt the shares, but the bonds can benefit.