Alan Greenspan once said, it is “very difficult to definitively identify a bubble until after the fact — when its bursting confirm(s) its existence.” My hearing is not perfect, but I believe I just heard a “POP” in the credit markets.

The rapid decline in the price of credit sensitive bonds effectively confirms that credit spreads had tightened to levels that were too low relative to risk. Investors in recent years received insufficient compensation for the risk of default, credit deterioration or a liquidity event. Any bubble can be sustained for a considerable period of time when investors start investing based on the greater fool construct (i.e., buy now, sell later to an even greater fool). But, as with previous bubbles from tulips to dot.com, there comes a day when there are no greater fools, leaving the last investor to purchase the security as the greatest fool. This timeless story plays out differently every time, but the outcome is always the same: large losses for investors who do not do their fundamental homework.

So, how was this mess created?

Most would attribute the bubble in credit markets to an excess of global liquidity, and the subsequent fall in prices to contagion from the meltdown in the U.S. sub-prime mortgage market. While this is broadly correct, analyzing the details provides insights into where future opportunities lie.

A prolonged period of low policy rates in industrialized countries sowed the seeds for the current turmoil. Low interest rates encouraged investors to go further out the risk spectrum to boost returns. Then when central banks in the industrial world began hiking policy rates, it was emerging market countries that helped keep long-term interest rates in developed markets low by plowing vast central bank reserves into the U.S. Treasury and other fixed income assets. These low rates and ample liquidity propelled more and more risk seeking behavior among other investors. In short, the indirect effect of this recycling of currency reserves was to create significant liquidity in riskier assets and strategies, including hedge funds and other levered investment vehicles.

While savings in emerging markets remains high and will not likely soon be reversed, what is being reversed is the excess liquidity created by leverage in alternative investments and structured products. Pension funds, endowments and other asset managers invested aggressively in hedge funds and private equity. While these investment vehicles use many different approaches, the one common element is that they seek to increase returns through leverage, which has been both plentiful and cheap in the relatively calm markets of the past few years. Private equity firms have been able to take public investment-grade companies private by issuing high yield bonds and leveraged loans. Hedge funds, riding the bull market in credit, were willing to invest in riskier and riskier bonds, including LBO debt created by private equity firms.  This is a classic case of leverage supporting leverage, which almost always makes for a volatile (dangerous) situation.  Another version of the leverage-on-leverage game is occurring with structured products, many of which used leverage in an attempt to enhance returns. Securitization has delivered a vast array of products to investors in the past decade or so, but the ones that have mainly been responsible for the inflating credit markets were: RMBS (residential mortgage-backed securities), collateralized debt obligations (CDOs), and conduits/SIVs (structured investment vehicles).

The Link Between U.S. Housing and the Current Credit Market Turbulence

PIMCO has warned of the fundamental flaws in the U.S. housing market for some time. Homeowners have been extending themselves to purchase homes beyond the reach justified by their incomes.  The reason this was able to happen was because of a simple economic principle known as an “agency cost.” An agency cost exists when an economic agent (a person or company) does not bear the cost of their actions. This simple theory has accounted for many a debacle. 

In today’s version, intermediaries in the securitization process generated the agency cost. Mortgage brokers, who were largely outside any regulatory oversight (expect this to change) were selling mortgages that provided them with the highest commissions – not necessarily the most suitable mortgage for the homebuyer. These loans were then sold to investment dealers, who repackaged them into RMBS with the help of a rating from the rating agencies, who also obtained nice fees for their work without committing any of their own capital. While the dealers are not completely agents (as they do have exposure to these loans during the time it takes to accumulate enough mortgages to securitize them), the dealers can be thought of as generating long run agency costs, as they have no intention of holding these loans. To recap, mortgage brokers, ratings agencies and investment banks all collect fees during the process of developing RMBS, and yet none of these agents have any long-term investment in the loans.  Any wonder that there was an explosion of bad loans made in the past few years? 

What about the investors?  Surely they had an economic incentive to diligence the loans in the portfolios? Yes, sophisticated investors such as PIMCO did do their homework and either did not purchase these bonds or required even more credit support than the rating agencies required before purchasing. However, another class of investors was much more willing to buy: those who relied heavily on the rating of the bonds. Some of these investors were simply a bit naïve, or did not have the resources to properly assess the collateral and structure. But many of the buyers were structured products themselves that rely on rating agency models to raise capital for themselves. This is where the leverage-on-leverage game begins in earnest.

Many of the buyers of RMBS were CDOs and conduits/SIVs. CDOs and conduits/SIV’s are basically diversified pools of debt that are financed by issuing rated debt themselves. CDOs issue rated long-term debt while conduits/SIVs issue rated asset-backed commercial paper (ABCP). The issue the market is having right now is the reliability of the rating agency models. These models are premised on historical default and recovery rates. With relatively new products such as negatively amortizing mortgages, teaser-rate mortgages, and other innovative features, the rating agencies do not have much historical data to stress test their models.  And with subprime loan defaults exceeding rating agency expectations, rating methodologies for a variety of credit products are now being questioned.  As a result, credit risk premiums have widened across the board, liquidity in the credit markets has dried up, and the credit bubble, if that is what it was, popped.

After a long slumber, investors are now waking up to the large mark-to-market losses in their alternative and structured product investments.  The most serious issue is the ability of conduits to place asset-backed commercial paper (ABCP) into the marketplace. To date, the independent conduit market in Canada has had the most severe dislocation in the global ABCP market. While some bank conduits in Germany have had some issues rolling their paper, Canada is the only country where an entire segment of the ABCP market has failed. As I wrote in last quarter’s article, Changing on the Fly, the main issue was that independent conduits were applying too much leverage to credit derivative portfolios that had too little disclosure. A number of market participants are trying to come up with an equitable way to distribute the losses. While it is too early to forecast what the final solution will look like, it is highly probable that there will be investment opportunities as banks and ABCP investors who inadvertently exposed themselves to risks are forced to liquidate their positions.

In response to these financial dislocations, the world’s central banks, including the Bank of Canada, have flooded the global financial system with liquidity to ensure that banks (many of whom sponsor conduits that cannot roll ABCP in current market conditions) have access to funding. Central banks are not unhappy to see risk premiums come back into credit markets, and might be inclined to let some conduits fail, but policymakers do not want a short-term liquidity squeeze to create a systemic banking crisis. Since banks created many of these conduits, investors are now getting cold feet and leery of many bank liabilities, not just the riskier conduit programs.

Do events on Bay Street and Wall Street really mean much to Main Street?

We believe tightening credit standards will affect the real economy. The U.S. economy will bear the brunt of the storm, but Canada, as the largest trading partner to the U.S., cannot avoid this storm spilling over into our economy.

The U.S. consumer is the main lynch pin connecting tighter credit standards to the real economy. We believe tighter credit standards will cause consumption in the U.S. to fall and GDP growth to slow for several reasons:

1. The wealth effect – Both the value of homes and stock portfolios have fallen, which will lead to a reduction in spending as consumers no longer feel confident about their net worth.

2. Fall in disposable income – Many U.S. consumers took out adjustable rate mortgages, which will reset to much higher rates. They are also paying more at the pumps as energy prices rise.

3. Concern about future employment – As the cost of corporate borrowing rises, and private equity firms can no longer pay large premiums to take public companies private, corporate CEOs are feeling less confident about the future value of their companies. They may start to cut back on capital spending and hiring.  An uptick in the unemployment rate will add to the concerns of  U.S. consumers – who are already stressed by falling wealth and disposable income.

A slowing U.S. economy will likely not import the goods and services that Canada counts on selling to them.

The Upside of this Meltdown

From a cyclical perspective, this contraction of liquidity has led to higher risk premiums in the market place. As leveraged investors are forced to make their margin calls into markets with substantially lower liquidity, we are starting to see forced liquidations of the highest quality assets (the assets that they can at least find a bid for). Eventually, investors may be forced to sell even the lower quality assets as bankruptcies and leverage unwinds take place.

We suspect that many of the highest quality (out-of-favor) structured products may be able to be acquired at significant spreads. This is the opportunity amongst all this doom and gloom.  Investors, such as PIMCO, who did not chase the credit bubble will have an opportunity to acquire assets that are cheap to their fundamental valuation as mounting losses force leveraged players to sell and some babies get thrown out with the bath water.

This fits very well into our secular view that the world economy will continue to grow at robust levels over the next 3-5 years, driven by strong growth in the emerging market economies. This cyclical liquidity crisis, centered on U.S. housing and over-extended credit markets, should create an opportunity to buy attractive assets that should eventually benefit from a robust global economy.

In Canada, the rising costs of leveraged buyouts should create investment opportunities in the debt of selected companies that still have LBO risk priced into them. Now that private equity firms have less ability to leverage up their balance sheets as they take public companies private, credit spreads should tighten. In addition, the implosion of the ABCP of independent conduits in Canada should allow investors to acquire the collateral owned by these vehicles at a discount.

For fundamental investors like PIMCO, clouds like the current dislocation in credit markets usually have a silver lining.