Issue 42 - February 27, 2008

Credit Hangover

Throughout this New Year, stocks and bonds have negotiated the inexorable unwinding of credit excesses. The unintended consequences of historically low interest rates have proven to be more numerous and pervasive than disclosed last summer. Valuations have taken a back seat to mechanical decision making around capital raising, balance sheet restructuring, margin calls, and fund redemptions. Value is certainly being created throughout all asset classes even if many market participants are not yet comfortable putting money to work.

Busy Banks and Brokers

To be charitable, financial institutions are distracted. With one hand they are effectively raising capital while on the other they are trimming down their balance sheet holdings and in some cases at significant discounts. In the meantime however it is fair to say they are not doing a heck of a lot of productive work for the economy. This past week, we saw a wholesale abdication of leadership of an entire market as dealers refused to use their balance sheets to support the auctions of money market securities. While these particular disruptions will likely be worked out over the coming weeks; disorderly markets do nothing to enhance a recovery or build back investor confidence.

This healing process is neither mysterious nor is it pretty. The Federal Reserve has received harsh criticism for acting too slowly, but the banks were never transparent as to the scope of their losses. In either case, the process is now well underway, but recovery is never in a straight line. The central bank has lowered their benchmark rate dramatically since last summer from 5.25% to 3% today. However the credit spreads that lenders now demand have widened sufficiently to mask much of the benefit provided by the easing. Just as spreads were too tight prior to last summer, they are predictably too wide now. We have seen this before, most recently in 1993 when there was a successful return to traditional lending practices in combination with the recognition of losses on those loans whose terms and conditions could never have been fulfilled. In addition to a lower benchmark rate, the US Treasury yield curve has also seen a return to its historical shape and slope. Appropriate credit premiums coupled with a positively sloped curve is the basic recipe for bank profitability. The recovery of the financial institutions will be impressive once it gets on track. However, the timing of this recovery is the topic of much debate.

As the banks return their attention to their traditional businesses, they will have the ability to make loans at attractive terms, and they will also have the opportunity to buy high grade securities. Whether a bank makes a loan directly or through a previously issued bond is up to them. The tipping point for lending activity to get back on track will be when spreads on securities are less than what the banks can charge directly. Consider however at this time that many fixed income securities are being sold at fire sale prices in order to meet a variety of investor redemptions or margin or balance sheet demands. Yields that can be “purchased” are considerably more attractive than those that can be “lent” to credit worthy borrowers. This imbalance will not last indefinitely, traditional investors will see to that once they feel that they are being fairly and adequately compensated for the risk.

Insurance Cleanup Underway

It is hard to imagine how three relatively obscure insurance entities could wreak so much mischief as Ambac, MBIA, and FGIC have wrought. Through their ill considered foray in mortgage and derivative contract guarantees, they have substantially wiped out their equity holders, brought municipal bond issuance down by a third, and thrown a monkey wrench into efficient tax exempt money markets. These three entities, along with a handful of others, simply provided stand by insurance for what is effectively an extraordinarily high quality set of borrowers found in the municipal market. Guaranteeing that an investment grade borrower will make timely payments of interest and principal is not a glamorous business. But for 35 years it was routinely profitable. By diversifying into higher risk guarantees they have jeopardized their bread and butter business. How these entities will be recapitalized is under discussion, but it is clear that there is a need for financial guarantors to be part of the credit solution. Warren Buffett has generously offered to purchase all three of these entities at what are no doubt rock bottom prices. While pundits dismissed his offer, it would seem that his public announcement has forced matters to a head. Either offer a better business solution or fix the current players. A resolution in this area would take substantial pressure off of a number of markets.

Risk versus Reward

There is a tremendous amount of cash on the sidelines and money market yields have plummeted. When you consider the value in investing in securities versus what cash is earning, the investment case is compelling. Warren Buffett who is routinely touted as the best long term investor going has been very publicly putting his money to work in names like Kraft and Burlington Northern Railroad and a reinsurance plan for all three of the troubled bond insurers. What does someone like Buffett see that the rest of the market can not or will not? The difference may not be in what he sees but rather in what he can afford.

We have long argued that it is important to build portfolios that are sturdy and that can weather difficult markets. By focusing on the highest quality assets at discounted prices we are well positioned to withstand further market turbulence.

• Credit Hangover
• Busy Banks and Brokers
• Insurance Cleanup
• Risk versus Reward