Issue 50 - March 5, 2009

Rebuilding Credit

We have been hearing for a number of months now that economic recovery will begin once “The Banks” begin to lend again. While this may sound self evident, it is important to understand the limited role that traditional banks now play in the broad, global credit market. The majority of modern day lending takes place through non bank entities and the process of securitization. These entities and functions have also been disrupted and those businesses which depend on this channel have been particularly hard hit. Banks alone can not fill this funding gap even if they were to substantially increase their current pace. Any lasting recovery will require that the entire system be refurbished. Consider the variety of borrowers in the market today:

• Commercial Paper
• Conforming Mortgages
• Jumbo Mortgages
• Auto loans
• Credit cards
• Investment Grade Bonds
• Municipal Bonds
• US Treasuries
• Commercial Mortgages
• High Yield Bonds
• Leveraged Loans for Private Equity
• Lines of Credit

Each of these borrowers and their creditors had over time established strict standards in underwriting processes and a market for the debts. However the reckless disregard of standards led to the failure of these channels and the institutions which serviced them. Credit is a process and it must flow consistently and reliably. In essence, the pipelines have all been fractured.

In September of last year, there was a brief period where virtually all credit stopped flowing. Through the combined efforts of the Treasury and the Federal Reserve, numerous facilities were put into place to provide loan guarantees in order to revive the basic functionality of the system. In addition, the Federal Reserve lowered its benchmark rate to effectively zero. The combination of these efforts re-established the flow of short term funds and liquidity within the commercial paper market (corporate borrowing at 9 months or less) at historically low rates. However, not every market enjoys this support and the re-establishment of credit will have a direct impact on the recovery time of each sector.

Under Repair

There are segments within the credit market which have begun to operate again. The most noteworthy is that for current conforming home loans (balances below $417k) with loan to values of 80% or below. While the return to standards may have been a shock to some, these prudent borrowers have been rewarded with long term mortgages of 5% and below. These loans can be packaged and sold to the agencies of FNMA and FHLMC as had been done traditionally. However, it has been instructive to see how long it is taking to complete a process. With the mergers and failures of numerous institutions and the coincident job loses, there are far fewer loan officers. The mechanics of underwriting still takes time and the queues will only get longer.

Jumbo home mortgages are another matter all together. These loans were never sold to the agencies, rather they were sold to institutions who packaged them together into securities after which the capital could be redeployed back into making a fresh set of loans. This was also true of car loans and credit card portfolios. Securitization has been effectively closed since last fall and as such, the underwriters of these loans are forced to hold them to maturity. There is no market for them and with no secondary market, there is simply a limited supply of capital. The banks and finance companies are no doubt doing the best they can with extremely limited resources but understand they are only going to make loans that they would want to hold for the full term and at levels that compensate them for the lack of liquidity in their portfolios. Securitization is not new; it has been standard operating procedure since the mid 1980s. It has provided access to credit to millions of consumers. However, it was the bastardization of this process which led to the packaging of so many worthless loans. Until these “toxic” products are fully understood and priced, securitizing quality home, auto, and credit card portfolios will have to wait and the infrastructure will then need to be rebuilt.

In regards to Investment Grade Corporate and Municipal Bonds, we have begun to see a return to a more normal process of underwriting albeit at inflated rates. However, each of these markets is beset by the fact that we have lost a large part of the underwriting infrastructure. There are fewer firms with smaller staffs and less capital. On the positive side, within the Muni market specifically, we have seen the recapitalization of MBIA, one of the major re-insurance firms. This is a major step in the direction of rebuilding the AAA status of the broad market. This will broaden the appeal of the securities and as a result, will lead to lower rates for many municipalities.

One entity enjoying access to credit at historically low rates is the US Treasury. Despite the promise of substantial future supply, investors continue to purchase bills, notes, and bonds at record pace. There is much debate as to whether investors will continue to subscribe at such low levels or for how long. But US Treasuries are enjoying a renaissance as an asset class. Since the mid 1990s when domestic investors held 80% of the US Treasuries issued, there has been a steady move away from these bonds by domestic accounts. This in part reflected a change in asset allocation towards higher yielding and less liquid income producing assets such as real estate. But it also reflected a decline in the US Savings rate. As our rate continues to climb back up to historical standards, these savings will look for a home and for the moment, the safety that comes with US Treasuries is in demand.

Just as we have seen a decline in the infrastructure of many other credit markets, the Primary Dealers of US Treasuries has also been significantly reduced. Established in 1960 with 18 dealers, the Primary Dealer system hit its peak in 1988 with 46. As of December 2008 there were just 17.

Problems Persist

Unfortunately there are areas of the market that are not functioning or that have yet to fully realize the depths of the problems that lay on their horizon. Specifically, these would be non investment grade corporate borrowings, leveraged loans, lines of credit, and perhaps most worrisome, commercial real estate loans.

When there is little appetite for quality, non governmental borrowers, it should come as no surprise that there is no appetite for junk. And while there are numerous analyses which point to the inherent value of buying high yield paper or leveraged loans at these inflated levels, there are very few takers. Once again, this may be a reflection of modern day allocations. Financing of private equity was a red hot sector among institutional investors and those buyers may be working off what they currently own for some time.

One of the most undeserving areas of collateral damage has occurred within small and mid size business lending. Whether it is for the financing of receivables or inventory, it has become increasing difficult and expensive for companies to conduct their affairs. These loans had historically come from banks and for the time being, the banks have definitely pulled back. These businesses have done nothing wrong but are suffering as a result of the current state of limited capital.

But by far the biggest worry is the coming wave of commercial real estate loan maturities. Recall that the failure of the entire Savings and Loan industry was due to problems within the commercial sector. Depending on which source you refer to there is in the neighborhood of $500 billion of commercial loans coming due within the next 3 years and of which $160 billion is due in 2009. There is virtually no appetite at this time for any of it. No sector of commercial real estate is immune; hotels, shopping centers, multifamily, and office complexes will all be impacted. And just as we have seen Private Equity go from being a provider of liquidity to a consumer of liquidity, so will real estate. In the absence of replacement financing, owners will need to dig deep to come up with substantial equity or risk losing all of their investment.

Big Chore

Rebuilding the credit infrastructure will take some time. It will no doubt come back in a more efficient, more widely distributed, and more discriminating manner. Meanwhile, there remain extraordinary opportunities within high grade markets. Any issuer coming to market without a government guarantee has to pay far more than they should. As Warren Buffett stated in his annual letter – “At the moment it is much better to be a financial cripple with a government guarantee than a Gibraltar without one.” As investors, we can certainly continue to take advantage of these elevated rates among the best issuers. Lower rates and access to capital will ultimately provide the keys to a lasting recovery.

• Rebuilding Credit
• Under Repair
• Problems Persist
• Big Chore