How bad will the credit crunch be? Will it last into 2008? Will it be worse than LTCM? Is this the end of structured finance as we know it? My quick answers: Yes, maybe, and no. Structured finance is too useful of a concept to regulate too heavily. Ratings are also difficult to do without from a regulatory standpoint. The concept of “buyer beware” must apply to fixed income managers inside regulated financial institutions. Ratings are ratings and not guarantees; they supply useful summary data, but are no substitute for due diligence.
Now, the ratings agencies’ stocks have been pinched by the crisis. I think that they will bounce back, and on more weakness, I could be a buyer. That said, it is interesting to see them edge away from their aggressive ratings on CPDOs [constant proportion debt obligations], particularly as the prices sink.
There may be some upward drivers for the ratings agencies. After all, investment grade bonds are being issued like mad. (Another reason to favor high quality companies at present.) The head of Deutsche Bank sees the market normalizing. (And maybe if you borrow in euros, it is.) On the other hand, high yield spreads are at a new record for the past few years, and distressed debt is finally arriving in size. (Maybe enough to choke all the vultures?) Risk is real for junk grade companies, and residential real estate related assets. The willingness to take financial risk has normalized; now it is time for the market to go beyond normal to petrified. Now, who can help us more with petrified than Jeremy Grantham? He sounds the alarm on real estate related assets, junk obligations, and the equity markets.
Finally, I should have included this in my last post, but the short term debt markets are rough in the UK as well. UK LIBOR hit a 10-year high recently. When many of the various LIBORs of the world are showing signs of fear, it is possible that a larger trouble is at hand. Until recently, all of the major central banks of the world were tightening, all at once. With the exception of Japan, I expect them all to begin loosening soon, and begin accepting higher rates of inflation. Perhaps I have my next investing theme?
Full Disclosure: long DB
Banks lend to each other short-term in several ways. For banks in the Federal Reserve System, they lend through Fed Funds, of which the Federal reserve provides more or less liquidity as it sees fit. Bigger banks can lend/borrow in the overseas euro-markets at LIBOR [the London Interbank Offered Rate]. This market is unregulated — outside the direct control of the Federal Reserve. It is an independent source of US Dollar liquidity limited only by the willingness of banks to grow/shrink their balance sheets.
The willingness of major banks to grow their balance sheets is in short supply today, so LIBOR is rising. Commercial banks like Barclays have a greater need for short term liquidity at present because they have to bring some short-term financing back onto their balance sheets because of failed conduits. In the bank of England’s case, it was enough to force them to inject some temporary liquidity. There is a secondary relationship between a central bank’s policy rate (like Fed funds) and LIBOR: as a central bank injects more liquidity, the less excess demand there is to borrow at LIBOR by banks. So, as the Fed stays tight, and the need for short term finance grows, LIBOR rises. And as I have mentioned before, the gap between LIBOR and T-bills [the TED spread] is very wide at over 1.5%. Anytime the TED spread exceeds 1%, there is significant worry in the euro-markets over credit concerns. Spreads of around 0.2-0.3% are more normal.
The short end of the credit markets is undergoing the most stress at present. Asset backed commercial paper on ultra-safe collateral is getting refinanced at penalty rates, while ABCP on questionable collateral is not getting refinanced. The reverse repo market is affected as well, as many mortgage REITs have found out, as haircuts on collateral have increased. Even Citigroup could be affected, if they have to collapse some conduits, and bring the assets onto their own balance sheet. The ratings agencies are awake, and are actually downgrading some conduit structures here and there. The ratings agencies do that every now and then, when their franchises are threatened.
With this much pressure on the short-term debt markets, it is my belief that the Fed will do more than they have. Maybe they will cut the discount rate again, or allow even more marginal collateral to be used. On the other hand, since such subtleties are wasted on the public, they will likely have to grab the blunderbuss of lowering the Fed funds target, and fire a few times. It won’t solve the problems of those who are under heavy credit stress, but it will eliminate problems for those with light to moderate credit stress, and begin the overstimulation of a new part of the US economy.
Here are parts one and two of this series. Rather than give a detailed list of what is right with my portfolio, I left the companies that were least likely to have problems for last. The entire portfolio is over at Stockpickr. What I will go through here are the potential trouble spots.
- Jones Apparel
- YRC Worldwide
- Deutsche Bank
- Royal Bank of Scotland
- Sara Lee
- Tsakos Energy Navigation
Barclays plc has already been sold, as have the two auto dealers. Deerfield is too cheap to sell, and I expect that they will not be able to complete their merger, which doesn’t harm Deerfield much, or help them much. Conditions in the
bank debt markets aren’t too cooperative now, and I would expect that there won’t be too many CDOs done in the next two years.
Bad shape: As for Jones Apparel, a lot depends on what they do with the cash from the sale of Barney’s. Personally, I would use it to reduce debt; if they use it to buy back stock, I will be one of the people selling the stock to them. YRC Worldwide is a cyclical company with more debt than I would like; trucking stocks have been weak so I might sell into a rally, or do a swap for a less levered company.
Questionable: None of these balance sheets are in great shape, but aside from the banks, their underlying businesses are likely stable enough to bear the strain. As for the banks, do they really have enough capital to survive through a real crisis? Probably, if only because they are “too big to fail.” Governments will take action to protect their existence, though not necessarily the interests of the current equityholders. That said, I am a little encouraged by Deutsche Bank’s relatively good positioning in this crisis so far, and the CEO’s willingness to encourage transparency.
So, for now, on rallies, I may be lightening some of the above names. I am in no rush at present, and will take my time in adjusting the portfolio.
Full disclosure: long DB RBSPF SLE GMK TNP CX YRCW JNY DFR
Additional tickers mentioned: BCS