“The Unwind”

I invest like a moderate bull and I reason like a moderate bear.  Why?  In general, in free economies, the equity markets favor the bulls over long periods of time.  So, I stay invested in equities in almost all markets, and let my other risk reduction techniques do my work, rather than making large changes in asset allocation.  That said, I appreciate the risks that the markets have been throwing off lately, and I am somewhat worried.

I have been a bear on residential housing and residential housing finance for the last four years.  I expected that those that took a lot of credit risk — subprime, Alt-A mezzanine and subordinates, would get hurt.  What has surprised me, though, is the degree to which AAA whole loan collateral and agency loan collateral has been hurt.  I failed to see the amount of leverage being employed there.  I looked at that area and said, “You can lever this stuff 10x, and you probably won’t get hurt if you are smart.”  Fine if 10x is the limit, but you had players at over 30x, and now you have that paper being tossed back into the market, depressing prices, and raising yields.  This raises the risk of a self-reinforcing move that will only end when unlevered and lightly levered buyers soak up the high yielding safe assets that couldn’t find a home elsewhere.

Any asset can be overlevered.   A house, a home loan, a corporation… there is some level of debt that will kill the owner of a given asset.  High quality mortgage paper got overlevered, and even though current market prices are attractive to unlevered buyers, there is the short-term risk that more players will be forced to delever.  So when is the right time to buy?

I have agonized on this one, because the problem is short-term financing.  Repo financing from brokers that have their own balance sheet worries.  (Note: some are talking about mark-to-market accounting — yes, that has a small effect here, but not as large as the financing issue.)  Repo financing is short-term collateralized lending.  97% of the value of the agency loan collateral gets loaned, with 100% of the agency loan collateral as security.  If collateral prices move down, more margin must be posted. This is an unforgiving situation.  If you can’t meet the margin call (demand for more funds to support a losing position), your collateral will be liquidated.  (There also issues in how one hedges, but that is for another time.)

When to buy?  Most repo funding is short — a day to a week.  Some extends over 30-90 days, and Annaly uses 1-3 year repo financing (where do you get that?).  My sense is this: wait for two weeks after you hear of any major fund liquidation, and commit half a position.  After another two weeks, commit the other half, if no further liquidations have been heard.

At my last firm, I would talk with my boss about “The Unwind.”  All of the areas of the credit market where ordinary prudence was being ignored, and in the short run, leverage was increasing, because is paid to do so in a rising market.  Eventually, asset cash flow would prove insufficient to finance the interest costs, and then “The Unwind” would happen.  Leverage would have to come out of the system, both from explicit loans and from derivative contracts.

We are in “The Unwind” now.  Leverage is coming out, even in asset classes that I did not anticipate.  “The Unwind” will end when players with strong balance sheets hold most of the previously overlevered assets.