The Great Escape?
Hopes run high that the worst of the credit-market turbulence has passsed, but are we really there yet?
By Aleksandrs Rozens May 12, 2008
Sentiment about US credit markets has improved in recent weeks, thanks in part to a March bailout of Bear Stearns orchestrated by the Federal Reserve as well as a steady campaign by the US central bank to improve liquidity of fragile capital markets. The slight uptick in confidence is reflected in narrower yield premiums in a variety of debt markets, as well as a pickup in the issuance of a variety of debt and equity securities.
At the same time, many investors remain more than a little wary, particularly those involved with securities backed by consumer debt that could be hurt by an economic downturn.
Other factors tempering the euphoria include a recent note to regulators from Bank of America related to its purchase of Countrywide Financial that prompted some investors to question if the transaction will happen, a Fed report on lending standards at banks, and news of massive losses at UBS and Fannie Mae.
So who's right?
As Citigroup economist Steven Wieting says, "it almost seems that going from a near-collapse of the financial system to 'business-as-usual' has become deceptively easy over the past month."
If nothing else, some of the more recent negative signs at least serve as a reminder for investors that there appears to be no quick escape from the credit mess that has gummed up Wall Street since last summer.
"Things are better now. [But] everybody is obviously concerned we'll take a step back," says Jeff Given, portfolio manager at John Hancock's MFC Global Investment Management. "Banks still have to de-lever. The financial system is still in the middle of deleveraging."
Of course, the extent of that remaining leverage is one key to how upcoming months will play out.
"Economic conditions have not changed, but market conditions have," says Andrew Harding, chief investment officer at Allegiant Asset Management Co. "The struggle with the housing market is not over by any stretch of the imagination. We have seen the worst. You are on a road to recovery, but it's going to be a rocky road," Harding says.
Several measures of credit conditions illustrate how investors and banks appear to be more upbeat about financial markets. For example, credit default swap spreads for banks and brokerages narrowed and other indices of corporate debt show a rosier outlook. At the same time, yield premiums demanded by investors in the world's largest credit market -- the US mortgage market -- narrowed as did spreads for securities backed by commercial real estate mortgages and various forms of consumer debt such as credit cards.
Given says the better conditions are evident in a variety of bonds and securities. "You are seeing it across asset classes," he says.
What has unnerved some investors, though, is a May 1 note that some market players took to be a tentativeness by Bank of America in its assumption of Countrywide Financial debt. Some market players even voiced concern that the merger may not happen; one investor who declined to be named said the deal has a one-in-four chance of not being completed. The same investor conceded, though, that regulators and the Fed likely would intervene to ensure the merger's completion.
Soon after that note to regulators, Standard & Poor's cut its ratings on Countrywide Financial Corp. and Countrywide Home Loans Inc. The credit agency also lowered its rating on Countrywide Bank because of terms of the merger, specifically a new reference regarding the treatment of Countrywide's debt. The rating agency noted that "as part of its integration planning in connection with the merger, Bank of America is currently evaluating alternatives for the disposition of the remaining Countrywide indebtedness, including the possibility of redeeming, assuming, or guaranteeing some or all of this debt, or allowing it to remain outstanding as obligations of Countrywide (and not Bank of America). Bank of America has made no determination in this regard, and there is no assurance that any of such debt would be redeemed, assumed, or guaranteed."
According to S&P, the filing indicates it is now possible that Bank of America may not support some of Countrywide's debt, including the approximately $17 billion of medium-term notes, $4 billion of convertible debt, $2.2 billion of junior subordinated debt, and $1 billion of subordinated debt currently outstanding.
Another reminder for Wall Street that credit conditions are not entirely back to normal came when S&P cut selected ratings of GMAC's Residential Capital, including its long-term corporate credit rating, and warned that ResCap may file for bankruptcy if the company's planned exchange offer for unsecured bonds fails.
Then, last week, US housing agency Fannie Mae announced its loss of $2.2 billion in the first quarter, or $2.57 a share, and UBS posted a $10.95 billion first-quarter loss related to its mortgage holdings.
The list of concerns for Wall Street grew when a Federal Reserve report issued on May 5 suggested credit conditions continued to tighten in April. According to the US central bank, "domestic and foreign institutions reported having further tightened their lending standards and terms on a broad range of loan categories over the previous three months. The net fractions of domestic banks reporting tighter lending standards were close to, or above, historical highs for nearly all loan categories."
Supply lines
While liquidity has returned to the various corners of the credit markets, the supply of new transactions is still off dramatically from year-ago levels. Also, much of the new issuance has been concentrated in the weeks between April 5 and May 5.
For example, between March 18 -- days after JPMorgan bought Bear -- and May 5, there were 44 asset-backed deals worth $32 billion, according to Thomson Reuters. That is sharply lower from a year ago when that same period saw 309 deals worth $180 billion. Thirty-one of the 44 deals were completed in the four weeks leading up to May 5.
One of the bright points for Wall Street has been the sale of debt by investment grade corporate borrowers. Between March 18 and May 5, 132 new investment grade issues were priced, down from 257 a year ago during the same period. Seventy-six of the high grade issues were sold between April 5 and May 5.
When it comes to high-yield debt, 21 deals were completed between March 18 and May 5, down from a pace of 43 transactions a year ago. Sixteen of those high-yield deals were completed between April 5 and May 5.
Bonds backed by commercial real estate, meanwhile, have seen a pickup in issuance, but the flow of new deals is sharply off from early 2007 levels. Between March 18 and May 5, five CMBS deals were completed, compared with 26 for the same period a year ago. Three of those transactions completed in 2008 were sold in the four weeks leading up to May 5.
When it comes to the equities market, initial public offerings have withered but there has been steady issuance of secondary offerings. Seven initial public offerings were completed -- five of them after April 5 -- between March 18 and May 5. That is off from 28 completed between March 18 and May 5, 2007. At the same time, 40 secondary offerings between March 18 and May 5 raised $19.5 billion, compared with 62 deals last year that raised $12.5 billion. Just over half of the secondary offerings in 2008 were sold in the April 5 to May 5 period to raise $15.6 billion.
That supply of new securities -- albeit, at a fraction of year-ago levels and concentrated in April -- is viewed as a source of optimism for Wall Street.
"Mid-March was clearly a peak in financial market risk across every asset class. Since then, it is very clear we have had a dramatic rebound in the credit markets," says Jeff Rosenberg, credit strategist at Bank of America. "In terms of the pricing of risk, the risk and fear has dissipated. Fear of systemic financial risk has dissipated."
Subtle changes in confidence
In addition to selling new bond issues and stocks, there are changes in how readily an investor can buy or sell securities. Bid-offer spreads have narrowed and there is a change in how investors respond to strength in the markets, meaning an uptick in prices or narrowing of yield premiums.
Investors these days are more willing to buy on any weakness in the market, which is an about face from steady sales by portfolio managers whenever there was any strength, according to the mortgage bond salesman, who found that liquidity has returned most to mortgage bonds pooling loans guaranteed by Fannie Mae and Freddie Mac. "People are starting to think that we have put in the wides and worst news for the year," the bond salesman says. But, he warned, the "cycle is not over. Does everyone dive back in? No."
Given agreed: "People have a longer term outlook that spreads will tighten. Even with strength [in the market] people are still holding on to securities."
Buyers returning to the market include money managers and housing agencies, such as Freddie Mac and Fannie Mae, say market participants. Also, the mortgage bond salesman noted that "hedge funds are being started up and they divert new money into spread products. People are using it as an opportunity to buy higher quality paper that was hit with the broader market downturn."
In addition to improved demand for conventional or conforming mortgages with guarantees by Fannie Mae and Freddie Mac, investors have also stepped up purchases of bonds backed by commercial real estate mortgage loans.
"Sentiment in the CMBS market has improved for a number of reasons. Those include steady-but-slow pace of buying of CMBS by investors such as pension funds and money managers," says Lisa Pendergast, head of commercial mortgage-backed bond research at RBS Greenwich Capital Markets. Pendergast noted that the CMBS market has seen new buyers such as opportunity funds seeking out "cheap" securities. At the same time dealer inventories of CMBS are light and there has been limited supply of new deals because many lenders have slowed their underwriting of new commercial mortgages.
Pendergast says the improved credit market conditions have narrowed yield premiums for CMBS. For example, AAA-10 year super senior classes of debt were at swaps plus 315 basis points in mid-March. Last week, the spread on these issues was at swaps plus 145 basis points. However, they are still dramatically wider from Dec. 28, 2007, when spreads for these securities were at swaps plus 85 basis points.
While there is concern that a slowing economy could hurt some CMBS -- many commercial real estate mortgages are tied to the well-being of retailers -- Pendergast notes that the market for commercial properties is not oversaturated with supply, a factor that could help CMBS weather an economic downturn. "There has not been this overbuilding on a national basis," says Pendergast. "In the last downturn in commercial real estate [in the 1990s] not only did you have an oversupply [of properties] you had a recession."
Will spreads of CMBS narrow from here? Pendergast believes financing costs for investors have to drop before there is enough demand for CMBS to drive yield premiums to late December 2007 levels.
In recent weeks, Harding says he purchased agency mortgage bonds, corporate bonds and high-quality asset-backeds, specifically bonds pooling credit cards as well as bonds pooling auto loans. He bought the bonds in the secondary and new-issue markets.
The Allegiant CIO estimates that mortgage debt spreads - the interpolated current coupon - are at roughly 200 basis points to US Treasuries and this could narrow to 130 to 140 basis points off of US Treasuries. Asset-backed AAA-rated tranches backed by high-quality consumer debt could narrow in spread from the current levels of 100 to 150 basis points off swaps to a range of 25 to 50 basis points off of swaps, according to Harding.
Taking inventory of corporates
When it comes to the investment grade side of corporate bonds, one of the more notable measures of credit quality is the IG 10 index, which tracks credit conditions for 100 different issuers within the high-grade world.
According to Mark Howard, head of credit research at Barclays Capital, the IG 10 index was as wide as 199 basis points in mid-March, but narrowed to 86 basis points on May 5. Hours after the earnings announcements by UBS and Fannie Mae, that measure moved out to a spread of 96 basis points. Meanwhile, a measure of high-yield credit risk -- which trades at a dollar price -- was at $97.50 early last week. It had traded as low as the low 90s when credit concerns were at their most pronounced level in March.
Market watchers say that in addition to the earnings from Fannie Mae and UBS and concerns related to Countrywide as well as Rescap, Tropicana's bankruptcy last week served as a reminder that credit conditions remain tough.
As Howard sees it, the narrowing in spreads of mortgage bonds aided the tightening seen within investment grade corporates. "Corporates usually trade at a significant risk premia to MBS," he says.
Looking ahead, Howard warns that corporate debt could be pressured in coming months. The recent survey of lenders by the Fed suggests that defaults will be on the rise later in 2008 and in 2009 "so the market can only tighten so much," says Howard.
No escaping the economy's woes
In recent months, signs of weakness in the broader economy have shown up in employment data, retail sales reports and, of course, home sales reports. Consumer confidence has been diminished by a steady rise in energy costs and the housing industry's woes.
"You are viewing [the improvement in credit markets] relative to March 14, which should rank as one of the most frightening days in financial history," says Rosenberg, adding that "we shouldn't overly interpret the rebound in the financial markets as telling us something about the real economy, anything more than a relief from financial systemic risk."
While what happens on Main Street may not, immediately, appear to have an impact on Wall Street, the two are linked. The mortgage market has sway over all other credit markets. If loans to consumers backing the bonds fail, this could impact how readily banks lend to each other and the investors buying bonds and stocks.
"It is a mistake to only talk about the capital markets being in distress and not the broader economy. The two are linked since last July, but people are still trying to separate them," says Jim Vogel, analyst at FTN Financial. "The reason people are worried about either lending against securities or putting them on repo is the potential for losses related to worse-than-expected" performance of consumer debt, according to Vogel.
For Harding, the two biggest concerns for financial markets are inflation and moral hazard, specifically the risk that some home owners find the value of their homes has dropped so much that they have little incentive to keep making payments on their mortgages.
Harding, a three-decade veteran of the debt markets, says while some market participants believe the tumult is different from others, the only factor that has changed is the asset class at the root of the problems. "The reality is it is the same effect and the same cause. The cause is excess leverage, and something like this will happen again."
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