Tuesday, March 06, 2007

Following the bouncing risk sentiment...

Stocks are bouncing higher today, and credit spreads are moving tighter.

I think this will play out like spring of 2005. What, you don't remember the momentous market moves of spring 2005? Its funny how marketeers seem to remember all the times it crashes and burns much more clearly than the times it smooths itself out. And here's a secret: the later happens more often.

So to counter all the old saws about 1987 or 1998, here is a story about 2005. At the time, General Motors was one of the top 2 investment grade corporate bond issuers. On May 5, S&P downgraded their corporate debt to junk status. Moody's soon followed. Because GM was a major holding of almost every core-style bond manager in the U.S., and because a large percentage of these holders became forced sellers when it was downgraded, the bonds got absolutely crushed.

The whole credit basis was getting whacked. Not that GM had anything to do with Comcast or Verizon, but everything was getting wider. Many market pundits had complained that corporate spreads generally had become too tight after huge rallies in 2003 and 2004. So many fearful investors took the excuse to shed credit risk indiscriminately.

The irony is that the fundamental problems ratings agencies cited when downgrading GM weren't really news. They were losing share to foreign manufacturers. They had huge legacy costs. They had an image problem with consumers. Their profit per car was declining. All this had been well known about GM for years. In fact, I attended a conference on credit analysis in February of 2003 at which the cocktail discussion among us geeky bond analysts was how in the world GM still had an investment-grade rating.

Given how well-known their problem was, why did the downgrade cause such a ruckus? Great question, but no easy answer.

Anyway, as we all know, by the end of 2005, credit spreads had rebounded nicely. And they continued to rally in 2006. Now its hard to fathom that GM was investment grade so recently, isn't it?

So now let's compare this story to the sub-prime story.

1) Just like 2005, today credits like Comcast and Verizon are getting wider ostensibly because of fears related to a credit which has nothing to do with either company. Then it was GM, now its sub-prime.

2) Just like 2005, the problems in sub-prime had been well known and oft discussed for a while prior to any actual credit event. A quick search of any financial newspaper going back to 2004 would show pundits expressing concern about sub-prime borrowers qualifying based on teaser rates. Or borrowing with limited documentation. Or borrowing 100% of the value of the house. I defy you to find the serious analyst who predicted there would never again be a period of rising sub-prime default rates.

3) And yet, just like 2005, the reaction to a widely anticipated event was quite violent.

4) Just like 2005, the vast wall of liquidity eventually brought spreads back in, and by mid 2008, spreads were back to where they were at the beginning of 2007.

Or so my crystal ball says.


Anonymous said...

Tom, don't forget that on May 6, 2005, Kirk Kerkorian announced a 9.5% stake in GM, sending the stock price up. Hedge funds who were short the stock and long the bonds were terribly whipsawed.

The difference is that "what's good for GM is..." no longer... "good for America." In 2005, it was two companies in a highly consolidated industry (autos) that had been sick for a while. And the non-US auto firms like Toyota are doing great.

In 2007, it's a major industry (housing, construction, building materials, mortgage finance, banking, home improvement stores, home decorating stores) that provided a great deal of the jobs created since the 2001 recession.

RW said...

Have to agree with Anon 5:20 here, history may rhyme but IMHO the shear scale and multi-sector reach of RE in the US economy makes the analogy to a 21st century GM implausible.

Tom G. said...

We'll see gents... we'll see.

Anonymous said...

this is just a blip in the economy