Tuesday, March 11, 2008

What will bring an end to the credit bear market?

So readers seem to want to hear about what I think could end this credit bear market. Of course I wrote most of this before the Dow surged 300 points today. And hey, maybe this will mark the bottom of the credit market. We'll see. I for one am not pouring into financial bonds right now, and I'm betting neither are a lot of real money buyers. Ironically, in talking to fixed-income portfolio managers and traders, it is almost universally held that credit spreads for investment-grade corporate bonds are too wide. That in 12-24 months bond spreads will have tightened significantly. And yet the same people are also very cautious about adding positions right now. In other words, people who believe certain bonds are fundamentally cheap are unwilling to actually buy the same bonds. Hence the severe bear market in corporate bonds continues.

What would bring an end to this bear market? Simple. Bear markets end when the market runs out of sellers. More on this in a bit. First, let's look at what won't end the bear market.

When the economy improves?
Nope. During the 2000-2002 credit bear market, the economy was already on the upswing by 4Q 2001, but credit spreads didn't peak until 4Q 2002. At that time, accounting scandals (Enron, Worldcom, etc.) caused investors to lose confidence in financial statements in general. Any company which made the most minor of accounting restatements saw their bond spreads widen dramatically. Fear of accounting surprises kept credit investors away.

The current market might turn out to be similar. Even if the economy starts to rebound at some point in 2008, fear that subprime losses will pop up in unexpected places may keep spreads wide.

When banks and broker/dealers have adequately written down subprime securities and loans?
Nah. See, we won't know when that's happened. Consider...

  • We don't know what the right number is for losses. $300 billion? $400 billion? $800 billion? Even if there were $400 billion in write downs already, there'd be plenty of commentators claiming more write downs were coming.
  • We don't know how much of the eventual write downs are held in private hands, and therefore will never show up in a public tally.
  • Some of the losses which will hit public companies will come in the form of failed hedge funds. The losses at the hedge fund are really part of the subprime tally, but may not be reported as such by the bank/brokerage.
  • The accounting treatment for various subprime exposed positions differs. There won't be explicit "write downs" for all of the eventual losses.
The bottom line is that write downs are going to continue. Some firms may have already written down and/or sold all their impaired positions, others probably have a long way to go. But even if, say, Morgan Stanley announces zero RMBS writedowns when they next report earnings, market sentiment is so negative that people won't believe them. After all, when Morgan Stanley reported 4Q earnings they announced that they only had $1.8 billion in subprime exposure, suggesting that possible future write downs would, at worst, be small. That's hardly stemmed the spread widening in Morgan Stanley bonds.

When housing prices bottom?
That's not it either. Again, we contemporaneously know when prices have bottomed. For one, most data on home prices had a serious lag, for example, the Case Shiller figures are two months old by the time we get them. Besides, we'd need several reports of moderating price declines before anyone would believe the market had bottomed. Imagine what would happen if the next Case-Shiller report showed that prices were flat in the last month. Would anyone really believe the housing crisis was over? Or would you figure that we hit a lull and price declines would soon continue?

The same would be true for other housing health indicators, such as default rates on mortgage loans. We'll need several months to know we've bottomed. By then it might be too late to be in credit.

When confidence in the financial system returns?
Uh uh. Just like every bear market, confidence doesn't return all at once. No one will make an announcement that now the banking system is perfectly stable and its OK to buy credit. By the time confidence is restored, credit spreads will be dramatically tighter.

When buyers start nibbling in credit?
I don't think so. Whenever someone sells a bond, someone must be buying it. So it isn't like there are no buyers at all. Plus from November on we've heard of plenty of stories of smart portfolio managers coming in to buy credit, MBS, commercial MBS, bank loans, etc. Unfortunately, every single time anyone has nibbled on anything, they've gotten crushed. Just last week, Bill Gross was reportedly buying CMBS, as well as Thornburg MBS. So people have been and will continue to nibble on these beat up securities.

The problem has been that there are so many willing sellers, and not just of highly distressed subprime or LBO bank loans, but of plan vanilla corporate bonds. Every time a modicum of demand emerges, its met with even larger selling.

So spreads won't tighten until sellers are exhausted. That may take a while longer. The maturation of the CDS market has made it easier and cheaper than ever to bet against a credit. At some point the cost of buying CDS protection will give short-sellers pause, but for now the momentum is so strong against credit, that the quarterly CDS contract payments must seem like a minor inconvenience. But the time will come where fast money decides that credit is oversold. Buying protection won't seem like such an easy trade.

The bottom line is that you have to look at the fundamentals of a given credit. If you think a bond is paying you the right amount to own it, then buy it. Otherwise, move on to something else. Trying to time the bottom in this market will be unusually difficult.

1 comment:

Ziggurat said...

Great analysis.

I am looking for *anything* to be contained. Munis, Auction Rate Securities.

However, I think the turning point will be when (if) the financials MTM reverses and the net writedowns are either zero or a writeup.

I'm thinking of a company like AIG that is screaming that its MTM accounting is inappropriate. The current problem is that they have a trillion in assets, and we know there have to be other problems.

All the valuation issues are basically timing differences, and they will unwind. Subjective and arbitrary valuations will converge on the ultimate cash result.

I suppose that things could continue to get worse for a long time, but at some point, the stuff runs off. Instead of it being a complex modeling problem, it is just adding up the cash (or lack thereof).