It's been a rough few weeks in the financial marketplace. The housing sector seems to be crumbling (especially the subprime market), financial stocks are bouncing around, the bond market has seized up and investors are besieged with fear. With new worries over a coming credit crisis, no wonder it looks to many like we're headed for a complete market meltdown.
With lots of media coverage online and in print, and economic analysis hitting the airwaves, there's no shortage of opinions when it comes to the current chaos in the mortgage and fixed-income markets. But to clarify where we are today and prepare for where we go in the future, let's take a look at where we've been.
A Look Back
The increase in delinquencies and foreclosures has been primarily tied to the subprime borrower, with rising rates concentrated in states with auto-related weakness or disproportionate home-price speculation. But no sector is immune, with problems likely to spread throughout the country as adjustable-rate mortgages (ARMs) reset over the next several months and into 2008. Currently, subprime ARMs comprise approximately 9% of outstanding first-lien mortgages.
Challenges of subprime mortgages have been magnified by Collateralized Debt Obligations (CDOs), in which securities and loans are packaged, securitized and sold to investors. In the past, buyers for CDOs were plentiful; not so anymore. CDO buyers have mostly disappeared, particularly following Bear Stearns' forced liquidation of two hedge funds that were deeply invested in this market after the value of securities backing the funds dropped dramatically. It didn't take long before investors started lining up to pull their money out of similar funds at the same time that the funds were struggling with new valuations of their securities. The result was a market swiftly flooded with securities, and a rush to unwind the sizeable amount of leverage used to create these funds in the first place.
In recent weeks, liquidity has mostly dried up in the mortgage market, making bids for whole loans and residential asset-backed securities difficult to find. The spreads on these securities have widened greatly and are now at or near historically wide levels on lower-tier credit. Indeed, valuations on "AAA" credit have nearly doubled the amount of spread investors usually insist upon to buy such securities.
Looking at the lending side, the volume of origination production is still trending down, with originators increasing rates and tightening standards - even for prime paper - as a result of a weak demand from loan purchasers. This, in turn, is leading a number of producers to retain more loans if there is room on their balance sheets. And while expectations for housing were already sluggish, it now looks like the broad-based slowdown in mortgage lending may have a much larger effect on economic growth than anticipated. It appears consumers will have a much more difficult time drawing on the equity in their homes for improvements and other spending projects.
A Wider View
Another issue to consider: The subprime fallout hasn't only affected the United States. BNP Paribas (the largest bank in France) had to shut down three funds that were heavily invested in U.S. mortgage-backed securities. To stave off panic, the European Central Bank, the Federal Reserve, the Bank of Canada, and other central banks began infusing liquidity into the markets for short-term funds. But don't be fooled: This did not reflect a movement to ease monetary policy; rather, it was only done to stabilize short-term rates. The central banks were just pushing (market) lending rates back toward their targets.
And with overnight LIBOR rates escalating above 6%, and the effective fed funds rate doing the same, the central banks have been put in a corner. These institutions regularly provide liquidity to the markets for short-term funds; but in this case, the size of reserves needed to even out market rates is what was unusual. Over three days, the ECB and Fed added more liquidity into the market than at any time in recent history, reckoning just how tight liquidity had become.
Now, the liquidity crunch has spread to the commercial-paper market-a vital source of short-term funding for many companies, and particularly mortgage issuers. Most investors have steered away from the credit risk connected with commercial paper, especially paper tied to home loans, choosing T-bills as an alternative. And central banks worldwide have continued to inject additional reserves to maintain rate targets and increase systemic liquidity. The FOMC followed with a temporary drop in the discount rate of 50 basis points, to 5.75%, and by extending the term of loans from the discount window from overnight to 30 days. The Fed's discount window can accept a wide range of collateral-including unimpaired subprime loans-although previous term borrowings against such positions were not allowed.
Time will tell how far these latest actions will go in helping to stabilize the markets.
Where do we go from here? At ALM First, we encourage credit unions not to abandon this market of issuing high-credit-quality, non-conforming loans to their members at 7%-7.5 %. But credit unions need to make sure they are compensated for the greater risk of exposure for valuation decline. At some point, the markets will recover and there might be high pre-payments on these loans. Right now, we are still in the early phase of this new liquidity cycle. It remains questionable whether or not tight liquidity will slow economic growth so much that the Fed drops its inflation bias and focuses on overall economic growth.
In the minutes of the August 7 FOMC meeting (just released August 28), the Fed noted that a "further deterioration in financial conditions could not be ruled out." Some think lowering the discount rate was the fist step for the Fed in easing its inflation bias. The markets have fully priced in a fed funds rate cut of 25 BPs. and the possibility exists that fed funds may be cut by 50 BPs at the September meeting. The markets may be sitting on their hands until then. Even the Fed doesn't have a crystal ball.
Lisa McDaniel, CFA, is Financial Adviser and Mike Manley is a Fixed-Income Trader with ALM First Investment Advisors, Dallas. For info: www.almfirst.com.
