March 2008

The Far Too Simple Beauty Of The Promises We've Made

You know we've been suggesting to the point of annoyance lately that it's the credit markets that hold the key to broader financial market and economic outcomes in 2008.  Having said this, it’s now clear that credit market issues of the moment have moved well past simplistic sub prime problems.  After all, why would the government and their financial sector buddies be trying to put together a program (project LifeLine) for all 90 day or greater delinquent mortgage holders?  And that’s ALL mortgage holders, not just the sub primers.  In early January of this year on the CI site, we wrote about a credit market issue that could be the “one big surprise for 2008”, as we termed it.  It's an issue that up to that point had not been consistent front-page news, but sure could become such in the New Year with further macro economic or financial sector deterioration.  Point blank that issue we wrote about was the credit default swaps (CDS) market.  Well guess what?  The issue of credit default swaps has now firmly moved from the back page of financial media far and wide to page numero uno. 

As you know, although monetary policy surely works with a lag, Fed and global central banking actions have mitigated little in what seems the ever spreading credit market tensions of the moment.  Add a corporate credit related credit market jolt out of the blue and that may indeed be enough to really shake broad financial market confidence.  We're just going to have to see what comes our way.  So why bring this up now?  Simple, because CDS financial landmines have been detonating on financial sector balance sheets as of late.  And we’re far from having witnessed the last explosion.  Case in point a few weeks back was AIG (American International Group) auditors apparently finding “material weakness” in company accounting for CDS they wrote against their subsidiary CDO (collateralized debt obligations) portfolios.  Additionally, you are already fully aware of the drama playing out with MBIA and Ambac.  We find it rather ironic that the Friday the Dow spurted 200 points up in the last half hour of trading based on a CNBC comment (the ultimate source of truth, right?) that an Ambac bail out plan was in the works, Moody’s cut its ratings three notches in one fell swoop on Channel Re from Aaa to Aa3.  Who is Channel Re?  An MBIA reinsurer whose only client happens to be MBIA.  Guess CNBC overlooked that one.

Very quickly, for a bit of perspective on historical Moody’s corporate bond default rates, the following details the Moody’s default rate data along with what has been the history of Moody’s Baa nominal yields.  You can see what has happened to default rates for corporate credits over the last three recessions.  In the early 1980’s, we need to remember that commercial banks were the primary lenders into the corporate community.  That has all changed as the US capital markets developed over the subsequent decades.  What were really the mild recessions of the early 1990’s and 2001 saw corporate bond default rates spike to between 8% and 11% of total bonds outstanding.  And this is for total corporate bonds outstanding.  High yield bond default rates were much higher than what is depicted below.  Given that the CDS markets now sport nominal exposure at a level ten times the total value of the US Treasury market, if we enter recession and again experience default rates of a magnitude even half of what was seen in the prior two recessions, there’s going to be some blood in the broader CDS markets.  Already in 2008, high yield debt defaults exceed the entirety of what was seen in 2007.  Famed NYU professor Ed Altman predicts a 4.64% high yield total default rate this year.  Wilbur Ross, clearly more than well versed in distressed credits, predicts a similar 5% level for 2008.  We’ll just have to see how it all unfolds.  But if Ross and Altman are even near correct, somebody is going to want to collect on existing CDS contracts as default rates rise from near record lows.  And, of course, it will be a matter as to whether another somebody currently holding the offsetting contract has the capital to pay.  But since no one in the CDS game is subjected to any type of reserves requirements against these contracts, one never knows how life will turn out, now does one?
                  

In addition to heightened recession pressure at the moment, why are we now bringing up subject of credit default swaps?  Maybe this is being far too simplistic, but we can directly see a number of striking parallels between what has transpired in the land of mortgage credit up to this point and the character of the CDS markets over the last three to four years.  Think about it.  In the sharp clarity of hindsight, mortgage credit standards were far too lax in the current cycle.  This laxity was itself a primary catalyst for asset value appreciation (home price inflation) upon which further misguided and risky credit largesse occurred.  In essence, the mortgage credit cycle perpetuated itself for a time, ultimately running out of risky borrowers to which to lend.  And then it was over.  As we've said a million times, the second derivative - the rate of change of the rate of change - is one incredibly powerful number.  The second derivative finally caught up with the mortgage credit cycle.  Secondly, the act of mortgage credit securitization in the recent cycle academically dispersed total mortgage credit risk far and wide among supposedly knowledgeable investors.  Further, in the securitization models, the key fatal assumption was that real estate prices always went north and risk in pools of less than investment grade mortgage securities was diffused, so these vehicles were blessed by the rating agencies.  It had been so long since we had experienced the reality of declining residential real estate prices, that fact simply was not accounted for in far too many models rating and pricing essentially mortgage credit that was packaged as CDO's, SIV's, etc.  Lastly, at the height of mortgage credit insanity, we were experiencing very low residential real estate default/foreclosure rates, and the massive amount of capital that rushed into this market to participate in the cycle created a scenario where spreads between mortgage backed and Treasury securities was incredibly tight relative to historical experience.  The exact environmental character where false confidence breeds and multiplies, virtually ignoring the entire concept of a cycle itself.

So let's jump back to the credit default swaps market.  Essentially CDS vehicles are unreserved insurance policies in their most simplistic characterization.  A buyer of a CDS vehicle is essentially buying protection against a corporate or mortgage credit default, and a seller is "selling" insurance against the same potential event.  Now for the parallels.  In recent years we have experienced literally record low corporate default rates, similar to what was seen in mortgage credit defaults a number of years back.  Up until really just the last few months, yield spreads between corporate debt, and especially high yield corporate debt, have been some of the tightest on record.  We saw the same thing with cost of mortgage credit relative to like Treasuries at the peak of mortgage credit mania.  What has been responsible for this type of environment over the past two to three years?  Very simply, we've lived in a period of incredible liquidity/credit availability, combined with a hedge fund and deregulated investment-banking community all but scrambling for rate of return as they put capital to work.  But set against the record low corporate default experience and the historically tight credit spreads, the CDS market was essentially pricing default insurance at bargain levels.  Much like the mortgage credit markets, perhaps ignoring or forgetting the true nature of longer-term economic and financial cycles?  The last important direct parallel between mortgage backed securities (CDO’s, SIV’s, etc.) and the CDS market is that so many vehicles have been marked to model.   

Unique CDO’s and SIV’s, for which there never was any stated price, are no different than CDS contracts where quotes are in the eye of the beholder, or more correctly the real market bid at any point in time.  Herein lines the potential left field risk.  Herein lines the potential for tomorrow's headline credit market issue of concern that has already shown up a time or two on the front page in recent weeks.  Is the CDS market destined to travel the now well know path mortgage credit vehicles have traversed as of late?  So now THE key question becomes, are these parallels and potential for similar outcomes fully priced into the credit markets or not?  Without question this also has direct implications for influence in the broader financial markets inclusive of equities.  Let's look at some facts.

What is obviously apparent, we believe very meaningful, and perhaps little understood in the greater investment community, is the growth in magnitude over the 2004 to present period in the CDS market.  From about $1 trillion in notional value outstanding at year-end 2003, we're looking at just shy of $14 trillion in notional exposure as of September 2007 for the US banking system singularly.  A near fourteen-fold increase in three and one half years.  We ask you, do you see this fact being discussed or at least being mentioned on the "front page", if you will?  Do you even see this mentioned in discussions or articles regarding what led up to the current mortgage credit debacle?  Do you see Senators and other assorted politicians grandstanding in their demands for investigations about how this could have come to pass?  We need to at least think through potential investment consequences if indeed credit default swaps become the next credit market shoe to hit the floor in some manner.  Why?  Because at the periphery it’s already starting to happen.

Very quickly, who are the major players among the US banking system elite?  The usual suspects, who else?  Here's how it shakes out at present:

As you might have guessed, the "usual suspects" listed above account for 99.6% of total US banking system credit derivatives exposure.  Concentrated?  How about massively as perhaps a stab at a characterization.  It’s no wonder the big banks have one huge vested interest to make sure MBIA and Ambac don’t fall off the face of the map, no?  As you already probably know, US banking system notional exposure to credit derivatives now stands at 85%+ of US GDP.  At year-end 2003, that number was 9%.  Of course what you see above is so-called notional value exposure.  But in the credit derivatives world, a potential loss against an insured credit that goes belly up can literally be maybe 50 to 60 cents on the dollar of the total outstanding bond issue against which the credit derivative is written.  True actual nominal dollar loss potential is not really found in the "value at risk" measure or against notional values, but in dollars and cents against the amount of total bond issuance which is being insured.  And you'll be thrilled to know that in the CDS market, many an outstanding corporate bond issue has insurance written against it covering two to three times the total actual bond issue being insured.  This is exactly the case with GM/GMAC.  Why?  Because like so many derivative vehicles these days, it's no longer about creating a specific insurance product, per se, but rather it has become about “trading” and ever expanding array of leveraged financial vehicles.  None other than Fitch puts out periodic reports that cover their interpretation of the character of the CDS market.  The latest hit the Street in the summer of 2007.  Specifically in the report, Fitch states the following:

Get the picture?  Do you really think the management of these big financial behemoths have their hands around implicit risk in these vehicles any more than they successfully foresaw the mortgage credit debacle that has come to us in the form of CDO's, SIV's, etc.?  Umm, maybe we should have characterized that as former management in a few cases.  And, of course, “former” managements still to come.

A few more quick facts investors need to keep in mind as we move ahead.  First, what we saw above was US banking system exposure.  And we only received a glimpse of the big-daddy US commercial banking players.  How about a broader view of life?  For in the Fitch credit derivatives report, a few other names are thrown around as being concentrated players - Goldman, Duetsche Bank and Morgan Stanley.  Luckily the BIS (Bank for International Settlements) reveals what they believe to be numbers for the global CDS market every half year.  The history of which is as follows:
          

Trajectory, growth, rhythm and magnitude of global credit derivatives expansion is quite like the character we observed above for the US banking system proper.  In three short years, global CDS exposure has increased roughly nine-fold.  We're talking about close to $45 trillion of credit derivatives on a notional basis.  The BIS kindly estimates a gross cash market value for this exposure at $700 billion.  But we all know how those initial estimates of potential loss in the mortgage and mortgage product markets made in 2007 have worked out as of late - they haven't.  

A few final wrap up comments to ponder.  Remember as you look at the charts above, it is absolutely clear that the bulk of total CDS vehicles outstanding today were written/bought in the last three years.  This is the exact period to have witnessed record low corporate debt defaults (and it's no wonder as credit was so easily and cheaply available).  This is the exact period to have witnessed historically narrow credit spreads, especially true for high yield.  Hence, the insurance premiums that truly are credit derivatives were mispriced (in our eyes) as they reflected and were modeled on experience that was an anomaly from the longer-term standpoint of total corporate credit cycles.  Lastly, this is also the period where so much questionable corporate credit product was brought to market (thank you private equity community).  Trust us, the corporate credit cycle has not been repealed.  Just as most are now coming to realize that the mortgage credit cycle has also not been repealed.  Of course those exposed are finding out the hard way.

Last very simple real world issue for CDS in 2008 is the very real potential for a recession, a key concern for the CDS market right here.  With each passing day, real world economic stats are “telling us” this is becoming a good bet that the US economy is headed directly toward a credit contraction/consumer slowdown characterized economic environment ahead.  We’re there now.  Whether we "officially" land in the territory of recession is almost a moot point to be honest.  But what is absolutely important is what happens to corporate profits.  Nominal dollar corporate profits, corporate profits as a percentage of GDP, and corporate profit margins recently reached all time record levels.  So the simple question becomes, do ever-higher records lie ahead for corporate margins and profitability?  Or does a broader economic slowdown compress both margins and profits in the aggregate?  If indeed corporate margins and profits come under pressure, as we believe they will, then what happens to the cash flow that is supporting the ton of speculative grade debt that has recently been issued in the past two to three years?  Debt that is in no way even close to being seasoned?  WeI simply cannot see how a number of corporate defaults are avoided.  Who knows, maybe with all of the covenant-lite paper that has been issued, there will be less "official" defaults than we believe will occur.  The important point is that domestic economic slowing, to whatever extent, that pressures corporate profits, margins and cash flow is the trigger for the corporate credit cycle on the downside.  Doesn't it seem that 2008 will be the initial test case for the models used to price and write CDS securities of the last two to three years?  This is exactly what may move the CDS markets onto the front page in a consistent manner, as opposed to the one off nature of occurrences at present.  Lastly, our intent is NOT to pen pessimistic discussions or fear mongering stories.  This is quite simply an attempt to anticipate alternative outcomes in the spirit of accomplishing the most elemental activity in investment management - acting to protect the downside.  We just need to make sure we as investors have thought through and acted to protect ourselves against any negative issues long before they hit the front page.  Successful investment management is about anticipation and scenario planning, not unprepared reaction.  The world is not about to come to an end.  Through adversity is born opportunity for those prepared both emotionally and financially.