To Spread Or Not To Spread

April 2007 Dr. Hans Black

At this moment, having witnessed the virtual collapse of the sub-prime mortgage market over the past couple of months, the pertinent question in the minds of most investors is whether or not these problems will spread into other classes of mortgages or other types of debt. The ultimate concern is that as a result of a more generalized scrutiny of current lending standards, a credit crunch may ensue.

For quite a number of months we have been commenting on the unhealthy trend of narrowing spreads — a measurement of interest rate differences between high quality treasury debt and low quality, single “B” or junk debt. With the diminishing of these spreads to an unprecedented low level, investors are in effect accepting less and less return for the risks they are taking. In some of our past essays on this subject, we have illustrated how the growth of credit risk, or default insurance, has led investors to believe they can simply insure out issuer risk and thus accept they will get a less-than-normal return on what would otherwise be low-quality debt. In the latest chapter (that is by no means finished) on the subject of sub-prime mortgage debt, it is not altogether clear just how much damage has been caused, nor where it will stop.

We are just beginning the new calendar quarter and all eyes will be focused on reports that hedge funds, banks, broker dealers and other interested parties will be publishing in the upcoming weeks. Our suspicion is that the preponderance of commercial mortgage-backed securities (and the derivatives thereof) are very widely held and it will be interesting to see just how these units are re-rated. But the puzzle gets only murkier here, as most of these instruments find their way into products known as CDOs, or collateralized debt obligations, which are even more complex. Some CDOs may be highly leveraged and more often than not, are under no obligation to mark assets to market. Indeed, I must confess that the more I read on this subject, the more concerned I become. In the final analysis, however, we must recognize that ultimately there is always someone at the end of the line holding the proverbial bag, and somebody — or, more likely, a lot of people — will end up as bag holders. In other words, they will lose money. Whether it is the holders of mutual funds or hedge funds, or a variety of financial intermediaries, someone will rediscover risk in a very real way in the next 12 months. Further complicating this process will likely be some form of political intervention as a number of Democrats in the Senate have already discussed this possibility. Headlines in recent weeks that have highlighted the fact that residential foreclosures are the highest since the mid-1970s will likely focus additional political attention on this issue. Isn’t it always terrific how politicians get involved to occasionally “wax the skis during the downhill slope”! Nor do we believe that banks, who have certainly been tireless in their efforts to syndicate out these risks, will be left unscathed. Our own internal reckoning is that fully fifty percent of outstanding mortgage debt is somehow still back on the balance sheets of banks and other lending institutions.

Finally, as we examine the question posed by our title above, we must come up with the inevitable conclusion that the answer is “Yes”. All these problems will indeed spread and before the year is out likely engulf a whole host of participants who are involved in this wonderful game. We note with interest that Moody’s is apparently on the verge of cutting the credit ratings of approximately fifty banks in Europe and in North America. This — despite the protests of both Merrill Lynch, J.P. Morgan and others — will surely wake up some people. What Moody’s is proposing to do is re-rate a whole host of financial institutions in light of the recent problems in the mortgage-backed market, but also in light of the entire issue of cross-contagion. In the ultimate analysis, Moody’s will attempt to calculate just who will stand behind banks in the event of any contagion effect from a mortgage-backed security crisis, for example. From a practical point of view, it is our belief that it will leave a lot of people scratching their heads during the next one to two months as they calculate just where they stand in this mess. We have been steadfast with respect to the avoidance in our portfolios of many sectors related to housing, credit and various kinds of consumer credit, as well as the associated derivatives and structured notes, as we continue to believe that we may be entering a consumer/housing-driven recession later in 2007. The second quarter of this year should be key as it will likely mark a more definitive turning point toward a more generalized slowing in global economic demand led, unfortunately, by these increasingly difficult issues in North American markets.