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Credit Cycle Breakdown Adjustment and Rebuilding in the
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Credit Cycle Breakdown Adjustment and Rebuilding in the Financial Sector. June 29 2009 SPECIAL COMMENTARY, deficit estimates are rising in anticipation that administration and Congressional. sources will raise their mid session deficit estimates Finally political emphasis on. jobs and housing suggest that the political risk for investors is that inflation targets. will be sacrificed in favor of goals for the real economy With the passage of time we. believe the exit from easy monetary policy is becoming more expensive and more. fraught with risks for investors, Credit Not Housing A Model of the Breakdown in the Credit Cycle. Long before the collapse in the housing market the global glut in savings was cited. as a possible force that would lead to lower real interest rates 3 These low real rates. were a concern at the time because of the possibility that they would lead to. excessive risk taking and indeed they appear to have done just that An excess. supply of capital due to the global savings glut generated an excess demand for. goods financed by credit housing and autos for example that in turn led to an. excess demand for labor in the construction and auto sector Therefore we do not. view the current economic difficulties as originating in a housing crisis but rather a. credit crisis driven first by excess global liquidity 4 In fact for some time now many. analysts have commented upon the sequence of price bubbles dot com and housing. being two of the latest examples that reflect the ongoing excess supply of global. Phase I Breakdown Collapse in the Credit Market, By early 2005 subprime mortgage delinquency rates had already started to turn. upward and by mid summer 2005 home price appreciation was peaking on a year. over year basis Figure 1 5 Meanwhile aggregate consumer and residential loan. delinquencies were clearly on the upswing by mid 2006 Figure 2 Consumer credit. risk had been under priced in our view symptomatic of an excess supply of capital. that was funneled into excess housing, Figure 1 Figure 2. Subprime Mortgage Delinquency vs FHFA Price Appreciation Consumer Residential Loan Delinquency Rates. Percent of Loans Past Due Seasonally Adjusted, 14 0 26 0 8 0 8 0.
4 0 16 0 4 0 4 0, 2 0 14 0 3 0 3 0, 1 0 Residential Loans Q1 7 9 1 0. 4 0 FHFA Yr Yr Price Appreciation Q1 3 3 Left Axis 8 0. Total Subprime Q1 25 0 Right Axis Consumer Loans Q1 4 7. 6 0 6 0 0 0 0 0, 1998 2000 2002 2004 2006 2008 1991 1994 1997 2000 2003 2006 2009. Source U S Department of Commerce and Wachovia, Credit deterioration also became apparent by 2006 as the 60 day plus delinquencies. on subprime adjustable rate mortgages for the 2005 ARM vintage had risen above the. rates of delinquency of the 2004 vintage Figure 3 The ultimate breakdown in the. private credit system is evident in the collapse of securitization in the second half of. 2007 and early 2008 Figure 4, 3 Ben Bernanke The Global Saving Glut and the U S Current Account Deficit March 10 2005. 4 See also Caballero R E Fahri and P O Gourinchas 2008 An Equilibrium Model of Global Imbalances. and Low Interest Rates American Economic Review 98 1 358 93. 5 John E Silvia Subprime Credit The Evolution of a Market Business Economics July 2008 pp 14 22. Credit Cycle Breakdown Adjustment and Rebuilding in the Financial Sector. June 29 2009 SPECIAL COMMENTARY, Figure 3 Figure 4.
Subprime ARMs 60 Delinquencies Growth of Securitization Markets. Percent Delinquent by Vintage Yearly Securitized Issuance Trillions of Dollars. 45 45 2 5 2 5, 40 2006 40 CDO, Non Agency, 35 35 2 0 Student Loan 2 0. 2005 Home Equity, Credit Card, 2003 1 5 1 5, 10 10 0 5 0 5. 0 0 0 0 0 0, 1 6 11 16 21 26 31 36 41 46 51 56 61 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008. Source U S Department of Commerce and Wachovia, Phase II Adjustment. We would agree with Chairman Bernanke s assessment that Conditions in a. number of financial markets have improved since earlier this year likely reflecting. both policy actions taken by the Federal Reserve and other agencies as well as the. somewhat better economic outlook 6 We would suggest that the improvement also. reflects the hard efforts of many in the much maligned private sector as well As. evidence of improvement there has been a significant narrowing of the TED spread. as well as average five year CDS bank spreads Figure 5 Figure 6 The decline in. the bank CDS spreads suggests greater confidence in the largest banks No reliable. CDS levels exist for the regional banks, Figure 5 Figure 6.
TED Spread Average 5 Year CDS Bank Spreads, Basis Points Basis Points. 450 450 440 440, TED Jun 43 bps Average CDS Spreads Jun 225 bps. 400 400 400 400, 250 250 240 240, 200 200 200 200, 50 50 40 40. 2004 2005 2006 2007 2008 2009 2007 2008 2009, Source U S Department of Commerce and Wachovia. Credit Further Along the Yield and Credit Curve, Meanwhile in the critical asset backed and mortgage backed markets there has also.
been marked improvement as spreads have significantly decreased Figure 7. Figure 8 For asset backed ABS securities the Fed s actions through the TALF. facility have helped the financing of credit card and auto securities Despite this. success our concerns remain that the Fed s position as credit policeman in selected. markets and to a varying degree in those markets is creating distortions in asset. pricing and credit availability 7 In particular we note that the current 30 year MBS. 6 Ben Bernanke Current economic and financial conditions and the federal budge Testimony before the. Committee on the Budget U S House of Representatives June 3 2009. 7 John E Silvia What Keeps Us Up at Night Presentation March 25 2009 at the Global Interdependence. Center Banque de France Conference Paris France, Credit Cycle Breakdown Adjustment and Rebuilding in the Financial Sector. June 29 2009 SPECIAL COMMENTARY, spread over the 10 year Treasury is as low as it was in the 2003 2006 period which. has been decried as a period of overly easy credit and under appreciation of risk. The gains in the Mortgage Bankers Association index for mortgage applications for. refinancing have been another benchmark for improvement This index has risen. over the last four months and suggests mortgage credit availability has improved So. far the Federal Reserve has purchased 430 billion of mortgage backed securities. The spread of Fannie Mae issues over the 10 year Treasury has narrowed to one. percent after peaking at 225 basis points in the fourth quarter of last year This may. be too far as this spread is below pre crisis levels of 150 basis points. Figure 7 Figure 8, Liquid AAA ABS vs Swaps Conventional Mortgage to 10 Year Treasury Spread. Basis Points Basis Points, 700 700 300 300, 3 Year AAA Credit Cards May 140 bps Mortgages Jun 170 bps. 600 Prime 3 Year AAA Autos May 210 bps 600 275 275. 500 500 250 250, 400 400 225 225, 300 300 200 200, 200 200 175 175.
100 100 150 150, 0 0 125 125, 100 100 100 100, 2002 2003 2004 2005 2006 2007 2008 2009 2004 2005 2006 2007 2008 2009. Source U S Department of Commerce and Wachovia, Improvement has also been unmistakable at the long end of the corporate financing. markets as both Aaa and Baa Corporate bond spreads Figure 9 have declined in. recent weeks Moreover both high yield debt issuance shown below in Figure 10. and high grade issuance not shown have picked up this year Leveraged loan. issuance is also up this year, Figure 9 Figure 10, Aaa and Baa Corporate Bond Spreads High Yield Corporate Issuance. Over 10 Year Treasury Basis Points Billions USD 3 Month Moving Average. 700 700 18 0 18 0, Baa Spread May 477 bps, 600 Aaa Spread May 225 bps 600. 300 300 9 0 9 0, 100 100 0 0 0 0, 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2004 2005 2006 2007 2008 2009.
Source U S Department of Commerce and Wachovia, Finally financial adjustments have also appeared in improvements within the equity. market As illustrated in Figure 11 we can see the pick up in initial public offerings. This improvement suggests that at least some investors are willing to take on. investment risk even in an uncertain economic recovery. Credit Cycle Breakdown Adjustment and Rebuilding in the Financial Sector. June 29 2009 SPECIAL COMMENTARY, LTM Equity Offerings. Deals and Backlog, Initial Public Offerings Jun 09 2 Right Axis. Follow Ons Jun 09 46 Right Axis, Backlog Jun 09 21 Left Axis 100. Jun 08 Aug 08 Oct 08 Dec 08 Feb 09 Apr 09 Jun 09, Source Wachovia Securities.
Phase III Rebuilding Leading to Problems, In a number of ways the rebuilding of the credit markets is beginning to exhibit. problems First the yield curve between 30 year and two year Treasury debt Figure. 12 has steepened significantly For some analysts the steepening might be. interpreted as driven by the improvement in investor confidence and thereby a. decline in the value of the flight to safety premium However we are concerned that. longer maturity Treasuries may also be affected by the growing perception that. temporary deficits may be increasingly permanent Such high and permanent. deficits suggest a rise in expected Treasury debt supply in the face of diminished. flight to safety demand Moreover sustained high levels of federal debt issuance. may have increased investor fears of monetization through monetary policy. Ten year Treasury benchmark yields bottomed on March 18 2009 and have actually. risen since the Federal Reserve announced a program for purchasing Treasury debt. As for inflation expectations five year forward TIPS bottomed in January at 50 basis. points and have since risen to 1 90 percent Calculations by the Federal Reserve of its. measure of the inflation breakeven rate have risen and on May 27th were up at 3 124. percent Along these lines investor focus has been on the ten year benchmark yield. Yet Federal Reserve purchases of 127 billion have included only 5 billion of. 2018 2019 issuance or just four percent of Federal Reserve purchases In contrast ten. percent of Fed purchases has been in the maturity range of 2020 or later and another. 79 billion or 62 percent have been in the 2010 2014 maturity range. Credit Cycle Breakdown Adjustment and Rebuilding in the Financial Sector. June 29 2009 SPECIAL COMMENTARY, Operationally we believe the Fed had been an effective policeman as Fed purchases. have favored the short end of the yield curve relative to the ten year area and as a. result the yield curve between two and ten year maturities has risen 8. Recent Federal Reserve operations have also included purchases of more than 400. billion of mortgage backed securities with the potential to purchase at total of 1 25. trillion The outcome of these purchases is that secondary mortgage spreads are now. below pre crisis levels Figure 13 This brings into question whether the size of Fed. purchases in this market is now distorting the market pricing of these instruments. Figure 12 Figure 13, Steepness of Treasury Curve 30s and 2s 30 Year MBS Current Coupon. Basis Points Spread over 10 Year Swaps Basis Points. 400 400 240 240, 30Y 2Y Jun 337 bps, 300 300 200 200. 50 50 80 80, 50 50 40 40, 2006 2007 2008 2009 Jan 03 Oct 03 Aug 04 Jun 05 May 06 Feb 07 Dec 07 Oct 08.
Source U S Department of Commerce and Wachovia, Implications of recent Fed actions may also be appearing in the decline of the dollar. Figure 14 In an economy with flexible exchange rates and capital mobility we. would expect that an easy monetary policy would lead to a decline in the value of the. currency 9 This issue is complicated further by the dependence on that global savings. glut that we have written about above in this essay As illustrated in Figure 15. foreign capital inflows have fallen dramatically for privately issued instruments. Treasury debt has found buyers in an era of safety concerns but how much this. demand will be there in the future remains a big question. Figure 14 Figure 15, U S Trade Weighted Dollar Major Index Foreign Private Purchases of U S Securities. March 1973 100 12 Month Moving Sum Billions of Dollars. 90 90 600 600, Treasury Mar 262 Billion, Corporate Mar 52 Billion. 85 85 Equity Mar 12 Billion, Agency Mar 71 Billion. Major Currency Index Jun 76 9, 65 65 100 100, Jan 2008 Jul 2008 Jan 2009 98 99 00 01 02 03 04 05 06 07 08 09.
Source U S Department of Commerce and Wachovia, 8 The role as Federal Reserve as policeman to the credit markets and its possible distortions in market. pricing was initially explored in my essay What Keeps Us Up at Night Global Interdependence Center. Banque de France Conference Paris France March 25 2009. 9 Rudiger Dornbusch Open Economy Macroeconomics Chapter 11 Basic Books 1980. Credit Cycle Breakdown Adjustment and Rebuilding in the Financial Sector. June 29 2009 SPECIAL COMMENTARY, Implications for Investors. For investors the economic recovery suggests opportunity but in our opinion there. are three risks to consider higher than anticipated inflation rising interest rates. and a weaker dollar What makes investment policy so difficult today is that these. are not three independent risks, Over the last few weeks we have seen capital markets react to continued credit. easing by the Federal Reserve with a steeper yield curve and a declining dollar. Moreover there is creeping suspicion that public policy is increasingly oriented to. Credit Cycle Breakdown Adjustment a nd Rebuilding in the Financial Sector June 29 2009 SPECIAL COMMENTARY spread over the 10 year Treasury is as low as it was in the 2003 2006 period which

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