Credit Market Meltdown

Credit Market Meltdown - Beyond the Front Page

Part One - Supply, Supply, and more Supply!

It is important to understand the past clearly before charting the future. As a large institutional bond investor by day, in the thick of the credit market meltdown, I have a perspective on the current market that is more detailed and complicated than what you will read on the front pages or hear CNBC constantly harp about. The Fed has lowered rates 50 basis points, not to placate the credit markets, but because it understands and realizes that this credit crisis is much more complex than others we have witnessed in the past 15 years. The Russia default, Long Term Capital bailout and the bursting of the Technology bubble, were all significant events but did not affect the consumer and the globe to the same degree as the current situation.

Now is probably a good time to warn the reader that parts of this are outright scary. With Halloween spirits abound, the intention is not to scare, but to help the reader better understand and make more educated conclusions about their investments. BOO!! All warnings aside, the end result has not played out and there are many positive and negative outcomes that may ultimately conclude this chapter in global economics history.

Before I move on it is vital for the reader to realize that sub-prime mortgages are the tip of an iceberg and not nearly the only problem facing us. In this first chapter I begin to lay the ground work for what has brought us to this precipice. In future additions, I will go on to explain the current credit market crisis and its implications. I will also take you through my thought process on what this means and where it leads equities and bonds in the near and medium term.

China, India and others have witnessed massive growth over the last 10 years. GDP's have been running in the double digits as these countries are expanding at increasing growth rates and well beyond expectations. There have been two major effects of this substantial tilt to the world's economy. The first is that the massive supply of labor from these countries has allowed for much cheaper production of manufactured goods. This in turn has led to an outsourcing of manufacturing from the US and other leading countries to China, India et al. This supply shock has kept inflation well contained, corporate profits soaring and created a new group of consumers. The flip side is that the US finds itself with a massive and growing trade deficit that is being funded through the issuance of public, corporate and individual debt, massive amounts of debt.

What does this mean? As Americans buy goods they are ultimately giving dollars to the manufacturers in exchange for such goods. China and India, in turn, are accumulating dollars and the need to invest these dollars. Since most central bankers are on the conservative side and politically motivated to to keep dollars, they then invest these dollars in US bonds. Over time the growing supply of dollars and thirst for higher returns has led the central bankers further down the credit curve. In other words, they have become less risk averse as they pile on corporate debt, mortgage debt and equities. So just as China and India have supplied the world with lower cost production, they have also supplied us with a large supply of cheap money.

Cheap money is not necessarily a term describing absolute rate, although that has been true over the past 7 years. It's also a term describing the relationship between Treasury yields and yields on non "risk free debt". Cheap money is a good thing for an economy. It allows borrowers to borrow money and invest in new growth. At some point however the supply of money becomes so large that investment decisions become compromised. And this is what has happened over the course of this decade. Investment returns/yields across the fixed income universe have significantly diminished versus those of treasuries, thus implying less risk. As spreads get tighter, all types of investors step down the credit curve or put more simply buy riskier, lower rated bonds in search of additional returns. Unfortunately, the large supply of cash, also allowed for the unprecedented use of leverage both here and abroad. Leverage is simply the borrowing of funds for the sole purpose of investing at a higher rate. This works well as long as bond yields and prices on the securities are not impaired.

Enter mortgages …


Tim Ord
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