Some investors finally see a light at the end of the monetary tunnel; others remain blinded by a juxtaposition of strongly positive and negative economic news. The Fed has aggressively doubled the size of its balance sheet by implementing a wide variety of facilities to enhance market liquidity and ease credit market conditions. Swap lines with foreign central banks, commercial paper funding facility, and MBS purchases have succeeded in reducing key money and credit market rates from peak levels. Furthermore, the Term Asset-Backed Securities Loan Facility (TALF) – with the Fed motivated to do what it takes to make it work – has the potential to significantly reduce credit spreads. However, TALF has launched to a lukewarm reception among investor-borrowers because of onerous customer agreements. In its first round of funding, the TALF program received only $4.7 billion in loan requests out of $200 billion in available capacity; only 19 hedge funds applied for funding. Unfortunately, none of the Fed’s programs address the fundamental solvency-based uncertainties that plague the financial system. As a result, while key spreads are well below peak crisis levels, they remain well above normal levels.
Additionally, the Treasury Department announced a new Public-Private Investment Program (PPIP), a collaborative initiative among the Treasury Department, the Federal Reserve, the Federal Deposit Insurance Corporation and private investors to create $500 billion to $1 trillion in buying power for the purchase from financial institutions of “legacy” or “toxic” assets, primarily real-estate and corporate loans and securities backed by such loans. The PPIP outsources asset valuation and allocates some of the risk of distressed asset purchases to private investment firms. The government will thus act as a lender to private investors and, to a lesser degree, as a co-investor. In this sense, the government will become the world’s largest prime broker.
At ground zero, U.S. new home construction has bottomed, but a floor for existing home prices is not on the horizon. Both housing starts and existing home sales bounced higher in February. The ratio of housing starts to the total stock of housing had fallen to all-time lows, while new home inventories have dropped significantly from the peak. These indicators suggest that the adjustment in home construction is over. Nonetheless, existing home prices are not near a bottom because the ratio of existing home sales to the housing stock has not yet overshot on the downside, due largely to a flood of forced selling of foreclosed homes. Over 40% of February’s transactions were distressed sales. Judging by the bloated level of existing home inventories, prices are still not sufficiently low to clear the market. Thus, the drag on GDP growth from the home construction sector will fade, which should contribute to marginally positive real GDP growth figures in the second half of the year. Nonetheless, investors, banks and other mortgage lenders cannot expect any relief in terms of a bottom in housing prices for some time.
Meanwhile, until meaningful recovery begins, the strong credits will get stronger and the weak credits will get weaker. Expect that the higher degree of differentiation between good and poor credits will be a self-reinforcing dynamic: weak credits will be separated from the herd and shut off from funding, thus accelerating their decline. Conversely, companies that are strong enough to issue debt in this environment should have the balance sheet liquidity to better withstand the rough road that lies ahead. The re-pricing of credit spreads across sector and rating has begun to reflect the sharp deterioration of credit quality that looms ahead. Thus, careful name selection is more important than ever. It is too early to shift away from a defensive allocation, despite the fact that investors are now being paid better than before to take on high risk exposure to the macro environment. Expect more downgrades, more defaults and lower recovery rates.
The strong downdrafts of the past two months will probably see some relief in the month ahead, as the markets seek a rational bounce. Economic numbers have fallen so miserably that the next wave of stats may surprise better than expected. Although volatility will probably create some near term positive returns, we remain cautions.
Michael Ashley Schulman, CFA
Hollencrest Capital Management