The Credit Crisis and Repricing of Risk, One Year Later
What We Saw, How We Positioned Our Fixed-Income Portfolios,
and What We See Coming Next
Robert V. Gahagan, Senior Vice President and Senior Portfolio Manager
G. David MacEwen, Senior Vice President, Portfolio Manager and Chief Investment Officer, Fixed Income
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Spin-off Crises Mark Anniversary
As the investment community marked the anniversary of 2007’s stormy “Summer of Subprime” and the damaging credit crisis waves it spawned, we were tossed and turned again by new credit and financial storms that had spun off from the original mortgage meltdown and spread throughout the financial sector during the past 12 months.
Whereas the original tempest blew in suddenly and anonymously over mountains of resetting, defaulting, adjustable-rate subprime mortgage loans, the latest storms arrived with more fanfare and bore familiar names—Bear Stearns, Fannie Mae, Freddie Mac, Lehman Brothers, AIG, Merrill Lynch, and Washington Mutual.
The familiarity and size of these companies seemed to breed more sympathy (and concern) than contempt—the government and the Federal Reserve (the Fed) resorted, for the most part, to extraordinary measures to limit damage from the downfall of these icons, particularly in the cases of Bear, Fannie, Freddie, Merrill, and AIG.
Financial Collapse Was Averted, But Not Recession
We believe the coordinated efforts of the Fed and the U.S. government helped prevent a complete financial system collapse, but we don’t think they prevented a recession. What maintains order on Wall Street doesn’t necessarily translate to near-term solutions for Main Street. That’s where food and fuel prices remain high, credit is still relatively expensive and hard to get, and job security and consumer confidence are waning.
Tough times face the average consumer, and they could get worse. What’s going to save Main Street consumers from a continued slow grind downward while Wall Street flameouts attract legislative, financial, and media attention? And when?
Effective Recession Due to Disabled Housing Market
Up until the past month, our assessment of the economy has been consistently less optimistic than market consensus. As we’ve been saying for most of this year, we believe the U.S. economy is effectively in a consumer-led recession that we think will extend into 2009 and follow a long, slow, L-shaped pattern of recovery (as opposed to a V-shaped, more rapid rebound). By ”effectively,“ we mean that it feels like a recession to consumers and businesses, whether the actual economic growth numbers have turned negative or not.
Our view is in line with how the National Bureau of Economic Research (NBER)—the think tank that identifies key inflection points in the business cycle—defines recessions. The NBER does not subscribe to the old recession definition—two consecutive quarters of declining real GDP. Instead, it defines a recession as a significant decline in economic activity spread across the economy, lasting more than a few months. We think the third and fourth quarters of 2008 could fit this definition, as well as the early months of 2009.
How did we fall into this effective recession? We believe it was the same way the financial crises erupted—it all began with an extended period of easy credit from 2002 to 2004, when the Fed’s overnight interest rate target remained at a generational low of 1% for over a year. In fact, inflation-adjusted (real) overnight bank lending rates in the U.S. reached negative levels from roughly the fourth quarter of 2002 through the first quarter of 2005. The Fed was essentially paying investors (and speculators) to borrow money, and they capitalized on that opportunity.
We saw easy credit translate to speculative booms in the housing, credit, and securitization markets, followed by bursting bubbles in those markets after the Fed raised rates, the economy weakened, home values declined, and borrowers defaulted on adjustable-rate loans that reset beyond the borrowers’ ability to pay. A vicious credit cycle erupted—credit became increasingly unavailable to financially stretched consumers who had relied upon debt to make ends meet and who needed it more than ever as their expenses increased and incomes remained static.
Financial-Sector Fuse Was Already Lit in 2006
We anticipated that bursting bubbles would rattle the financial sector, and positioned our fixed-income portfolios accordingly, actively shielding portfolios from creditsensitive areas in both the mortgage and corporate sectors. For example, as far back as March 2006, we were favoring higher-quality government securities over corporate bonds because we felt that corporate securities offered inadequate compensation for the added risk involved.
More recently, when many market participants seemed to optimistically view the merger of Countrywide Financial with Bank of America and the government takeover of IndyMac during the summer of 2008 as signs that the credit crisis was coming to a close, we instead hardened our conviction that more subprime-related shakeouts were yet to come. Indeed, by September, a host of banking and brokerage institutions were in trouble. The impact of their instability extended far beyond their direct business relationships and securities markets, compromising even the sanctity of money market funds. We think more financial sector troubles lurk ahead.
No Consumer Sector Signs of a Bottom Yet
It’s important to note that while we’ve positioned our fixed-income portfolios for recession, we’re also actively preparing for better credit conditions and an improved risk/reward environment. Our investment teams are watching for both economic and market signs that it’s time to seek more aggresive opportunities.
Focusing first on the economic signs, beyond the attention-grabbing glare of financialsector fireworks, we still see this recession as consumer- and credit-driven, versus business related. We think the core cause of recent troubles can be traced back to declining home values and consumer-credit repayment issues. Therefore, we still strongly believe the ultimate springboard for economic recovery will be housing price stability, along with improved effective availability of consumer credit.
According to our analysis, neither has happened. We see home prices continuing to decline, and believe the contraction will continue while the employment situation worsens to what we consider more typical recession levels (monthly job losses of 200,000 to 300,000 or more). Meanwhile, we’ve observed that mortgage interest rates are finally falling after being stuck at the same level from September 2007 to September 2008, but qualifying for those low rates and actually obtaining a loan from financially stressed lenders has become increasingly difficult.
When will home prices stabilize and credit become more readily available? We believe the latter will help drive the former—increasing demand for housing will be the key factor that ultimately puts a floor under falling prices. But demand requires confidence and credit, which we see in short supply right now. We believe the financial sector needs to settle down to loosen the lending purse strings, but restoring consumer confidence goes beyond that. It will likely require some combination of increasing labor and housing market stability, low interest rates, easier credit availability, falling energy prices, improving corporate credit quality and earnings, and a stock market recovery. We see a couple of those factors already in play, but not enough to make a difference.
Market Signs of Nadir Not Apparent Either
The crux of the matter is that we don’t believe we have reached the bottom of this economic cycle; conditions will likely deteriorate in the fourth quarter and possibly into 2009 before they improve. We see that investors are fearful, but they haven’t yet capitulated, a mindset that we think marks market bottoms. Other market-based signals we’re closely watching—including high-yield corporate spreads and the steepness of the Treasury yield curve—also indicate that the bottom lies ahead, rather than behind us.
During the last recession, in 2002, high-yield spreads (the yield difference between high-yield corporate bonds and comparable-maturity Treasury securities) exceeded 1,100 basis points. We’re not quite there yet—by mid-September 2008, we saw that high-yield spreads had extended to about 950 basis points, after being as low as 230 basis points in June 2007.
Similarly, the Treasury yield curve is not as steep (indicated by the yield difference between two- and ten-year Treasury notes on a given date) as we’d expect at the bottom of a recession. We’ve observed during recessions that the difference expands to about 250 basis points as the Fed seeks to stimulate the banking system. A steep yield curve encourages financial institutions to lend by increasing the difference between their cost of capital (what’s paid to depositors) and returns they achieve by making loans. As of mid-September 2008, that two- to ten-year Treasury yield difference was approaching 200 basis points.
Closing Thoughts
As we sensed would be the case a year ago, the credit crisis launched during the “Summer of Subprime” is still with us, housing prices are still declining, home inventories remain high, and consumer spending continues to be constrained. In a paper distributed at the 2007 National Accounts Investment Forum, we said, “We expect that the housing downturn is far from over, and will continue to exert downward pressure on consumer spending and the economy for months to come. The expansion of subprime woes to other real estate lending sectors, combined with the tightening of credit standards, have the potential to undermine housing prices for an extended period.” Take away the words “far from over,” and we could say pretty much the same thing today.
We think American consumers face hard times ahead that are not addressed directly or immediately by the much-publicized responses to the seemingly accelerating stream of institutional failures in the financial sector. We foresee weak economic growth for the rest of this year and into 2009. Despite that, we remain vigilant for signs that the markets and the economy are turning, and for the opportunities those changes bring. As we write this paper, conditions are changing almost by the minute. So new opportunities may already have opened up by the time this paper is published and presented.
For now, we favor the securities of large, diversified corporations, U.S. government agency mortgage-backed securities, and municipal bonds. The Treasury yield curve has steepened dramatically in the past year, and we expect it to steepen further. The Fed is boosting market liquidity through various extraordinary activities and facilities designed to mitigate the credit crisis and boost economic growth, but we think it’s fighting an extraordinarily uphill battle. We believe the Fed will be forced by ongoing economic weakness to cut rates further in coming months, giving an additional boost to the Treasury sector and other high-quality securities.
Times like these favor bond managers with superior security selection skills, risk/return management discipline, and credit analysis expertise. Our fixed-income portfolio management teams at American Century Investments® possess those traits, as their track record shows. We appreciate having the opportunity to share their thinking and results with you.
The opinions expressed are those of the Fixed Income investment team and are no guarantee of the future performance of any American Century portfolio. Statements regarding specific holdings represent personal views and compensation has not been received in connection with such views. This information is not intended to serve as investment advice. Diversification does not assure a profit or protect against a loss in a declining market.