Its A Risky New World: Credit Spreads
A: Back to blogging in a very different world. While the news that has come out in the past few weeks at Bear Sterns, American Home Mortgage, Countrywide Financial, etc. is by no means a surprise, they have been the most direct contributors to the current instability in the mortgage markets leading to a re-pricing of risk in the corporate and residential debt markets. As a result of this uncertainty, stock prices have corrected from record highs, especially the financials and homebuilder stocks, and there has been a flight to quality into the bond markets driving down yields as investors seek the safety of treasury returns. However, you may have noticed that lending rates have not dropped that much considering the 10YR yield fell by over 50 basis points in the past 4-5 weeks. The reason why lies in RISK!
Lets get right into this mess! For the past few years I have been explaining the relationship between stock markets and bond prices/yields, inflation, fed moves, currency trends and global growth and how they all relate to the Manhattan real estate marketplace and your investment! I try my best to simplify these macro issues so that you can understand what is going on in the world and why rates go up or down leaving you with either a lower or higher monthly payment on mortgages, credit cards, and other forms of debt. But now, the world is really changing and rather than stick to the old model, we MUST adapt quickly with the markets to understand where we are RIGHT NOW in the hopes of best understanding how any changes might relate to our investment decisions.
In the Old World (2002-2006) - Money was very inexpensive to borrow, especially in the beginning of this range. After Sept. 11th and the dot com stock market crash, the fed did everything possible to pump liquidity into the financial systems via cutting the fed funds rate all the way down to 1%. The effect took a year or so to kick in with stock prices bottoming out in 2003 (in hindsight), and lending rates fell to ultra low historical levels providing homeowners with amazingly low rate offers for home purchases. This pumped up affordability and led to a housing boom involving real buyers, developers, and speculators. Lenders of all types jumped on the bandwagon and offered very creative loan products to prospective buyers as home prices boomed and buyers found asking prices out of their budgets. The exotic loans made the home payments more affordable, albeit for a little while. The fed started raising rates at very small increments (mainly at 0.25% clips, or 25 basis points) all the way up to today’s level of 5.25%. The effect of this rate tightening took some time to kick in again, leading to the new world of higher rates and more expensive debt.
In the New World (mid 2006 - Present) - Subprime woes, bad loans, resetting ARM’s, rising rates, falling home prices, rising defaults, tighter lending standards all started to come to a head. Higher rates started to wake up homeowners to the new reality that monthly payments are significantly higher than they first thought; especially for those with resetting short term ARM products and interest only loan products. Defaults started to rise. The lenders found themselves in a bit of trouble as the repackaging and reselling of mortgage backed securities became more and more difficult as risk started to rise in the mortgage markets. In lay terms, with defaults rising and home prices falling, fewer and fewer investors wanted to buy these mortgage backed securities. Those funds that had to sell were forced to liquidate their holdings at levels far below what they thought they were worth; Bear Stearns funds are a great example of this. Other funds and lenders tried to ride out the wave until they had margin calls due and couldn’t pay up; American Home Mortgage is a great example of this. All in all, there is a re-pricing of risk going on in the tradable markets right now and risk is getting very expensive driving up rates for risky debt. As a result of this, those holding mortgage backed securities and CDO’s are having trouble finding buyers and are forced to liquidate at big time losses. Liquidity is drying up and that is bad for everyone. This is the world we live in. This is the beginning of a credit crunch. Every company with exposure to this is feeling pain.
Credit spreads are widening as a result of all this. In other words, the difference between corporate bond yields and US government treasury yields are increasing as the risk associated with corporate paper rises! Relating this to the mortgage markets, while short and medium term US gov't treasury yields are falling fast due to a flight to quality as stock prices fall, the rates on mortgage products are NOT falling at the same pace! This is because mortgage debt is now MORE RISKY than treasury bond notes and therefore demands a HIGHER RISK PREMIUM to gather investorsl i.e. higher yields. This is causing the spread between the two to widen.
Confused? I'll put a pure definition of credit spreads up here to hopefully clear things up.
Credit Spreads - In finance, a credit spread, or net credit spread, is the difference in yield between different securities due to different credit quality. The difference between the yield on a corporate bond and a government bond is called the credit spread. As such, the credit spread reflects the extra compensation investors receive for bearing credit risk (these last 2 sentences & hypothetical chart example below via Investopedia.com).
I have said for a long time that the 10YR bond is our most reliable short term indicator as to where lending rates are headed in the very near term. Due to the current credit crunch and re-pricing of risk, this NO LONGER APPLIES as a reliable indicator!
Due to the re-pricing of risk, mortgage rates are NOT falling as much as one would think with such a dive in 10YR bond yields over the past 4-5 weeks. As more and more lenders go under and less options become available to homeowners and perspective buyers (stated income loans are starting to go away now), rates are going to be in a generally upwards trend (Wells Fargo recently announced that 30YR rates for jumbo loans are going to be around 8% - I'll write on this topic shortly)! In short, the risk is too high to allow mortgage rates to fall in conjunction with falling bond yields; again, causing the widening of credit spreads.
Starting to get it? If I were a soon to be homeowner, I would keep my eyes glued to what is going on in the credit markets. Its hard to miss! Just watch CNBC for 15-20 minutes at any given time and you should catch at least one economic discussion on the topic. For those interested in more in depth conversations on the topic, tune in to Kudlow & Company on CNBC from 5-6PM daily and I guarantee you will start to learn more about what is going on in regards to the re-pricing of risk currently underway.
It’s a changing world. Either you realize it and adapt with it, or you lose; plain and simple. I believe bond yields will continue to be pressured as long as this credit mess is around with more and more lenders and home builders getting into trouble in the near future. Every time a major lender goes under, tighter lending standards get more real, risk gets more attention, and home loans should demand higher rates and stricter underwriting requirements.
In the end, its healthy for all markets that this is a known problem and that its OUT for the markets to adjust to. It would have been worse if there were cover ups on this delaying the inevitable to a later time; this is yet to be seen. Instead, lets get it all out now or in the very near future and let the tradable markets do what they have to do to absorb the problems so that a longer term sustainable growth pace can reveal itself. In the meantime, we are still trying to find out how deep this rabbit hole is!
Lets See Why This May Ultimately Hit Manhattanites - Stock/Job losses are the most direct threats to the continued sustainability of the New York City real estate marketplace. If stocks flounder, it could start a chain reaction of events that includes job losses, contraction in bonuses, lower salaries, weaker buyer demand, and forced resales of already purchased properties that were bought by unsuspecting high earners hurt by job loss or salary/bonus cutback. It could also put some fear into non wall street homeowners who will choose to sell and pocket profits made over the past years. The current inventory tightness could reverse as a result providing more competition amongst sellers during a time with weaker buyer demand and higher interest rates on loans. All of this has not yet occurred and is only a potential outcome should stock losses really hit the market. I will not comment on the likelihood of this happening due to the uncertainty in the credit markets and what may be done about it.