The
stock market had a rough month in July, with the S&P 500 Index
losing approximately 3%. Small cap stocks, as measured by the Russell
2000 Index, were hit even harder falling 7%. The primary catalyst
for the losses centered on growing concerns over subprime mortgages.
What exactly are subprime mortgages?
“Subprime” mortgages are those taken out by borrowers with lower
credit scores, higher loan-to-value ratios (i.e., smaller or no down payments),
and higher debt-to-income ratios. Subprime borrowers also tend to hold more adjustable
rate mortgages, which may cause additional financial stress depending on future
economic conditions. Needless to say, subprime borrowers are more likely to default
on their mortgages.
At the opposite end of the spectrum from subprime are “prime” mortgage
loans where the borrowers tend to have high credit scores and lower
leverage statistics. Another term, “Alt-A”, refers to
those loans that fall between prime and subprime. Despite the negative
attention of late, it could be argued that on balance, the increase
in subprime lending has been a good thing for the economy and society
at large, as it has enabled many more people to own their own homes.
The subprime mortgage securities market has grown considerably in
recent years. Back in 2000, it totaled $56 billion. By 2005, that
number had grown nine-fold, to $508 billion. Today, the subprime
market represents approximately 14% of the over-all mortgage-backed
securities market. Subprime lending has grown for a combination of
reasons. It is often mentioned in the press these days that many
lenders simply became too aggressive in their lending practices and
too lenient in their lending standards. There is some truth to that.
In addition, there have been powerful incentives to buy homes in
recent years, including the very low level of interest rates. One
very important factor that doesn’t get mentioned as much is
the growth of the subprime mortgage securities market within the
larger mortgage-back securities (MBS) market. This has enabled lenders
to transfer some of their risk exposures away, which in turn have
enabled them to make even more loans.
Mortgage-backed securities (MBS) are created by placing a pool of
mortgages in a trust and then selling bonds to investors secured
by the principal and interest payments on those mortgages. Because
MBS created from subprime mortgages offer higher interest rates,
they can be more profitable for investors (assuming default rates
do not rise too much). Then, these mortgage-backed bonds are pooled
into new trusts and securitized yet again, creating what are know
as collateralized debt obligations (CDOs). These CDOs can be targeted
to specific risk and yield levels, which make them attractive to
many types of investors, especially some hedge funds.
The “Virtuous” Cycle
So far, so good, all this lending and securitizing activity is a win-win
situation for nearly everybody involved in the subprime world — as
long as the credit cycle remains “virtuous.” This virtuous
cycle can be illustrated as follows:
A strong housing market generally leads to lower credit losses (defaults),
so credit ratings remain stable, which increases investor demand
for mortgage securities such as MBS and CDOs, which results in more
demand for mortgage loans to create those securities, which tends
to cause lenders to ease their loan standards to generate more loans,
and lastly, more people with loans to buy houses makes the housing
market even stronger.
This virtuous cycle repeats itself again and again — until
it doesn’t anymore. As shown on the graph below, on a national
level housing prices peaked in 2005. This has lead to more delinquencies
and defaults. Mortgages issued in 2006 are in the most trouble and
experiencing higher delinquency levels as they were issued near the
height of the real estate market.
The Cycle Turns “Vicious”
What was once a virtuous cycle has now turned into a “vicious” cycle.
Weaker home prices have led to increased credit losses and that has led to
lower demand for MBS and CDOs. Weak loan performance (greater defaults) has
lead to a fall-out in subprime loan originators. Approximately 25% of the
subprime volume in 2006 came from originators that have now either exited
the business or filed for bankruptcy. That number could continue to increase
sharply. Banks have also started to tighten their lending standards, with
56% of senior bank loan officers reporting tighter standards on subprime
mortgages in the first quarter of this year. This tightening of standards
is the biggest increase since the early 1990s. There have been dramatic declines
in subprime bond prices.
Is the worst behind us? Probably not. Is this a crisis, or an opportunity?
How about both? The subprime mortgage situation bears close monitoring
and it surely means that some significant adjustments within the
financial markets could occur. Within the fixed-income markets, it
could be expected that after several years of underperformance, higher
quality bonds will outperform as they already have so far this year.
The yield spread between high quality bonds and low quality bonds
reached extremely tight levels earlier this year, meaning there wasn’t
much cushion in case something went wrong. Well, the subprime situation
appears to be the catalyst to finally push those yield spreads back
into the direction of their historical averages.
It is also important to realize that the mortgage market is just
one part of the overall economy that took advantage of plentiful
and cheap capital. As access to capital gets more expensive and harder
to get, stock buybacks, acquisitions, leverage buyouts and hedge
fund operations, which have been a major support for the stock market,
will all be adversely affected.
So it is not surprising that we see a parallel situation in the
stock market. We expect relative valuations between higher quality
stocks (more stable earnings streams and lower debt levels — generally
large-cap stocks) and lower quality stocks (more volatile earnings — generally
small-cap stocks) to widen. As with higher quality bonds, we expect
higher quality large-cap stocks to outperform lower quality small-cap
stocks.
Don’t Be Unnerved by the Market’s
Swings
These major adjustments in the financial markets have led to an increase
in volatility that can be unnerving. But, remember that higher volatility
means increased “opportunity” for many active managers. Today’s
higher market volatility creates changes in the relative prospects between
securities and provides the opportunity for many portfolio managers to upgrade
the portfolio and buy securities “on sale.”
Our concerns over the real estate market, tighter capital conditions,
and increased volatility suggest some modest and measured moves to
a more defensive positioning. We will continue to maintain the course
with reasonably balanced, diversified portfolios, though maintaining
a tactical emphasis on higher quality stocks and bonds through the
use of actively managed mutual funds.
Sincerely,
Eric M. KobrenRusty Vanneman,
CFA
PresidentDirector of Research
Portfolio ManagerCo-Portfolio
Manager
