Mauldin excerpt

When the Facts Change

John Keynes, upon being confronted by someone that he had made a different prediction than what he held a his current view, is famously quoted as having said, "When the facts change, I change my mind. What do you do, sir?"

And I think that everyone in the group would agree. While we take the "game" of investments very seriously, if you do this long enough, you will get humbled quite often. That is why you constantly evaluate your analysis, and change them when the facts change.

And the credit markets are changing their opinion in a very rapid manner. Earlier this spring, the credit markets started to get concerned about subprime mortgages. But "everyone" said it would not spread to the rest of the credit markets, so there was no cause for concern. I was not so sanguine. I have consistently thought that the entire credit markets would be affected, through a tightening of credit standards. And now the markets are starting to agree. Let's look at a few charts, and then think through the opportunities, especially in the high yield space.

Let's first look at the BBB paper in the mortgage markets. It is now trading at less than $.38 cents to par (100), and that chart is still pointing down. Catch a falling knife, anyone?

The Subprime Virus

But that is just the subprime stuff, John. A few weeks ago, no one thought it would spread. But spread it has. And spread is the correct word. Spreads on high yield bonds have widened. By spreads I mean the difference, or spread, between the yield on a bond and its corresponding yield on a government bond (of the same time frame). If a high yield bond had a spread of 300 basis points, or 3%, then it would be yielding 3% over the government bond.

Let's look at this next chart, which is the spread on credit default swaps on high yield bonds. Note that the spread has risen from below 250 basis points as recently as early June to almost 500 basis points this morning. That also means that high yield bonds have dropped in value by almost 9% from the high, which was slightly over par less than two months ago!

In other words, less than two months ago, the average trader and manager did not think there was any risk in the high yield space, or at least there was historically less risk than at any other time in history.

So, let's look at the next chart to put this into perspective. Let's look at this chart from Bear Stearns (courtesy of good friend, business associate and high yield maven Steve Blumenthal of CMG) which shows high yield spreads for the last almost 20 years. Now, this is a different index than the Markit CDX high yield, with different underlying bonds, but the point is to show that even though yields have almost doubled, they are still not all that high by historical standards.

Now, even if you take out the ugly periods in 2001-2 which were caused by Enron, WorldCom, etc. it would still take another sharp rise just to get back to the average yield spread.

Now, Steve tracks yet another high yield index. It reached a low in late February of this year of a spread over treasuries of only 209 basis points. Today it is at 504! That is a significant move! And the spreads are widening. They could easily (and probably should) go higher.

So, what stops them from going back to the 2001 yield spreads? Just as CDOs and subprime derivatives have made the markets more volatile and risky, Credit Default Swaps on high yield bonds will soon have traders licking their chops in anticipation.

First, let's point out that defaults are at an all-time low. Corporations are generally in better shape than they have been in a long time in terms of being able to manage their debt. Even in a slowing economy, there is not reason to think that defaults are going to rise back to 2001 levels.

Let's start with a very simplistic analysis. Say you're a high yield trader sitting at a fund or a prop (proprietary trading) desk at a major investment bank. You can buy $40 million of high yield bonds yielding almost 5% over cost by putting up just $10 million in collateral. You get 5% on you margin capital and a total of 20% ($40 million x 5%) on your invested capital from the excess yields on your bonds (which you probably bought as a credit default swap, avoiding the time consuming hassle of buying the actual bonds). You are making a total of 25% on your money.

So far so good. If the bonds drop 2.5% in value, you are down 10% on your margin money but still making a net 15% over a one year period. However, if they drop 10%, you are down 40% and it will take two years of those high yields just to recover your initial capital, if you and your investors can stand the pain and the margin calls.

But what if you were leveraging a few months back when yield spreads were just 200 basis points? You were getting a total of 13% returns (4 x 200 basis points on the spreads plus your 5%). Not very juicy, but respectable in a low return world. But then the market falls outs, and drops by 9%. You are now down almost 36% of your original capital, and it will take a long time to get back to even, assuming you can hold on that long, and of course assuming you meet your margin calls. Otherwise you take the losses.

And that will be the game over the coming months. The underlying debt that creates the credit default swaps in the high yield space is well defined and transparent. You can bet that there is a lot of work being done on the credit quality of each of those bonds that comprises the index. At some point, traders step in and decide the risk is worth the reward, and the market stops falling.

By the way, this whole market is a fairly recent development. You couldn't do this even five years ago in any size and with any liquidity. Now any Tom, Dick and Harry fund or prop desk can do it. But if trader's think the market is going lower, they will wait.

Credit? What Credit?

Over 40 Leveraged Buy Out (LBO) deals have been pulled in the past few weeks. The biggest investment banks are having to "eat" the paper on the Chrysler and Boots LBOs, as they cannot find buyers for the paper. In essence, they committed to lend the money and planned to sell the bonds into the market, keeping fat fees and commissions. Now, they have to put the loans onto their books.

This is not all bad. It simply means they have to use their own capital, and at yields lower than they could get today, to fund the deals. It is not that the paper is bad. It is just that the market wants a higher yield, and the banks would have to lose money to sell at the higher yields.

But what it does mean is that now the banks have less capital to fund new deals, and that private equity funds will have to pay more interest and put more equity into a deal to get it done. That makes a lot of deals less attractive than they were a few weeks ago.

Part of the sell-off in the stock market is from stocks which were thought to be "in play" but are now no longer take over candidates. The wind in the sails that has been private equity and buybacks is dropping, as funding is drying up rapidly.

Issuance of collateralized loan obligations (CLOs) soared to a record $57 billion in the first half of 2007. That has since slowed to a trickle. So far this month, just $1.9 billion of CLOs have been sold, according to Standard & Poor's Leveraged Commentary & Data. "Leveraged finance's cash engine -- the CLO market -- has ground to a halt," S&P noted in a written commentary on July 19. (WSJ Online)

CLOs prices, like high yield bond prices, have dropped in the past month. Just last month they were priced over par. Now the index is down about 6%, as yields have risen from a spread of a little over 100 basis points to almost 350. That is a major change. And this is on loans, gentle reader, which are generally senior to bonds and usually have some type of collateral baking them.

This simply illustrates that all the credit markets are acting in tandem. Part of the reason is that the margin clerks are demanding increased collateral on the riskiest loans, and when there is a crunch you sell what you can and not necessarily what you want. That is why nearly every asset is going down in tandem - stocks, bonds (except for government debt), commodities, gold, etc.

This is acerbated substantially by the unwinding yet again of the yen carry trade, as the yen is rising rather rapidly against a host of currencies and those who borrowed long yen are rushing to the exits only to find everyone else trying to get out the same small door.

The yen was almost 124 to the dollar almost a few weeks ago. Now it is below 119, a drop of over 4% in a few weeks, which is huge in the world of currency trading.

If you are leveraged long the yen to invest in the Australian or New Zealand dollar (or whatever your poison of choice is), you are now down 3-4% times the amount of your leverage in just a few weeks. That is also putting pressure on the markets.

In short, it is going to be a while before credit markets stabilize. They will, of course. But it means businesses are going to be paying higher rates for loans, mortgages are going to be harder to get (and now cost 50 basis points more than they did a month ago), and fewer deals are going to get done.

The subprime virus has spread. The markets are getting a fever, and like most viruses, it will simply have to run its course.

Next week, we will look at what all this means for the economy, but the short version is that it will mean slower growth in the last half of the year.