Opportunity Knocks With Fannie and Freddie
Over the next year or two, those of that didn't get run over by the credit locomotive will be in position to take advantage of those that must sell.
Mama, put my guns in the ground
I can't shoot them anymore.
That long black cloud is comin' down...
I feel like I'm knockin' on heaven's door.
- Knockin' on Heaven's Door (Bob Dylan)
For the better part of four years, I have been writing that investors were not getting properly compensated for taking credit risk. As it turns out, those that took a lot of credit risk in corporate bonds (particularly bonds issued by financial institutions) wish they had not done so.
Those that took risk in buying structured products like CLOs (Collateralized Loan Obligations) and CDOs (Collateralized Debt Obligations) most likely now wish they had never heard of them. Bloomberg defines CLOs as "special purpose vehicles with securitization payments in the form of different tranches" and CDOs as "structured debt securities backed by a portfolio" consisting of the following:
- Secured or unsecured senior or junior bonds issued by a variety of corporate or sovereign obligors.
- Secured or unsecured loans made to a variety of corporate commercial and industrial loan customers of one or more lending banks.
Now that is a mouthful. I have always operated under the assumption that if it takes more than 60 seconds to explain an investment vehicle to me, as I have been around a while and have seen my share of financial alchemy, I will not invest my funds or my client's funds in that vehicle.
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Further, my firm operates under what one of my old bosses taught me a long time ago. It's called the 'New York Times Test,' which simply asks you if you would feel good about putting your portfolio on the cover of the New York Times. If the answer is 'no', than you had probably better stay away. Living by these two simple rules takes quite a bit of discipline but tends to produce satisfactory results over long periods of time. Not necessarily the highest results, but it keeps me from making major mistakes. This leads me to the question "Is opportunity finally knocking?" The answer: yes and no. I will outline below where I find opportunities currently exist.
Is There Now Opportunity in Corporate Bonds?
In the following exercise, I will examine the yields of Bloomberg's 10 Year BBB Rate Industrial Corporate Bond Index versus the yield of 10 year Treasuries. I will leave it up to you to decide whether value exists in the sector. At the end of the analysis, I will offer up my opinion.
1 Year Chart of BBB Industrial Bonds versus 10 Year Treasuries (in basis points)
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6 Year Chart of BBB Industrial Bonds versus 10 Year Treasuries (in basis points)
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15 Year Chart of BBB Industrial Bonds versus 10 Year Treasuries
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90 Year Historical Perspective of Moody's Baa Corporates versus Treasuries in Percentage Points
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The reason I opened this piece with the answer "yes and no" when evaluating if we are being properly compensated for risk is that it truly depends on one's perspective. If your perspective is one year, BBB corporates look cheap.
Using a 16-year perspective still shows them as cheap. But note what happens when you go back into history, say, to 1980, BBB corporate bonds look expensive. Going back to 1933 makes them look downright unattractive. While I am not comparing today's environment to the heights of inflation in 1980, or the depths of deflation in 1933, from my perspective, BBB industrials are still not nearly cheap enough for me to include them in portfolios.
Since an unprecedented amount of credit market debt exists relative to the size of the economy, we could see an unprecedented widening of spreads as the credit market unwind continues. The chart below, which I have been highlighting since 1998, says it all. Like they say, a picture is worth a thousand words. Some investors that haven't really ever seen a credit crunch before would likely answer 'yes' to my original question. Those old guys, like yours truly, that have been through credit 'events' would likely say 'no.'
Total Credit Market Debt as a Percentage of GDP
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Does Opportunity Exist Anywhere?
The short answer, in my opinion, is yes, as it pertains to both preferred stocks and bonds. It is widely known that the mortgage and housing meltdown has had a dramatic effect on most financial companies, including Fannie Mae (FNM) and Freddie Mac (FRE). Because Fannie and Freddie have both been disciplined by their regulator, OFHEO (Office of Federal Housing Enterprise Oversight) to maintain a 30% surplus of capital on the balance sheets, and they had to issue a huge amount of preferred stock in late 2007 to stay in compliance as they wrote down bad loans.
Both companies have stated that they believe they are fully funded as it relates to 2008 OFHEO guidelines and will not need additional capital during 2008, even if housing deteriorates to record default levels. As a result of the large amount of issuance, they were forced to pay rates that I feel were much higher than 'normal' and I have taken substantial positions in these securities at yields ranging from 7 to 8.3%.
I will show below just how cheap these securities have become relative to Treasuries in a very short time on an absolute basis. Then I will show how cheap they have become on a 'tax equivalent basis' as their dividends qualify for the DRD (Dividend Received Deduction) that allows U.S. corporation to exclude taxes on 70% of dividends received from the preferred stocks of other corporations and the QDI (Qualified Dividend Income) that allows individuals to pay a capital gains tax on the dividends. The fact that we can buy these preferred shares at tax equivalent yields approaching 11%, or a tax-free yield of approximately 7%, is why I have steered clear of municipal bonds in favor of preferred shares of GSEs (Government Sponsored Enterprises).
FNM 8.25% Preferred Yield Analysis
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FRE 5.9% Preferred Yield Spread versus 10 year Treasuries (in basis points)
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As you can see, opportunity is knocking in this area and I have taken the 'other side of the trade.' I have said for years to only take credit risk when you are being properly compensated for credit risk. In this case, I believe that I am being properly compensated. And there is a 'kicker,' I believe, in these shares. According to the 'Implode-O-Meter,' 214 major U.S. lending operations have 'imploded' since late 2006.
With credit standards being tightened by major banks as they write off bad debts in the sub-prime and now the prime mortgage space, Fannie and Freddie may be looked at as the mortgage lender of last resort. I would offer up the following possibility, that while remote, may be a real solution for the housing implosion. Why not, by an act of Congress, nationalize FNM and FRE and allow their balance sheets to grow and take them from having the implicit backing of the U.S. to an explicit backing, like as is the case with Ginnie Mae, which only originates FHA/VA mortgages?
I realize this potential solution may sound draconian but I could see it as a real help to the economy, as opposed to band-aids like surprise rate cuts by the Fed, unlimited money supply from the European Central Bank and rapid money supply growth around the globe. While a long-shot, it would give a boost to all owners of the debt and preferreds of these companies. After all, the total equity market capitalization of Fannie Mae and Freddie Mac are only a combined $55 bln, as of Friday's close.
Another example of opportunity knocking is the deal sold by MBIA (MBI), the large municipal bond insurer, on Friday afternoon. Fitch Ratings, one of the largest ratings agencies, gave MBIA until the end of January to stave off a downgrade from AAA. So MBI was forced into selling $1 bln on 'surplus notes' on Friday via Lehman. MBIA's CEO, Gary Dunton, was quoted that "MBIA was committed to keeping its AAA rating 'without qualification'." The deal got done late Friday. The yield? 14% fixed until 2013 and then LIBOR plus 11.26%. Now that is opportunity. I bought the bonds on the offering. As I have said, 'buy from the fearful and sell to the greedy'. Since MBIA was fearful of losing its rating, it had to sell.
In summary, these are just a few observations that I have made lately. I have said that I am neither bull nor bear, simply an opportunist. As opportunity arrives, on either a micro or macro basis, I look forward to taking advantage of mis-priced bonds. Over the next year or two, those of that didn't get run over by the credit locomotive will be in position to take advantage of those that must sell.
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