“Smart Money” Finally Catching On

Sometimes it takes a while for the so-called “smart money” to catch on.

Over the past year, for example, the S&P financial sector has fallen by about a third and is off nearly 50 percent from its February 2007 peak. Banks’ losses from the credit crunch have exceeded $500 billion, according to Bloomberg, and are set to rise much further. And origination and trading volumes for the vast majority of credit instruments — except super-safe Treasuries — have fallen through the floor.

Yet it’s only now, as the following report, “U.S. Credit System Remains Crippled a Year after Crisis Erupted,” by the New York Times’ Vikas Bajaj, seems to be saying, that investors are “starting to realize that the stress in the credit market will persist for some time.”

A year after the credit crisis erupted on Wall Street, one of the most important arteries of modern U.S. finance remains broken.

And until it is fixed or replaced, analysts say, borrowers in the United States can expect to face higher than normal interest rates even as access worsens to home mortgages, student loans, auto loans and commercial mortgages.

The problem - the drying up of financing for a vast swath of the economy - has intensified as bond investors have grown leery of the securities priming the pump. The inability to revive credit markets has served as a drag on both the U.S. and the global economies. Economies elsewhere are caught in the backwash, affected both directly by the financial problems emanating from the United States and the American economic downturn that has followed.

The market for securitization, through which mortgages and other debts are packaged and sold to investors, has become moribund and almost totally dependent on government support. And the problems have persisted despite the use of extraordinary powers by Washington policy makers to support the financial system.

“The mortgage finance system in the United States has been badly damaged,” said Anthony Lembke, co-head of investments at MKP Capital Management, a hedge fund firm that is a big investor in mortgages. “There is definitely some reinvention that will need to occur and that will include some explicit involvement by the government.”

Bond investors first stopped buying private home mortgage deals, then shunned commercial mortgages. Now, they are becoming wary of credit card debts and auto loans. In the first half of 2008, private securitizations reached $131 billion, tumbling from $1 trillion a year earlier, according to data compiled by Thomson Reuters.

Some analysts say investors are acting like the “bond vigilantes” of the 1980s and early 1990s. These traders fueled a surge in interest rates because they feared inflation and a mounting U.S. budget deficit. Their actions helped slow the economy and pushed policy makers in Washington to rein in spending and raise taxes, at least for a time.

“The bond vigilantes took law and order in their own hands and pushed yields up, which would slow down the economy and bring down inflation,” said Edward Yardeni, the investment strategist credited with coining the term. “This time the bond credit vigilantes are refusing to go into the saloon and start drinking what Wall Street’s financial engineers are mixing.”

For their part, bond traders say that the weakening economy is making it harder for them to invest with confidence because even areas like auto loans, credit cards and commercial mortgages that earlier seemed secure now look vulnerable to losses. They are also worried that demand for securities will be weaker in the future as banks, brokerage firms and other investors feel pressure to sell.

Their reluctance to invest implies credit for businesses who want to expand or people who want to buy homes will remain tight. That concern was underscored by the Federal Reserve’s most recent survey of loan officers, which on Monday showed that most domestic banks had tightened lending standards and that demand for loans had weakened in the second quarter.

“It appears that every time we peel away this onion, there is another layer,” said Curtis Ishii, the senior investment officer for fixed income at the California Public Employees’ Retirement System. He added that investors are starting to realize that the stress in the credit market will persist for some time.

Analysts say housing prices are the most important numbers to watch for the economy and markets. Investors will be able to estimate the size of their losses once it becomes clear how far prices will fall and when they will bottom.

“To the extent that home prices keep spiraling down, the need for capital keeps increasing,” said Alejandro Aguilar, a portfolio manager at American Century Investments, a mutual fund company.

As they wait for the pain to ebb in the housing market, many investors have rushed to havens like U.S. Treasury securities and other debts with a government backing or a short pay off. That move suggests to analysts that many investors remain unwilling to invest in mortgages and other debts even though lending standards have improved from the go-go days of the housing boom.

Money market funds, the short-term cash alternatives, grew to $2.9 trillion in June, up from $2.1 trillion a year ago, according to Crane Data. Those funds, in turn, have more than tripled their holdings of Treasuries and other government debt while reducing the share of their portfolios invested in somewhat riskier corporate notes.

Patrick Ledford, chief investment officer at the Reserve, one of the nation’s largest operators of money market funds, said some institutional investors had moved assets into government funds from broader money market funds to avoid exposure to commercial paper, which are short-term debts.

Some of the slack in the credit market has been taken up by the government-chartered mortgage finance companies Fannie Mae, Freddie Mac and Ginnie Mae. The three companies have securitized $692 billion in home mortgages through June, putting them on track to approximately match the $1.2 trillion they securitized in 2007, according to Inside Mortgage Finance, a financial trade publication.

But even with their backing, prices for these securities have fallen in the last two months, despite initiatives by Congress and the Treasury to create a stronger government safety net for Fannie Mae and Freddie Mac. The two companies, which reported big losses last week, have said that they might reduce or slow the amount of large loans they purchase from banks, pushing the price of mortgage securities down even further and raising the cost of borrowing for home buyers.

Because those developments have dampened the private mortgage market, the Treasury Department has sought to revive activity by encouraging the use of covered bonds, which have been a popular investment in Europe.

Unlike a mortgage security, the home loans that back a covered bond stay on the issuing bank’s balance sheet. If loans default, banks replace them, making the bonds less risky to investors but more so to the banks. In July, four big U.S. banks - Bank of America, Citigroup, JPMorgan Chase, and Wells Fargo - said they would issue covered bonds.

But before jumping in wholesale, investors say they want to know more about the quality of loans backing the bonds and see more detailed government rules about how the bonds will be handled if banks fail.

“It may be a step in the right direction, but I am not sure it will solve all the problems,” said Daniel Shackelford, a bond portfolio manager at T.Rowe Price, a mutual fund firm.

Bond investors say the steps taken by policy makers so far have been helpful but not sufficient to revive the credit market. They have not, for instance, addressed thorny issues like excessive leverage used by investment banks or faulty credit ratings that suggested some risky securities were safe.

“Across the whole financial sector from the individual mortgage all the way up to private equity, the system was lending on momentum in asset prices and not on the borrowers’ ability to repay,” said Peter Fisher, co-head of fixed income at BlackRock, the asset management firm.

“We should fix a number of problems,” he added, but if “we don’t address how things got so amazingly overleveraged, we won’t be fixing the system.”

Some New York loans shunned

Freddie Mac said Tuesday that it would stop buying subprime loans issued in New York State as a new law takes effect that holds investors accountable for mortgage fraud.

Freddie will not buy loans dated on or after Sept. 1 that meet the state’s subprime definition, the government-chartered company said in a lender bulletin on its Web site. Governor David Paterson of New York signed new foreclosure and lending laws last week that tighten legal protections for borrowers.

The legislation holds mortgage buyers like Freddie liable in ways that “we have no way of monitoring and preventing,” Brad German, a company spokesman, said.

The state law may disproportionately affect borrowers looking to use state and federal mortgage rescue programs to refinance out of unaffordable subprime loans, German said, but he said it would affect a “very, very small number” of loans.

A spokeswoman for Governor Paterson, Erin Duggan, had no immediate comment.

Posted in Categories: Contributor, Economy, Eurozone, External Research, USA.

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