The recent upheaval that has swept the financial system leaves in its wake a radically altered investment landscape. The latest wave of financial market realignment began on September 7th when Fannie Mae and Freddie Mac were placed into a conservatorship under the Federal Housing Finance Agency. This action secured bondholders, however shareholders’ stock values fell below $1. Further upheaval followed with a flurry of bank closings, hurried mergers, and stopgap government bailouts.
A predictable flight-to-quality ensued as investors fled to the safety of U.S. Treasuries, driving their prices up and yields to new lows. While this rally will subside when normalcy returns to the markets—be it in a month or a year—other effects of the cataclysm will remain.
The Government Sponsored Enterprise (GSE) bailout, for example, challenges two conditions—ample supply and near risk-free appearance—that have made Federal Agency debt a mainstay in many short-term, fixed-income portfolios.
If the GSEs are privatized, investing in Fannie Mae and Freddie Mac debt may remain an option only for those permitted to invest in corporate securities. In the public sector, will this lead to increased pressure on legislative bodies to expand the scope of permitted investments? If so, then additional investors may be thrust into the world of corporate credit. This could be complicated further if the privatized GSEs fail to keep their AAA rating. It is generally accepted that without some sort of government backing, the GSEs would not have maintained this top rating in recent years.
For those who invest in anything but Treasuries and Federal guaranteed debt, in-depth credit analysis will become more critical. Credit ratings alone have proven unreliable guides to credit quality as rating agencies appear to have mischaracterized the risks of a great number of investments. Over the past year, 16 AAA-rated issuers in the Merrill Lynch 1-10 Year Corporate Master Index were downgraded to AA or A. An additional 136 issuers previously rated A or BBB fell below investment grade. Downgrades are usually accompanied by an erosion of market value as investors demand higher yields for holding lower credit bonds and in some cases are followed by defaults, which produce real losses.
GSE debt could also go from plentiful to scarce. The Fannie Mae and Freddie Mac conservatorship stipulates that beginning in 2010, each must reduce its portfolio from $750-$800 billion to $250 billion at a rate of 10% per year. A reduction in Federal Agency debt supply could result in a diminished yield advantage over U.S. Treasuries.
If the GSEs become truly private corporations and/or if their debt issuance shrinks substantially, risk-averse investors may be pushed into the U.S. Treasury market. U.S. Treasury securities, however, typically produce the lowest returns of any fixed-income investment. The recent flight-to-quality pushed short-term U.S. Treasury yields to near 0.00% in September. While this is an anomaly, 3-month Treasury Bills yielded 0.26% less than 3-month Federal Agency discount notes over the past 10 years. This translates to $650,000 less earnings on a $25 million portfolio. Investors limited to the U.S. Treasury market will face additional challenges in seeking a reasonable rate of return.
Meanwhile, the market upheaval has
also resulted in a reworking of the broker/dealer and banking landscape. The
top 5 U.S. broker/dealers of
a year ago are now gone, continuing the trend of consolidation and
globalization of the U.S. securities markets. The number of primary dealers (broker/dealers and banks
that trade U.S. Government securities directly with the Federal Reserve Bank of
With fewer primary dealers, there is bound to be less competition among trading desks. This may lead not only to less attractive quotes and increase the importance of competitive security shopping, but small money managers and in-house finance teams may see the service level they receive from remaining banks and brokerage firms significantly reduced.
Similarly, consolidation of commercial banks into a small number of super-banks is likely to bring about changes in the relationship between investors and their local bank. In this new era, the largest three or four banks will control 30% to 40% of all deposits, giving them enormous power to set prices for services and diminishing their need to raise deposits in the local market. The small local/regional banks will find it increasingly difficult to remain independent as benefits from economies of scale encourage further consolidation.
With unprecedented worldwide government intervention in the financial markets, the outlook is partially clouded. Each action was initiated to restore stability, but that goal has been elusive to date. In the interim, risk-averse investors have preferred U.S. Treasury securities. We continue to view GSE debt, with its explicit Federal commitment of support, to be appropriate as well.
Corporate and bank obligations should be treated with the utmost caution because the full extent of the economic downturn and the interrelationships among banks and corporate borrowers is not yet fully known.
An investment approach involving discipline, rigorous credit and counterparty analysis, and prudent risk management, will be all the more critical in navigating these difficult and uncharted investment waters.
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