Problems in the subprime fixed-income market played perhaps a larger-than-expected role in presentations and discussions among the experts at Morningstar's annual Investment Conference, this year held at Chicago's McCormick Place, June 27 to 29. The timing of the conference was perfect for starting a debate about the extremely complex issues that are unraveling part of the bond markets following the seizure of hundreds of millions of dollars of assets by Merrill Lynch from a Bear Stearns hedge fund to which Merrill had lent money, the High-Grade Structured Credit Strategies Enhanced Leveraged Fund, according to Wall Street Journal
Fixed-income experts addressed the fallout from the subprime universe in opening and closing sessions of the conference, starting with keynote speaker Jeffrey Gundlach, CIO of TCW Investment Management and Morningstar's 2006 Fixed Income Manager of the Year, who asserts that for a number of fundamental reasons, coupled with the complexity of how these structured securities--for they are not bonds--are created, rated, valued, and the very illiquid market for these securities, the subprime market is a "total unmitigated disaster."
The insulation advisors might think clients would have from these synthetic products may evaporate as more of the story is told, for, as Gundlach puts it, if you've heard, "don't worry, it's AAA," in reference to collateralized mortgage obligations (CMOs), and collateralized debt obligations (CDOs), "in the world of subprime [they] could be on the margin of risk." (For more about the possibility of subprime tainting clients' accounts, please see lead story in the Broker/Dealer Briefing section.)
Who's Watching the Store?
The issue resurfaced in the closing general session, when Morningstar convened three bond manager all-stars: Keith Anderson, vice chairman and CIO of BlackRock; Robert Rodriguez, CEO of First Pacific Advisors; and Stephen Walsh, deputy CIO at Western Asset Management, to discuss the subprime/junk situation. All three run or oversee bond portfolios and agreed that rating agencies will have some explaining to do to regulators about "their role in this," according to BlackRock's Anderson, who notes that with rates so low, some investors have given up bond covenants and structure for the yields on the CMO-CDO synthetics, although he hastened to add, "that's not us at BlackRock."
It's "hard to get a sense of how bad it is," Rodriguez argues, adding that it's not only hedge funds that own CMOs and CDOs, but banks and other financial services companies that may have thought they bought investment grade tranches of CMOs--even AAA-rated securities--and are finding that what they have instead is not trading at the same prices as other AAA securities. "I don't buy the ratings from the ratings agencies," Rodriguez cautioned, adding that he's "not sure how widespread the unknowable risk" is.
Already, ratings agencies are reacting to the subprime issue. Standard & Poor's announced revisions in its methodology for rating subprime mortgage-backed securities on July 10, putting "612 U.S. Subprime RMBS Classes" on its watch list for potential downgrades. Moody's downgraded its ratings on 131 mortgage backed securities on June 15 and put 237 under review for possible downgrades--including some investment grade mortgage-backed securities with ratings all the way up to AAA.