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October 01, 2007 at 04:00 AM
For one of the most comprehensive perspectives on the subprime mortgage crisis, Research turns to Jeffrey E. Gundlach, Morningstar’s 2006 Fixed Income Fund Manager of the Year, TCW Group’s Chief Investment Officer and portfolio manager of the TCW Total Return Bond Fund (TGLMX)*.
*The fund invests primarily in mortgage-backed securities guaranteed or secured by collateral guaranteed by the U.S. Government, its agencies, its instrumentalities or its sponsored corporations and in privately issued mortgage-backed securities rated Aa or higher by Moody’s or AA or higher by S&P.
What caused the current subprime mortgage problems?People bought bonds backed by subprime mortgages based on credit ratings bestowed by the rating agencies. These credit ratings were based upon a na?ve extrapolation of historical default rates. In fact, mortgage lending had undergone a serious deterioration in underwriting standards – to the point that, in an open letter on May 3, I forecast a cascade of downgrades and losses on subprime-backed bonds rated “investment grade” and on collateralized debt obligations (CDOs) backed by these bonds.
By June, two Bear Stearns hedge funds with nearly $22 billion in subprime exposure were in a state of collapse. Then during July 10-13, the rating agencies downgraded or placed on negative watch some 1,300 recently issued subprime-related securities.
Many investors had assumed that the risk profile of these bonds was comparable to that of like-rated bonds of earlier vintage. Instead, they took part in the biggest calamity in the history of rated debt. An unprecedented inventory of securities only recently rated investment grade have been marked down in some cases to less than a third of par value. Today investors in these securities are echoing a lament heard time and again in financial crashes – “I thought I owned this, and now I realize I own that.”
More than a wake-up call, the subprime mortgage market has suffered a psychological blow whose effects probably will extend well past 2007. Fortunately, to help us foresee what lies ahead after such a blow we have an historical template: the crash of certain esoteric mortgage securities in 1994.
What do you predict?We should expect to see the liquidation of billions more in subprime-related assets by all manner of investors as further waves of downgrades and defaults roll over the market. Many portfolios with concentrated exposure to subprime will be forced to sell assets. A number of hedge funds and subprime lenders have already succumbed under the pressure of margin calls and repurchase demands. There will be more. Other portfolios will be forced to liquidate downgraded securities to satisfy minimum ratings requirements and other investment constraints. This also will be the case for certain structured-finance vehicles, including CDOs.
I also expect many investment managers with relatively limited subprime allocations to voluntarily sell off these assets at large losses. Their ranks will include asset managers for insurance companies, mutual funds and pension funds. In time, many of them will tire of explaining the deterioration of this part of their portfolio to their boards of directors, investment committees and Wall Street analysts in the face of an ongoing news media barrage.
What are the parallels between the ’94 crisis and now? History appears to be repeating itself in subprime. In 2006, the first signs of trouble emerged in the form of heightened delinquency rates due to the deterioration of underwriting characteristics in securitized loan pools. As more fully described in my May 3 letter, the first casualties included subprime lenders, which were overwhelmed by repurchase demands on early-default loans.
The long grind will result in forced sales by and of structured-finance vehicles such as CDOs. I suspect that ultimately there will be capitulation sales coming from certain less-exposed institutional investors once they have soured on the subprime portfolio “sweeteners” they purchased solely on letter rating criteria. I expect some selling will even come from certain supposedly “top-tier” bond investment firms who are known to have waded into the subprime morass ill-equipped for managing the now evident risks.
