July 9, 2007
Call it the "cockroach theory."
It's the assumption among investors that if one cockroach takes you by surprise, there are more to come, even if you see no sign of another at the moment. You apply the same thinking to investing as you apply at home.
In other words, on some unsuspecting day you are startled by a lone cockroach darting across your floor. You might crush it, but then for days afterward you are leery when you turn on a light at night or open the cupboard under the sink. Anyone with experience with cockroaches knows that if you spot one, there are probably more hiding, ready to surface and rattle you when you least expect it.
Likewise, investors worry when financial messes seem to surface. And they now are on guard, fearful of hidden cockroaches related to years of lax lending practices and tremendous borrowing by everyone from financially stressed home buyers to overreaching private-equity firms and hedge funds.
The cockroaches that surfaced this spring are subprime mortgages and securities based on those mortgages, which are loans to home buyers with weak credit. Some of the worrisome securities are called CDOs, or asset-backed securities called collateralized debt obligations. The value of these securities is based on homeowners making monthly mortgage payments on schedule. But lenders went too far with subprime mortgages, granting them to people who obviously could not afford them. And with defaults on mortgages rising, the securities have plunged in value.
On the face of it, few have suffered seriously besides a Bear Stearns hedge fund. Yet analysts believe banks, insurance companies, mutual funds, pension funds and hedge funds have invested close to $600 billion in these securities.
There is a growing insecurity that institutions that invested in subprime investments have yet to surface with large hits to their investment portfolios.
"People didn't understand the risks" in investing in subprime mortgage-related securities, Jeffrey Gundlach, chief investment officer of the TCW Group, said at a recent Morningstar conference in Chicago. "Now that the tide is going out, all the wreckage is showing up at the bottom of the sea."
Among subprime loans, which make up about 12 percent of mortgages, "the delinquency rate is climbing and it should climb at a very high rate," undermining the value of the related securities, Gundlach said. Delinquencies are now at 14 percent, and he estimates they will climb to 20 percent.
Gundlach notes that investors who didn't realize they were taking a chance with the securities are being surprised with huge losses.
Many investors bought subprime loan securities thinking they were rated AAA, ratings that suggest very safe bond investments, he said. Yet, they are discovering the sophisticated computer models that suggested the investments were safe are not valid, and investors bought junk bonds rather than safe bonds.
"That's a problem," he said. "People bought thinking they were buying something else."
But it's not just cockroaches in the subprime area that are on investors' minds. During recent years, cheap money has gushed into the financial system, a result of low interest rates worldwide and complacency about taking risks.
Private-equity firms, for example, have raised $300 billion this year but will depend heavily on borrowed money, or leverage, to do $1 trillion in deals, said Ranji Nagaswami, chief investment officer for AllianceBernstein Investments. Hedge funds follow similar practices.
"Leverage works both ways," noted Jean-Marie Eveillard, who does not use leverage in the First Eagle Fund he manages. When conditions are on an investor's side, borrowed money enhances returns. But in unpredictable downturns, "leverage can really kill you."
With subprime lending follies in the background, Wall Street analysts wonder if excessive borrowing will show up in some other infestation, perhaps related to hedge funds or private-equity deals.
"Leverage is building up," AllianceBernstein Chief Executive Lewis Sanders told investors at the Morningstar conference. "It is a destabilizing force that will affect all of us, even if we do not think we are involved."
Historically, whenever borrowing has become excessive, lenders eventually have had a day of reckoning with bad loans. In response, they have cut back on credit or raised interest rates on bank loans or corporate bonds, even to solid borrowers. Investors fear such a response because businesses and consumers cut back spending when it costs more to borrow. That can stifle economic growth and corporate profits, sending stock prices down.
"We urge caution," Nagaswami said.
Robert Rodriguez, CEO of First Pacific Advisors, is so worried about risk that he has about 41 percent of the FPA New Income (bond) fund and 35 percent of the FPA Capital (stock and bond) fund invested in cash. In addition, he has only 1 percent of the New Income fund invested in junk bonds, or corporate bonds most likely to default. He said his exposure to junk has never been lower.
He is concerned because of a breakdown in lending practices, he said. Mortgages were given to homeowners that clearly weren't qualified to get them. Between the most-qualified borrowers and the least (subprime) is a category called Alt-A, and defaults are showing up there too.
Borrowers started missing payments within just a few months of receiving the loans, an obvious sign that lenders gave loans to people who couldn't afford them, Rodriguez said.
In addition, he complains that when the securities were rated for safety, examiners did not build into their models the presumption that housing prices would decline, as they now are doing in some areas. In other words, investors invested in bonds without an appreciation of the risks they were being exposed to.
"Alan Greenspan has said there won't be contagion" from the mortgage securities, said Rodriguez, referring to the former Federal Reserve chairman. "I'm not sure that's correct. We are quite concerned."
Nagaswami also is concerned that a long period of relative calm in stock and bond markets worldwide has made investors too complacent about the riskiest of investments.
"Bond investors are acting as if nothing can go wrong," she said.
She contrasts the behavior of bond investors with those in stocks. Investors don't like uncertainty and expect to get paid for it when they invest. But very low yields on bonds throughout the world suggest investors have let down their guard and aren't asking to be paid for risks they are taking.
A stark example is evident in emerging-market bonds, noted Steven Romick, manager of the FPA Crescent Fund.
"The yield on an Iraq bond is just 10 percent. That's crazy given the risk," he said.
While investors have been willing to invest in the riskiest of bonds without being compensated for potential defaults, stock investors have not been as complacent, Nagaswami said.
Overall, the price of stocks compared to earnings remains similar to historical averages, as do other measures. But she said investors are taking extraordinary risks in some parts of the stock market too, especially areas where they'd least expect problems.
So-called value stocks and value stock funds, which investors typically buy because they are cheap and less risky, are anything but that today, she said.
Investors, she says, appear to be making the same mistake about value stocks today as they made about growth stocks seven years ago. Then, investors pushed up the prices of growth stocks to extraordinary levels, and stocks such as technology collapsed in March 2000. Technology stocks as a group fell more than 70 percent, and investors have shunned them while buying value stocks for the last seven years.
But now, Nagaswami said, value stocks are as vulnerable as growth ones once were. "Value is no longer value. ... Cheap is not cheap anymore. They have crossed into the realm of the absurd."
That's because sectors such as materials, commodities, energy and financial services typically are defined as "value stocks" and are what people buy when they invest in value funds.
They have "outperformed to a level never seen," Nagaswami warned, and are vulnerable to any economic slowdown.
Investors now have $426.6 billion invested in large-cap value funds and only $156.9 billion in large-cap growth funds, she said. "Nothing concerns me more."
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