October 2007: Credit Market Concerns

Sub-Prime Mortgage Problem

You have undoubtedly read about and seen on television many stories about the "sub-prime" mortgage problem and the growing number of residential foreclosures. The term “sub-prime loan” is a euphemism for "risky loan."

The factors that led to the sub-prime fiasco were three-fold: lax lending standards, the ability to package and sell bundles of low quality loans, and poor assessments of the underlying risks of those packages.

These loans were made to borrowers with poor credit histories, and/or little to no documentation to verify claimed income and, in many instances, with a small down payment or none at all. As home prices climbed ever higher, lenders became more lax about who they were lending to and the value of the collateral (property) backing up the loan.

Adding fuel to the fire, newly embraced ideas of "financial engineering" enabled these loans to be packaged, re-packaged and peddled worldwide. This fueled the acceleration of creating risky loans by shifting risk from the loan originators to investors. Bundles of mortgages were sliced and diced into an array of esoteric collateralized mortgage obligations ("CMOs"), structured investment vehicles (“SIVs”) and exotic, illiquid derivatives that were difficult, at best, to monitor, assess and value after the fact.

The originators of the loans usually sold the loans upon or before completion of the loans, shifting the risks to investors -- hedge funds, insurance companies, pension funds, private equity firms and other investors -- both here and abroad. The more mortgages they would write, the more profit they made, often times without absorbing any of the risk themselves. This is the newest version of imprudent behavior in the late stages of a credit cycle.

What this Really Means - the Bigger Picture

Credit cycles are a fact of life in the financial world. It's the same old story, but told differently each time. The credit expansion phase of the credit cycle is over. The contraction part of the credit cycle has begun. This is sometimes referred to as the "cleansing" process that brings overzealous borrowers and lenders back to normalcy.

Current credit woes are not isolated to just sub-prime loans. They are merely the first clearly visible symptom. These same conditions apply to other types of credit instruments including other types of mortgage-linked securities and derivatives, junk bonds, loans for leveraged buyout deals, loans to hedge funds, corporate loans, and even credit cards and automobile loans.

Credit conditions are not neatly segmented by geographic region or separate lending categories. Rather, credit conditions are intertwined and they are global. This is a world-wide credit problem that impacts many types of credit instruments. Witness recent worldwide loss announcements from Citibank (United States), UBS and Credit Suisse (Switzerland), Deutsche Bank (Germany), PNB Paribas (France), and the Bank of China (China).

Why the Federal Reserve Lowered Interest Rates

The Federal Reserve lowered interest rates last month in an effort to bolster confidence, lubricate credit markets, stimulate the economy and fend off a recession. However, their actions did not come in a vacuum. An unintended consequence of the Fed’s action has been a further weakening of the U.S. dollar and strengthening of foreign currencies.

What This Means to Investors

The stock market met the Fed’s rate cut with enthusiasm and markets rose to their earlier high levels. However, there was another benefit to investors from the Fed’s action; as the U.S. dollar weakened, the value of foreign denominated investments increased.

How Our Investors Benefit

Roughly 15% of Asset Allocation Advisors’ client portfolios are in foreign stocks with smaller amounts in foreign bonds. Nearly every fund in your portfolio owns foreign investments in varying degrees. In addition to potential price increases in foreign markets, investments in foreign stocks and bonds are impacted by fluctuations in currency exchange rates. If the U.S. dollar weakens even more relative to foreign currencies, as we expect, our foreign investments will become worth even more in dollars. Of course, it works both ways. If the dollar strengthens, foreign investments will be worth fewer dollars.

How it works

As the dollar weakens, stocks and bonds denominated in foreign currencies become worth more dollars if sold and repatriated back into U.S. dollars. Three months ago, just prior to the first audible rumblings in the sub-prime mortgage market, it took $1.35 to buy one euro (the currency of the European Economic and Monetary Union). At the end of September, one euro was worth $1.42. If an investment was worth one million euros three months ago, and it is still worth one million euros today, what would that equal today in U.S. dollars?

Let’s say we owned a one million euro investment three months ago. That would be the equivalent of a $1.35 million investment in U.S. dollars (one euro was worth $1.35). But, that same one million euro investment was worth $1.42 million dollars (one euro is now worth $1.42) at the end of September. That’s a 5% increase in the investment’s value (in U.S. dollars) because the dollar weakened. And, if the price of our foreign denominated investments increased (the Dow Jones World stock index, excluding the U.S., was up +2.5% last quarter), that’s an even bigger profit. Our foreign investments profited two ways: higher prices, and a more advantageous exchange rate when converting the foreign denominated investments back into U.S. dollars.

Conclusion

Change is inevitable, in life and in investment markets. It always has been, and always will be. Bear in mind that change simultaneously produces opportunity and peril in investment markets. As your investment managers our job is to capture opportunities and avoid peril. We thank you for the trust, faith and confidence you have placed in us, and we will continue to do our very best to achieve our twofold objective: profits, and protection of capital. ***

Greg Schultz & Bruce Grenke
© 2007 Asset Allocation Advisors, Inc.