Tuesday, March 18, 2008

Risks Of Irrational Fear In The Market

As the credit confidence crunch takes a major victim in Bear Sterns, there are a growing group of investors and financial advisors that are talking about the next bank to fail. The current speculation is on Leman Brothers, with some still talking about Citigroup, Merrill Lynch, and the other usual suspects. While recent events do lend credence to the worrywarts, the level of negativism has sunk too far into the nadir of pessimism. It is the growing strength of the negative sentiment that is driving the market right now and causing significant loss in market value of many firms, especially the financial institutions.

What can an informed investor do? First take note of historic data, below, which indicates that the losses, while large, will be easily absorbed by the market correction. Second, know that the fear factor is driving the market right now. And it is this driving fear that is causing the irrational moves that can easily lead investors to substantially losses.[i]

So, let’s take a look at the facts, then figure out the potential losses, and conclude with why all of that really doesn’t matter in the current market.

A Look At Past Major Economic Events
One thing that investors need to realize and understand is that the fear of losing money created the actual losses to the creditors. While some of the Alt-A loans securities and high-yield bonds are going to default, the default rate will not be in the range that begets a run on the bank.

Junk Bonds: According to Moody’s, historic default rate of corporate bonds, from 1920 to 1999, have been below 2%. However, there have been periods of high default rates:

1. 1932, the historic peak during the Great Depression: peak of 9.2% in July
2. 1970, due to default of Penn Central Railroad and affiliates: approximately 3% (>8% for junk bonds)
3. 1991: 4.1% (5.71% default rate for junk bonds)
4. 1999, after the Russian financial crisis: 2.19% (5.51% default rate for junk bonds)
5. 2000: 2.28% (5.71% default rate for junk bonds)[ii]
6. 2002, post dot-combust: 10.9% default rate for junk bonds[iii]

Additionally, from S&P, via the way of Sterns Business School, is a chart of the recent junk bond default rate from 1998 to 2006:

Mortgage-back Securities: According to Fitch Rating, the average annual default rate of Fitch-rated
MBS and CMBS, from 1994 to 2005, were 0.231% and 0.268%, respectively.

Rational View Of Potential Defaults And Losses In 2008-2009
Moody’s report notes that the average recovery was 43%[iv]. This means that if a bond defaults, an investor received, on average, 43 cents back for every $1 invested.

So the doom and gloom forecast of near total collapse by fly-by-night blogging charlatans seem way too pessimistic and unreal, when put into historic perspective.

Junk Bonds: Moody’s is now projecting the global junk bond default rate to rise to 4.2% in 2008 and reach 4.7% by November 2009.[v] Moreover, Professor Edward Altman, the New York University professor who created the Z-score mathematical formula for measuring a company's bankruptcy risk, stated that the junk bond default rate would go to 4.64% in 2008[vi]. So there is a range of 4.2% to 4.7% rate of probable default out of the $1.1 trillion junk bonds currently outstanding.

Assuming that this range is correct, we can arrive at a loss potential of $46.3 billion to $51.7 billion in junk bonds will default. Using a recovery rate of 43 cents on a dollar, the net loss to investors is expected to range, approximately, from $31 to $34.6 billion.

Mortgage-back Securities: As for MBS, which had $6.1 trillion outstanding as of 1Q 2006, the historic default rate is lower than the junk bond default rate. Even if we apply the Moody’s 2008-2009 default rate projections for junk bonds to the MBS, the total loss potential ranges from $256.2 billion to $286.7 billion.

Applying a recovery of 60cents on a dollar, which conservatively assumes that the value of the real estate securing the loans will drop by a total of 40%, the net loss to investors is expected to range, approximately, from $102.5 billion to $114.8 billion.

The Future Looks Bad But Is Not All That Bleak
While a potential loss to investors of $133.5 billion to $149.4 billion in 2008-2009 is a large sum, most of the projected losses has been baked into the market already. In their paper "Leveraged Losses: Lessons from the Mortgage Meltdown," by David Greenlaw, Jan Hatzius, Anil Kashyap, and Hyun Song Shin, the total credit loss from the mortgage melt down is expected to be $400 billion with U.S. leveraged financial institutions experiencing about $200 billion of this loss[vii].

However, Pessimism Runs Deep
So, while the reality is not that bleak, as Fed Governor Miskin had said in his February 2008 speech:

“…relatively small losses in one sector of the credit market can have an outsized impact on aggregate economic activity if they cause a disruption to the financial system that leads to an amplified impact on lending.”

“It is not just the impact on leveraged financial institutions that matter, but on the overall ability of the financial system to channel funds to those institutions with productive investment opportunities.”

For a Fed Governor to come out and clearly articulate that there is a major disruption to the financial and investment industries is, given the current nervousness of the market, a clear indication of how pervasive this irrational fear is gripping our economy.

So, informed investor take note that, due to the currently high level of irrational fear in the market, the slow down in the U.S. economy will be more severe that if this was a simple case of the market correcting itself, as was the case after the dot-com bubble popped. Even if the facts are indicating the slow down may not be that severe, the market is now being driven lower by a collective movement built around irrational fear that things will get worse than it is already. While the facts indicate otherwise, it is not a wise move to fight the market when it is stampeding. And right now, the market is stampeding right over a cliff.

May Your Trading Be Profitable

Ed Kim
[i] http://blogs.wsj.com/deals/2007/12/20/joseph-lewis-cautious-bear-stearns-tale/
[ii] Default Risk.Com
[iii] http://www.cfo.com/article.cfm/3551981?f=search
[iv] http://www.moodyskmv.com/research/whitepaper/52453.pdf
[v] http://www.cfo.com/article.cfm/10272612?f=search
[vi] http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aYqRAVjaH4DY
[vii] http://www.chicagogsb.edu/usmpf/docs/usmpf2008confdraft.pdf

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