Anatomy of the Crisis
The first visible indications of crisis came in early 2007. Subprime home mortgages that had been originated in the previous year were observed to be defaulting at rates far higher than expected, which called into question the value of securities collateralized by these loans. Some of those securities were, in turn, held by money market and cash management pools. Others became embedded in more exotic investment structures used by hedge funds and sophisticated institutions. As the condition of the subprime loans deteriorated, so did the securities that were backed by them, as well as the condition of investment vehicles that held these securities. The ripples spread quickly, and they often appeared to grow in magnitude as they developed. To understand how, it's helpful to review the how the system evolved.
Mortgage Market Share of the 67-Trillion-Dollar Global Debt Securities Market (as of year-end 2006)
Subprime loans make up a relatively small piece of total mortgage loans, and thus an even smaller fraction of total debt securities. But due to the manner in which subprime loans have been marketed to investors, they have become the tail that wagged the global fixed-income dog.
To see how, consider the detailed mechanics of the subprime loan system that had evolved by early last year. After a subprime loan was originated and closed, it was bundled with others of similar structure into a mortgage pool. The cash flows from that mortgage pool were then stratified according to their degree of risk, and each division was assigned to a different collateralized debt obligation, or CDO. Each CDO was then rated according to a series of assumptions about borrower performance.
Subprime payment histories over the previous decade suggested that borrowers generally kept their loans current for one year or more after origination, so payments made early in the life of even subprime loans were considered relatively risk free. It was also generally believed that the underlying real estate value would cover the principal obligation of a loan even if the loan were to be foreclosed. As a result of these assumptions, CDOs representing the earliest payments were generally given top investment grades by rating agencies (Typically AAA or Aaa, depending on the agency). With such grades, these short-term securities were eligible for use in money market funds, municipal government cash management pools, and a wide range of structured investment vehicles.
Loss histories for subprime mortgages in their first year after issuance formed a predictable pattern between 2000 and 2005, but the loss history for subprime loans issued in 2006 broke the mold during the first eight months of 2007. See below.
Unfortunately, the performance assumptions underlying the AAA/Aaa ratings began to break down in 2007. For one thing, anecdotal evidence suggests that loan underwriting standards appear to have changed; weaker borrowers may have entered the subprime pool in growing numbers, often through so-called NINJA (No Income, No Job or Assets) loans.
General subprime loan performance weakness was amplified by the first widespread real estate price declines since the Great Depression. The declines left many troubled property loans without enough collateral coverage to assure loan repayment in liquidation. The result was an unprecedented rise in losses on top-rated CDOs.
The first-order effect of this rise in subprime defaults was a heightened perception of risk in the mortgage market, which depressed values of many mortgage-related securities and reduced investor demand. This, in turn, created a series of second-order effects as funds (and institutions) which held CDOs began to report losses triggered by those declines. Many investors were surprised by the extent to which write-downs occurred in areas with no direct ties to the mortgage industry. This, in turn, made many investors reluctant to participate in any fixed-income market segment, freezing credit across a wide swath of the U.S. economy.
It is now possible to question whether bond markets might have overreacted and depressed some valuations much farther than might be justified by fundamentals. As a result, there are a wide range of opportunities for experienced bond managers to position their portfolios to benefit from a reasonably anticipated return to normality. It is also possible to profit from well-placed positions whose performance is contingent on continued market abnormality. What is more, a broad unwinding of financial structures should result in significant deleveraging across many sectors, a secular change that could create its own family of strategic investment opportunities.
The collapse of the subprime market has brought the bond market to a turning point, one that fundamentally shifts the nature of investment opportunity.
"We are in the midst of a global reckoning in the fixed-income market,'" said Steve Van Order, Calvert's fixed income strategist. "After five years of leverage, lax lending, and speculative frenzy in the U.S. housing market, we are entering what I call 'The Great Unwind' - a broad-based move in the credit market to revalue investments, write down overvalued securities, repent for past excesses, and repair the damage to portfolios."
Investment in mutual funds involves risk, including possible loss of principal invested.
Bond funds are subject to issuer default risk and interest rate risk. When interest rates rise, the value of fixed-income securities will generally fall. Conversely, a drop in interest rates will generally cause an increase in the value of fixed-income securities.