Special Report: The Subprime Crisis and Calvert's Response

An Historical Overview

The years leading up to the market crisis point were generally an era of modest yields and seemingly minimal credit risk in fixed-income markets, backed up by economic stability and negligible inflation. In others words, it was a relatively safe, if unexciting, time for bond investors.

However, such climates also offer relatively little real return. To gain extra yield, many investors turned to securities with greater risk. As demand for those investments increased, the yield advantage they offered diminished as investors bid up their prices, creating a market dynamic known as yield compression.

At the same time, demand also grew for investments that leveraged what yield might be had. Many strategies emerged that involved borrowing funds in the money market at very low short-term rates and investing those funds in longer-term investments that offered higher rates-a tactic known generically as a carry trade. In some cases, the inherent carry trade spread was magnified-or levered up-by using derivatives and borrowed capital. The general tools used to enhance yield were layered securities called "collateralized debt obligations" and complex closed-end funds known as "structured investment vehicles."

Additionally, as long as credit conditions remained benign and interest rate trends remained favorable, the potential negative effects of carry trades, compression, and leverage remained dormant. Then the property bubble burst. Securities backed by subprime mortgage loans had increasingly been thrown into the intricate blend of leverage and risk. Last year, those subprime mortgage loans began to sour in significant numbers. Due to the complexity of the investment structures, it was often impossible for investors to assess the subprime risks inherent in their portfolios. As a result, the markets began to treat complex structured financial devices generally as toxic, piling illiquidity upon losses.

"The opacity, illiquidity, correlation, and valuation issues with new-generation structured finance instruments may not have been the trigger of the collapse, but they were an essential component of the crisis that resulted," said Steve Van Order, Calvert's fixed income strategist.

Now, the market is entering a new phase. Many of these financial structures are to be disassembled. Some structures are, of course, now trading at realistic market values, but many are likely to be excessively discounted or overvalued as a consequence of structural opacity and extreme market reactions. There is opportunity in these situations for bond managers who can infer appropriate value for a particular structure and can create trades that exploit the potential variance between real value and current market value.

"We expect that business fundamentals will ultimately drive returns, but accurately appraising those fundamentals during the period of readjustment may be a test for many investors," Van Order said.

Assessing Collateral Damage Among Bond Insurers

The development of complex investment vehicles was driven in good part by the use of bond insurance to guarantee certain highly-rated classes of debt securities. The spreading credit contagion increased the risk of default associated with these debt securities, which in turn increased the burdens on insurers and forced the market to reevaluate insurers' capacity to meet their obligations. The two largest underwriters-MBIA and Ambac-were forced to seek outside capital support in order to maintain their top-shelf (i.e., AAA or Aaa) credit ratings. However, insurers' share prices plunged precipitously-by as much as 85% between July 2007 and January 2008.  Smaller firms in the industry generally were not able to maintain their AAA ratings, and at least one has been driven to the brink of insolvency.

Bond insurers lend their own credit ratings to the bonds of their clients,including not just the securities in structured vehicles but also hundreds of billions of dollars in conventional municipal bonds as well. Millions of dollars in municipal bond market value disappeared as investors began assuming that bond insurance suddenly had no real value.

"I believe this was a knee-jerk reaction to subprime exposure in general and did not fairly reflect the true impact of potentially higher-than-expected defaults," said Cathy Roy, CFA, Calvert Chief Investment Officer, Fixed Income. "The fact is that principal bond insurers face no short-term liquidity risk in the case of credit deterioration or default in the underlying collateral because they are obligated only to make principal and interest payments when due, and not on an accelerated basis. They will have to allocate additional capital. That will reduce the size of their capital cushions, but it should not generally lead to insolvency. In fact, we continue to believe that, if given the chance to raise capital, the four large bond guarantors should be able to survive the subprime crisis."

Auction Rate Securities - A Case Study in How Risk Propagates Across Market Boundaries

In an abstruse corner of the bond market lives a family of fixed-income investments known as auction-rate securities. These are long-term bonds whose coupon interest rate is reset periodically after a public auction. The bond issuer is obligated to pay the auction-determined interest rate on all bonds in the issue. Investors who believe the results of any particular auction provide inadequate compensation for the associated risks normally have a put option that allows them to sell their bonds back to the underwriter at par immediately after the auction.

This system allows municipalities, student loan providers, museums, and other bond issuers to finance their long-term borrowing needs at near-money market interest rates. That gives borrowers the stability of long-term capital commitments and the benefit of paying short-term interest rate levels. The same system offers investors the flexibility of an easy exit at bond par value. The system worked well until February 2008, when it came under siege on two fronts: from the struggles of bond insurers on the one hand, and from the difficulties of the underwriting firms on the other.

Bond insurance in this system was used to give investors a modicum of extra confidence in issuers they might not be familiar with. It also served to give the auction rate securities themselves the aura of fiscal invincibility they needed to be considered suitable money market alternatives. Both factors added considerably to the overall liquidity of the auction-rate market.

Meanwhile, underwriters of auction-rate packages were recognizing billions of dollars in losses in their own portfolios in the second half of 2007, and continued to announce reserve adjustments into the first quarter of 2008. These write-downs and increased reserve allowances had a significant impact on many banks' working capital, forcing many to refuse to act as market makers when auction-rate securities were put for tender. Goldman Sachs, Lehman Brothers, Citigroup, and UBS all declined to accept tenders, thus allowing auctions in securities they had issued to fail.

It should be noted here that investors holding securities from failed auctions have not lost any money. When an auction fails, investors are deprived of the put option for redemption, but they receive interest at a generally higher penalty rate. They may also be left holding a possibly long-term bond as opposed to a security with money market-type risk and liquidity.

"We may become interested in some of these issues as opportunistic investments, especially if they begin to cheapen or trade with attractive coupons," Roy said. "Some creditworthy issues were offering penalty rates as high as 20% in early March."

Economic Trends Can Magnify the Financial Risks

The economy entered a slowdown phase in the waning weeks of 2007, with indications of declining production and adverse price trends. Collateral effects of that slowdown have magnified the effects of the subprime meltdown and forced adaptations in fixed-income investment strategies.

Consider the interplay of forces shaping market interest rates. Banks' ability to provide credit is a general function of their Tier 1 capital, levels of which have been eroded by subprime mortgage-related losses-lower capital levels mean fewer loans. Shriveling levels of credit in the market have been a driving force behind the Federal Reserve's moves to lower short-term interest rates.

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.

Publication Date: May 6, 2008

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