FOR CELEBRATED BOND FUND MANAGER Jeffrey Gundlach, the intensifying meltdown in the U.S. housing market has all the inevitability of a Sophoclean tragedy.
The Chief Investment Officer of Santa Monica, Calif.-based TCW Group has been sounding warnings for more than a year that mortgage lenders had taken leave of their senses by spooning out mortgages without owner-equity cushions and with little or no verification of the borrowers' ability to pay back the debt.
By now, with mortgage defaults climbing and home sales falling, the plot line of this drama is becoming clear. But Gundlach says there are still several acts to come -- and that the curtain may not come down until the close of this decade. He sees U.S. home prices dropping an average of 12% to 15% annually from the highs achieved last year and not reaching their eventual trough until late 2008, at the earliest. And they may not start recovering until 2010 or 2011, inflicting, in the meantime, real damage on the economy.
About the only bright spot: the mortgage market may offer some excellent investment opportunities in the year ahead, he says.
GUNDLACH WAS AMONG the first to rail against the profusion of new types of home loans -- interest-only mortgages, adjustable-rate mortgages with artificially low teaser interest rates in the early years of repayment, and so-called option ARMs, which allowed borrowers to make monthly payments that didn't even cover interest costs -- all of them designed, in Gundlach's phrase, to "shoehorn" borrowers into homes often far beyond their financial means.
|Gundlach thinks median U.S. home prices are unlikely to recover until the decade's end.|
Sure enough, all these dicey loans helped bring about what Gundlach now calls "the great margin call of 2007." As home-price appreciation flamed out, subprime borrowers began to default in droves, especially on new mortgages, and mail back the keys to lenders. As a consequence, major subprime mortgage lenders like New Century began hitting the wall. Ultimately more than 100 subprime lenders were forced to close their doors as Spring turned into Summer.
That was followed in June by disclosure that two hedge funds managed by Bear Stearns were in deep trouble because of highly-leveraged subprime-debt bets that had gone bad. Soon a number of hedge funds, banks and other financial institutions from Asia and North America to Europe were reporting heavy losses on subprime debt investments. A number of hedge funds ended up being liquidated, and banking authorities in Germany and England were forced to arrange hasty bail-outs to save various banks.
The financial markets were further shocked in July and August when Moody's and Standard & Poor's and Fitch belatedly took over 5,000 negative ratings actions, decimating prices on all manner of residential mortgage-backed and home equity loan securities. "This was the biggest credit ratings catastrophe that our markets have ever seen," Gundlach observed to Barron's during a lengthy telephone interview.
Soon, the subprime contagion spread to other markets -- from leveraged-buyout debt to asset-backed commercial paper, triggering a full-scale seizing up of global credit markets. Yields on risky debt paper soared. Buyers went on strike. The ascendancy of fear over greed forced central bankers to flood their financial systems with liquidity, and in the case of the Fed two weeks ago, to drop short-term interest rates.
As the rest of the tragedy unfolds, the pain may be especially bad in what Gundlach calls "the bubble markets" of California, Florida, Nevada and Arizona and hard-hit Rust Belt areas in Michigan, Ohio and Indiana. Housing prices in those locales will likely fall 30% to 40%, he maintains.
HIS PESSIMISM IS GROUNDED in some two decades of trading mortgage-backed securities and analyzing homeowner behavior with the underlying loans. He lived through, for example, the housing bear-market of 1989 to 1993 that saw home prices fall 30% to 40% in some overextended markets like Boston and Orange County. In his opinion what happened in some of those pockets of price weakness may be but a dress rehearsal of what impends for broader swaths of the country.
Moreover, the worrisome trends in mortgage delinquencies, defaults and foreclosures figure to accelerate in the months ahead. That's because next year and early-2009 will see a crescendo in the troubled 2006 and early-2007 subprime mortgage vintages reaching their two-year rate reset points, when the low teaser rates expire. Facing jumps in monthly payments of 30% or more, many homeowners are likely to just throw in the towel and default on their mortgages.
Worse, Gundlach doesn't see much chance of a recovery in home prices until still later. Housing cycles in his experience typically trace elongated U-shapes rather than the V-type patterns so often seen in stock markets. For one thing, home-price information is often episodic and poorly-reported. Too, housing market fundamentals take a long time to play out, making shifts in market psychology far less mercurial than in the stock market.
|The Sludge Factor: Subprime and somewhat-closer-to-prime "Alt-A" mortgages have made up an ever greater portion of securitizations in recent years. Lately, subprime deals have plunged.|
It's easy to dismiss such dark ruminations. After all, Gundlach is a fixed-income guy. And at least up to a point, bad news is good news in the bond market. A slowing economy, for example, eventually causes the prices of high-quality bonds to rally as a result of reduced inflation expectations and less demand for credit. At the same time, the differences among yields on bonds of varying credit quality often widen to better reflect levels of risk, allowing investment managers like Gundlach to be more properly compensated for any risks they may take.
He is still agog at the galvanic moves in yield spreads that occurred last month at the height of the global crunch. Yields on top-rated asset-backed commercial paper that on Aug. 8 traded at just 41 basis points (or hundredths of a percentage point) over the three-month T-Bill rate soared to 289 basis points over on August 20 before settling back to around 185 basis points over. "This is what happens when the ocean of liquidity that everybody was talking about just a couple of months ago has turned into a swamp of troubled debt," Gundlach observes.
But Gundlach is more than a mere bondo spoilsport. Indeed, he has earned much street cred over the years. He was named Morningstar Fixed Income Manager of the Year for 2006 after being a finalist for the three previous years. The $900 million TCW Total Return Bond Fund, which he has co-run for some two decades, has been a top-performer in credit cycle after cycle, finishing in the second percentile of the Morningstar universe of intermediate-term bond funds for the 10 years ended Aug. 31 and in the seventh percentile for the year ended Sept. 27. In all, Gundlach has direct control over some $90 billion in fixed-income portfolios at TCW, mostly for institutional investors.
"His performance has been all the more remarkable since he has done it by mostly focusing on the mortgage-backed securities, while many of his peers have much more flexibility in what they own," says Morningstar analyst Lawrence Miller. "And this year he has done well, despite all the convulsions in the mortgage-debt sectors, by concentrating on high-quality paper, much of it guaranteed by government and quasi-government agencies like Fannie Mae."
Gundlach was early in seeing the virulence of the housing slump that the subprime debt excesses would spawn. In a Barron's Current Yield1 column last December he opined that the U.S. housing bust was merely in its "early innings" and would likely continue well into 2008 because of subprime-debt problems. At the time, no less a personage than former Fed chairman Alan Greenspan claimed that stabilizing new mortgage applications indicated the housing market had already bottomed.
To Gundlach, the problem is not so much the losses that investors in the U.S. and around the globe will take on the $2 trillion or so of subprime and "Alt-A" mortgage-backed securities and collateralized debt obligations that are currently outstanding. Those losses will probably top out at around $300 billion, which, in his estimation, constitutes a rounding error in a $14 trillion economy.
The problems lie in the knock-on effects that subprime is having and will continue to have on the economy. Gundlach asserts that the mortgage-triggered housing downturn has already cost GDP about one and half percentage points of growth. That negative impact figures to intensify some in the quarters ahead.
Increasing defaults and foreclosures will add to an already swollen inventory of unsold homes that now stands by some reckonings at 10 months. As last week's August numbers showed, new home sales are continuing their descent, falling over 20% year-over-year.
The Bottom Line
As the housing slump deepens, the toll on the American economy could be severe. Already, Gundlach says, it has cost GDP one-and-a-half percentage points of growth.
Likewise, says Gundlach, demand for housing is likely to continue to suffer as now-timorous lenders and mortgage bond investors pull back from the market. And dicey subprime mortgages exist at all price points of the housing food chain, from the most modest starter homes up to fancy $700,000 homes.
Housing woes, of course, radiate far into the general economy. Firstly, housing accounts for a big chunk of U.S. employment when one takes into account all the construction, finance and retail jobs that depend on a strong housing market. Consumer confidence and spending suffer mightily when cash-out refinancings dry up and the value of most families' primary asset falls in value.
Gundlach and TCW haven't emerged completely unscathed by the current credit crunch. Two weeks ago, TCW was forced to liquidate a $3.2 billion mortgage-backed CDO it managed called Westway's Funding X, when the market price of certain tranches fell below certain levels. There was nothing wrong with any of the assets backing the CDO. "They were of pristine quality and performed fine," says Gundlach. It was just a case of market jitters that led to the price markdowns.
But overall Gundlach is salivating at all the mortgage-market investment opportunities that are likely to emerge in the quarters ahead. TCW has already raised $1.6 billion from various institutional investors for a new vulture fund. After all, one investor's grief can be another's opportunity.