Bonds Decrease as a Result From the Subprime and Mortage Mess

by | Nov 23, 2007 | Asset Management, Stock Market Comments

I’ve labeled this *the yikes spiral* because typically this happens when certain markets are in free fall. The most often example occurs when a company runs into trouble and may need to contemplate bankruptcy.

It’s a sad event, because people are losing money, and jobs may also be lost in the process, but it’s also interesting to watch what happens to the bonds of a particular company when things start to spiral out of control — the yikes spiral. I’ll try and stitch this all together at the end to show you the comparisons between bankrupt companies and the current mortgage mess.

The process *might* go like this: a company will continue to expand, and borrow money (often for as long as the bankers will lend them money), and expand to a point where they can no longer manage or effectively grow. After a period of time the company will begin to disappoint Wall Street because their revenue growth (or the rate of earnings growth) will flatten, and then eventually slow down…or drop.

The stock begins to tank, and analysts begin to wonder how “all that money” that was lent to this company (coincidentally by Wall Street firms and banks) will ever be repaid.

At this point, the price, or value, of the bonds (representing what the company owes) also drops. Stories circulate that the company will begin to “explore alternative means of raising capital and/or refinancing.” Throughout this period, the bonds continue to drop in value.

Next, someone may write an article discussing the (at that time) far-fetched concept that this company could ultimately file for bankruptcy if the situation does not improve. As soon as the “B” word is mentioned (bankruptcy), the bonds begin an immediate, sharp nosedive in value. Keep in mind that the price of the bonds represents the market’s assessment of their ability to re-pay the loans. Lots of talk and rumors begin to swirl. At some point, the rating agencies for the bonds (examples of rating agencies include Moody’s, Fitch’s, and Standard & Poor’s) will announce that they are beginning “a review of the financials and bond ratings of this company.” The bonds fall even further in price.

If you are a portfolio manager who happens to own bonds issued by this company, you don’t want to get stuck holding a bankrupt bond, so you call around and see what kind of price you will get…if you can find a buyer.

The bond market is still mostly a negotiated market – there are very few listed bonds that trade on an exchange. The other firms you call around to (that you do business with) honestly do not want to buy this bond, but do not want to appear as if they are “stiffing” someone they often do business with. So they will offer an abnormally low price to buy the bonds from their counterpart — with no serious intention of buying. You might see a price that’s far below the last traded price, or even 30 or 40 cents on the dollar…or lower.

The surprise comes when that really low offer is accepted. Yikes!

Just like a real estate transaction, (when a home on your street is sold, the “bar” is reset for your neighborhood), the bar has now been reset for the bonds of this company. In practically no time at all the company’s bonds indicate they’re trading at a level that indicates severe problems are happening with the company, to the point where the company must at least contemplate filing for bankruptcy.

It’s usually only at this point that the company publicly discusses some serious financial problems…and the company officially announces there “may be issues. The stock and the bonds of the company are already trading at fire sale prices.

Now…as a reminder…if you’ve been hanging around, waiting for the news …you have lost big.

The problem with the scenario above is that no one really knows the value of these bonds — until they are sold. It’s easy to see how a “somewhat normal” situation can spiral out of control… quickly. So Wall Street firms never really know “for certain” with the value of their bonds are on their books.

Why go through this long presentation?

Take the above example (what happens to the value of one company’s bonds), and then multiply it by millions upon millions of homeowners. Every time a mortgage is created (or refinanced), a new loan is created. This loan is then repackaged by the mortgage originator and sold to a bank. The bank then often turns around and sells this same package of loans to Fannie Mae, or to a bank or a Wall Street firm. These firms are then sold as a package, often in what’s called a collateralized debt obligation, or CDO. These investments could be found in bond funds, mutual funds, and with hedge funds.

There is no way of knowing what these mortgages are actually worth for two reasons:

1. The underlying asset beneath the mortgage (the value of your home) continues to drop. And since real estate sales have been grinding to a halt, there’s no accurate way to value the asset which is being borrowed against. There is a huge vacuum of information between the “most recent” sale on your street and the next closing. They could be months apart.

2. There’s no way to forecast what percentage of these loans are in trouble…or…more importantly…what percentage of loans will become troubled over the next six to 12 months.

So there is no real way to accurately value these investments.

Which is why you are seeing financial firms take multi-billion-dollar write-offs… just months AFTER taking billion dollar write-offs! There’s just no way to accurately reflect the value of these assets. Additionally, mortgage departments are shuttering. These departments have been an enormous part of the financial sector’s growth over the last 10 years. This “leg” of the business has dried up — and gone away.

So, not only are you having a write-down of assets, entire divisions of businesses are going away overnight. Compared to a year ago, all of these financial firms are now smaller in size (because their assets have shrunk) their revenue streams are smaller — because large divisions of the business have gone away.

This is why many people are finally realizing that you cannot stay in the stocks of these financial companies. It is nearly impossible to accurately value many of the investments they hold.

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