Great Lakes Advisors, Inc.

Bond Market Recap

2Q10 Commentary

The outlook for economic growth is less optimistic given the winding down of some government stimulus programs, renewed unemployment concerns and trouble brewing in the Eurozone.  As tax credits for home buyers were due to expire, housing numbers weakened again.  The unemployment picture was colored by the termination of most census workers and a big decline in the number of people looking for work.  And, the creditworthiness of the countries in Europe as well as their financial institutions was also in the forefront of investors’ minds in the second quarter.

All of the above conditions have caused the Fed to revert to a gloomier economic view as well.  Deflation risks are not abating, and forecasts regarding a Fed rate hike have been pushed further out into 2011.  There is minimal demand for credit, consumer and corporate debt levels continue to be paid down and an elevated level of excess capacity would likely absorb any upticks in economic activity.

Beyond the tax credit flurry, housing is not giving off any signals of a consistent recovery.  The sector is not exhibiting any sensitivity to record low mortgage rates, which are currently below the 5% mark.  Starts remain at recession-type levels and applications for mortgage loans are at record lows.  And, the inventory of unsold homes continues to grow.  Finally, median home prices peaked four years ago at $230,000 and have now fallen to $173,000.  With rapidly rising foreclosure rates, another 15+% decline in prices is possible.

As a result of lowered lending standards in the sub-prime era combined with political initiatives to increase mortgage lending to lower income groups, FNMA and FHLMC currently have millions of bad loans on their books.  And, given their recent push to buy all the bad loans from mortgage-backed securities that they guarantee, they are also the not-so-proud owners of approximately 150,000 homes.  These agencies are 80% owned by the government, which makes the securities that they guarantee essentially government obligations. 

The cost to taxpayers of the FNMA and FHLMC bailouts currently stands at $145 billion.  And, given the state of the housing market and the fact that these agencies have an unlimited credit line with the government, the amount and duration of further assistance is a critical question.  A legitimate economic rebound could make the OMB’s estimate come true, which would see only an additional $15 billion being required.  Worst case scenarios factor in more significant housing price declines and multiples of the current default rate.  The total tab under these scenarios could reach as high as $1 trillion. 

Any questions surrounding the sustainability of the government’s support for these agencies are in large part answered by the critical role housing plays in the economy and its recovery.  Additionally, and more than ever, these agencies are policy arms of the government, vehicles for effecting change and improvement in the housing sector and the general economy.  The latest thrust is to mitigate the number of foreclosures and reduce loss severities through mortgage loan modifications.  FNMA and FHLMC have undertaken hundreds of thousands of such modifications with better-than-expected results.  And, as aforementioned, bad loans are being bought out of existing FNMA and FHLMC pools to improve the credit quality of these securities.  Finally, Congress and the administration are all too aware that foreign governments hold over $1 trillion in FNMA and FHLMC debt.

The FNMA and FHLMC situations will not be specifically addressed in the upcoming financial reform legislation, as any possible long-term solutions for these unwieldy businesses are not possible to undertake in the current economic environment.  The nation’s biggest banks are lobbying hard to retain their current lines of business as Congress has the banks most lucrative, and risky, operations in its sights.  Proprietary trading may be allowed in only the safest of securities.  Higher levels of capital retention are almost assured.  In the end, however, the large, dominant financial institutions will likely remain in place, as will most of the downside risks associated with being too big to fail.

A very uncertain environment has now pushed bond market returns ahead of stock market returns over the last twenty years.  In the second quarter, the Treasury sector was, once again, the beneficiary of a flight to quality.  Treasury yields were driven substantially lower.  The two-year note dropped over forty basis points to close the quarter at a yield level of 0.60%.  The ten-year note fell almost ninety basis points and ended below the 3% mark.  Treasury returns topped all other investment-grade sectors, a flip-flop of first quarter rankings.  Overall bond market returns were driven primarily by maturity in the second quarter with longer maturities generating bigger returns.

Over the first half of the year, however, the credit sector produced the best returns, with the overall number exceeding 6%.  Investors rewarded improved creditworthiness with strong demand for corporate bonds.  Balance sheets were generally stronger as debt continues to be reduced, borrowing rates remain low and cash positions have increased.  Earnings growth has been driven by greater efficiencies and productivity.  

Mortgage-backed securities (MBS) have also produced solid returns, but with less volatility.  They have benefitted from the Fed and Treasury buying a total of $1.4 trillion of FNMA and FHLMC MBS in recent buy programs to support these securities, agencies and markets.  As FNMA and FHLMC have become almost the only source of mortgage lending, there has been virtually no issuance of private label MBS.  MBS spread differentials relative to comparable Treasuries have narrowed to very rich levels, making the sector somewhat less attractive going forward.