Have We Become Sufficiently Distressed?

Why patience is a virtue in this asset class

Originally published in the June 2008 issue

Since the summer of 2007, we have witnessed some extraordinary financial events with global ramifications. The massive sub-prime meltdown and subsequent seizing up of the credit markets have led to widespread losses at US and international financial companies and cost the jobs and reputations of scores of previously widely admired executives. Swift intervention from the Federal Reserve has mitigated some of the damage, but the impact on the US economy is still unfolding and it is increasingly clear that the credit infection has travelled beyond US borders. When and where will it end?

Crisis conditions in the US financial sector subsided in April following a series of dramatic moves by the Federal Reserve. To quell fears of a financial meltdown, the Fed, in March, invoked emergency authority to offer direct loans to the 20 brokers that trade Treasury securities directly with the New York Fed, and rescued Bear Stearns from bankruptcy by facilitating its sale to JPMorgan. As part of its effort to pump liquidity back into the system, the US central bank has allowed primary dealers to swap up to US$200 billion of AAA-rated commercial and residential mortgage-backed securities and other collateral for the Fed’s holding of US Treasury securities for up to 28 days to help dealers finance mortgage bonds, and subsequently extended that facility to AAA-rated asset-backed securities. The Fed has also moved to boost its cash auctions to banks to encourage lending. To stimulate US economic activity, the Fed slashed the federal-funds rate seven times, to 2% in April from 5.25% last September, while the US government mailed out rebate cheques to millions of Americans.

Some prominent Washington officials and Wall Street executives appear confident that with these moves, the worst days of the credit crunch are behind us. Fed Chairman Ben Bernanke’s words are more measured. The Fed’s actions have yielded ”some improvements,” he said, but the markets are still ”far from normal.”

Indeed, fallout from the US sub-prime meltdown has spread to Europe, where optimism about financial market conditions is in retreat. First quarter earnings results now emerging from major European financial institutions reveal that loan losses have increased, crystallising the need for additional capital infusions.

Worldwide, the overriding concerns have not diminished, even as strong medicine to contain the sub-prime virus is being prescribed. Though the size of the final tally isn’t clear yet, the largest global financial institutions have reported $335 billion of markdowns and credit losses since the beginning of 2007, according to Bloomberg data.

It’s unclear how long the turmoil will persist for diverse corners of the fixed income markets such as sub-prime mortgages, corporate bonds, home equity loans, structured debt, and emerging markets bonds.

The decline in the US housing market has not bottomed out, according to the National Association of Realtors. This trade group recently reported that median home prices fell in approximately 100 US metropolitan areas – the most since 1979 – while rising in only 48 US metro areas – the lowest number on record. Housing markets appear to be under pressure in parts of Europe as well.

This Bloomberg graph of volatility (see Fig.1), as measured by the VIX Index, highlights moments of investor uncertainty during the first quarter of 2008. After such a wild and tumultuous slide, a respite in volatility injected a dose of investor confidence as evidenced by major capital markets perking up in April. This has led some investors to scramble to find opportunities in the most beaten-down sectors and to show a greater interest in distressed securities.

To some, the greatdistressed debt era has already arrived. We at Coast are not convinced. When will we see the bottom? When the default rate on high yield debt is substantially above the 1% reported recently by Standard & Poor’s. Although, we believe the opportunity set in distressed securities will grow, there’s more pain to be endured in the short term.

How do we navigate through this environment? Coast advocates a conservative approach in all markets and we intend to remain defensive with the current uncertain outlook.

Our approach has long focused on preservation of capital. To achieve this goal, we stress active risk management. Our portfolio allocation strategy centres around low correlation on a strategy and manager basis. Our leverage overlay is at historically low levels. Early last year we began increasing the amount of capital allocated to our defensive investment strategies, and that has rewarded investors.

In the current market environment, we are pleased with the size of our allocation to distressed securities. We believe patience is a virtue with this asset class. We expect the future will present numerous opportunities with attractive risk/reward profiles.

Coast Asset Management, LLC

Established in 1991, Santa Monica, California-based Coast Asset Management, LLC is an independent multi-strategy alternative investment firm managing approximately $6.4 billion in assets for institutional and high net worth clients worldwide.