Having gone through the turbulence of the fixed-income markets during the last few months, it seems the current circumstances fit the definition of a vicious circle very well.

The current vicious circle started with the move in market sentiment from greed to fear as subprime losses increased. Investors, who had happily leveraged their investments, started to feel uneasy and stopped buying. In certain cases, they started selling positions, causing an initial repricing in several markets. This repricing forced leveraged structures to start to deleverage. As the deleveraging got messier, banks discovered that, in a very illiquid and risk-averse market, this process was going to produce an ‘unwanted’ expansion of their balance sheets as loans from the “shadow banking system” – a term coined by PIMCO’s Paul McCulley and explained by Bill Gross in his latest Investment Outlook¹ – of non-regulated financial vehicles are being dragged out of the shadows and incorporated in the bank’s balance sheets. The banks’ plumbing problems increased as their ability to securitise their loans disappeared. At this point in the vicious circle, the rating agencies finally woke up and started downgrading everything that came under their scrutiny. This caused more deleveraging, more risk aversion, and on and on. We are – as Paul McCulley pointed out  – on “A Reverse Minsky Journey²” where instability will eventually restore stability.

In reviewing the vicious circle from a European standpoint, three aspects stand out, namely: the European Central Bank (ECB) response, the blockages in the asset-backed securities (ABS) market, and the outflows from mutual funds.

The ECB Response
Whilst ECB bashing is a favourite sport around the world and one that has found an avid adept in Mr. Sarkozy, I think the ECB has been less reactive than some suggest.  During the summer, the ECB was aggressive in its repo operations to make sure that the banking system had the necessary liquidity to deal with the expansion of the balance sheets. Somehow, though, if you look at the last three to four months, these repo operations have not exactly worked to plan. The ECB repo operations succeeded initially because banks were not lending to each other due to uncertainty about who was nurturing the biggest losses. This aversion to lend was reflected in the wide differential between the 90-day ECB repo rate and the 3-month LIBOR rate.

More recently, though, that differential has decreased. On the 22nd of November in fact, it was down to 7 basis points (bps). In normal market conditions, this drop might be considered a positive a sign. But in the current situation, it is not. That’s because the reduction in the differential between the 90-day ECB repo and the 3-month LIBOR rate was due to an increase in the 90-day repo rate, which means banks’ initial aversion to lend to each other has now developed into a full fledged liquidity crisis. European banks largely know where the losses are but do not have the liquidity to deal with the expansion of their balance sheets. The liquidity provided by the ECB is not the cure to this problem but just a much needed ‘fix’ to keep the banks away from a worse spiral.

The ABS Market
The problems of the ECB are closely entwined with those of the ABS market. In October, total primary volumes issued in the European ABS market were 78% lower than during the same period in the year before. In fact, since July only $7 billion of residential mortgages were securitised versus $114 billion in the same time span in 2006. In other words, banks have lent money at the tight margins we have become used to as borrowers, but they have not been able to pass the parcel to someone else. These loans are now on their balance sheets together with the assets coming from their off balance sheet structured-investment vehicles (SIVs), the conduits, and all other players trying to deleverage. Two aspects of the problems of the ABS market are clearly unresolved.

First of all, the cost of funding has gone up. Unfortunately, if you had been lending to your clients at very low margins over LIBOR, it is not too appealing to securitise at the much higher levels that the market dictates now. Therefore, banks are waiting for a return to ‘normal conditions’ and are not willing to change their definition of normal. The solution will have to be higher margins charged to borrowers, enough to make the lending/securitising equation work. As borrowers, take advantage of current rates whilst you can because it isn’t going to last!

The second problem relates to the rating agencies. As the agencies adjust their rating methodology of ABS/MBS structures, investors without sufficient research and analysis capabilities have limited insight into whether BBBs are real BBBs or possibly CCCs. The comfort levels in buying the more subordinated tranches of the ABS/MBS structures have largely disappeared. This could be a great opportunity for asset managers like PIMCO who analyse the underlying components of every ABS/MBS structure they invest in. PIMCO has kept some powder dry in this crisis, but this does not help the primary market to reopen as long as other market participants stay at the sidelines.

Mutual Fund Flows
The third piece of the puzzle is the mutual fund industry. The historical preference by European investors for deposits over mutual funds has returned to the fore during the recent crisis. In France, the mutual fund industry has lost more than 8% of its assets in the third quarter alone, according to a recent article in the Financial Times, amounting to €30.5 billion. Headlines highlighting the temporary closing of money market funds to redemptions and losses of up to 30% in funds supposed to preserve capital have not helped slowing the outflows. Going forward the situation is unlikely to change much. Recent discussions with European banks indicate the common way to resolve the liquidity crisis may be to make deposits more attractive to savers. Mutual funds are certainly not going to benefit from this strategy. Further redemptions will put more pressure on funds to sell holdings or at least to remain more liquid, further compounding the current liquidity crisis.

Circuit Breakers
How do we get out of this mess? And what recommendations should we pass on to European investors?
The first ‘circuit breaker’ in the current vicious circle is monetary action by the ECB. Whilst the uncertainty regarding wage negotiations will keep the ECB on hold over the next two to three months, the current spiral will likely force the ECB to cut rates later in 2008. I would expect the repo rate to be closer to 3.5% than 4% by the end of next year. In this scenario, investors should favour the front end of the European curve, as well as strategies to capitalise on a steepening of the curve.

The second ‘circuit breaker’ will be the Sovereign Wealth Funds (SWFs). European banks are likely to find in these institutions interested parties in recapitalising their balance sheets. Their cost of funding will come down gradually as this happens. Bank capital paper should provide attractive returns over a two to three year time horizon in such an environment. Similarly, we would expect SWFs to show greater interest in the ABS and MBS sectors. In two to three years, this could make them a major investor in the securitised sector and could provide a solid anchor to ABS and MBS valuations.

The final ‘circuit breaker’ will be fiscal policy. The temptation for governments in Europe and the US to solve the problem of lower growth by spending is likely to become greater. Issuance of government bonds to finance this spending wave will help reduce the interest in government bonds and make other sectors of the market more attractive at the current wide interest rate differentials.

All in all: Whilst the outlook for the bond markets will remain pretty unclear for the next few months, investors should become ‘greedy’ now that fear in the market is greater.

Emanuele Ravano
Managing Director

¹ See PIMCO’s Bill Gross, “The Shadows Knows” Investment Outlook, December 2007.
http://europe.pimco.com/LeftNav/Featured+Market+Commentary/IO/2007/IO+12-07.htm



²See PIMCO’s Paul McCulley “A Reverse Minsky Journey” Global Central Bank Focus, October 2007.http://europe.pimco.com/LeftNav/Featured+Market+Commentary/FF/2007/GCBF+10-07.htm