The Worst Loans are Made in the Best of Times

This memorable phrase was uttered to me in the middle of 2005 by a good friend and senior well-respected financial services industry analyst. We were discussing option-ARMs and other exotic financial products that were serving to perpetuate the growth of the home mortgage and real estate markets. Surely enough, eighteen months later, the negative consequences of these easy credit terms were exposed, and their unraveling has led to a severe downturn in the housing market and a liquidity crunch across the mortgage markets. There has been no shortage of publicity devoted to this subject this year, and the story is now well known.

I was reminded of this phrase again while reading the financial press stories over the weekend about the recent up tick in interest rates in the context of the current private equity boom. The “smart money” has been essentially buying equities and selling debt to finance their purchase in the hopes of pocketing a spread between a 7% earnings yield and a 5% bond yield (along with earning all of the other “fees” that are part and parcel of the private equity fund world). Now even sovereign nations want to invest their wealth in assets other than government bonds, the latest example being China’s investment in Blackstone. This fact has not escaped the notice of Bill Gross of Pimco, the United States’ largest bond fund manager, who estimates that China and its peers currently own 65-70% of our longer-dated US government bonds (Barron’s, June, 18, 2007).The fear that the marginal buyer of that paper might seek better returns elsewhere has been cited as one of the factors behind the recent bond market contraction.

As long as markets are able to function efficiently at some point the yields on earnings streams of equities and the bonds used to finance them will converge, or even invert.  We should stop focusing on interest rates and start focusing on credit. We will look back on these days where nearly every company has someone publishing an LBO model on it much in the same way we now look back on the adjustable rate and option ARM loans made in the first half of this decade and ask ourselves, what were people thinking?

For a stock-picker searching for value, the current environment presents the usual challenges. Another sometimes less-cited reason for rising interest rates is that global economic growth remains robust. There do exist publicly traded companies with A or better credit ratings that have no desire to pile on traunches of debt run by honest, capable management teams willing to forgo a quick 25%  LBO pop in their stock price. They eschew financial engineering and actually think about creating long term wealth tied to compounding earnings and dividend streams. Many, but not all, of these companies have such large market caps that it is hard to imagine them being bought out.  They often sell consumables or essential products and services and have recurring revenue-based business models that have been stress-tested through various economic cycles.  Some sell for what might be considered a reasonable price based on their growth prospects. These companies are out of fashion in the stock market right now, and owning some of them might even be considered contrarian.

Joseph Piropato
Managing Director

The views expressed by the portfolio manager in this article are current as of the date of this article, and are subject to change at any time based on market and other considerations