Q & A with Emily Hollis

Emily Hollis
September 22, 2008 | COMMENTS

Question: I am a board member of a $500-million credit union and I must confess that I don't really understand all this talk about the credit crisis. Is it real? How can a financial institution say that they have wiped out their equity, but only on a temporary basis? If my investments lose value, even if I have not sold, to me, it is still a loss.

The crisis is so real and so frightening that I only hope we don't see irreparable damage in the financial markets. The concept of unrealized and realized losses can be difficult to grasp, especially if one attempts to correlate bonds to unrealized losses of stocks. I will try to give you a somewhat simplistic example. The chart below illustrates yields of various security types. AA-rated mortgage related asset backed securities which are backed by non-conforming first and second-lien mortgages are now yielding over 25 percent in annualized returns while in years past returns approximated 4.50 percent (given today's yield environment). Assuming that the AA-rating is a correct assessment of its credit risk, the chances of principal losses are low. Unlike stocks, if losses are not realized, cash flows from the bond will exist and the bond will mature with principal being returned to the investor. Of course in this example, minimal losses would still produce returns in the double digits.

Due to concern regarding the continued downward pressure on prices, (when bond yields go up, prices go down) there is currently no market for these types of securities, which is why the yields are so high. The market collapse is due to the severe lack of liquidity. With anxiety about mutual fund and hedge fund woes gripping the market, investors are panicking and withdrawing funds from the market. In addition, depositors are grappling with news of potential bank failures, causing withdrawals in deposit institutions. With so much supply and little demand, the fundamentals of economics are overwhelming the fundamentals of bond math. Forced liquidations and the inability of some institutions to raise capital to support unrealized losses are creating a devastating domino effect of continually falling prices. Akin to a falling knife; just try to catch it.

You, the credit union, is in the midst of this crisis, but if liquidity is not a concern, you will be spared any effect.Using the above graph, if you, the credit union, are issuing first- and second-lien non-conforming mortgage loans at a combined yield of less than 25 percent or car loans at yields less than 8 percent, you cannot sell these loans into the secondary markets without losses. If you are forced to sell, then the losses are realized. As a result, members become frightened of negative earnings, withdrawals occur forcing more liquidations, more losses, etc. On the other hand, if deposits are maintained, the unrealized losses could eventually vanish and capital-to-asset ratios will be restored.

So how are we going to get out of this mess? Investor confidence will be critical to stop the bleeding of withdrawals and fund redemptions. The first step in building confidence will most likely be a plateau in defaults and delinquencies of mortgage loans. In tandem, an increase in liquidity is needed. The government's bailout of Fannie Mae and Freddie Mac will help. As quoted by James Lockhart, director of the Federal Housing Finance Agency (FHFA), “The goal of these actions is to help to restore confidence in Fannie Mae and Freddie Mac, enhance their capacity to fullfill their mission, and mitigate the systematic risk that has contributed directly to the instability in the current market.”

The conservatorship of these entities should reduce mortgage rates in the near future and strengthen the backing of mortgage-backed security (MBS) senior and subordinate debt. The FHFA is allowing FNMA and FHLMC to grow MBS guarantees without limits and continue to purchase replacement securities at $20 billion per month which should aid liquidity.

Investor confidence is an amazing thing. At some point, confidence will come back. Yes, it will only be a matter of time; but, unfortunately, as things get worse, it might be a very long time.

Emily Hollis is a CFA and president of ALM First Financial Advisors in Dallas, Texas. Contact Hollis at 800-752-4628 or ehollis@almfirst.com.