Zaks Investment Advisory Service

Risk and the Market Plunge of July 26-27, 2007

Last time, we discussed credit risk – and who would have guessed how relevant that program would become! We spoke, it seemed, about things that were not terribly entertaining, relevant only to bonds and for the most part aimed at people who avoid risk. As it turned out, we described certain phenomena that ended up being at the center of a financial storm that sunk the stock market by about five percent. So what happened to the stock market, and what relevance does it have to our program?

It can all be described by one word: risk. You may remember we mentioned how by lending money, you are almost always taking a risk. The exception is with federal government obligations: Treasury bills, notes and bonds. In all other cases, when you buy a bond, i.e. lend the issuer some money, there is a possibility that the company (or municipality) may be unable to pay off the coupon and the principal. This possibility might be microscopically small (when we are talking about bonds of a company like General Electric), or indeed relatively high – in cases of the so-called junk bonds, or, to use a more respectable term, high yield bonds. “High yield” means they are both high earning and risky. Investors who buy them put a value on the risk that some of money they are owed might not be returned. The price of risky bonds is determined by how investors value the risk: the higher the risk, the lower the price.

For a long time (and by that I mean the previous two or three years), investors believed that the risk associated with high yield bonds was, overall, not that high. They were basing this on our economy being in terrific shape and nothing, it seemed, standing in its way: inflation under control and interest rates – though having risen a bit – still very low in historical terms. Yes, economic growth had slowed over the previous 12 months, but this was natural since it had previously grown too fast: we were witnessing what economists call a “soft landing.” The economy did not slip into recession, and one could assume that growth would accelerate again soon. Under these almost idyllic conditions, investors decided that the default risk on even relatively risky bonds was very small. As a result, prices of junk bonds rose to levels comparable to those of Treasury bonds: if the likelihood of default is very small, then the yields of junk bonds and Treasury bonds should be similar, right? The spread in junk bond and Treasury bond yields shrunk. It is hard to recall another period when it was so small.

But a cloud blotted the crystal-clear financial horizons – in the shape of the so-called subprime loans. Subprime loans are mortgages issued to people without very good credit histories, or to those who will have trouble meeting their mortgage payments. Financial experts from the large investment firms repackage these bonds, creating series of bonds, and then sell them on to investors. This process is called “securitization.” Investors, and these are frequently the so-called hedge funds, buy these bonds with an understanding that they are risky: a possibility exists that people who purchased the homes will be unable to pay for them. But up to a certain point, investors believed that the economy was in good shape, that unemployment was low, and that even if the mortgage holders did stop making payments and there was a foreclosure – i.e. creditors were forced to sell the home in order to get back their money – the risk was not high since housing prices were soaring fast. Which is why bonds backed by subprime loans were priced highly, as if they were carrying no risk at all.

Some time ago, the situation changed. Investors realized that the risk associated with subprime loans was very real. Moreover, subprime loans forced them to reassess the risk of numerous other bonds. Something that seemed all but guaranteed just yesterday turned out being quite risky today. We do not know how these processes occur: why this happened last week and not one month ago. We know only one thing: last week, a radical revaluation of securities risk occurred. The numbers are there to prove it: on Thursday, July 26, the yield demanded by investors on the High Yield US Corporate Bond Index went up by 32 points, or 3.45 percent. That is a gigantic leap – usually the yield changes by one or two points a day. On Friday, it went up another 19 points, or an additional two percent. Interestingly, the frightened investors simultaneously started buying up less risky bonds, i.e. Treasury bonds and notes, whose prices rose and yields correspondingly fell. Over two days, the difference between Treasury bonds and junk bonds, which had been negligible just a short time earlier, grew dramatically.

This, of course, could not but have affected the stock market. The revaluation of risk affected the market from two sides. On the one hand, the very perception that securities were riskier than investors had so recently thought dragged down prices: as we have mentioned numerous times, we do not like risk, and we pay less for risky securities than less risky ones. On the other hand, a part of the market growth over the past few years has been linked to the borrowing done by some financial organizations, which issued fairly risky bonds and then used the money to buy up companies that they restructured and then sold on at profit. Had interest rates on these bonds grown, it would have become much more expensive for these companies to borrow money. This would have resulted in there being fewer such deals, i.e. there would be fewer stock buyers. This, of course, also negatively affected share prices.

The past week’s events once again confirmed that investments are fraught with risk. This does not mean that one should not be investing in the market. It simply means that this should be done soberly, weighing both the benefits and the potential risk. Our time is up. This was Sergey Zaks. Thank you for your attention and until next time.