The upside to the current credit crunch

Courtesy of Cumberland Advisors, there is an upside to the current problems in the credit markets:

http://www.cumber.com

Dysfunctional markets = opportunity. Written by Peter Demirali.
December 19, 2007

This commentary was written by Peter Demirali, Cumberland’s VP and lead portfolio manager in the taxable fixed income asset class. Peter can be reached at peter.demirali@cumber.com.

Volatility has increased dramatically in virtually all markets since this summer. The credit markets have made the most headlines because they stopped functioning normally.

This change was due to the news about sub-prime mortgage delinquencies and defaults reaching record levels. In addition, we saw major banks and brokerage firms write down the value of their Collateralized Debt Obligations (CDO) and Structured Investment Vehicles (SIV). Losses are measured in the tens of billions.

The result has been a reduction in risk taking by market makers as well as investors. We see this in the actions of banks that have become unwilling to lend in the inter-bank market. At Cumberland, we believe that volatile markets are not always a bad thing. They can also present opportunity.

Here is an example of an actual trade.

During the time that market tension grew before the last Fed meeting, the Idaho Housing and Finance Association came to market with a $15 million taxable municipal bond. We found this offering extremely attractive for our clients that had cash to invest. These bonds are rated AAA on their own. This is the natural rating and without any bond insurance as a credit enhancement.

The new issue bond yield at the time it was offered was 6.45%. That was a spread of more than 290 basis points over the five year treasury reference benchmark. This yield spread level was unheard of just two or three months ago for a bond of this quality.

The bond was structured so that, under normal assumptions, these bonds would have an average life of less than five years. Under the slowest prepayment speed scenario, its average life extended to roughly nine years. In addition, the deal was over-collateralized by fifteen percent. That insured that under almost every scenario there would be enough cash flow generated to cover interest and principal payments. The maximum loan-to-value of each mortgage in the deal was 80 percent; that’s a very conservative position for bond investors. Having borrowers pay 20 percent of the value of a home is an added cushion that we believe made this deal attractive in the present climate.

We were very fortunate to get a reasonable allocation of bonds from the underwriter. We expect these bonds will perform extraordinarily well and provide our clients with excellent income and total return results.

We offer this as an example of some of the extraordinary pricing that is now in the market due to the widening of credit spreads. The current dysfunctional environment in the credit markets enables us to capitalize on situations like this one. Opportunities like this occur infrequently. When they appear in times like these, one must act quickly and seize them.