June 29, 2010
That leaves the final option, which is to print money. That has already occurred, Gundlach said, but only to a very limited degree. The US has printed about a trillion-and-a-half, which he said was “nothing.” “We have $50 trillion of credit market debt and another $50 trillion unfunded promises to pay. There are $600 trillion of derivatives that could blow up at any time,” he said. “I just don't think that we can realistically print that kind of money absent a huge crisis.”
Gundlach sounded an optimistic note about the flexibility of our economy, which he said has helped the US grow out of recessions in the past. Adaptability, however, will come hand-in-hand with austerity, which he said was the “new cool,” reflecting the desire of governments to get the “fiscal house in order.” That requires sacrifice, which he said was inconsistent with increased economic growth.
Ultimately, though, Gundlach expects a seventh option: “some type of polite default, at a minimum, will happen.” He expects the US to renege on some of its debt or entitlement obligations, such as by imposing a tax on the maturity of government debt or by cutting back on entitlements. “That would be a way of engineering a default in a creative way,” he said.
Opportunities in Alt-As
After outlining his deflationary thesis and the paucity of policy options, Gundlach discussed market conditions affecting his funds.
To illustrate the opportunities in mortgage-backed debt, Gundlach discussed a specific security – an Alt-A Wells Fargo bond that was issued in 2007 (which was a year when many securities backed by poor credit were issued). This example trades at 68 cents on the dollar and has a coupon of 5.75%.
An Alt-A bond has loans made to borrowers with better credit records than those in the sub-prime category, but not as good as that of a prime borrower.
Gundlach said the loans underlying this bond are from “good borrowers” with FICA scores higher than their Alt-A status would indicate. The loan-to-value ratios on the loans are not yet in the territory where homeowners will “mail in the keys” and default. “This one hasn’t suffered that problem yet,” he said, although about 15% of the loans are not currently paying.
Even assuming for the worst-case scenario of a continued dip in the housing market and an increased rate of defaults, Gundlach still believes this bond would yield over 13%. Even if rates rise, the bonds will increase in value he said, and they are inversely correlated to Treasury bonds. “These bonds protect you for the inflation case or the monetization case to an extent that other bonds do not,” he said
A final warning
Gundlach concluded his talk by warning that at some points “something bad” could happen relative to risk, causing the dollar to drop and Treasury yields to rise. “That is what you need to watch out for.”
“If the world starts to behave differently,” he said, “you need to sell immediately, because you don't have much time. So I suggest that all of us watch the way the markets react to bad news regarding risk. If their behavior changes, you have to sell very, very quickly.”
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