January 19, 2010
Data on delinquencies, Galligan showed, support this forecast. Whether one looks at prime, Alt-A, subprime or option-ARM mortgages, the pattern is the same: defaults and delinquencies are rising without any indication of peaking or reaching a plateau. Moreover, the gap between these two measures is significant.
For the market to stabilize these two numbers need to intersect. Ideally delinquencies need to decrease, but Galligan said there is “no sign that is happening.”
Galligan cited a “universal consensus” that the agency market is overvalued, due primarily to the Fed having been an active buyer in that market. That Fed program is scheduled to end in March, at which point Galligan expects spread to widen by at least 30 basis points. Galligan thinks that the day is near, and said the residential housing market is in the “seventh inning” of its crisis.
Eight to 10 million homes will be sold out of foreclosure and “we have barely scratched the surface” on that front, Galligan said, adding that the housing crisis will not end, and home prices will not stabilize, until that happens.
Loan modification programs are not working, because they are not decreasing the principal outstanding and economic conditions and unemployment have worsened.
Perhaps the only good news in this market is that loss severities have come down somewhat, he said, although that may be due to the process by which banks are liquidating their loans, through initiatives such as “short sales.”
The commercial real estate market, where Gundlach’s team admittedly has less expertise, is only in the second inning of its crisis, Galligan said. This year will be the “year of reckoning” for that market, as lender and borrowers scramble to rewrite contracts on hundreds of billions of dollars of maturing debt.
Galligan believes banks still have $1 trillion of bad assets on their books. The Fed’s zero-interest rate policy is allowing banks to earn an extra $300 billion per year as they earn their way out of their problems. “Everyone understands the game that is being played,” he said. Meanwhile, banks are not lending and not originating new loans.
When I asked Galligan for his forecast for interest rates over the next decade, he said he is “tremendously concerned with what is going on” and “it will be very inflationary and rates will be a lot higher,” despite a short-term bias toward deflation.
The big question – perhaps the only question – for long-term investors in this market, therefore, is whether sector and security selection skills will be sufficient to overcome rising interest rates and accompanying value erosion.
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