My personal trainer, Ekaterina, asked me over a year ago, "What is your main fitness goal?" "Slimming down," I replied. Those two words helped launch a regimented exercise program to improve aerobic and cardiovascular conditioning, strength and flexibility. Despite having a strong upper body, my overall fitness level was lacking in stamina, endurance, core and leg strength and flexibility. Through discipline and daily commitment, we have made great progress and, most importantly, I discovered a new found passion for fitness in the process. Doing Ekaterina’s 50-minute non-stop cross-fit workouts is now almost as enjoyable as making a 15-foot birdie putt. Her exercise programs constantly challenge and evolve – from strength training, to core and balance work, to cross-fit and time trial workouts. Thanks to Ekaterina’s high standards, focus and determination and my commitment to the program, I am well on my way towards slimming down.

It turns out consumers, banks and financial companies are going through a similar period of slimming down after years of becoming bloated on easy credit, rising home prices and financial innovation. The U.S. economy is entering a new era in which both individuals and companies are delevering and repairing balance sheets. The combination of falling asset prices, high debt levels and poor liquidity means that "getting into shape" is a reality many will have to embrace. This low-calorie financial diet, often forced, has significant implications for credit markets and investment strategy. Fortunately, investors who have not over-extended themselves are in a unique position to capitalize on opportunities set to surface in this new environment.

U.S. Consumers Are Going on a Diet

The U.S. consumer has gotten fat through a high-calorie diet of growing personal debt, and limited exercise evidenced by low personal savings. Thanks to a banking and financial system willing to lend as long as housing prices were rising, consumer spending grew to almost 72% of U.S. real gross domestic product (GDP)¹ due to a credit-induced spending binge. The nearly endless supply of credit and liquidity kept Americans spending unlike any other country.

Unfortunately, U.S. consumers’ "vital signs" – income, savings, liquidity and wealth – are weak and set to get weaker. U.S. real disposable income growth has fallen to almost zero now due to rising energy, gas and food costs. Not surprisingly, real retail sales growth excluding spending on gasoline (Chart 1) has not only turned negative but is now at its weakest level in over 15 years. Employment growth is slowing sharply due to deteriorating corporate profitability. As we discussed in our January 2008 U.S. Credit Perspectives: Triple Play, corporate profits tend to lead employment growth by 6-12 months. It’s no wonder that the U.S. labor market has softened, given that corporate profit growth for U.S. companies selling domestically turned negative in the first quarter of 2007.

Consumers’ real income is not only stagnant, but it is more unstable due to heightened tensions with regard to employment (Chart 2). Consumers are struggling to keep up with the rising cost of living, and with limited savings, it’s not surprising that consumer confidence is hitting 26-year lows. At the same time, banks and other finance companies are significantly cutting back loans to consumers across mortgage credit, home equity lines of credit, credit cards, auto and student loans. Consumer liquidity has been negatively impacted by falling home prices as banks, struggling to control rising and unforeseen liabilities, are cutting off consumers’ lines of credit.² To top it off, housing price declines are accelerating, and stock market returns have turned negative.

While the near-term outlook for consumer spending has clearly deteriorated, it is also likely we are entering an extended period of consumer retrenchment. There is still debate about whether the whole U.S. economy is in recession, but it appears clearer each day that a U.S. consumer recession has already started and could last longer than some envision. And at the same time consumers are pulling back, business confidence is deteriorating (Chart 3). This contraction in "animal spirits" for both individuals and companies could lead not only to a prolonged U.S. consumer slowdown, but to an atypically long U.S. recession.

Housing Prices No Longer Feeding Consumption

The central factor in the consumer recession is that home prices remain vulnerable, and housing is the American consumer’s single largest asset. Unfortunately, this asset is still over 20% overvalued nationwide based on some indicators like the price-to-income ratio (Chart 4). As we discussed in our June 2006 U.S. Credit Perspectives: For Sale, and in our May 2007 U.S. Credit Perspectives: Still Renting, housing prices became an unmistakable bubble, diverging from fundamentals due to cheap financing and investor euphoria. While government efforts to soften rising foreclosures and reduce mortgage rates will help, U.S. home prices remain too expensive nationwide relative to personal income and relative to rents. In high-cost regions of the country, like Orange County, California, housing is still up to 35% overvalued relative to rental property (Chart 5).

I believe housing prices will likely continue to decline despite increasing government support. Besides home prices being overvalued, inventories are alarmingly high, foreclosures are soaring and credit availability is tight. Lower housing prices mean consumers will remain defensive, already evidenced by sharp deterioration and weakness in recent auto and retail sales data. Consumers are stretched, mortgage equity withdrawal has fallen, and lower housing prices are acting to further restrict liquidity and credit availability. The U.S. economy is near the end of a credit-driven consumer spending binge, and now starting what is likely to be an extended period of balance sheet repair as American consumers start living within their means. As a result, U.S. consumers will be forced to shape up and go on a massive diet.

Banks to Reduce Bloated Balance Sheets

The banking and financial system, like U.S. consumers, has gotten fat. For banks, the extra weight put on over the past several years is the result of unforeseen liabilities and commitments coming back on balance sheets. Declining asset values and an intensifying credit crunch have led to massive write-downs and losses for the financial system. Collectively, total banking losses are now over $240 billion through April 2008.³ Given the magnitude of these losses, banks are in riskreduction mode, selling assets and cutting back credit to both individuals and companies. This can be seen in the Federal Reserve Loan Officers’ survey in which banks’ willingness to make all types of loans has deteriorated significantly. Further write-downs on loans, as a result of declining asset values, will further shrink bank balance sheets and liquidity. The net result is a lack of capital, which could starve the economy of credit needed to finance new growth.

Fortunately, banks and financial companies have been able to raise over $160 billion in new capital over the six months3 through April 18, 2008. The magnitude and speed of this recapitalization has been extremely positive for the banking and financial system, with new capital coming to the market from institutional, government, sovereign wealth funds and private sources. Why? The Federal Reserve’s pro-active initiatives, combined with upcoming tax rebates and numerous new liquidity facilities offered to both banks and non-bank financials, have given investors confidence that the U.S. authorities will support the overall health of the financial system. Internationally, the European Central Bank (ECB) and Bank of England have initiated new measures to improve liquidity and support the banking sector.

In addition to the confidence that central bankers have instilled, many investors have been enticed by credit spreads that are at historically wide levels for many banks and financials (Chart 6). Amid heightened risk aversion, bank and financial issuers have offered wide spreads and high yields to attract new capital. New issues in the investment-grade corporate bond market are pricing at significant concessions to secondary bonds (Chart 7). Over the past months, demand has picked up, causing a lesser degree of new issue concessions. Nevertheless, the spreads offered on today’s new issues, and, in particular, new bank issues remain attractive. PIMCO has sought to capitalize on this opportunity by selectively buying high-quality bank and financial issues at attractive valuations through the new issue calendar. Slimming down and recapitalizing the banking and financial system has created an opportunity for investors to pick up AA-rated and A-rated bonds at a significant discount.

Option Adjusted Spreads - measures the yield spread that is not directly attributable to the security's characteristics. This is a measurement tool for evaluating price differences between similar products with different embedded options. A larger OAS implies a greater return for greater risks.

Investment Opportunity In High-Quality Bank Debt

Despite aggressive monetary stimulus and upcoming tax rebates, consumers are caught in a perfect storm of falling housing prices, a weak labor market, high energy and food prices and deteriorating credit availability. These large headwinds may lead to a significant consumer retrenchment, implying an increasing risk of significant pain ahead for consumer spending. Given this outlook, we believe cyclical sectors, like housing, retailers, paper, building products, airlines, autos, gaming and lodging, are likely to continue to underperform. Similarly, non-cyclical and defensive industries likely to outperform include energy, metals and mining, aerospace and global industrials, which are being supported by robust growth in developing countries.

With banks on a diet to reduce their balance sheets, investors will likely find continued opportunities for high-quality bank debt. While large write-downs and provisions have improved transparency, the need for fresh capital to repair balance sheets will result in asset sales, dividend cuts and increased equity and preferred issuance. While painful, banks should take advantage of any renewed investor interest to strengthen their capital base. Over the next several quarters, investors should increase their exposure to senior bank debt and selected bank capital or preferred issuance. While challenges remain, credit spreads for banks are near all-time wides and present compelling value. Monetary policy remains supportive for the banking sector, with short-term rates keeping yield curves steep, helping to restore bank profitability. Non-traditional policy initiatives are helping to ensure both banks and non-bank financial firms have the necessary liquidity to get through today’s challenging environment.

No Pain, No Gain

Financial fitness and getting into shape require awareness, sacrifice and commitment. The Federal Reserve’s proactive initiatives, combined with banks’ renewed efforts to raise capital, indicate a heightened effort has begun to restore liquidity into the banking and financial sector. Through the process of balance sheet repair, banks are starting the painful process of recapitalizing in order to prepare for the environment ahead. While financial markets are likely to remain volatile amid sub-par U.S. growth, a number of large global banks have begun to take a decisive first step to slim down, evidenced by their commitment to take aggressive write-downs, raise new capital and restore their balance sheets.

Given our cautious economic outlook, PIMCO is maintaining a high-quality credit portfolio. We have, however, increased our credit exposure in selected global banks and financials, as well as in high quality investment-grade senior CDX tranches (Chart 8) as opportunities have developed. Many recent bank and financial issues have been issued at attractive levels, suggesting that banks’ nearterm pain may mean investors’ longer-term gain.

30-100: Senior tranche of the IG-CDX product. The 30% is the attachment point and 100% is the detachment point. The attachment point represents the level of cumulative losses that would need to be reached before the seller of protection bears a loss. The detachment point represents the level of cumulative losses at which point the seller of protection would experience a loss of 100% of the notional value of the contract.

IG-CDX: Investment Grade Credit Default Swaps

For those fortunate investors who have not over-extended themselves, today’s slimming down period for banks and financials will likely offer an attractive entry point to increase high-quality credit exposure at a time when valuations are as attractive as they have been in over a decade. Ekaterina always says, "Believe in yourself, work hard towards your goals and you can accomplish anything." Banks are well on the way toward their goal of recapitalizing and building healthier balance sheets. It turns out that the process of slimming down should not only benefit those committed to fitness, but also investors willing to increase credit risk in high-quality banks and financials as these companies get into better shape.