The mortgage servicer company I worked with was frustrated with the custodian’s tracking system. Frequently the servicer company would inquire about where the documents were located and the custodian couldn’t tell them. The firm of mortgage custodians felt they had a good process for identifying and retrieving documents and didn’t want to hear complaints from the servicer. Nancy, the custodian CEO, told me, “Those mortgage servicers are never happy, no
matter what we do!” In time, however, this servicer got a bad reputation among closers and lenders. It seemed that every time there was a closing and this particular company was involved, documents arrived late—causing late closings, scheduling nightmares, and angry buyers and sellers.Gradually closers and lenders started to avoid this servicer.

When I discussed the issue with Bob, the servicer CEO, he said the custodian was trying to drive them out of business. I thought this was a bit paranoid—especially since Nancy, the custodian leader, had told me several times she had tried to improve the situation between the two groups. But, Nancy said, “mortgage servicers just aren’t interested in partnering to fix the process.”

A strong negative correlation between default rates and economic growth could always be expected, but during the economic crisis in the United States in the 1970s and 1980s a sharp increase of the default rates could not be observed. It was the economic slowdown in 1990, which was accompanied by extremely increasing default rates. The same acceleration of default rates occurred in 2001 due to a prolonged downturn of the economy, high political uncertainty after September 11, 2001, company accounting scandals, and aggregate weak credit fundamentals. Structural changes in the credit markets can explain the weaker than assumed relationship between the default rates and the economic cycle. This leads to the conclusion that the relationship between default rates and the spread level in the corporate bond market is a very complex one and that a good performance in the corporate bond market (tightening of credit spreads) can be consistent with increasing default rates at times where the market anticipates future decreasing default rates.

Interestingly, the relationship between equity and bond markets differs in deflation-risk periods and inflation-risk periods. In inflation-risk periods, rising inflation rates push up long-term interest rates, reflecting the fear that aggressive monetary tightening will depress future earnings and hence stock prices. Thus, in periods of rising inflation risk, government bond prices and stock prices tend to fall. In deflation-risk periods government bond prices and stock prices usually go in opposite directions, because fixed income markets benefit from the expectation of falling interest rates, while equities suffer from the worsening profit outlook and increasing default risk. Credit spreads tend to benefit from rising inflation because it becomes easier for companies to pay down their debt.

Deflationary periods usually lead to a spread widening across the whole credit market, hitting consumer-related industries the hardest. However, long-term interest rates seem to have a minor influence on fluctuations of credit spreads in the short term. Companies that borrow at a fixed rate are immune to changes in yields and spreads over the life of the borrowing. Yet, there is a refinancing risk, when debt has to be rolled over. Conversely, when companies borrow at floating rates, they are directly affected by changes in money market rates, which are primarily driven by monetary policy.