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 September 2007 The Liquid Prescription
Unless you’ve taken the European approach to summer and have been out on holiday since June, you’ve probably heard all you want to hear about subprime loans. That’s too bad because you’re bound to hear a lot more about them before this is finally over. Just as it takes time to get over an illness, the financial markets won’t recover overnight.
Fiscal Unfitness But as such illnesses often do, this one has been slowly making its presence known. Less than a year ago homebuilders were offering encouraging forecasts for a recovery in the slowing market. Lenders felt free to lower credit standards to bring consumers with shaky credit histories into the market. As long as there was plenty of liquidity and rates remained low, homebuyers could make their payments or refinance at even more favorable terms. Throughout it all, there was an underlying belief that if the economic patient started to show tangible signs of illness, Dr. Bernanke and his Fed cohorts would step in with the right prescription. After all, this had happened several times in the past when Dr. Greenspan was the physician on call. Oddly enough, the Fed worried more about the patient’s waistline than the growing internal tumor – at least that’s how it appeared to market participants. Ever since the start of the year they had expected the good doctors to administer the medicine of rate cuts to shore up the economy’s weakening health. Instead, the Fed physicians feared sparking inflation with a highly caloric liquid diet. By mid-summer, analysts were coming to the conclusion that there would be no stimulants prescribed this year, and the patient would have to draw strength from other sources. Ever since the Fed moved to a neutral stance in June 2006, the fixed income market had discounted anticipated rate cuts. With that prospect now receding, interest rates started to rise back to arguably more realistic levels. Unfortunately, with that cutoff of the easy-credit blood supply, the subprime tumor showed signs of rupturing. The confluence of rising rates, falling home sales, and adjustable rate loans resetting at higher levels sent tremors through the stock market. Until that point, many of the few who acknowledged the subprime tumor’s existence believed its impact wouldn’t be far reaching. Instead they thought it was just confined to the financial sector of the economy. But easy credit and low defaults had been driving more than investment bankers’ bonuses. Much of the stock market’s strength in the first part of the summer was driven by takeover activity, most financed at low rates with lenient terms. As long as there was plenty of liquidity, banks were more than willing to offer financing with favorable terms. But when rates started to rise and funds grew tighter, banks found themselves with commitments they desperately wanted to renegotiate. On the merger and acquisition side, new deals were much more difficult to finance. With this catalyst gone, stocks stalled and eventually fell. Adding to the selloff was the fact that many hedge funds found their portfolio insurance was about as valuable as an expired term life policy. This was particularly true for the so-called “quant” funds that used statistical modeling to build and “protect” portfolios. As it turns out, many were holding the same assets and making identical bets. When market turmoil hit some it hit all. Making matters worse was the fact that they were also often the not-so-proud owners of subprime debt. When they couldn’t price or sell their subprime holdings, they were forced to dump what was liquid – stocks. The tumor’s effects were suddenly spreading.
Ironically, it took a French bank to bring the subprime problem home to the U.S. In early August, BNP Paribas SA shocked the market by suspending three funds due to a lack of liquidity and the resultant inability to accurately price them. The Dow ended down 387 points on the day of the disclosure. With vital signs fading fast, the Fed physicians – and their colleagues around the world -- sprung into action. The European Central Bank injected $130 billion into the market and then another $83 billion the next day. To put it in context, when the Fed gave the U.S. markets a shot of liquidity in the wake of the September 11 terror attacks, it only added a little over $100 billion. Obviously the ECB felt the current liquidity crisis called for serious action. Others central banks adding liquidity included Japan, Australia, Singapore. The Fed doctors did their part, too, first with direct injections through open market activity and then by cutting the discount rate to 5.75% from 6.25%. The credit markets stabilized, but investors remained jittery. The stock market interspersed rallies with bouts of selling.
Stronger Medicine The concerted efforts of the world’s central banks signaled they were both aware of the situation and willing to act when necessary. That helped, but certainly wasn’t sufficient to end the crisis. Investors and many CEOs are calling for stronger medicine. The discount rate cut was nice, but mostly symbolic. The discount rate applies to short-term loans from the Fed to member banks. Over time, this avenue has seen fewer and fewer loans. Most transactions are now between banks themselves, and these are at the Fed Funds rate. To this point that’s remained steady at 5.25%, the same level it’s maintained for over a year. In the late summer, rate speculation was the dominant theme, not only for fixed income but for the equity market as well. Volatility increased with daily swings determined by the latest odds of a rate cut. Even second quarter earnings reports took a back seat.
The Fed has to walk a fine line: Without moving to ease the credit crisis, the economy could tilt towards recession. Acting too quickly however, could ignite inflation while signaling a willingness to bail out speculators. This is a message Fed Chairman Bernanke has been struggling to avoid. As he told his colleagues in late August, "It is not the responsibility of the Federal Reserve -- nor would it be appropriate -- to protect lenders and investors from the consequences of their financial decisions." It’s hard to believe the Fed should act to bail out investors who willingly played in the subprime market. Their outsized returns were a function of their outsized risk. Many that benefited were professional investors and the so-called “smart money”. Why should they now expect to be bailed out, particularly when there’s a risk of touching off inflation? As P.T. Barnum put it, “You pays your money and you takes your chances.” Unfortunately, the subprime virus has infected more than professional speculators. Investors who never realized their mutual funds held such securities are now finding out the hard way. The sudden credit crunch has even sent tremors through the money markets with fears and rumors that some lower quality funds may be forced to “break the buck”.
Homeowners are feeling the effects, too. Many who purchased homes or refinanced their current ones with adjustable rate loans in anticipation of moving to fixed rate loans before rates moved up, are now finding themselves in quite a jam. With credit now tighter, refinancing is more difficult to find, especially at favorable terms. In addition, those who stretched to buy as much home as possible believing values would only continue rising are also facing disappointment. Home prices held up over the summer despite declining sales, but the two are really linked as rising inventories will eventually drag down prices. No one wants to sell their house for less than they paid, but eventually that’s going to have to happen, especially for those who need to make the sale. Eventually, that will lead to lower prices, reversing the “wealth effect” that’s thought to have supported consumer spending. All of this paints a pretty bleak picture for the near-term prognosis. But the U.S. economy is still strong and has proven to be surprisingly resilient in the past. And believe it or not, there are actually some positives here, too.
Long-Term Prognosis Just as in the tech bubble, capital has been misallocated over the past several years. More and more had poured into real estate and real estate related investments. Riskier and riskier corners of the markets have drawn more and more capital. Everyone knew these imbalances would eventually need to be corrected, the only question was could it be occur without severe damage to the economy and markets.
Now we’re starting to get the answer. There’s been some pain, but it’s been far from devastating. Stocks are well off their mid-July highs, but are still in positive territory for the year. The selling has affected all areas of the market, not just overpriced speculative shares. As the situation stabilizes this fall, bargains will emerge possibly setting the stage for a year-end rally. Financial stocks have been hardest hit, and indeed, further declines are highly likely. Banks, brokers, insurance companies, and investment banks have all been involved in the subprime area, and only time will tell how deeply. Smaller banks and those that haven’t dabbled as much in the mortgage lending market will be the first to recover. Previously neglected growth shares are finally starting to come around. Not only do they boast fair prices, they also offer steadier earnings in a lower growth environment. Under conditions of tighter credit, mergers and acquisitions will be harder to come by, moving the spotlight back to growth. That’s already started to happen as for the first time this decade, growth issues are moving ahead of their value counterparts.
Earnings growth has decelerated over the past few quarters, and may continue to decline in the third quarter. If interest rates do eventually fall however, that could quickly reverse as soon as the fourth quarter. Although the effect of lower rates could take up to one year to make their way through the economy, the perception of easier credit could be enough to provide some near-term impetus. Short-term rates have decreased sharply as the subprime crisis deepened. It’s not because investors are anticipating interest rate cuts as much as the fact that short-term Treasury securities have been the safe haven of choice. As a result, yields on the short end of the yield curve, which move inversely with prices, have been on the decline while longer yields have remained relatively stable, pricing in some additional credit and inflation risk. The steeper yield curve is precisely what the financial and credit markets have been seeking as a means to return to normalcy. A major factor leading to the current subprime crisis was the fact that with a flat yield curve, lenders couldn’t rely on the spread between short-term and long-term rates to create their typical revenues. Forced to step up their reliance on riskier transactions, they lowered their credit standards which set the stage for this summer’s difficulties. Longer-term, the return to the upwardly sloping yield curve is just what the doctor ordered. Ultimately this will bring risk and return back in line and work in favor of financial issues, the traditional bull market leaders. So don’t declare the bull market dead just yet. Without a doubt, there’s still some short-term suffering ahead, but a healthier economy, stock, and fixed income market will eventually emerge. Any time there’s excesses – whether in technology stocks or easy credit – there’s a price to pay, but it eventually leaves a stronger, healthier environment behind. As medieval doctors knew, an occasional purge is the best prescription. Let’s just hope this purge isn’t too painful. Search this site! Just enter you key word or words:
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HE SUMMER OF 2007 won’t be remembered for the final Harry Potter book or the launch of the iPhone, but rather for the subprime lending crisis. Everyone should have seen it coming – there was even a prelude in late February – yet everyone seemed utterly surprised when it finally hit.
