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 January 2009 Uncharted Territory
That's certainly not the case a year later. As 2009 gets underway, the credit and housing markets are still frozen, unemployment stands at a fifteen year high (6.7%), and the global recession is still deepening. Lehman Brothers, IndyMac Bank, and Washington Mutual are no longer with us, Merrill Lynch and Wachovia are no longer independent, and corporate icons such as General Motors, AIG, and Bear Stearns have been to the brink of bankruptcy.
Throughout it all, the government's response has been even more surreal. As recently as September 2007, the Federal Funds Rate stood at 5.25% and was still 4.25% at the end of the year. But a year later, the Fed's benchmark rate is now a range of 0 - 0.25%, the lowest it's ever been. Not only that, the Fed is printing money as fast as possible. Over on the fiscal side, the democrats who swept into office just a little over two years ago with talk of PAYGO (pay as you go) budgeting, now can't spend fast enough to bailout any industry with a need. The most striking thing about this is all the money being spent is money we don't have -- it's all deficit spending and something that will eventually catch up with us if in no other way than through inflation. The laissez-faire government of the Bush years has already been replaced by the more interventionist version -- and Bush still has a fortnight left in office. No one knows how all of this will ultimately shake out, but one thing does seem certain: No matter what happens, the economic and financial landscape will be dramatically changed from anything we've experienced or perhaps even dreamed of. The U.S. may look a lot more like the semi-socialist Western European economies -- or it might not, but either way it will be vastly different than it was just a year ago.
A Challenging Time Prior recessions didn't begin when interest rates were already hovering near historic lows. Aside from the Great Depression, they didn't center on the financial sector but on broader and/or other sectors of the market. The government wasn't so willing to spend so widely and freely, either. Each of these factors will have an impact on the subsequent recovery, but it's their combined effect that's the hardest to predict. In an attempt to draw insight from the past, two events may offer some parallels: The Great Depression and the Japan's experience over the past two decades. The Depression is an obvious comparison because of the strain on the credit market and its ultimate effect on the banking system. Japan's "Lost Decade" was the result of an overheated real estate market and "zombie" banks reluctant to write off what proved to be worthless debt. There are, however, differences, too. Despite the headlines whenever one occurred, there have still been relatively few bank failures in the current credit crisis. This was not the case in the Great Depression. In fact, it's because of some of the banking reforms resulting from the Great Depression that today's system is more stable. Unlike the Japanese who relied more on monetary policy's zero-interest rates to get money back to the banks, the U.S. is currently also offering direct aid to the institutions. This is what saved AIG and Bear Stearns, and led to Treasury Department brokered deals for Wachovia and Merrill Lynch.
So the current situation is similar to several previous declines, but is far from identical. No two recessions are ever completely alike, but it is possible to get some bearing from past experience.
How We Got Here Low prevailing interest rates drove investors to seek higher yields, providing a ready market for packages of mortgages known as "asset backed securities". Many of these issued by Freddie Mac and Fannie Mae carried the implicit backing of the federal government suggesting they had the security of Treasuries but higher yields. More aggressive investors were tempted by so-called "subprime" pools -- loans to those with less than pristine credit records -- carrying even higher yields. Understandably, it was these that suffered the first hit when the housing market collapsed and foreclosures accelerated. The first tremors swept through the economy almost two years ago, in the winter of 2007. As the housing market began to stall and the first subprime foreclosures started to surface, stocks suffered a sharp decline in February 2007, one of the deepest since the equity recovery started back in late 2002. Ignoring the warnings of many seasoned market watchers, investors quickly shrugged off the early warnings and stocks completely recovered their short-term losses in less than a month. Potential damage was thought to be limited to the subprime sector which was only a minute part of the overall credit market. With the housing industry clinging to rosy forecasts, stocks moved to new highs in October 2007. But you can't talk -- or wish -- your way out of reality. By late 2007, the housing market was showing signs of decline. Homes were remaining on the market for longer periods of time while some just weren't selling. Defaults were still on the increase and the credit markets were getting jittery. Stocks finished 2007 off their highs, establishing a downtrend that accelerated in 2008 as the economy further declined. In hindsight, the National Bureau of Economic Research (NBER) recognized the U.S. economy entered recession in December 2007. The true turning point came in 2008 when it became obvious that the credit crisis wasn't simply limited to subprime debt. That's where it started, but when institutions that focused on low quality debt (e.g. IndyMac and Washington Mutual) needed to raise capital, they found little market for their subprime holdings and instead had to dump higher quality securities. This set off a chain reaction that ultimately exposed the extent to which subprime debt and derivatives based upon it permeated the market.
Bear Stearns was the first venerable institution to falter, but the government rushed in to guarantee its ongoing existence. After this, few doubted the depths of the problem. The credit market shuddered, but the government's willingness to intervene gave investors enough confidence to build a slight recovery. That all changed a few weeks later when Lehman Brothers was pushed to the brink. Short sellers who did their homework realized that Lehman had significant exposure to the subprime market, not only though direct investment but through swaps (a type of derivative) as well. Relentless selling drove shares into the low single-digits, but this time the government having been criticized for treating Bear Stearns as being too big to fail, declined to intervene. Over the span of one weekend, Lehman Brothers went from being a troubled but respected company to bankruptcy.
Despite everything that had led to this point, Lehman's demise was a surprise to the market. The company's reach was as big if not bigger than Bear Stearns, but now it was gone. Counterparties who held the other side of Lehman derivatives were left hanging. As the extent of the damage began to emerge, the credit markets froze. Not only were banks unwilling to lend to the public, they were leery of institutions and even other banks, not knowing what was on their balance sheets or if they could reasonably expect repayment. Without the free flow of credit, economic activity sharply declined. On the heels of the deepening credit crisis, stocks tumbled in late summer. The Federal Reserve slashed key rates at a faster pace, yet the credit markets remained frozen. With Election Day fast approaching, Congress debated, rejected, and then finally passed the Troubled Asset Relief Program (TARP). Although flawed (the whole thing depended on the government buying troubled assets from struggling banks, but how could the government price them when even the banks themselves couldn't?) the plan offered investors some hope. Stocks hit a low on October 27 and then stabilized. Unfortunately, in their haste to pass the TARP, Congress didn't really define how it was to work, put any restrictions or requirements on institutions that would benefit from it, or really give the Treasury Secretary any real guidance regarding its administration. This led to two problems. First, Treasury Secretary Henry Paulson quickly disbursed $350 billion of the TARP's total $700 billion to troubled banks -- or in reality, any banks that asked for it. Without any restrictions or guidelines, most simply retained the proceeds to shore up their ailing balance sheets rather than actually make any new loans. Secondly, without any restrictions or guidelines on him, Mr. Paulson unilaterally decided on November 12 that the purpose of the TARP would change from supposedly buying troubled assets from banks to becoming some sort of consumer rescue plan. Needless to say, the plan didn't have its desired effect (except perhaps to help the democrats sweep to election victory) and the credit markets are still suffering. Stocks sank to new depths and revisited their 2001 bear market lows on November 20 and have since stabilized..
The (Fairly) Obvious Secondly, simply adding liquidity into the economy won't solve the credit crisis. With half of the TARP's $700 billion along with President Bush's tax refunds from earlier in 2008, the problems persist and have arguably grown worse. Without effectively targeting the infusions, the desired results won't be achieved. Third, and most troubling, is the fact that the government is running out of options. With the benchmark Fed Funds Rate currently targeted in the 0 - 0.25% range, there's little real monetary policy left. Fed Chairman Ben Bernanke says other tools are available, but in reality they amount to nothing more than printing money. As suggested above, simply increasing the money supply without properly targeting it will not achieve the desired results. It will, however, serve as a catalyst for inflation when the market finally does turn.
Fourth, although by the NBER's reckoning the current recession has persisted for over twelve months already, it can still last longer. The causes of this downturn were more severe than those leading to recent recessions in the early 1990s and the early part of of this decade. As a result, it stands to reason it will take longer to resolve the underlying problems. The depth already reached in this downturn attests to this. Fifth, bonds are presently a poor investment. Short term bonds have rallied as the Fed brought down rates, but at present levels, there is little more they can do. Longer term government debt may still have a way to go before becoming fully valued, but at this point there's much more downside than upside. Fixed income investors are probably well advised to stay in short certificates of deposit issued by stable banks. Corporate debt may seem more attractive, especially if the credit market thaws, but there's one other wild card there: inflation. With so much liquidity being pumped into the economy, it's quite likely that inflation will quickly return with recovery. If so, that would erode the value of longer term bonds and increase borrowing costs. Not a favorable environment for fixed income. At this point, stocks are also an iffy proposition. Investors who are properly positioned at the market turn are able to reap maximum returns. Unfortunately, those who have made such bets over the past year and a half have seen shares fall to new, lower levels. To a certain extent, stocks are acting as if they may established a bottom. As 2008 came to a close, they were virtually range bound only slightly above their November lows. Stocks typically trade like this after finally hitting a low, but they can do so indefinitely. In other words, even if November marked the low point of the current bear market, there's no reason to rush in now. The "bottoming process" can take months before a true uptrend emerges. Again, given the breadth of the excesses that fostered this recession, that process may take longer than usual.
Where We (Might) Go From Here
In the ideal circumstance, the government and the private sector working together should come up with a solution that will buoy the economy without damaging the underlying free-market system. Opportunities for this have already arisen, but for the most part have been ignored. The initial intention of the TARP funds, to purchase troubled loans from private firms' books, was a move in the right direction, but its purpose was quickly altered to simply provide bailout money to struggling firms. The government's assistance in finding a willing investor for Bear Stearns and similar efforts to find a partner for Lehman Brothers was also a step in the right direction. However, after Lehman ultimately failed, federal money is now being offered directly to troubled firms with few strings attached. And that brings us to what will probably happen. As we've detailed elsewhere, both Congress and the incoming administration are aggressively embracing the Keynesian approach of using government spending as their primary means of combating recession. This not only means offering help to struggling companies, but to consumers through additional stimulus programs and loan relief. Also on the drawing board are funding for New Deal type infrastructure projects in an effort to fend off rising unemployment. Within limits, such programs may be helpful, at least in the short-run. In the longer-term, they're very likely to be inflationary. It's hard for the government to dial back spending and cut the money supply when the economy turns and such stimulus is no longer needed. In addition, if the TARP legislation is any indication, the upcoming spending will carry few if any conditions for those who benefit. There's also talk of funneling it toward so-called "green" initiatives which, while expensive, may not bear fruit for years -- if ever. The New Deal projects never suffered from such limitations. This isn't to say that Congress and the new administration aren't acting in good faith, but rather external forces such as political expedience and the desire to help the economy as quickly as possible are likely to lead to misallocation of resources and overspending. Again, look no further than the TARP legislation and the automobile manufacturers' ill-conceived bailout. Hard times require hard choices, but elected officials (especially those who want to be elected again) have difficulty making them. Left alone, the U.S. economy may be in a position to finally begin a definitive recovery in late 2009. It's quite likely that things will get worse (at least as far as unemployment) before they get better. The fact that the credit market is finally starting to show signs of thawing is a major positive as the New Year begins. Earnings are likely to fall in both the first and second quarters of 2009, but as comparisons become easier in the final two quarters, results may begin to look up. If the credit market continues to improve and light appears at the end of the earnings tunnel, stocks can follow suit. The U.S. led the global economy into recession and given the proactive response of the government, the U.S. should be the first on the road to recovery. The timing and strength of the recovery will be dictated by the lasting effects of the government's intervention on inflation and the U.S. markets. Search this site! Just enter you key word or words:
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LOT CAN CHANGE IN A year, and last year a lot did. When 2007 came to a close, stocks were not far from their October all-time highs. There had been a few tremors from the subprime market, but things were still looking pretty good on December 31.
