Aug 30 2007
What happened and what it means?
The late MIT Professor Rudi Dornbusch sagely observed that in financial markets things always take longer to happen than you expect but once they happen, events unfold much more quickly than you expect and this perfectly describes the events of mid-August
Good news on the economy has helped investors put aside concerns about the wobbly credit and mortgage markets and kept them in a buying mood.
However, I am cautioning against full-blown optimism, the global credit crunch triggered by trouble in U.S. subprime mortgage lending is far from over.
I’d like to point out that billions in adjustable-rate mortgages in the United States are coming due for resetting in the coming months, the impact of which could bring further turbulence to markets.
What we saw was the collapse of the $1.1 trillion market for US mortgages that were issued in recent years to poor-risk homebuyers. These subprime loans were packaged and sold with investment-grade ratings, sometimes even AAA, to hedge funds, banks, pension funds (and a few mutual funds).
Then in July, with delinquencies rising, the geniuses (!!) at the ratings agencies relabeled a slew of these securities as junk, (all of a sudden these bozo’s who are relied on by the investment community to make accurate assessment on credit risk, apparently had their research and brains on the delay button) causing them to be marked down by as much as two thirds and setting off a financial panic that threatened to cut off credit to even the best risks – So blame it on the numskulls at DBRS, Moodys. They should have marked them as junk the day these investments came out – I mean sub-prime does mean to those who do not have adequate ability to get a prime loan! - i.e. bad credit.
Then on August 16, when the US’s largest mortgage lender, Countrywide Financial, drew down its entire $11.5 billion line of credit just to stay in business and avoid bankruptcy. The day before, Countrywide had lost access to the market for commercial paper, its customary source of short-term funding.
Bear in mind that Countrywide wasn’t a big player in subprime loans, that prize goes to banks such as HSBC.
As an aside - Some interesting things on all this ABCP (Asset Backed Commercial Paper) problem. I never thought that a socially responsible fund run by investment firms such as Meritas would have as much as 30% of its assets in its money market fund in ABCP. It’s amazing how chasing after the higher returns can cause such problems. The money market that we work with has zero ABCPs – nada not one. Sometimes being dumb to all these so called “attractive†products can be smart!
The worst of it is, nobody knows the full dimensions of the subprime fiasco. So it’s impossible to do more than guess at how this story will play out. Apparently up to 90% of the subprime loans in California’s Central Valley involved fraud. Most subprime paper is held by secretive banks and hedge funds. Every time word trickles out that an over-leveraged hedge fund holding subprime paper has imploded, the stock market shudders.
The subprime debacle also hurt leveraged buyouts, which had been a pillar holding up stock prices. Merrill Lynch economist David Rosenberg observes that all public and private U.S. debt now amounts to 340% of US annual economic output — a record-breaking ratio fed by years of easy-to-get money. Big contributors to the debt bubble were leveraged buyout, or private equity, firms that borrowed money at low rates to take public companies private. Now the credit window has closed. Deal-making has ground to a halt. And the next shoe to fall could be these private equity and LBO firms.
While Central Bankers hope the markets have now stabilized, they are not assuming that this is the case. They are braced for possible further bad news as different financial institutions mark their portfolios to market.
They recognize that confidence remains fragile, and that even in optimistic scenarios it will take time for the market to heal, with distressed investors selling into market rallies. They expect trading will remain volatile as investors try to evaluate the implications of market turmoil for the economy.
Central Bank policymakers assess market developments from a slightly different perspective from market participants – putting more weight on liquidity and trading volumes rather than prices.
Their objective is to get markets working again, and allow the “price discovery†process to resume. They are, or at least claim to be, relaxed about the price at which the market clears.
These officials see a pattern by which market conditions are improving initially in relatively simple parts of the credit market.
These include single name investment grade corporate credits, where markets are open again for business more or less as usual – proably the next opportunity in the Fixed Income markets.
They also believe the market turmoil has revealed that a number of investment vehicles that normally fund themselves through the commercial paper market are heavily exposed to liquidity and duration risk.
With word that New York Federal Reserve Bank is now willing to accept a broader range of collateral at its discount window, which may include mortgage-backed commercial paper, it’s clear the Fed is committed to doing all it can to unwind the tightness seen across the credit spectrum..
A clue to what the Fed will do on Sept. 18 could come on Sept. 6 when the European Central Bank weighs in on interest rates. If the ECB opts to forget about the quarter-point increase it has talked about, that would suggest there’s a coordinated effort between Japan, Europe and the U.S. to keep rates low.
Earlier there were expectations of a Bank of Canada rate hike in September and no movement from the U.S. Federal Reserve. Now, we’re looking at no Bank of Canada rate hike and a rate cut in the U.S. next month.
Legg Mason’s Bill Miller says “The current credit crunch is “much more serious†for the U.S. financial system than the 1987 stock market crash wasâ€. “The mortgage market is bigger than the whole U.S. economy, and that market is effectively shut down.â€
But once the immediate crisis has passed, Miller thinks stocks will head higher. And he predicts that the industry sectors that have led the market in recent years, such as energy and basic materials, will become laggards. “The leadership is likely to change,â€.
The good news is that the world economy is sound. There are record amounts of money sitting on the side. Growth is running around 5% per year, which is more than a percentage point above the long-run average. Even with some spillover from the US Housing market to other economies this may soften to about 2%. Previous credit crunches in 1987, 1998 and 2001, had relatively happy endings and the underlying economic conditions were not nearly as favourable as now.
In each case, equity markets recovered after one quarter and were in positive territory after two. Central bank responses were a key factor in calming markets in those previous episodes. And Central Banks are once again playing a major role by providing liquidity.
Just how likely is further trouble in the stock market?
Since the recent share-price declines can be traced directly to problems in the bond market, that’s probably a good place to look for clues about the future performance of stocks. What the credit markets are saying: Bond prices are coming down, but they haven’t reached what looks like the bottom yet. That likely means more bad news to come. Remember as Bond prices go down, the yield goes up.
We can see the change in the bond markets by the sudden (and ultimately healthy) re-pricing of the junk-bond market: The gap in yields between low-grade bonds and Treasuries has widened dramatically in recent weeks, to more-normal levels.
In short, common sense is beginning to return to the bond market, but we’re not there yet.
Why should bond prices matter to stocks? For all kinds of reasons. After all, the unwillingness of many market participants to buy bonds, commercial paper and other types of IOUs — a situation known as a credit crunch — caused the stock market’s correction. Credit is the lifeblood of many businesses. Until the credit crunch eases, many will have trouble borrowing money. Particularly imperiled are private equity firms, which borrow to take companies private, and hedge funds, which use borrowed money to amplify investments in risky bonds and other securities. These activities directly affect stocks.
The subprime mess, has just begun to affect the economy. More than one-fifth of all mortgages made during the past three years were subprime. As the rates on these mortgages start to reset, more and more people will default, and there will be a ripple effect through the economy. So, it ain’t over.
Nevertheless, we think the North American economy will avoid a recession. The economy is still very strong. The Central Bankers must lower the interest rates a couple of times to safely get past the soft patch in the economy. The US Fed’s August 17 move to cut the discount rate, the rate it charges banks that want to borrow from it, was important in providing liquidity, but, It’s also the Fed saying we’re going to be there. Now they need to deliver.
What’s next? No one can consistently foretell the short-term fluctuations of the market. What is a good bet, though, is that volatility will remain a constant over the next several months. In all likelihood, the market will continue to gyrate wildly because of conflicting currents running through the economy.
So how is one to approach stocks in this murky environment? You can’t panic – most moves on the upside are unpredictable, just like the downturns.
Focus on the most important single perspective you absolutely need to have to be a stock market investor. Ready? Stocks are not a short-term investment.
Yes, a big pullback in stocks prices can produce anxiety. And yes, that anxiety gets fed by the media, which is in the business of breathlessly announcing what’s happening right now, and not in the business of reporting comparatively dull long-term trends. But when even the short-term performance that you shouldn’t be concerned with is positive for stocks.
If you signed on for investing in stocks, you signed on for the long term. Years. Not days, months, or even a year or two. You buy stocks because you want to own those businesses, often for long periods of time. The stock markets generally represent our enormous cumulative self interest in building and running profitable businesses of every description. We know that over long periods of time, that self interest generates relentless motivation, heroic resolve, and breathtaking innovation. You want to own equities because history has shown that being an owner of excellent businesses creates more wealth over time. History also teaches us that to reduce the jarring ups and downs in the stock market you need those boring old bonds in your portfolio.
However, even though you’re a long-term investor in stocks, your personal risk tolerance is probably such that you still couldn’t live with all your long-term money in stocks. So you should have a portfolio that is well diversified with other investment asset classes. If you’ve been careful about your portfolio construction, your risk management and your long-term planning, you don’t need to sweat the headlines about the recent market volatility. You can get on with your summer, and know that whether this short-term volatility gets better or worse in the short term, things will smooth themselves out in the long term. You don’t need to do anything. That’s the lesson of history.
That being said, another lesson of history is that market price declines bring buying opportunities. There are relative bargains out there now.
Price corrections in the market are normal, healthy - and great for value investors. So if you absolutely must do something, you may well wish to be a buyer.
So we know that we don’t know the specifics of the future, but we know not to make long term bets against the power of self interested entrepreneurialism. We know to be well diversified in our equity holdings. We know that stock prices will fall every third or fourth year on average. Wee know that there will be worry, and yes, that babies will cry, and there will be much gnashing of teeth. But for those who stick to their discipline, they will be rewarded for the ride.
Market volatility can be unsettling, but it is a normal part of investing. While the market performed well we would expect volatility to remain in the near-term. Long-term investors should focus on ignoring this short-term “noise†and focus on the long-term fundamentals which we believe remain strong. We advice investors to make sure their portfolios do not look like the TSX, and thus would rebalance if necessary. Proper diversification is key to reaching your long term goals in our view.
R - If you can’t beat your computer at chess, do what I did — try kick-boxing.
