1/01/08 –

 

On 12/31/07 the S&P 500 closed at 1468, resulting in a total return of 5.49% for the year, and undervalued by 39% on an error correcting basis. One year ago, the undervaluation was 46%. We are cautiously invested in non-cyclical equities, below our normal equity target. We are assuming that the U.S. will fall into a moderate recession in 2008, slowing economic growth compounded by the credit crisis.

 

Market Analysis

 

If there is a recession, the U.S. stock market will follow the economic fundamentals downwards. We are not going to buy the dips; we think that waiting for the stock market to stabilize at a lower level, as the credit markets resolve their various problems, will be a better course.

 

Reason

 

The economic problem in the headlines is, of course, the subprime mortgage problem and its effect on broker/dealer writeoffs, at both the specialized firms and the major international commercial banks. Assuming a 10% drop in home prices from the peak and using OECD and a Street assumption, we estimate that the total writeoffs of three problem assets: subprime mortgages, their derivatives, and specialized investment vehicles at the ten largest broker/dealers and commercial banks could be $130 billion¹, or 24% of the industry’s $550 billion book capital in August. This estimates the permanent loss of capital to the existing shareholders of these companies. All other issues aside, the government sovereign wealth funds now providing some of the replacement capital will demand more conservative business practices.

 

This analysis suggests a general direction and a reason for our caution. A continued drop in house prices would have a continued negative effect upon the rest of the economy and on other loan assets.

 

Implications

 

The subprime problem more generally affects credit creation. Central to the nature of this financial crisis is the concept of credit that enables the banks to finance real GDP growth.

 

Under the traditional fractional reserve system controlled by the Fed, the depository banks used their deposits to make loans, withholding a fraction of their deposits at the Fed. The amount of credit the entire banking system could create was thus limited. In the last decade, this system has broken down as the ever inventive capitalist economy created new forms of credit to finance transactions, not under the control of the Fed. The banks sold their commercial and subprime loans to other investors and to structured investment vehicles, funded in the short-term commercial paper markets. They could then make more loans from the same deposit base.

 

Since the shutdown of the structured finance and commercial paper markets, unmarketable mortgages and returning commercial loans have increased the loan assets at the commercial banks, securitization in reverse. According to Fed statistics, between 10/06 and 10/07, the largest U.S. commercial banks expanded commercial and residential loans by 11.4%; but probably including writeoffs, their book net worth expanded only by 2.6%. This process of involuntary lending cannot continue at that rate. Additional writeoffs will impair the commercial banks’ ability to expand credit to the rest of the economy, their net worths affected by both direct commercial and real estate subprime loan losses, and structured finance losses.

 

Some say that the effect of these losses on the banks’ ability to create credit will be around 10X these writeoffs, in this case $1.3 trillion or more than 9% of GDP. Due to the profitabilities of the banks’ other non-subprime businesses and foreign capital investments, we think the impact of these writeoffs will be less drastic – but there will be an effect. OECD writes, “(these writeoffs) would lead to some periods of instability in the credit supply process.”

 

Portfolio Strategy

 

Equity investing requires optimism, but the basis for that optimism must be realistic. We think that a recession is already baked into the cake by currently large imbalances, in real estate supply and its financing. We have invested mainly for income; there is nothing wrong with being paid to wait. The stock market will have to meet two value criteria and, admittedly, one technical before we increase our asset allocation to common stocks. At some point, the markets will begin to resolve their widespread credit problems with increased transparency and reduced complexity.

 

 

¹ As of 12/20/07 these firms have announced, or Wall Street has estimated, $62.0 billion in third and fourth quarter structured finance writeoffs.

 

 

1/22/08 –

 

The S&P 500 has dropped 10.7% since the beginning of the year to 1310. Other markets abroad extended their losses for the year as investors abroad saw increasing unknowns in the U.S. and the world economies. The general reaction has been to head for the lifeboats.

 

Since we are value investors, making a distinction between market prices and a permanent loss of capital, we certainly don’t see lower prices as a reason to sell. But neither are presently decreasing prices any particular reason to buy. We don’t think that housing prices, bank loan portfolios, and the U.S. stock market have bottomed. Keynes wrote, “In the main…slumps are experiences to be lived through and survived with as much equanimity and patience as possible.”

 

 

2/1/08 –

 

Why do business downturns occur? Since the economy fluctuates, business downturns occur because there are business upturns. As is obvious this time, a business downturn will error correct the excesses to which the capitalist economy is prone.

 

Over the years, the market economy has developed sophisticated institutions. The Fed, however, can only ameliorate recessions. It cannot eliminate them due to the error correcting nature of markets and to the decision maker’s imperfect information *. The Fed’s likely strategy under these conditions is to stabilize output when inflation is low and then aggressively hike rates when the economy-wide expectation of inflation begins to increase.

 

Unfortunately, this cycle, two of the three major monetary policy channels for stabilizing output are not effective. Early cyclical real estate is in excess, and consumer debt is at an unsustainable level. That leaves only business investment, which currently remains high but could also drop. The Fed’s strategy is to lower rates rapidly to do what it can to stabilize output; the dollar will suffer the consequences until the rest of the world also starts cutting rates. The use of fiscal policy to stimulate the economy is limited by the budget deficit.

 

The U.S. and, perhaps, the international economies are in for a bumpy ride. Patience is a virtue while the economy clears the stage for future growth by the necessary current writeoffs ** and perhaps by a government program.

 

 

* This Fed article is in mathematics. A decisionmaker with a “quadratic loss function” is happiest when results are on target, and less happy when results deviate from that.

 

** This AICPA accounting bulletin raises some interesting issues. Benjamin Graham’s Mr. Market now mandates large subprime writeoffs, having previously signaled a large investment. Could the whole subprime problem have been avoided in the first place by being somewhat rational over the long or even medium-term? The information then available to do this was not imperfect; it was almost causal.

 

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An authority on the subprime debacle recently spoke. The problem was not the general irrationality of the market, but the short-term hyper-rationality of the borrowers (who were given the money by lax lenders), the investment banks (that sold the CDO paper to earn their fee, and got caught when the music stopped), the rating agencies (that sold their AAA rating for a $600,000 fee on a transaction that closed, rather taking a $25,000 inspection fee for saying “no”), and finally hypo-rational investors who relied upon the rating agencies to rate their opaque and confusing tranches.

 

The sum total effect of this long chain was irrational market behavior in the short-term. In this chain of woe, a healthy investor skepticism would have resulted in a more rational credit market, requiring less error correction. In the long-term no one was rational – that is, considered the consequences of their actions. Borrowers got houses they couldn’t afford; the financial companies degraded their franchises; and investors lost their capital.

 

It is not possible to control risk without also considering the underlying investment fundamentals. In finance, it is possible to be too smart. The pyramids of financially engineered paper: the CDOs, CDO², CDO³, and credit swaps are now collapsing. To mix a metaphor; as the environment changes, these layered icebergs are now crashing into an opaque sea of market illiquidity. We remember seeing a television show about global warming; when the icebergs are crashing, its better to be cautious.

 

 

3/1/08 –

 

Will the recession look like a “V”, a “U”, or a “L”? This could affect a decision to increase our asset allocation to stocks. To say, for instance, that the economy will recover by midyear assumes that this recession will be mild like the ones of the recent past, and that the recovery will look like a “V”.

 

We have analyzed the consequences of a mild recession upon financial company earnings. What will be the actual recession’s duration? Its going to take a while. The recession’s causes are housing related, it is becoming widely consumer based, and the credit structures seizing up the financial markets are very complex. What began as a somewhat limited subprime mortgage problem has now become a pervasive structured finance problem *. At a G7 meeting on 2/9/08 Fed Chairman Ben Bernanke was quoted as saying that while housing prices are falling, it is not possible to determine how long and deep this crisis will be. We think that targeted measures to stabilize the housing market are necessary for the financial system, with all its complications, to recover. Government efforts should be focused directly on the housing problem. From congressional testimony on 2/14/08, we sense that the lawmakers and regulators are very concerned with this financial crisis.

 

 

* There was a fundamental credit flaw in many structured finance investments. The constituent subprime loans did not have cash flow margins of safety. Mathematics and statistics imply precision, making packages of risky loans appear as safe ones. Investors were not aware of the difference between simple statistical distributions and reality. Very good events or bad events can also happen.

 

Economics is a social science. Peter Bernstein observes that Nobel laureate economists disagree on where the border between theory and reality lies, not on the theory. In 1921, the economist Frank Knight made a crucial distinction between risk and uncertainty. Risk is when the distribution of the alternatives can be calculated a priori or specified from historical experience; uncertainty is when it can’t be, because the instances are to a high degree unique. 

 

To make decisions about events you have to know the specifics of what’s happening, rather than the operation of some statistical law. That’s why judgment and a long-term margin of safety, just in case, are good ideas.       

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This website is about the stock market, financial markets in general; and thus about human behavior. Markets are places where people come to buy or to sell based upon price. That requires information about the merchandise on sale; consider how customers inform themselves in open-air markets. The root of the word “credit” is the Latin word “credere,” to believe. Markets do not function if there is no informed belief because there are simply no buyers, as is presently happening in the credit markets. Many structured finance investments having become incredible, investors are hunkering down, guarding their capital.

 

House prices continue to decrease although the Fed has cut short-term interest rates. A problem, Professor Peter Morici of the University of Maryland points out, is that the mortgage business model is broken. Most U.S. house mortgages are privately financed, bundled into securitized packages. It is no longer possible to get these packages funded in the markets. He suggests the Fed chairman should have a good talk with the banks about the viability of the business model that created these unintelligible, complex securities.

 

 

3/22/08 –

 

We left for a trip on March 7^th , when the S&P 500 began to tumble below 1260. We returned on March 20^th, when the S&P 500 rallied to 1329. Does this volatility, full of sound and fury, signify nothing?

 

We don’t think so. The market is volatile because it is grappling with uncertainty, when the macro outcomes ordinarily assumed to be stable, cannot be clearly known *. This steadily morphing credit crisis began last August, imperiling overleveraged financial institutions and creditworthy borrowers alike, the exchange rate of the dollar, and ultimately the real economy. In a 3/13/08 Financial Times article, Mohamed El-Erian, PIMCO’s co-chief investment officer, writes that the stock market and the credit markets will have to converge, and “the longer the delay in strengthening the (housing) policy response, the greater the likelihood that such convergence will involve share prices falling to levels implied by the debacle in credit markets.” This means that there is only so much time for government to act.

 

The problem facing both the credit and stock markets is falling house prices, that continues to erode the pyramid of financial paper that derives its value, in some form, from housing. All economic downturns have their differences. Since the 1930s, previous financial crises have been localized and localizable, limited to the failure or bailout of financial companies that became overextended and to the S&L industry. This downturn is unfortunately characterized by its pervasiveness, the result of large-scale lending without considering the ability and willingness of borrowers to repay their loans and a lack of external regulation, a major downside of world-wide market securitization. As house prices continue to fall, the financial system will continue to experience recurrent crises until the government steps in to enable the orderly writedown of roughly $2 trillion in subprime and Alt-A mortgages and the housing stock. Housing prices and mortgage debt service must ultimately fall to levels sustainable by consumer income.

 

Our next article will discuss how current stresses reveal the nature of markets.

 

 

* We speak, for convenience, about “the market.” It is usually more useful in financial analysis to ask what people are actually doing. A 3/25/08 NYT article states well what is actually happening. “The violent  (market) swings indicate that traders are seizing on daily events to jump in – or out – of the market, grasping at clues about where the economy is heading. A result is a jittery, bewildered pack of investors (actually traders, who act with and at the margin) whose mood can quickly swivel between fear and optimism.”  

 

 

4/1/08 –

 

A present S&P 500 level of 1370 assumes only an inconsequential economic slowdown, with expected capacity utilization remaining around 82%. We think the stock market does not reflect worsening economic conditions due to bank lending problems. Iraq also doesn’t help.

 

There seems to be a convention when anticipating a change for the better, just wait six months. Recall the serial predictions by foreign policy makers about an improvement in Iraq, in six months. Consider now the current wisdom that the economy will begin to recover in six months after the beginning of the slowdown in January. There is a gaping logical disconnect between assuming that less than half of the bad loans have so far been written off (according to one Street estimate, the total writeoffs by the U.S. leveraged financial institutions will be at least $460 billion), and then assuming a rapid cyclical economic recovery. A greater economic slowdown would compromise more consumer credit than residential mortgages.

 

Both the problem in Iraq and in the financial markets have become very large and complex. Their solutions require much more than ideological simplicities and finger pointing. An opinion already exists on Wall Street (on the buy side) that the investment banks have to be subject to real regulation if they are to be given any access to the Fed’s discount window. A 4/1/08 FT article indicates that global policy makers remain very worried about the condition of the financial system and are thinking about temporarily suspending capital requirements and in “assisting financial institutions in remaining as going concerns.”

 

At a minimum, this means that the financial companies will have to be more careful about the merchandise they sell *, as ought to be and is generally true in business.

 

 

* A major question is how to value those subprime structured mortgage concoctions.

 

Consider a simple bank loan with a cash flow margin of safety. The value of this loan can be calculated relatively simply by discounting the present value of future contracted cash flows, to be paid as agreed. Now add a simple structured finance complication. Slice that investment into tranches, the first tranche has a cash flow and collateral priority. Within the finance structure, its like debt and should have a higher credit rating than the following tranches. Does it ever warrant a AAA credit rating like some of the subprime mortgage tranches? It doesn’t because the credit rating of the highest tranche should be the credit rating of the loan. Since a defaulting loan almost inevitably results in a very large writeoff, not to put too fine a point on this, the subordinate claims will have almost no value.

 

Does “diversifying” the portfolio help matters, packaging many borrowers into the financial structure? It could, but only if the loan outcomes of all borrowers are truly independent. If subprime loan performances depend on a single factor like the state of the economy, then all those loans can be regarded as a single mistructured loan whose performance depends on the state of the economy. Taking the example we discussed on 3/1/08, 94.3% of all tranches are rated AAA; only 5.7% of all tranches are rated below that. To draw an analogy, this structured transaction does not contain enough “equity.” What is a senior tranche worth?

 

The current market apparently assumes worse. The AAA tranches of the notorious 2006-2007 vintage of subprime CDOs trade on average around 68 cents on the dollar. More generally, current Street estimates of total subprime real estate loan losses run around $230 billion, with about 80 cents on the dollar remaining. However, from our 1/1/08 analysis, this implicitly assumes residential real estate prices do not deteriorate much further from current levels.

 

Since house prices continue to deteriorate badly, there is a role for government to enable an orderly writedown of prices to levels where borrower income can support restructured mortgages. That’s the core of the credit problem . A lot more is at stake than the doctrinaire quibble that the government shouldn’t help irresponsible borrowers.

 

 

4/11/08 –

 

GE just reported its first quarter earnings; the S&P 500 dropped by 2%. The company is a bellwether of the U.S. economy. In comparison with the previous year’s first quarter, the operating profits of the company’s infrastructure business (that sells exportable capital equipment to the utilities, transportation, oil & gas industries) increased by 17%. GE’s finance businesses decreased by 19%. The company’s industrial business (such as appliances) decreased 16%.  Overall, the company’s operating profits decreased by 4.2% from the previous year. The U.S. economy, accounting for around 25% of the world’s GDP, is slowing down.

 

We think the present economic environment justifies an extreme degree of caution. A 4/08 IMF Global Financial Stability Report writes that their analyses, “point to a degradation of financial stability, with credit and macroeconomic risks having deteriorated the most.” They analyze the impact of restricted credit upon the U.S. macroeconomy: In the postwar period, credit has grown on average by around 9% of private sector debt per year. What if, due to the financial shock of lender writeoffs, annual credit growth were reduced to 4% and 1%, respectively? The slowing of credit growth to 1% is comparable to that experienced during the comparatively severe 1990-1991 recession.

 

Using an econometric model that includes real GDP growth, inflation, private sector borrowing, and interest rates between the first quarter of 1952 and the third quarter of 2007, and assuming no other shocks to the system, the analysis shows that in either case, the effect of credit stringency will continue to dampen growth well into 2009. We consider this a base case. The analysis, however, also lists the following other factors:

 

1)       Unusually aggressive monetary policy easing by the Fed. (It’s doing only some good.)

2)       The impact of slowing credit growth upon the European economies.

3)       The securitization of questionable financial assets at the heart of the banking system, causing many system complications.

4)       We add: further large loan losses that are comparable to those of the Japanese banking crisis of (1990-1999).