The
Economic and Market Perspective
Stock markets around the globe are down
substantially on a year-to-date basis, and even more since
2007 peaks. In the United States, the large cap Dow Jones
Industrials and S&P 500® Index are each down between
5-10% this year, while the technology-heavy NASDAQ and Russell
2000® are down in the low to mid-teens range. Most European
markets are also down in the low- to mid-teens range while
most emerging markets are down 20% or more.
Credit markets are in even more disarray
as the relative value of credit products reflects significantly
heightened risk aversion. Even more importantly, the extension
of new credit has almost dried up except for the most worthy
borrowers.
Credit
"Crunch" and Sub-Prime Mortgages
The cause of all this market turmoil is a
credit crunch that started with a peaking of the housing boom
in late 2005, followed by rising delinquencies and defaults
among sub-prime mortgages at the end of 2006 and beginning
of 2007.
In the first quarter of 2007, the U.S.-based
unit of the U.K.-domiciled international bank HSBC announced
an $11 billion write-off of sub-prime mortgages and dramatically
scaled back its U.S. mortgage business. Over the next several
months, a number of the smaller mortgage originators declared
bankruptcy as declining home sales and prices reduced volumes
while concerns over the value of sub-prime mortgages previously
packaged and sold to investors came under question and undermined
further such "securitizations." Then, in June of
2007, two Bear Stearns hedge funds that specialized in sub-prime
mortgages went bust when Merrill Lynch called in loans that
had been used by the funds to leverage their investments.
Bear Stearns was forced to dip into their capital to the tune
of $3.0 billion to make the funds' investors whole.
Fast-forward nine months: Bear Stearns is
on the verge of ceasing to exist as an independent firm after
85 years in business, as J.P. Morgan Chase, with the assist
and blessing of the Federal Reserve and U.S. Treasury, offers
$2 per share for the firm. Bear Stearns' stock price at its
peak in early 2007 was $170 per share, and just prior to the
collapse of its hedge funds was $150 per share.
What
Happened to Bear Stearns
How did this happen? In effect, what happened
to Bear Stearns, the company, was essentially the same thing
that had happened to its two hedge funds. In fact, Bear Stearns
as a firm was effectively a hedge fund: The value of its obligations
was over 30 times the amount of its capital. As Bear Stearns'
creditors became concerned about the true value of the assets
backing its obligations, they began to call in their loans.
However, Bear Stearns did not have the liquid assets to pay
back all the loans, and when they turned to other liquidity
providers in the market, there was no one there, except, in
the end, the Federal Reserve, the lender of last resort.
The Federal Reserve's first response was
to extend credit to support $30 billion of Bear Stearns' riskiest
assets through J. P. Morgan Chase. The idea was to keep Bear
Stearns afloat as a going concern, but to transfer the risk
off the broker's balance sheet onto the government's, while
J.P. Morgan Chase would provide the actual loan with a government
guarantee. The news of the Fed's involvement in the attempt
to prop up Bear Stearns broke on Friday, March 14, 2008. But
over the ensuing weekend, the Federal Reserve and the U.S.
Treasury department came to the conclusion that such a plan
would not go far enough to quell the panic that seemed to
be roiling the credit markets. Invitations for bids were largely
declined, partly because of the time pressure to complete
the outlines of an agreement before the Asian markets opened
late Sunday U.S. time, and partly because of the risks involved
because of the open-ended question regarding the true value
of Bear Stearns' assets. J.P. Morgan Chase was in the best
position to assess the risks and do a deal quickly because
they had already been doing due diligence on Bear Stearns'
prime brokerage business, and, as a result, had been the Fed's
choice as the initial plan's credit conduit. The choice for
Bear Stearns was stark: sell the entire firm for $2 per share,
the only offer on the table, and one supported by the government,
or declare bankruptcy.
The drama of Bear Stearns will continue to
unfold. Shareholders, many of whom are Bear Stearns employees,
will have to approve the deal, and some have already launched
efforts to find an alternative and better offer, as well as
to initiate class action lawsuits against what appears to
them a "shotgun wedding." However, the key issue
for markets and the financial system is what this episode
portends for the future.
But first, a little perspective regarding
events between these two Bear Stearns episodes. As suggested
previously, stock markets have witnessed increased volatility
and across-the-board declines; bonds other than U.S. Treasury
securities have declined, pushing credit spreads back toward
their highs during the recession of 2001-2003; and credit
markets have all but closed down. The Initial Public Offering
(IPO) and Leveraged Buyout (LBO) markets have similarly become
moribund.
Economic
Considerations
On the economic front, most indicators suggest
a tremendous slowdown in growth, and in all probability, a
U.S. recession beginning in the first quarter of 2008. Consumer
confidence has plummeted and consumer spending has slowed
substantially in the face of declining house prices, as well
as high and still rising energy prices. Employment growth
has slowed and actually declined in the most recent monthly
report, while the unemployment rate has risen from a low of
4.4% to 4.8%. Given that consumer spending represents two-thirds
of the U.S. economy, not even the facts that: (1) capital
spending remains firm, although not robust, (2) exports are
accelerating with the assist of a weakening dollar, and (3)
government spending remains positive, have been sufficient
to convince most observers that a recession is unavoidable
at this point.
The key issue is how deep and how long such
a recession will last. The answer depends upon several interrelated
contingencies: (1) When will the housing recession bottom?,
(2) When will impaired assets on the books of banks and institutional
investors around the globe be able to be properly valued,
and then traded?, (3) When will credit markets begin to extend
credit again?, and (4) How will the consequences of the credit
crunch and ensuing U. S. recession (including their effects
on growth in the developing economies, and a historically
weak and declining U. S. dollar) affect the ability of these
problems to be resolved?
Pulling
Out All Stops to Mitigate the Crisis
It is humbling to realize that, despite
the fact that the responses to the problems witnessed over
the past nine months have been unprecedented, their resolution
remains questionable. To recount: (1)The Federal Reserve has
lowered the Fed Funds rate by 300 basis points in successively
larger increments; along with other central banks around the
globe, (2) the Federal Reserve has injected hundreds of billions
of dollars of liquidity into the financial system during that
timeframe; the Federal Reserve has also established (3) a
variety of credit facilities for the U.S. banking system,
and creatively, a similar credit facility for brokers most
recently in conjunction with the Bear Stearns bailout; (4)
Congress passed a bipartisan $152 billion fiscal stimulus
program in a few short weeks which will be injecting cash
into U. S. consumers' hands very soon; (5) the U.S. Treasury
department has promoted, and Congress has approved, an expansion
through the Federal Housing Authority (FHA) of mortgage lending
to homeowners under stress, while both, along with the publicly
stated support of Ben Bernanke, the Chairman of the Federal
Reserve, are working on more aggressive plans to help homeowners
likely to default on their mortgages stay in their homes;
(6) and Congress and the key regulator of Fannie Mae and Freddie
Mac, the government-sponsored mortgage lending agencies, have
reduced the capital constraints and encouraged the raising
of additional capital by these two organizations to enable
them to purchase more distressed mortgages in order to help
bring the housing recession to an end.
It is becoming clear to economists and market
strategists that, in the end, the taxpayer will in one way
or another be asked to take some of the pain of the deflation
in the value of mortgages originated during the housing boom.
Key members of Congress are currently advancing plans that
would, in essence, lead to at least a partial government bailout
despite the Administration's reluctance to move in that direction
up until just recently.
The point is that the best and the brightest
among our regulatory, administrative and legislative leaders
are clearly pulling out all stops to address the problems
and bring this crisis to a close. The fact that such dynamic
and creative responses have not yet restored confidence to
financial market participants, or stability to the credit
system or financial markets, is disconcerting and worrisome.
But the history of market crises makes clear in hindsight
the validity of the old adage: “It is always darkest before
the dawn.” History would also confirm that bottoms in markets
during such crises are often marked by the demise of a major
financial institution, as strongly suggested by the accompanying
chart. Skeptics would perhaps argue that Bear Stearns is not
a major financial institution, and that there are bigger casualties
to come; or that it is different this time around given the
leverage involved, the depth of the crisis, the exacerbation
of the situation created by a declining dollar, and escalating
inflation. And they may be correct.
Source: Strategas
But it is our judgment that the situation
is nearing some form of stabilization. The worst of the news
is likely behind us, although the piper will still have to
be paid by a variety of parties. If we are correct, we should
see a gradual recovery in economic growth, and probably an
accompanying rally in stocks. That said, the road ahead remains
more uncertain than usual and will likely provide a bumpy
ride over the next couple of quarters.
We have seen many other periods of tumult,
uncertainty and change. Ultimately, money management is done
one security at a time. There are always moneymaking ideas
regardless of the environment investors face. Moreover, excellent
money management incorporates an assessment of risk in any
investment decision-making process. As noted elsewhere in
this publication, Mutual of America Capital Management Corporation
employs an investment process that attempts to balance the
opportunities and risks in security selection and portfolio
construction in such a way that performance outdistances benchmarks
(even in down markets) and inflation over complete market
cycles. We believe our approach to money management positions
us very well to meet the challenges ahead.
The
views expressed in this article are subject to change at any
time based on market and other conditions, and should not
be construed as a recommendation. This article contains forward-looking
statements, which speak only as of the date they were made
and involve risks and uncertainties that could cause actual
results to differ materially from those expressed herein.
Readers are cautioned not to rely on our forward-looking statements. |
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