October 2008

On October 3, 2008, President Bush signed into law the Emergency Economic Stabilization Act of 2008, an unprecedented $700 billion economic bailout plan for the financial system. Thomas Dillman, Executive Vice President of Mutual of America Capital Management Corporation, takes an inside look at the tumultuous events that led to this historic bill and what it means for the U.S. economy and Americans in the near future.

An Unparalleled Mess

The third quarter of 2008, and especially the month of September 2008, is likely to go down as one of the most memorable, and frightening, chapters in financial market history. Over the course of 30 days, the American public watched in shock as:

• The U.S. Treasury took control of Fannie Mae and Freddie Mac, as well as AIG;
• Lehman Brothers declared bankruptcy;
• Merrill Lynch sold itself to Bank of America;
• JPMorgan Chase bought Washington Mutual's assets and deposits;
• Citigroup and Wells Fargo engaged in government-brokered negotiations to purchase Wachovia;
• Goldman Sachs and Morgan Stanley applied to become commercial banks, foregoing their independence from Federal Reserve oversight;
• The House of Representatives rejected the U.S. Treasury's $700 billion plan to rescue the financial markets.

Today, stock and bond markets around the world continue to be roiled, while credit markets, which provide funding for the day-to-day operations of businesses, have essentially ground to a halt. The ongoing financial market crisis, which began a little over a year ago with the meltdown in the subprime mortgage market, has evolved since then into a credit crunch.

Furthermore, in spite of the approved bailout plan, the failure of policy makers to agree sooner to an effective solution continues to threaten the solvency of some of the largest financial institutions in this country and abroad, while significantly raising the probability that the global economy will slide into recession, if it has not already done so.

Prelude to A Crisis

One need only look to the subprime crisis that began in 2007 as a launch point for the most recent turmoil. The subprime crisis was the result, in part, of the burst of the housing bubble that had been spawned by very low interest rates engineered by the Federal Reserve in response to the recession following the burst of the tech bubble of 2000 and the events surrounding 9/11.

Low mortgage rates encouraged borrowing to purchase houses, which, in turn, pushed up house prices. This created wealth in the form of home equity that people were encouraged to borrow against to make purchases, or buy larger, more expensive houses.

Securitization (the process of pooling and repackaging cash-flow-producing financial assets into securities) permitted banks and mortgage brokers to generate more mortgages to earn handsome fees. These mortgages were then packaged and sold to investors so the banks and brokers could generate even more fee-earning mortgages.

Of particular importance to today's crisis was a lowering of lending standards and, as a result, a dramatic decline in the credit quality of borrowers. New borrowers were induced by low "teaser rates" that would reset at higher rates in the future, and were given loans in amounts nearly equal to the full purchase price of the houses they were to purchase.

This vicious circle continued to prove lucrative until there were too many houses available relative to demand and prices began to decline. As sales of houses declined so did housing prices, which led delinquency rates, and eventually foreclosure rates, to escalate. That process continues to this day.

In the meantime, most of the mortgages that had been generated in this frenzy were tucked away in securitized products that were sold to investors all over the world. Inevitably, the value of the mortgages in these securities began to decline.

In June 2007, Merrill Lynch asked Bear Stearns to increase the collateral backing the subprime bonds held in one of Bear's mutual funds, based on Merrill's belief that the value of the portfolio had declined substantially. We believe that event sparked the current crisis.

Unbalanced Balance Sheets

Like all such crises, we are living through a period of asset deflation. During the past year, policy makers have taken aggressive steps to keep the economy and financial system functioning. Each successive action has been more dramatic than the last, including:

• A series of Federal Reserve Fed Funds and Discount Rate cuts;
• The passage of a bipartisan Congressional Economic Stimulus package;
• The forced sale of Bear Stearns to JPMorgan Chase; and
• Congressional authorization for the Treasury to inject capital into Fannie Mae and Freddie Mac.

While the policy makers provided a cushion, banks, brokers, and other holders of assets have been taking writedowns and attempting to raise capital. Essentially, writedowns reduce the book value of an asset because it is overvalued compared to the market value. So far, total writedowns exceed $550 billion and capital raising has netted about $400 billion, but both efforts have slowed significantly over the past few months.

These efforts have slowed because there remain a lot more writedowns to go, and the institutions with the capital have become unwilling to make it available to those who need it. The implication is that there are a lot of institutions that may have liabilities greater than the value of their assets.

As a result, U.S. policy makers stepped in—first with ad hoc measures, and more recently, with the more comprehensive and reworked bill to provide a safety net, and enough liquidity to provide time for asset devaluation to occur in a measured way rather than in a panic.

The rescue bill is aimed at taking these bad assets off the books of financial institutions, and holding them for resale at some time in the future when calmer heads, and more rational prices, will prevail. The immediate goal is to restore confidence in the financial system in order to get banks back to the business of lending to consumers and businesses, and thus fueling economic growth.

Presently, as noted above, the system is rapidly coming to a virtual standstill. Even though the bailout bill has been signed into law, the longer it takes to address these problem assets, the greater the risk to the global financial system and the global economy.

Facing the "R" Word

Over the past three months, and even before the current credit crunch, the pendulum had already swung sharply away from the view that inflation was a greater worry than growth to the global economy. In essence, markets had begun to embrace the notion that the world, not just the United States, might be sliding into a recession.

During the second quarter of the year, in response to accelerating prices for oil, metals and foods, and the consequent slide in the strength of their currencies, many central banks—most notably those in India, China and Brazil—began aggressive programs of monetary tightening, generally in the form of interest rate hikes.

Despite the fact that reported inflation statistics remained high, the economic fundamentals were pointing to slowdown, or recession. One fundamental factor supporting the notion that inflation is unlikely to spiral out of control is the continued stagnation in wage gains, buttressed by rising unemployment in the U.S.

During the last month the economic data has shown rapid deterioration. New home sales in August plummeted 11.5%, personal consumption came in at 1.2% for the second quarter (a much weaker reading than the expected 1.7%), and the August report on personal spending came in at 0%. These numbers imply a substantial decline in consumer spending for the third quarter, which is worrisome given that the consumer represents two-thirds of economic activity.

Compounding this problem has been the recent data suggesting that the manufacturing sector is also beginning to roll over after having been one of the only components of the economy showing any growth. For example, auto sales declined 27% during September versus the same month a year ago.

We believe it is fairly clear from these data that the U.S. is either already in a recession, or quickly sliding into one. Similar indications suggest the same for Japan and Europe, and even China seems to be slowing more than observers had expected only weeks ago. Stock markets around the world have been telegraphing that expectation for most of the current year.

A Cautious Look Ahead

Few could have forecast the events of the past few weeks. But the markets have actually been driving policy makers and the managements of financial companies toward these kinds of steps for the past year.

Stock prices of financial companies have recently been under assault because more and more investors believe that those companies have not fully disclosed the true value of their assets. Indeed, Lehman Brothers is bankrupt because its assets were less than its liabilities, and that's what markets have been sniffing out across the spectrum of financial firms over the past six months.

As suggested already, Lehman Brothers is not the only financial entity in that situation. The implication is that markets will continue to be under pressure until assets get written down to their appropriate level, and other excesses get unwound. The rescue plan is largely designed to accommodate this goal over time.

In such an environment, asset prices may get pushed well below their true value. Some of the recent market action looks like a classic "capitulation," a last panic effort to get out of stocks and bonds when all the bad news has already been revealed. The good news for the economy is that there is lots of cash waiting to purchase attractive assets, including $3.5 trillion in money market funds and probably more than that in sovereign wealth funds.

We're not predicting a turnaround tomorrow. There's still a lot of bad news to be acknowledged, even though it might already be partly discounted in stock prices. Even though Congress passed and President Bush signed the rescue bill, it will take time to purchase the toxic assets, and even more time before a market for their resale can be established. The addition to the originally proposed plan to expand deposit insurance from $100,000 to $250,000, and the inclusion of robust oversight of the process to insure that taxpayer dollars are not wasted, may provide further solace. But success hinges on the central feature of the bill, the purchase of toxic assets by the federal government.

In the meantime, investor confidence in markets has clearly been severely damaged. Restoring confidence in the system will also take a long time. Furthermore, the financial crisis is exacerbating an already struggling domestic and global economy. We estimate that stocks will remain very volatile, with a downside bias, but will move toward some stabilization over the next 3 to 6 months.

Key to that outlook was passage of the U.S. Treasury's financial rescue plan and its relatively quick implementation. Even with that, it will take time before financial markets begin to function with anything close to normalcy. It will also take time for the economy to stabilize and begin to grow again. It is true that markets tend to anticipate recovery well before it happens.

In our judgment, the economic, profit and credit news will likely remain on the negative side for at least the next couple of months, providing little clarity for the market to make a sustainable advance.

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.