October 22, 2008

Throughout October, government, financial and economic leaders from around the world have worked relentlessly to create and implement a comprehensive plan that will help return stability both to the U.S. and global financial systems. Thomas Dillman, Executive Vice President of Mutual of America Capital Management Corporation, provides an in-depth look at the ongoing economic crisis, the immediate and future impact of these measures, and how Mutual of America has fared during these turbulent times.

Treasury Acts, Banks Freeze

Since our last report a few weeks ago, the financial crisis that began in the early summer of 2007 came to a head on October 10 with the announcement by the U.S. Treasury of a plan to invest $250 billion directly into U.S. banks in exchange for preferred stock in those banks. Half of that money was earmarked for the nine largest domestic banks: Bank of America, Bank of New York Mellon, Citigroup, Goldman Sachs, JPMorgan Chase, Merrill Lynch, Morgan Stanley, State Street Bank, and Wells Fargo. Terms of the investment included a 5% dividend payment (increasing to 9% after five years), as well as restrictions on dividend payouts on common and non-government preferred stock, and on executive compensation. While the program was billed as voluntary, it was a deal none of the banks could really refuse.

In addition, the Treasury authorized the FDIC to provide unlimited guarantees for all newly issued senior unsecured debt issued by domestic banks and bank holding companies on or before June 30, 2009. This included promissory notes, commercial paper, inter-bank funding, and any unsecured portion of secured debt as well as non-interest bearing bank deposits.

The purpose of these efforts was to unfreeze the credit markets, which had become paralyzed immediately following the bankruptcy announcement of Lehman Brothers on September 15th. Despite the provision of huge amounts of liquidity by the Federal Reserve and other central banks around the world, banks hoarded cash and refused to lend. The commercial paper market, essential to maintaining the daily operations of corporations by providing funding for payrolls and inventories, began to shrink precipitously as short-term paper matured and could not be refinanced. Corporate bond issuance narrowed to a trickle and even currency markets witnessed a dramatic reduction on volumes. Without active sources of funding, the global economy was on the verge of a freefall into depression.

The Lehman failure had confronted lenders with the specter of a potential cascade of defaults among existing borrowers, while the weakening economy raised the probabilities that new loans would not be paid back. The entire global financial and economic system seemed on the verge of collapse.

Global Action—Uncertain Outcome

The funding for the Treasury's plan comes from the Emergency Economic Stabilization Act passed by Congress on October 3. The centerpiece of that legislation was the so-called "Troubled Asset Relief Program" (TARP), whereby the Treasury would purchase "troubled assets" directly from financial institutions. The idea of direct investment in financial institutions had previously been discussed but was rejected as an overly invasive involvement by government in the market economy. However, events during the week following the passage of the bill quickly made it evident that the U.S. plan was insufficient to address the crisis at hand within a reasonable timeframe.

First, a number of emergency bank rescues were hastily arranged in Europe. Simultaneously, the European Central Bank (ECB) announced a full guarantee of all bank deposits within the Euro banking system. Then central banks around the world, including the U.S. Federal Reserve, the ECB, and the Bank of England implemented a coordinated reduction in base lending rates by ½ percent. At the same time, the United Kingdom announced a £50 billion bank bailout plan.

Despite these actions the Dow Jones Industrial Average fell 2,030 points, or 19.3%, from October 3 through October 10. Ironically, the Dow's all-time high, which marked the start of the current bear market, occurred almost exactly one year before, on October 9, 2007, at a price of 14,164. Since then, it has declined more than 40%.

It was over the weekend of October 11 and 12 that the U.S. bank recapitalization plan finally took shape. On Saturday, leaders of the G7—finance ministers from seven industrialized nations, including the U.S.—and other international leaders, met in Washington, D.C. to discuss the global financial crisis. Their final statement was short on details but pledged a coordinated solution using all available resources. The following day a formal meeting of the European Union, organized and led by French President Nicolas Sarkozy, forged a European agreement to implement national bank recapitalization programs based on the U.K. example. The U.S. plan was being readied for release on Monday, October 13.

The bank recapitalization initiative, which is being carried under the TARP authorities, relegates the initial plan to directly purchase troubled assets from eligible financial institutions to a secondary role, because the freeze in credit markets required a more immediate and direct response. The direct investment route, coupled with the deposit and loan guarantees, provides this. However, its success is by no means assured, as the plan begs more questions than it answers, and probably includes a variety of "unintended consequences" that are currently unknown.

More Questions than Answers

The key issue is: Will it work? No one really knows for sure, but in our judgment there is a good chance it will ultimately stabilize the global financial system. This will take time. Trust has been severely damaged. Indeed, some cynics have declared our free market economy dead, given that it is almost totally on government life support on a global basis.

Assurances have been given that government involvement will be temporary. However, once governments get involved, they tend to stay involved. There is no doubt that whatever system evolves will be highly regulated. When regulatory mechanisms are established, they are very hard to take apart. And the almost universal public anger over the financial implosion means that the Wall Street of the immediate and, probably, long-term future will be a shadow of its former itself.

Which begs the question: Can the bank recapitalization eventually lead us back to a capitalist economy? Hank Paulson, Secretary of the U.S. Treasury, has essentially ordered the banks to begin lending. What if they refuse? And what's their motivation to obey? The point is it is difficult to see how the spark of incentive will be reignited, at least within the finance industry. After all, it has been the finance industry that has driven the economic growth and stock bull market of the past twenty to twenty-five years.

It is ironic that the fateful decision to let Lehman Brothers slide into bankruptcy was driven by the perceived need to take a stand against "moral hazard"—the notion that, if governments remove the threat of failure, financial institutions will take on undue risks that may become systemic. For moral hazard to work, risk takers must suffer the consequences of their incorrect bets. But Lehman's bankruptcy set in motion a series of events that ultimately required the elimination of moral hazard through the nationalization of the global banking system.

Ben Bernanke, Chairman of the U.S. Federal Reserve, stated the issue differently when he recently noted that the U.S. financial system has "a too-big-to-fail problem." Restoring a free market will require restoring moral hazard. That will require the restoration of confidence in the credit system. And both will take time—probably years, not months.

Bracing for a Global Slowdown

It is clear that stabilizing the financial crisis will not prevent recession. In fact, the U.S. and Europe, and probably Japan, are almost surely in recession already, and will likely remain so for at least the next few quarters, especially if lending remains weak. The U.S. housing recession continues, with foreclosures rising, housing prices falling, and waves of adjustable-rate mortgages ready to reset at much higher interest rates over the next six to nine months. In addition, auto companies have stopped leasing, auto dealers are beginning to go bankrupt, retail sales have gone negative, and unemployment is rising.

Meanwhile China, the most important among the developing economies, will likely avoid recession, but its growth is already on track to slow from the 10–12% range achieved over the past five years to 8–9%. While still robust, such a slowdown will feel like a recession within China, as expectations raised by recent economic success will not be able to be funded at even those high levels of growth. And with most of the rest of the world in recession, risks to China remain to the downside.

Under such circumstances, equity markets are unlikely to perform well. Uncertainty regarding earnings is rising, but estimates are falling quickly, and final results in the quarters ahead will almost assuredly be lower than current expectations. Moreover, growth prospects over the longer term are likely to prove anemic given the deleveraging that has occurred and the constraints that new regulations will have on economic activity.

Thus, the outlook for stock returns is not promising for at least the next few quarters. That said, markets have discounted a lot of these negatives, and the stocks of some very good companies are trading at what may prove to be exceptional prices for patient long-term investors.

One outcome of this crisis might be to lengthen investment time horizons and slow the frenetic trading pace created by the hedge fund world over the past decade. Another is the likely shrinkage of that world over the next couple of years.

Navigating the Storm

Like other similar investments, the mutual funds in which the Mutual of America Separate Accounts are invested have experienced losses this year because they invest in the equity and bond markets. However, these funds are carefully screened and constantly monitored.

Throughout this turmoil, our General Account has remained strong. The portfolio has never invested in sub-prime mortgages, credit default swaps, and other exotic financial instruments, which have had such strong adverse affects on other financial institutions. Moreover, the Company remains financially sound, with nearly 900 million dollars in surplus—representing one of the highest surplus ratios in the industry, at around 14%.

In addition, the ratings that Mutual of America receives from the major independent rating agencies continue to confirm the Company's financial strength, placing us among the strongest of all life insurance companies in the United States. In September, even as the economic crisis reached a boiling point, Standard & Poor's affirmed our AA- (Very Strong) rating. Plus, A.M. Best and Fitch currently rate the Company as A+ (Superior) and AA- (Very Strong), respectively.

While the ratings provided by these agencies do not apply to the safety or investment performance of the Separate Account investment alternatives available under our products, the ratings do reflect Mutual of America's ability to fulfill its obligations, including as to amounts placed in the Interest Accumulation Account, annuity payouts, and life insurance and disability income payments.

Ultimately, Mutual of America's long-standing, prudent and conservative management policies, consistently implemented over the years, continue to serve the Company's customers well, especially during this turbulent market environment.

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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