A Saga for the Ages
September 15, 2008
I say with confidence 30 years from now the events of the past 48 hours will be remembered with as much clarity as the JFK assassination, the explosion of the Space Shuttle Challenger, Black Monday and the events of 9/11. As Hurricane Ike pounded the Texas coast, a category five hurricane blasted Wall Street and the fallout is now unfolding.
Over the past 15 months, as the collapse in sub-prime mortgages exposed the significant leverage associated with those loans, we have seen the U.S. Federal Reserve step in time and time again to “bailout” market participants on the grounds of the collateral damage a failure of significant magnitude would extract on the financial markets overall and Main Street in particular. At some point, this approach would reach its maximum potential. That moment arrived this weekend with Lehman Brothers filing for Chapter 11 bankruptcy protection and Merrill Lynch being acquired by Bank of America.
Although my heart goes out to the thousands of rank and file employees of both firms who had little ability to make a difference this unfortunate end had to occur.
This week marks the 10th anniversary of the collapse of large private hedge fund Long-Term Capital Management and the eleventh hour bailout orchestrated by the Federal Reserve under then Chairman Alan Greenspan. While risk taking has always been part of the Wall Street culture, this event may have ushered in a new chapter in this endeavor. Over the past decade the proliferation of derivative and structured financial instruments has been unprecedented. With perfect hindsight the events of September 1998 may have lead to a moral hazard. As a result, we are witnessing today a historic breakdown in underlying credit confidence. The inter-related nature of counter-party credit exposure means that problems at one institution spread quickly to others and leads to a freeze in activities needed to provide daily liquidity for these institutions. The complexity of this activity is beyond the scope of this commentary, however all that needs to be understood is that the leverage in the system became unsustainable and is now being eliminated.
Why did these events need to occur? Using Japan as an example, propping up problem loans in perpetuity clogs the system and reduces available credit for qualified borrowers and worthwhile financial investment. For many years and to a lesser extent even to this day Japanese banks were under strain and that has held their domestic economy at growth rates far below potential. The United States is an economy driven by hundreds of thousands of small private businesses. For many of these businesses, access to the public capital markets is cost prohibitive. Therefore, they rely on their bank relationships for needed credit for a variety of purposes. In addition, these small businesses create the vast majority of new jobs in this country a critical need for maintaining a healthy economy. The sooner the problems can be extracted from the market and their losses absorbed the sooner a platform for sustainable growth can emerge. I’m not here to tell you everything is now in good shape – this is clearly not the case. However, continuing to prop up businesses that are no longer viable will only prolong the process and lead to stagnation for an extended and unnecessary period of time. We view that facing up to financial and economic ills is in fact a positive.
The past 13 months have been incredibly tumultuous for the world’s credit and equity markets. Diversification has to some extent softened the declines in portfolio values but has not saved the day. Over the past few weeks the deceleration in global economic growth forecasts have also forced foreign stocks lower and taken demand out of the commodities market. To some extent, this pullback may give the Federal Reserve more flexibility in crafting monetary policy in months ahead but at present there is no indication they will be stepping in to lower interest rates.
As is well understood at this point the first domino to fall was sub-prime mortgages. As such, restoring stability in the housing market is the crucial development for our economy. Unfortunately, this is not something that can be mandated and may take some time. Against a backdrop of rising unemployment and constrained credit there are serious headwinds that must be overcome. That said, mortgage rates have now dropped below 6% nationwide and could go lower now that the risks of Fannie Mae and Freddie Mac are defined. Although the housing market cannot improve until the excess supply of homes is back in equilibrium with demand, lower mortgage rates combined with the double digit declines that have already occurred in housing prices in major metropolitan areas could bring some demand back into the market (or at least stop the declines in home prices) and give banks an opportunity to rebuild their capital bases. How long it will take for this to have a positive material effect on the economy and financial markets is largely unknown.
In the weeks and months ahead we have a great deal of work ahead of us. The next few days may be rough as the markets digest the unwinding of some of Lehman Brothers positions. The next several months will undoubtedly contain more negative surprises. As we have said before, we must do what is necessary to avoid emotional decision over-reacting to the news of the day. Many of the world’s economic sectors are holding their own (outside of financial companies). Although revenue and earnings growth will come down on slower underlying economic activity at current price levels compelling total return potential exists over the next 3-5 years.
As you may know, we have worked to become more defensive in our equity positions over the past 12-15 months. For those clients in the asset accumulation phase or for the long-term growth portions of portfolios, our immediate focus will be on adjusting portfolio holdings and allocation strategies to position assets to benefit from the eventual recovery and do whatever is possible to take advantage of tax-loss harvesting in 2008. For the capital preservation portion of portfolios, we have already taken steps to provide stability of principal and to ensure that funds are available for cash flow needs for the near-term.
When it is all said and done, my biggest concern is over-regulation which will constrain recovery potential and hasten a march toward centralized government. Neither blind faith in free markets nor trust in centralized government works absent moral and ethical behavior. This may be the fundamental principle that has failed us.
Jack E. Payne, CFA
Chief Investment Officer