Market Comment Q1 2009

Without Precedent

If a novelist wrote the story of the past two years as fiction, he or she would have been hard pressed to find a publisher for such an outlandish tale. The economist Hernando de Soto (not the conquistador) wrote in The Wall Street Journal on March 25 that total outstanding subprime mortgages are about $1 trillion, and about 7% of those are in default. The chain of events triggered by problems originating in this paper has led to paper losses of $50 trillion worldwide. For all of us as consumers,some solace lies in the fact that the price of oil fell more than any other asset.

Television and print media devoted to business have grown very tiresome as they endlessly regurgitate the reasons for the bursting of the housing bubble, the collapse of major commercial and investment banks, and the concomitant stock market decline. Since the end of 2007 we ourselves have published five market bulletins for our clients on these subjects in addition to these quarterly Market Comments. At the risk of becoming tiresome ourselves we think it might be useful to offer some added interpretation of the continuing series of unfortunate events before we make any predictions.

Three legs down. We first commented on the slowing housing market and the subprime loan issue in these pages two years ago. There was a small stock market downturn in Spring, 2007, when markets focused on this problem, but, as the year wore on, continuing positive results in the rest of the economy allowed stock prices to improve. The S&P 500 hit a new all-time high in October, 2007. As recently as the spring of 2008, Fed Chair Bernanke and other national experts were saying in speeches that the mortgage problem was unlikely to have major negative impact on the rest of the economy.

Nonetheless, forecasts of a slowdown or recession spread through financial market so causing stock prices to sag through the summer of 2008.

Then came the de-leveraging. In the wake of the September 15 Lehman bankruptcy, the situation worsened for all market participants who were using significant levels of borrowed money. Loans were called, and margined positions were sold out at whatever price level necessary to complete the sales. The resulting price declines panicked many mutual fund holders who demanded liquidation of their equity holdings, forcing another round of selling – this time by conventional fund managers. By now potential buyers were in a state of paralysis,creating the February slide.

Is it over? A significant rally began March 9 when Citigroup’s CEO sent a memo to all employees saying that the company would very likely be profitable on an operating basis in the first quarter. That statement revived enough investors to move market pricing pressure from selling to buying, prompting higher prices.

The bare beginnings of helpful economic data are also appearing. Sales of both existing and new homes plus housing starts and building permits increased nicely in February despite poor expectations. Mortgage applications, including refinancings, have risen sharply. All these statistical improvements came from very low levels after severe decline, but they are encouraging nonetheless.

Confidence. To the extent the aforementioned paralysis was the stock market problem, a resurgence of animal spirits among investors can have a salutary effect on consumer confidence as well as investor confidence. Improving confidence will go a long way toward renewed economic vigor.

An understandable failure of confidence underlies this whole miserable episode. Declining home prices revealed an absurd level of financial irresponsibility among many players in real estate – borrowers, lenders, securitizers, and investors. The resulting financial turmoil led many prudent people, even the wealthy, to trim their spending as a way to assure their own fiscal safety. U.S. unemployment is near 8.0% compared to about 5.0% a year ago, and some of the employed majority fear their turn will come. The savings rate in the fourth quarter of 2008 was about 3.2% compared to less than 0.5% a year earlier. This sudden drop in spending caused providers of goods and services to shed employees quickly as sales dropped, sending additional fears through populations around the world and reducing further the propensity to spend. The comic strip below by Cathy Guisewite is on the mark in describing both the cause and the cure.

Government action. Students of the Great Depression often point to government as a leading cause. Before Keynesian economics became the standard,the U.S. government then tried to save itself first, cutting spending in order to maintain budget balance. These actions further reduced already slack economic activity with disastrous results.

Government today has a far different attitude. A staggering amount of money is being thrown at the slowdown through increased direct Federal spending,Federal Reserve securities and loan purchases,and corporate rescue missions. President Obama has said that this spending will not be perfect,that there will be mistakes. We can only hope the batting average is high. If all these programs are completed,Federal deficits and debt will be far beyond any levels seen before.

Many of these expenditures would be called investment, not spending, in conventional accounting. When the Fed or Treasury or the new Public-Private Investment Program buys the so-called toxic securities and loans,they receive earning assets, many of which will pay off. When the Resolution Trust Company did a version of the same thing in the early 1990s, the government ultimately made a profit.

If these new support programs do create jobs, and if asset purchases improve credit availability,then confidence will leap higher, more of the government-bought assets will pay off the economy will improve, and these government efforts will prove worthwhile.