Wednesday, July 25, 2007
Occasionally we depart from politics and wander into territory that actually fits our job description. Since I am in the investment business, I do feel well armed to engage in market-based rhetorical combat. And there is something quite important afoot that bears paying attention to. A lot. And we should hope the politicians don't do anything to mitigate or exacerbate it.
Our credit markets have caught the flu. And it seems to be a pretty severe gripe, spreading across markets. Let's hope that it only leads to a temporary case of lender constipation, and not a full fledged intestinal blockage. The former hurts a bit, the latter can kill you.
To function properly, any economy -- like an engine -- needs its own version of oil. If you operate in the financial markets, you call it liquidity. It's a mystical thing, liquidity -- a combination of real capital or equity, access to credit (a multiple of the equity) and a psychological appetite for risk. Some refer to this as "animal spirits." Others call it greed. Whatever. That combination of forces drives liquidity. And helps to fuel growth in our economy -- hiring, capital spending, home buying, car buying and so forth. The term money alone does not capture the phenomenon of liquidity. Money does nothing if it isn't in use. Liquidity is about using it, putting it in circulation over and over again. Oil in the motor; blood in arteries; air in lungs -- you get the point.
Now when money stops circulating, you get problems. Big ones, like recessions. So what has happened? Let's start with the Federal Reserve, which works in conjunction with the markets to determine the price of money. When our economy slowed down as a result of a variety of forces in 2000 and 2001, the Fed aggressively reduced rates, the cost of money, to motivate people to go get some and put it to use. Having succeeded in this feat the Fed reversed course in 2006, raising rates again. Why? So as not to overstimulate the economy -- which can give rise to economic bad guys like bubbles and inflation. Raising the cost of money always works, and seems to always work with a lag, usually 9 - 12 months. And here we are. The purchase of homes slowed as mortgage rates went up. The value of real estate -- especially marginal real estate -- fell. Lenders to marginal real estate -- what you are reading about as subprime lenders -- began to suffer declines in the value of their portfolios. And since they in turn are themselves levered (they borrow money to buy assets), these lenders suffer -- even go broke. When that happens, the assets they own flood the market, driving prices down further. And so the cycle turns.
Now we are in the midst of a spreading problem. Why does the problem spread from marginal real estate (and marginal borrowers) to corporate assets? Or cars? There is little denying that the problem has spread. There are at least 20 corporate borrowers and their investor/acquiror/sponsors who are trying to tap the credit markets to finance themselves and -- for the moment -- can no longer do so on terms remotely close to what they thought they could do 30 or 60 days ago. Commercial terms have "backed up" 150 basis points (1.50 percentage points) and perhaps more in that short time span. And financings that were thought to be "do-able" then are simply no longer feasible. We are talking about over $100 billion of financing. We are talking about big banks losing hundreds of millions and perhaps billions of dollars -- Bank of America, Deutsche Bank, Goldman Sachs, Morgan Stanley. We are talking about them having to hold much larger amounts of risk on their balance sheet rather than syndicating that risk to other buyers -- and therefore an inability for them to continue to take risk.
That is what we call in the finance business a serious case of constipation. Bonuses on Wall Street go down or do not get paid. People get fired. Fear trumps greed.
Now, these things can go a couple of ways. Markets are resilient, and its participants don't necessarily like to pick up their ball and go home. You don't play, you don't get paid. So when the repricing phenomenon takes its toll, as long as it's not too devastating, most players come back and re-engage on new terms. As long as their capital base remains intact. If too much capital gets destroyed or impaired during the repricing of risk and paralysis prevents buyers and sellers from re-engaging, sometimes you need help from the Fed to help spur risk-taking again by reducing the cost of money. The Fed did this in 1998, for instance, when the Russian and Brazilian markets collapsed and a major US hedge fund blew up (Long Term Capital).
Always remember, it's not so much about the borrowers -- for the moment, they're pretty much fine and their prospects haven't changed, at least not yet. It's about the health of the lenders that we need to worry. And the market isn't a bad place to look to see how they doing. Bank of America is down over 10% from its highs. So is JP Morgan. And Citi. Goldman Sachs is down nearly 15%.
So far, not a disaster. But these things bear watching very closely. Confidence is not all gone; the animal spirits have not been replaced by fear completely. The Wall Street job exodus has not commenced -- though I am told the hiring freezes started a few weeks ago. We are at one of those crossroads that each economic cycle faces when the direction is not completely clear as yet. And it could still go either way. We don't yet know how far the contagion might spread and how much capital might be impaired, nor do we know what the Fed might do -- reduce rates to encourage liquidity back to market -- or stand firm to fight inflation.
As an investor, I have to say that I don't mind the higher rates too much, yet. Ten year treasury yields at 4.904% are on the high side of rates over the past five years, but still on the low side of the last 25 years.
It's clear that many projects get financed late in a credit cycle that ordinarily would not get funding (sub-prime being an example), and a segment of the market blows up, and that there is a resulting effect on more mainstream niches of the credit market, perhaps undeserved, since, as CP states,the borrowers are "pretty much fine."
As someone holding a fair amount of index ETFs, I would start to mind the higher rates when overall equity markets start to tank because real growth slows or stops, or because the medium-term fixed income high quality coupon is too good to pass up. I just believe real rates aren't at that point yet.
The other markets that blew up in 1998, if memory serves, were some of the Asian / Pacific Rim markets.
If a major hiccup happens, say something knocking 10-20% off of the S&P 500, you can bet it will become a political issue in the 2008 elections (can't resist bringing it back into the political arena, sorry, CP).