Return OF capital not return ON capital is the key to success as the credit contraction picks up momentum and the best investment idea for the remainder of the year.
July 17, 2008
The past week has been painful for almost every sector of the U.S. economy with continued oil price hikes, the failure of the 2nd largest bank in U.S. history, a stock market decline to new lows for the year and questions about the survival of the twins (Fannie and Freddie). EWW readers (growing every week) should not have been surprised at recent events as we have warned of the impending credit and liquidity crunch for the past two years even though being right about bad news brings no friends just reluctant acknowledgement and hopes that our forecast will soon call for clear skies. Unfortunately we are in the beginning stages of the worst credit contraction seen since the Great Depression of the 1930’s. Major changes in the economic and political landscape will take place in the next few years as the de-leveraging of American businesses, lenders and consumers has devastating effects on the way we see the future. Fasten your seat belts as the ride is going to be similar to a roller coaster at an amusement park without the thrills.
The Fed
It is amazing how market perceptions change so quickly and lose sight of the major trend because we often project our own needs onto market conditions. We do see the future from our own past experiences and since 99.99% of investors did not witness the early 1930’s they can only hope it will not be repeated. Early this year with the stock market plunging and Bear Stearns being bailed out (except the common stockholders) the consensus view was for the Fed to lower short-term rates to zero and open borrowing facilities for any and all lenders. Panic and fear were at extreme levels in March and the Fed did manage to create enough liquidity to temporarily calm the waters. One of the most difficult patterns to detect is the one that is rarely seen and today is a long-term bear market. It is slow, vicious with violent counter trend rallies and doesn’t end until everyone has left the playing field with vows never to return. The Fed bought time and breathing room as spring ended with relative calm (similar to after an earthquake) but one must remember after shocks are frequent and remind us of fault lines under the surface that are not easily repaired. Debt creation was one of the main causes of the real estate bubble and once it peaked is very hard to restart the process similar to putting toothpaste back in a tube. Not surprisingly since lower short-term rates have always solved every past economic problem investors and consumers assumed (incorrectly) that history would repeat and along with fiscal stimulus (IRS rebate checks) the economy would bounce quickly and would be back on the road to wealth we enjoyed over the past many years. In early June market players were 91% confident of a Fed increase in the Funds rate at its August 5th FOMC meeting. This was more hope than reality as the dollar’s decline was blamed for the price hike in oil and the old game of hiking interest rates to attract hot currency flows (similar to high bank CD rates) was picking up momentum from Wall Street analysts. Doesn’t anyone remember what caused the 1987 U.S. stock market crash? If not, review the recent happenings in Iceland where the central bank increased its overnight rate to 15%+ in an effort to stem outflows from an economy addicted to foreign deposits. The level of overnight rates in the U.S. is somewhat irrelevant today as banks can’t lend what they don’t have and underwriting policies are so tight the only way to obtain a loan is if you are in better financial shape than your lender. There is one important reason the Fed MUST not raise short-term rates and in fact needs to lower the Funds rate to 0.01% (similar to Japan a couple of years ago) and that is to help its member banks repair their balance sheets. Despite $350 billion in new capital injected into banks over the past year (with massive dilution to shareholders) many large banks are on the verge of insolvency as the value of the collateral (real estate) for their loans continues to decline and borrowers go into default.
The majority of banks will survive this turmoil and this presents a once in a lifetime investment opportunity for investors. The Fed will use its most powerful tool to create badly needed profits for its member banks. It will continue to keep short-term interest rates low (below the inflation rate) thus allowing banks to borrow at 2% (current fed funds rate) while lending at much higher long-term rates. If banks can’t find worthy secure borrowers that meet the new tougher underwriting guidelines they will send their low cost $$ to the U.S. Treasury and purchase notes and bonds which yield much higher returns. The yield curve (relationship between long term and short term interest rates) has entered a long term bull market phase where the spread will widen to all time record levels and remain there for many years. What about inflation? The dollar? Foreign investment in the US? All important items but a credit contraction is a rare event not often seen in anyone’s lifetime and it brings the most evil of all threats to an economy…DEFLATION. Like a virus, it spreads slowly but deep into the decision making process of a country, and only leaves when credit becomes available and is used by business and investors.
At this point you probably are wondering if I am delusional as inflation appears to be the problem today due to rising oil and commodity prices. An increase in price levels is inflationary only if demand increases as people believe they need to accumulate items for future use because we will never see today’s prices again (similar to the 1970’s). Isn’t this the reason most people bought houses in the late 90’s? Fear of not being able to afford a house in a few years led people to buy before they actually needed (space, family, etc) or could make the monthly mortgage payments. I often heard the quote from real estate agents that there is “never a bad time to real estate” and the average person saw rising prices and believed that they would continue to rise. The availability of credit to anyone breathing created the demand and it became a self fulfilling prophecy. The same thing occurs on the downside as prices fall, credit tightens, prices fall more and the cycle continues for many years. The only way to stop the fall is through bank lending and banks need capital to lend, without it momentum builds and demand drops which leads to more price level declines and that is DEFLATION.
My best bet for the next 12 months is a play on the Fed giving banks every chance to build up their balance sheets and stay alive….a widening yield curve. It’s easy, you don’t have to watch it every day and a year or two from now the rewards should be huge to patient investors.
Covered Bonds
The mortgage market has suffered many devastating blows in the last 12 months and most wholesale residential mortgage brokers will be seeking new jobs in another field soon but some good news is on the way for banks that originate retail loans. With Fannie and Freddie representing almost 90% of loans closed in the 2nd quarter due to a lack of available funds by banks a new funding source will appear soon creating liquidity for lenders and more borrowing outlets for buyers of homes.
Covered bonds began in Europe around 1770 and represent senior debt obligations of a financial institution that are secured by a pool of loans that remain on the bank’s balance sheet. Buyers of these bonds have recourse to the issuer (banks) and the underlying pool of assets (mortgages). With over a trillion dollars outstanding (mostly in Europe) the U.S. has never embraced this idea due to Fannie and Freddie’s dominating presence in the marketplace. One of the concerns among investors has been what happens to the collateral if the underlying bank goes into receivership. The FDIC cleared the way earlier this week by giving bondholders access to the collateral in the event of bank failure. We will soon see an explosion of these types of bonds in the next couple of years but this only applies to residential mortgages and only those that were completed using “full doc” programs. The days of stated income loans are gone for a very long time. What makes this new type of financing so easy is that the mortgages always stay on the balance sheet of the issuing bank but the yearly interest is paid from bank cash flow and not the mortgages so there is no pre-payment risk to the bond holder. Of course if the bank does fail the bonds will be paid off early through liquidation of the collateral.
Fannie and Freddie have huge solvency problems and the common shareholders will most likely be wiped out if the government does step forward and inject capital or lend them funds. Covered bonds will soon be able to take a great deal of pressure off the twins and allow them time to also regroup and replenish their capital. None of these events will happen overnight and the next couple of years will be painful for most investors, homeowners and consumers as the de-leveraging of America continues to wipe out billions in wealth that was created in the last decade. Good investment opportunities will be rare but betting on government intervention and increased regulation will give you a better chance of survival and return ON capital at a time when most will be wishing for a return OF capital.