April 2008 |
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We have been thinking a lot over the past nine months. As we've reviewed our past thoughts, dating back to last June's skeptical commentary on the consumer and the precarious housing market, entitled "There's No Place Like Home?," it is becoming increasingly clear to us that everything boils down to the housing market. The question on the minds of most investors is just how deep this recession will feel and exactly how long it will all last. Let's tackle these $64,000 questions.
First off, let us be clear, the current economic condition roiling global financial markets is not easy to understand nor is it easy to predict the path of things to come. However, in times like these, there is something to be said about the practice of focusing on the factors that matter most. In our mind, we've boiled it down to two key things to monitor; the path of home prices and how it will affect the employment picture. Beyond that, not much else matters.
As things stand today, according to the S&P/Case-Shiller Index of 20 select US cities, home prices are now down over 10.7% from their peak through January. In Los Angeles, Las Vegas, Miami and Tampa, to name a few, prices are down about 20% from their peak. The only other time home prices fell nationally was during the Great Depression. No wonder the Federal Reserve is concerned. No wonder credit markets are worried.
We had a full-fledged real estate bubble from 2000 to 2007. Nationally, home prices rose a staggering 100% in six years. This was insane and was driven by low interest rates and stupid lending. Bank employed mortgage officers and freelance mortgage brokers wrote the loans and then easily sold them into the investment markets. The rating agencies slapped an irresponsible "investment grade" sticker on mortgaged-backed bonds and other complicated investment products, and the whole game went on too long.
As the stated value of homes rose (backed by appraisers who unethically delivered what the mortgage broker wanted to hear), banks kept on lending. Worrying about collateral coverage or proof of income was for the stodgy, old lending officers of yesteryear. No lending meant not making money. It was easy to make money. So, the lemmings leapt off the cliff. These days are completely over and it probably won't to be repeated for another generation.
All of this began to really unravel last July. Yes, it started with sub-prime loans. That was the start, but despite the Federal Reserve lowering short-term rates by 3% in six short months, the credit markets have been dislocating far beyond the lowest quality loans. It was not "contained", as they hoped.
We've written about it before, but it bears repeating; consumers borrowed extensively against the false values of their home via home equity lines as well as doing cash-out re-financings. It is always easy, until it isn't. As a result, prime mortgages are seeing a troubling rise in late payments.
According the American Bankers Association that tracks eight categories of consumer debt, from credit cards, to home equity lines and auto loans, late payments have hit the highest levels seen since 1992. This spreading of the problem beyond simply sub-prime mortgages is concerning.
All of this points to the fact that people are pulling back and doing so rather quickly. The drop in home prices has affected consumer confidence and, as we see it, a rendition of the famed investor George Soros' "Theory of Reflexivity" is starting to play out. It goes something like this.
As the housing bubble bursts, the days of easy credit abruptly ends. As the credit markets shut down, the increasingly indebted consumer begins to pull back. Then, you start to see late payments rise across all kinds of consumer debt. [We are at this point today]. The slowing spending forces businesses to reign in their expansion and investment plans and then job growth slows. Shortly after, you see net job losses. [We think this is on the horizon]. Once jobs are lost, the housing market takes another leg down, the consumer pulls back even more, [this time for fundamental reasons] and the cycle continues.
The "reflexivity" in this case is that the credit market's initial fear triggers the actual thing it fears (the loan losses) and in turn, more loans actually become troubled and that, in turn, further sparks the credit market's fears. In a finance-based economy, the theory of reflexivity is real and speedy.
Often, this cycle is shut down via outside stimulus. The typical response comes in the form of lowered interest rates and changes in tax policies.
The Federal Reserve has aggressively lowered rates by 3% since August, they've bailed out Bear Stearns and they've taken unconventional actions to set up lending programs with a broad swath of financial institutions. The affects are often felt with a lag.
On the fiscal front, Washington has responded by sending out about $160 billion in cash to the consumer. The money will start to arrive in May and it will likely provide a boost to the economy. The longer term impact is not certain. We have our doubts.
Since the start of the year, we have grown increasingly concerned that our banking industry is severely damaged. With collateral values still searching for a legitimate floor (meaning the value of the homes they've lent against), we don't see the credit markets improving all that much any time soon. Until a true floor is found, we are having a hard time seeing consumer spending perking back up. The credit crunch and adjustment will drag this recession into deeper territory than most investors see today.
Over the past decade, consumer debt levels as a percentage of GDP has risen about 50%. As a society, we have been borrowing more and more to fuel our spending growth. This appeared sustainable as long as interest rates were falling and as long as collateral values were rising. All you had to do was refinance the debt and the payments stayed manageable. But, once a tipping point is reached - no matter how low rates go - the cycle ends and we pay the piper by way of slower future growth.
This process of reversal can take time and given ample time to unfold in an orderly way, it can make the pain more manageable. In fact, we believe that a "smooth adjustment" scenario is exactly what policy makers are working to achieve.
First, they've cut interest rates quickly and they are sending money to help slow the consumer pullback. Next, they have correctly acted as the lender-of-last-resort as the credit markets have convulsed. At the same time, they are encouraging banks to rapidly recognize the losses on their balance sheets and they want them to modify existing mortgages at lower rates to help borrowers. The process of quick loss recognition will also be accomplished by forcing the weakest banks to sell out to the stronger banks. And, sooner or later, the federal government may have to simply buy or guarantee the most troubled mortgages outright.
They hope these actions will effectively allow the air to be slowly let out of the balloon rather than simply popping it and starting things fresh. Pragmatically speaking, in a debt burdened economy, you can't just pop it and start anew. That was inadvertently done during the '30s and it was a huge mistake. Beyond that deflationary fear, an attempt at gradualism is a far more humane policy.
We feel that investors need to begin to recognize that even a successful "let it hiss" policy will mean the recovery from this recession will also be slower than currently anticipated. To be sure, stock prices have adjusted some, but we see a deeper and slower process unfolding - investors have a lot to think about these days.