A Look Back to see Ahead

It is difficult to develop high conviction that the recovery of the U.S. Economy has now passed beyond a point where it could still be impacted by the “subprime mortgage” phenomena.  Actually it is more than an impact. These securities had the financial sector of our economy by the throat and were squeezing with all the force imaginable.  What Congress thought was a benevolent idea to make home ownership readily available to the “working poor”, (their term, not mine), cascaded into a Tsunami of debt and over leveraged balance sheets of almost every investment and commercial bank in the world.  The modern cowboys of Wall Street came up with a way to increase return on the plethora of mortgages being issued to anyone and everyone who wanted to buy home (the subprime mortgage) by securitization of them. Underwriters just bundled these mortgages together into a bond and after convincing Moodys, Fitch or Standard and Poor to rate them based on a skeptical formula for determining the credit value therein, they would sell them as a bond holding Government backed securities, an AAA security. As the demand for income yielding or income enhancement securities continued to grow, Wall Street (or at least some of the more ingenious young Turks in the bond underwriting departments) came up with the idea of selling something, a derivative, called a Collateralized Debt Obligation (CDO).  They piled a range of mortgages backed bonds into these instruments and sold them as investment grade vehicles or quasi money market instruments.  Then they created a security described as a Credit Default Swap (a transfer of risk that the covered bond would fail). The CDS would be bought by holders or a portfolio to protect them in the case that one or more of the mortgages in the Bond or CDO bought by qualified institutions would fail.  At first, the CDS would be available only from an insurance agency like AIG Corporation but in the belief that real estate never declined in value but always appreciated, the Banks, and some money market funds decided to sell credit default swaps to enhance the yields they were receiving on their portfolios. Investment banks like Goldman Sachs, Morgan Stanley, Bank of America, Deutche Bank, and so on, just created these instruments out of thin air.  The buyer would pay the seller a certain percentage annually of the par value (or adjusted FMV from time to time) and he would receive a mark to market adjustment if the value would rise or fall from a baseline value.  While the underlying sub-prime mortgages were originated for 30 years, they usually had a teaser rate of 4-5% per annum for the first two or three years and thereafter they would become an adjustable rate mortgage with interest at some 4-6 points over the base rate (usually LIBOR, the London interbank offered rate).  The logic of issuing a mortgage to someone who is unqualified financially for this obligation is the belief that real estate values always go up and the borrower will be able to refinance the property when the sharp increase in Adjustable rate kicks in.  How many of these derivative instruments were written by Wall Street can only be guessed at because there is or was no regulatory control of them.  In effect it was just a bet between two parties that the FMV of the mortgage would or would not change.  Mortgages were offered to buyers who in no way could qualify under normal standards.  Financing for homes was available no matter what the price.  The government would guarantee 80% of these mortgages since everyone expected payback when the rate adjustment kicked in. Wall Street began to figure that it was crazy to sell all these derivative instruments to hedge funds, other commercial banks, and money market funds, when they could just keep them and leverage their capital to buy more. The stupidity of this decision is beyond understanding but it was happening throughout the Financial Industry. After all real estate values always appreciated, right?   

As anyone without their head in the sand should have known, the real estate market was in a bubble formation with prices advancing far beyond the expected normal demand supply relationship.  When prices stopped appreciating the value of these mortgages would fall like a stone as marginal home owners began to default in the payment of their loan.  The sub-prime mortgage based securities began to unravel as the mortgages therein began to go into default.  Transfer of mark to market securities on balance sheets of major Wall Street firms caused huge declines in their capital base overnight.  The 100 year old firm of Bear Sterns closed at $30.00 per share on Friday, lost all counterparties over the weekend and was bought by Morgan Stanley for $2.00 per share on Monday. Lehman declared bankruptcy. Merrill Lynch was bought by Bank of America. Countrywide was taken over by Bank of America and Washington Mutual was absorbed by Chase Bank.  Others fell by the wayside or were bought out by a survivor.  Hank Paulson, President Bush’s Secretary of the Treasury and Timothy Geithner, President of the N.Y. Federal Reserve, realizing that the financial system worldwide was freezing up, got together to organize a massive capital infusion plan into the financial markets, including AIG. This controversial “bail out bill” was passed by the Congress over the weekend September 19, 2008 and on Monday the financial markets began to function again.  Now, in June of 2010, we have come to the point where our financial institutions are fairly healthy again but they are still deleveraging and are not making loans to smaller businesses even those that have good strong balance sheets.  Why?  Well one reason is that risk management in our banking and other financial institutions is concerned about the Obama Administrations fuzzy tax and regulation policies.  They are reluctant to commit money to anything they are not sure of.  Cap and trade is a big unknown; Healthcare is yet to be understood; Consumer Protection law about to be passed is confusing.  The full effect of the BP disaster is uncertain and the President’ rhetoric sounds too political to allow confidence.  The economic damage from the destruction of business, and fisheries is unknown but must be huge. 

From this uncertainty the investor must make plans and execute strategies designed to fulfill their objectives.  I believe Mohammad A. El-Erian, of PIMCO Investment Management, has it about right.  He believes that the adjustment of the global economies will take several years. He expects the U.S. Economy will continue to recover but only grow at about 1½ to 2% per annum for several years. When the time comes when European, American and Japanese economies have completed their rationalization and consumer and commercial deleveraging, wonderful buying opportunities will exist.  For that reason half invested and half reserves is appropriate at the present time.    

One Man’s Opinion-Bud Brewer