Credit Tsunami

Posted on October 6, 2008 by David Laidlaw 

Beginning with the seismic shift last summer when two hedge funds sponsored by Bear Stearns failed, the credit crisis gathered strength over the past 15 months and finally crashed onshore in mid-September with unexpected force. Investment banking as an independent business model has ceased to exist; Lehman Brothers went bankrupt, Bear Stearns and Merrill Lynch were bought by large money-center banks and Goldman Sachs and Morgan Stanley are converting to commercial banks. AIG, the world’s largest insurer, is now 80% government owned and in the process of auctioning off its assets. Finally, Washington Mutual and Wachovia have been absorbed and both Fannie Mae and Freddie Mac are now fully under the government’s control. During the past few days, the contagion has spread to Europe as its commercial banks including Dexia and Fortis required massive capital injections of $9 and $16 billion.

Many credit markets have frozen so that overnight LIBOR (the rate at which banks lend to each other) ballooned to almost 7% on September 30th which is 5% greater than the target Fed Funds Rate. As Ben Connard discusses later, these high rates are stifling real economic activity.

Treasury Secretary Henry Paulson’s rescue plan, the Troubled Asset Relief Program(TARP), just passed both houses of Congress on October 3rd. This legislation allows the Treasury to hire asset managers to buy up to $700 billion worth of troubled assets from financial institutions. The idea is that once these assets are removed from the system, the banks will then function again and begin lending to each other and to real businesses. The main problem with the plan is that it provides no information regarding what price it will pay for the troubled assets. Buying assets at market prices would help the taxpayer, but force the banks to take heavy write-downs and possibly face insolvency. If the assets are purchased at above market rates, pressure on the banks will be alleviated, but the taxpayer will end up paying much more for the program.

Needless to say, this plan is hugely unpopular since it is viewed as a Wall Street bailout. Politicians running for re-election initially voted against the proposal to the market’s detriment.

Even though there have been many bad actors, singling out scapegoats is not productive. Our current plight is a reflection of imbalances in our system. The Federal Reserve monitors aggregate household spending on debt relative to income through its Financial Obligations Ratio (FOR) over time. The numbers show that Americans used to spend roughly 13% of their income servicing various types of debt during the early 1980s. Households increased their borrowing so that this ratio increased to 18% until the last quarter when the debt spending actually decreased to 17.5% in response to the economic turmoil. As a society, we spend too much and do not save or invest enough for our future.

Given these problems …

What to Do

Survive …The first dictate has to be to own bonds that will not default on their interest payments and stocks that will not go bankrupt. One of the pillars of our investment discipline is to buy bonds that will pay interest in the face of credit stress. In this market, this has meant accepting low current yields on bond investments. Many investors have been burned by taking on way too much risk to get slightly higher yields through buying instruments such as Auction Rate Securities. Accepting low yields in an inflationary environment is very difficult to stomach, but it is a necessity.

Our investment process also screens out highly indebted companies for common stock purchases. Aside from gross debt levels, we also favor companies that are able to finance their operations from internally generated cash flows. Companies that rely on external funding will have a difficult time meeting their basic expenses now and may have to change their business models.

Do Not Try to Time the Market …We have been surprised by the severity of the current bear market, but do not believe that it makes sense to sell stocks now and wait for conditions to improve. As we have discussed in prior commentaries, successful market timing is close to impossible because rebounds occur very quickly and usually months before economic conditions actually improve. The stock market is down roughly 20-25% so far this year, but there have been 4 days during which stock prices climbed more than 4%.

Assuming one tried a strategy where he or she was fully invested every day or totally out of the market and the strategy caused you to miss out on those four days, the resulting portfolio would have fallen 34% instead of 20%. Stated another way, being out of the market on those highest performing days would cause losses 70% higher than those experienced by staying fully invested. Looking at 1 year periods, the US has experienced 7 years during which the market declined by more than 20% (2002, 1974, 1937, 1931, 1930, 1917 and 1907). During the following year, the markets averaged returns of about 8% (two of these years in the Depression were negative, but the other 5 produced very positive returns). Finally, the current turmoil represents the second serious bear market in the last 8 years. 10-year periods of loss and stagnation during the 1970s and 1930s led to subsequent decades such as the 1980s and 1940s where stocks returned well over 10% annually. Even though a recovery does not appear at hand, history suggests that markets improve after such drastic selloffs.