submitted by James Baker Welch, VP of Rothschild Investments
One of the most stunning facts of the 2008 Financial Melt-down has been the wholesale wealth destruction that has transpired in almost every asset class in every region of the world. But the most frightening feature of this financial typhoon has been the astonishing pace and breadth of its destruction.
I believe it is important that investors gain a better understanding of the causes of the financial meltdown so that the knowledge will help them achieve better returns in the future. From my research, I assert that one of the underlying cornerstones of the crisis developed over the last 30 years. In 1977 President Jimmy Carter signed the Community Reinvestment Act (CRA) into law. The Act was the result of national grassroots pressure for affordable housing. The CRA mandated that all banking institutions that receive FDIC Insurance be evaluated by the relevant banking regulatory agencies to determine if the institution has met the credit needs of its entire community.[1]
The CRA began to compel banks to underwrite less credit-worthy mortgage loans in order to meet the needs of “the entire community.” In order to achieve similar goals, the Federal Housing Enterprises Financial Safety and Soundness Act of 1992 required Fannie Mae and Freddie Mac, the two government sponsored enterprises (GSE’s) that purchase and securitize mortgages, to devote a larger percentage of their lending to support affordable housing.[2] In 1995, the Clinton administration significantly strengthened the regulations of the CRA. The Clinton-enhanced CRA enabled consumers to secure mortgages with “no verification of income or assets; little consideration of the applicant’s ability to make payments; and no down payments were needed.”[3]
In October 2000, in order to expand the secondary market for affordable community-based mortgages and to increase liquidity for CRA-eligible loans, Fannie Mae committed to purchase and securitize $2 billion of "MyCommunityMortgage" loans.[4] In November 2000, Fannie Mae announced that the Department of Housing and Urban Development (“HUD”) would soon require it to dedicate 50% of its business to low- and moderate-income families."[5]
Fannie Mae and Freddie Mac became focused on pushing out more and more mortgages to less credit-worthy borrowers. Franklin Raines, Jim Johnson, Jamie Gorelick and Rahm Emmanuel, all executives of these GSE’s, developed programs that paid themselves staggering amounts of money based on the increased amounts of loans. Congress, using the CRA as a club, progressively forced banks to lower their lending standards so that normally unqualified borrowers had access to capital. Congress punished banks by restricting their ability to expand if they did not lower their standards and provide these loans. To better protect themselves, lenders began to “repackage mortgages”, combining strong credits with unstable borrowers and then selling them to Wall Street.
About seven years ago, Wall Street, realizing that Congress was pushing these “no documentation” mortgage programs (that had no public market and could be easily manipulated) added credit insurance and multiple layers of credit quality. After which, Wall Street greatly accelerated the program. Structured Mortgage Products were sold world-wide and became a major asset class and a huge profit center for hedge funds and Wall Street. Regrettably, because of the complexity of these structured investments and the fact that no public exchange traded these products, theoretical prices, calculated by a Wall Street Broker’s computer (the same firms that were funding, structuring, and selling the investments) were the only means of assigning a market price — a system often criticized as “mark to make-believe.”
The combination of four underling forces were now in play and I believe were the inherent seeds of the destruction of our financial markets in 2008: 1) A government lending program gone bad; 2) A complex structured investment that had no public markets; 3) Unhealthy use of leverage, and 4) A Federal Reserve that was printing too many dollars.
The world wide market for these defective mortgage-backed securities started to unravel in 2007. The Wall Street financial firms that were structuring and selling these investments and the plethora of financial institutions purchasing these structured securities (on mostly borrowed money), were now going to be forced to mark-to-market a lower value of these securities. The term mark-to-market is an accounting methodology of assigning a value to a financial instrument held by an institution based on a current market price. The Financial Accounting Standards Board (FASB) issued Statement 157 which included rules called “Fair Value Measurements”. FAS 157 became effective for financial entities with fiscal years beginning after November 15, 2007. FAS Statement 157 defines "fair value" as: “The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”[6] After FASB issued statement 157, the prices of these structured products began dropping.
Because the U.S. Federal Reserve had been administrating a monetary policy that was debauching the dollar (printing too many dollars and forcing the value of the dollar lower), foreign investors that had been purchasing these investments slowed their buying in 2007. The five major Wall Street Prime Brokers that created the majority of these securities and participated in the secondary market saw the demand dropping and started to adjust their bids to protect themselves. The dropping demand forced the valuations lower. The foreign investors then started to sell in 2008, which forced the prices even lower and demand for structured mortgage-backed securities plummeted.
The falling prices led to a vicious cycle of further price declines, a contraction in the number of buyers in the secondary market, further price declines, additional write-offs, and so on. That in turn led (in part because of new mark-to-market requirements) to significant reductions in the capital base of many financial firms.
The Banking industry became increasingly uncomfortable extending credit to financial firms, especially the Prime Brokers because these firms were heavily leveraged, (Lehman Brothers was reported to be leveraged 30 to 1).[7] Leverage is a double-edged sword. It is a potent ally during boom times, but can quickly become your worst enemy during the ensuing bust. These Prime Brokers quickly became unstable as their asset bases melted. A crisis in confidence in the credit markets developed. Major financial firms could not acquire short-term funding. This led to the demise of Bear Sterns, Lehman Brothers, forced Merrill to be acquired by Bank of America, and compelled Morgan Stanley and Goldman to become banks.
The highly leveraged investment strategies of hedge funds were a large contributing factor to the 4th quarter financial melt-down. Morgan Stanley analyst How Van Steenis estimated that “the hedge fund industry managed over $1,930 billion of assets in June of 2008. But hedge funds controlled many more times that number because some hedge funds were leveraged up to six to one.” One of the prime drivers of the rapid financial disaster was the hedge fund’s lenders calling in their loans. These remaining Prime Brokers were now banks with more restrictive lending rules. These banks dramatically raised their margin requirements of their hedge fund clients almost every week. These lower lending thresholds only succeeded in driving further liquidations and dramatically lower prices in the most liquid of investments: listed stocks, rated bonds, and commodities.
As the financial markets spiraled out of control, the Fed and other world central bankers tried to ease the problem by flooding the monetary markets with easy credit. The new capital did not initially help. Fear became overriding, as evidenced in the staggering increases in lending rates like Libor and other short-term money market rates. Banks and financial institutions could not correctly value their balance sheets because of the FASB accounting requirements of mark-to-market. These financial institutions gobbled up the easy credit from the central bankers but hoarded the capital, refusing to lend to anyone.
A moderate decline in the stock market turned into a crash. This in turn led to real fear in the hearts of the consumer, and a major downturn in retail sales. The down turn has started to force firms to lay off employees which are now feeding this vicious cycle, all of which will add fuel to the talk of global recession. In many ways, the talk has become self-fulfilling.
The world financial market crash was caused because of too much leverage, too much speculation, and no open free market system for valuing these defective structured investments and their credit insurance. The financial crash of 2008 was not caused by recession, bad fiscal policies, restrictive trade policies, higher oil prices, runaway inflation, or earnings problems. But the financial meltdown will have caused the first world economic recession in my lifetime.
2009
I had initially hoped that a quick resolution to the financial crisis last fall would have lead to an improved outlook for the economy. I still assert that had Treasury Secretary Paulson’s original TARP plan (purchasing mortgage-backed securities) been implemented, combined with a modification of the mark-to-the-market accounting rules, a more rapid stabilization of the financial markets would have ensued. Financial stability would have fostered a better economic outlook. Now, unfortunately, the worldwide financial crisis has led to the likelihood that severe economic downturn will develop. The “negative wealth effect” will probably now lead to a much longer and more severe world wide recession. Economic growth will be negative, possibly well into 2009, and maybe into 2010. U.S. Earnings growth will slow because of the economic slowdown, and will be worsened by the now strengthening dollar.
As 2009 emerges, consumer spending which is 2/3rds of GDP is plummeting at an alarming rate. It is dropping more than would normally be associated with the current trends in income and payrolls.[8] Business investment is following the consumer. Businesses are retrenching and preparing for the worst. As with consumer spending, fear is driving trends as much or more than the underlying demand. Nonresidential construction, which is very vulnerable to the credit markets, has started to retreat. My concern is that because of the credit freeze, a normal downturn could turn into a rout.
It has been my view that the macro-economic trends have been significantly worsened by the negativity in the press, and scare tactics associated with the various bailout and stimulus proposals. The main-stream media have been talking down this economy for the last year and a half. They have been so successful many will be out of jobs by 2010! With the new administration coming to Washington, I assume the negativity will abate, at least for the next 12 months.
One of the future concerns hanging over the financial markets is the possibility of significant redemptions pending for hedge funds. Funds recorded their worst performance since 1998 according to Hedge Fund Research (HFR), the Chicago-based data compiler. HFR calculates that globally, hedge funds were down by more than 23 percent for the year through December 30, 2008.[9] Many hedge funds, having been hit with major withdrawals during the second half of 2008, suspended all redemptions. By suspending withdrawals, many industry experts believe that investors have developed a heightened sense of mistrust. By blocking withdrawals, hedge funds are creating a pent-up demand to get out. "Hedge funds were an integral part of the bubble," said George Soros, one of the world’s wealthiest and most prominent hedge fund managers, in testimony to Congress last fall. "But the bubble has now burst, and hedge funds will be decimated." [10] Craig Baker, global head of manager research at consultants Watson Wyatt, said funds would continue closing down in 2009 and “mass redemptions over coming weeks will affect short-term performance”. The question is how large will the redemption wave be, and how will it affect the financial markets?
The good news is in the monetary front. Persistent depression style deflation is unlikely to take hold. From 1930 through 1933, the M2 measure of the money supply contracted by a staggering 33%.[11] The Ben Bernanke-run Fed understands deflation and has expanded M2 at an annual rate of 14.5% in the past three months. At the last FOMC policy meeting on December 12th the Fed announced that “The focus of the (FED) will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve’s balance sheet at a high level.” The Fed is set to drive mortgage rates lower, purchase asset-backed securities to finance consumer-related bonds, and supply ample credit to industry to stimulate the economy. The Bernanke Fed is locked and loaded to help the economy in every monetary way possible.
On the fiscal front, much of the talk is surrounding the incoming Obama Administration’s huge big-government-spending infrastructure programs. The latest estimates call for $350 billion to create jobs by building or repairing roads, bridges, and other public works projects; $250 billion to maintain education; and another $250 billion in “counter-cyclical” spending such as extending unemployment benefits and food stamps.[12] As the government becomes a much larger portion of the U.S.economy in terms of allocating the citizen’s capital, there are risks of poor (political) decisions. If the new economic optimism is based on the idea that 535 elected congressmen will make efficient decisions on where to invest in infrastructure instead of looking out for (their) political interest, count me as skeptical. Amtrak is a perfect example of the government’s ability to efficiently allocate resources. The first policy the new Obama Administration should champion is a relaxation in FASB Statement 157, mark-to-market. This would quickly, without any cost to the taxpayers, help financial institutions better value their balance sheets and begin lending again. The second simple policy adjustment should be to offer incentives to investors to join the Treasury and purchase these toxic structured mortgages. Offer a five year tax holiday on all income and capital gains from purchasing and holding these investments. Structured correctly, the plan should open a floodgate of much needed capital to this beleagured sector without spending one dollar of the taxpayer’s money.
Analysis of traditional fundamentals scarcely matters as we enter 2009. The economy, interest rates, earnings, energy problems, imploding hedge funds and credit availability are now impossible to analyze using traditional economic models developed over the last 50 years. The first stone placed in the foundation of economic stability needs to be calm in the global credit markets, and the Bernanke Fed is working towards that goal. Once the financial markets stabilize, credit will become available to industry and consumers alike, and the economy will heal. Then, and only then, can analysis truly begin.
I personally believe the best stimulus for this economy would be a move to cut taxes across the board for both individuals and businesses, and relax the mark-to-market rules by incorporating a five year weighted average for certain asset classes. But no matter how much money the Fed prints, or how many roads, bridges and mortgages the U.S. Government purchases, if none of the programs create new incentives for private enterprise, risk-taking, job creating and investment, the economy will stagnate. Entrepreneurs and investors have always been the providers of new jobs for Americans, not politicians or federal bureaucrats. Hopefully, new incentives are forthcoming.
John Baker Welch, Vice President
January 5, 2009
The information and opinions in this report were prepared by John B. Welch. The information contained herein has been obtained from sources which he believes to be reliable, but he does not guarantee its accuracy, adequacy or completeness. Rothschild Investment Corporation is not responsible for any errors or omissions or for the results obtained from the use of such information. All opinions and estimates included in this report are the work of John Baker Welch, portfolio manager.
This report is intended for qualified customers of John B. Welch. The investments discussed in this report may not be suitable for all investors. Investors should make their own investment decisions based upon their own financial objectives and financial resources.
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[1] Community Reinvestment Act
[2] Ben S. Bernanke, the Community Affairs Research Conference, Washington, D.C., March 30, 2007.
[3] Sandra F. Braunstein, Director, Division of Consumer and Community Affairs, the Community Reinvestment Act, Testimony before the Committee on Financial Services, U.S.House of Representatives, 13 February 2008.
[4] Fannie Mae Announces Pilot to Purchase $2 Billion of "MyCommunityMortgage" Loans; October 30, 2000.
[5] Fannie Mae increases CRA options, American Bankers Association Banking Journal, November, 2000.
[6] Financial Accounting Standards Board Statement 157
[7] Seeking Alpha, Leverage 101: The real cause of the financial crisis. September 25, 2008
[8] Briefing.com: Economic view, December 15,2008
[9] The Wall Street Journal, Hedge Fund Returns: The Worst Year Ever, December 30, 2008
[10] The Washington post, Fund Chiefs Back Oversight, November 14, 2008
[11] First Trust; Fed Balance Sheet Expansion. Brian S Wesbury, Chief Economist, December 23, 2008
[12] Reuters, Jon Hurd, January 2, 2009
