Credit Crunch - What's it all about?

I seem to remember hearing in a marketing presentation that the normal attention span for a “pitch,” once interest is established, is around five to ten minutes.  Never to be out done, our media tries to answer complex questions with ten second sound bites.  So, it is not surprising that there is a great deal of misunderstanding about our current stock market decline, its causes, and its eventual recovery.  Allow me to spend the next five to ten minutes summarizing my interpretation of the issues.

First, the ten second media version is that the current crisis is the result of sub-prime mortgages.  While certainly a major piece of the puzzle, what is seldom discussed is where that piece falls and the short and long term ramifications.

To begin, it is important to keep in mind that the slow down in the U.S., and to a lesser extent the non-U.S. developed countries, mainly Europe, began before the mortgage crisis hit.  The possibility of recession coupled with inflation, a condition known as stagflation, was seen as the big economic risk brewing.  To suggest that the current, mild U.S. recession is the result of the mortgage crisis is overly simplistic, if not outright wrong.  That said, the mortgage crisis will play a major role in how fast, or more likely how slowly, we recover.  To use the technical economic jargon, this is predicted to be a long hangover after the big party.

Back to the mortgage crisis.  How did we get here?  We must first take a big step back and look at government policy since World War II.  This is important for two majors reasons.  First, president after president talked about the great American dream of owning a home.  To back up that rhetoric, our policies have long been designed to help facilitate home ownership though tax breaks on mortgage interest and special lenders like the VA, FHA and other programs to insure loans.  This has helped many deserving people to own homes who normally would not.  This historical bias toward home ownership laid the foundation to allow the more speculative buying and lending.

However, the current crisis did not start with the U.S. housing market.  It started with the run in commodities prices, namely oil, gas and the major metals:  copper, gold, silver, aluminum, steel, etc.  Record profits were being earned by the countries and companies who are involved in these commodities.  The result was an increased supply of cash to be invested.  And the investment goal with many of these countries is a conservative one.  Meaning, there was a great deal of demand for safe, fixed income type investments.

To help meet that demand, banks and brokerage firms around the globe created investments to meet that demand.  One of the ways to do this is to collateralize mortgages.  Wrap them up in neat little bundles of high grade bonds, leverage them to the hilt, and sell them as low risk investments.  The point is that much of the crisis was created by the need to meet the demand from the commodities producers.  (This is important; we will revisit this point later.)

Then the dominos started to fall.  The following sequence of events unfolded very quickly but not necessarily in this exact order:

1. Rating agencies became concerned about the quality of these collateralized products and the underling assets.
2. The housing market was staring to deflate from the unsustainable highs it had reached.
3. Partly as a result of point two above, the rating agencies downgraded the credit ratings of the bonds.
4. With the ratings of the bonds downgraded, they could not be leveraged as highly as they had been and, for lack of a simpler term, there were margin calls.
5. In order to meet the margin calls, banks and other institutions started selling some of their debt investments.
6. This selling put downward pressure on the price of bonds resulting in further margin calls.
7. At some point during this process, fear arose that the companies that insure bonds, would not be able to meet all the obligations if a substantial amount of bonds defaulted.
8. This put further pressure on the ratings and perceived quality of the debt.
9. Thus causing added pressure to call in the margin loans and to stop issuing more debt.
10. This lack of liquidity, caused by the need to pay down margin debt and the difficulty of finding other forms of financing, caused a further need to sell securities.
11. This downward spiral happened very fast, and suddenly no one knew the real value of what anyone else owned.  Keep in mind, that lending money has a large amount of faith and trust involved.
12. This need for liquidity bled into the global stock markets.  The main downturn in the U.S. market was driven more by lack of liquidity, fear and uncertainty than by any fundamental factors.

An illustration of how far this has gone, many tax free municipal bonds yield higher rates of return than that of taxable bonds.  Not based on an after-tax calculation, but on an absolute basis.

In an anecdotal piece of evidence of just how fast and unsound this whole process has become, Bear Stearns was initially purchased for $2 a share, with a guarantee by the Federal Reserve.  It is estimated that real property alone owned by Bear Stearns is worth much more than the $2 a share.  Once the panic was averted, cooler minds prevailed and the offer jumped to $10 a share a week later.  Even that may be to low.

On the economic front, where does all this leave us?  First, we are most likely in a recession.  It will likely be mild, but the recovery could be slow.  The good news is that the rest of the world is doing pretty well.  It is an indication of the power of the global markets that when the U.S. sneezes, the world is not catching a cold.

Remember those commodity producing nations with all the extra cash that helped create this problem?  Well if you have filled up your car lately, you know that prices have not gone down.  That cash is still there.  It has been waiting for the right investment opportunity.

If you will allow me to get out my crystal ball, my best guess is that sometime in the next 18 months, there will be a collective sigh that the crisis has passed, and that there is now an incredible investment opportunity.  All that cash will come flooding back into the bond and stock markets.