March 2008
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Addendum |
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The Federal Reserve (the Fed) this morning approved an emergency funding measure to ensure the short-term viability of Bear Stearns Corporation, after the firm’s financial position took a sudden and sharp turn for the worse. The measure allows Bear Stearns to access 28-day short-term funding through the Fed’s discount window. The Fed window is normally off-limits to Bear Stearns, a nondepository institution, which necessitated that JPMorgan be brought in as a conduit for the transaction. No amounts have been released on the amount of the emergency funding, but the news severely rattled equity markets, which continue to react sharply to any hint of news.
This development, in our opinion, portends potentially greater government intervention to underpin the credit markets. The Fed is seeking to avoid a scenario where the failure of a major financial institution, like Bear Stearns, creates a domino effect across a wider swath of the credit markets and further impairs the current lending environment.
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Sudden Turnaround
On March 11, the Fed announced a temporary lending program geared toward relieving some of the short-term stresses in the currently dysfunctional credit markets. The news led to an abrupt reversal in what had been a multiday downward trend for stocks; markets spiked by 3 percent to 4 percent in the largest, single-day jump in several years. Commonwealth’s Research team views the announcement as an important new step in the Fed’s overall effort to unfreeze access to capital, while allowing market participants additional time to reprice and clear the logjam of now illiquid mortgage-related securities on their collective books. In addition, this action demonstrates to them that the central bank is not a one-trick pony and is willing to be creative in addressing the continuing fallout from subprime.
Contrary to the CNBC-led, frenzied speculation as to whether Tuesday’s resultant spike in stock prices represented a market bottom, we do not view this recent news as a panacea for all that ails financial markets. Deeper analysis reveals that several underlying concerns that have driven recent Fed policy still exist. In particular, continued deterioration in housing, tight credit conditions, employment concerns, and inflation remain acutely on the Fed’s radar. We consider the most recent action to be another step in a longer process, as financial institutions continue to reprice risk and deleverage their balance sheets. We believe the Fed’s actions—those undertaken so far, as well as those yet to come—will eventually allow the mortgage blockage to be purged from the credit markets.
It is foolhardy to attempt to assert with any degree of certainty what the picture will look like in the months ahead—market forces may cleanse the financial system on their own or political interests may inspire a taxpayer-funded bailout. But in the near term, we expect overall economic weakness to persist.
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Fed Announcement
The Fed’s announcement centered around changes to its Term Securities Lending Facility (TSLF), one mechanism by which it can provide liquidity to member firms. In short, the Fed is offering to lend up to an additional $200 billion to its 20 primary dealers—a virtual who’s who of the world’s most influential credit market participants. As collateral for the loans, in addition to what is usually accepted, the central bank will now accept a variety of residential mortgage-backed securities (MBS), the liquidity of which had dropped precipitously in the aftermath of the subprime mortgage crisis. Key aspects to the new program include:
Most important—acceptable collateral has been expanded to include AAA-rated, nonagency, private-label MBS.
The new lending program makes short-term funding available to nine additional nondepository member firms that had benefited little from the previous efforts to provide liquidity.
Loan terms were extended for up to 28 days versus the current overnight term.
This approach appears to be a more precise strike than previous initiatives, providing relief more directly to the segment of the market in greatest need of reinforcement. The more broad monetary initiatives attempted previously—direct injections of liquidity, reductions to both the federal funds rate and the discount rate, and term auction facilities—have fallen short, as financial institutions trying to repair their balance sheets have been averse to lending under almost any circumstances.
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Next Step for the Fed
Prior to the recent announcement, interest rate futures markets were predicting a near-certain 75-basis-point cut in the federal funds rate at the Fed’s next scheduled meeting on March 18. Our sense, however, is that the recent Fed announcement represents a departure from the blunt-force approach that another interest rate cut would represent, in favor of a more targeted strategy. We expect a cut—and would not be surprised to see 50 basis points—but would view a deeper cut as a sign of increasing aggressiveness by the Fed in combating credit market issues.
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Economic Backdrop
Mortgage market and residential housing conditions have thus far failed to show signs of a turnaround. Supply continues to outstrip demand in many areas of the country, even against a sharp drop-off in new construction. Home prices in 2007 suffered their first annual decline since the Depression era. The potential exists for a negative cycle where increased foreclosures put more homes on the market, increasing supply and putting further downward pressure on home prices. This, in turn, would increase the foreclosure rate, as more homeowners discover they owe more on their mortgages than their homes are worth. In fact, a recent Fed report highlighted that homeowner equity dipped below 50 percent last year—to 47.9 percent—marking the first time that debt has outweighed U.S. homeowner equity.
Should it persist, prolonged weakness in the housing market has the potential to exacerbate the ongoing credit crunch. Some reports indicate that we are near the end of subprime-related write-downs, with Standard & Poor’s, for example, saying on March 13 that it believes most of the bad news has already been announced. While we hope that is the case, we are not convinced.
In research entitled “Leveraged Losses: Lessons from the Mortgage Market Meltdown,” by David Greenlaw et al, the authors use various estimation methods to project that total mortgage losses will eventually reach $400 billion—far exceeding the approximately $170 billion in mortgage-related asset write-offs taken so far—with much of that exposure held by leveraged intermediary financial institutions. Those institutions (major lenders in the global financial system) are typically leveraged by roughly 10:1, meaning that for each $1 of assets on the balance sheet, they take on $9 of debt. When asset prices rise, each $1 increase in the value of securities results in an additional $9 of borrowing or available credit to the marketplace. On the downside, each $1 drop in the value of securities (i.e., mortgage-related write-offs) results in the bank needing to either raise equity (via capital infusion from sovereign wealth funds, for example) or sell securities worth $9 in order to maintain its 10:1 leverage ratio on the balance sheet.
This deleveraging effect has put pressure on a variety of asset prices and has also led to the ultra-tight credit market conditions we have witnessed recently. Should the report’s estimates of yet-to-come write-downs prove accurate, the remaining $200+ billion worth of value in MBS yet to vaporize would translate into a $2 trillion to $3 trillion reduction in the funds available to businesses and consumers—in effect, tying an anchor to our domestic economy.
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The Fed’s options for dealing with the credit crunch are complicated by the specter of rising inflation. Prices for gold and oil have surged to record highs, and prices for a wide variety of industrial metals and agricultural products that are key components to most consumer goods have also soared in recent months, driving up the price of food, gasoline, and other basic necessities.
And there are signs that economic woes are indeed hitting consumers in the wallet. With consumers facing rising prices and feeling less wealthy due to home price declines, U.S. retail sales fell by 0.6 percent in February. In testimony before key congressional committees in late February, however, Fed Chairman Ben Bernanke made clear that the Fed views inflation as likely to moderate in 2008, as weaker economic conditions worldwide put a damper on demand. In fact, preliminary inflation data for February released March 14 indicated flat inflation for the month. The Fed’s policy focus on fostering economic growth and responding to deteriorating credit market conditions therefore seems warranted—at least in the near term.
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Where To From Here?
As the Fed continues to take steps to address what it sees as the pressing economic concerns of the day, the question is, what if current policy measures just don’t work?
The Fed’s recent action is its most creative—and targeted—effort so far to score a direct hit on subprime MBS and the availability of capital in the credit markets. The economic stimulus package pushed through Congress should also have beneficial effects that are yet to be felt. But those measures do little to benefit homeowners who are either currently facing foreclosure or who, due to falling prices, risk owing more on their homes than they are worth. That said, various other proposals have been enacted or are being considered by policymakers to address those concerns.
The Mortgage Forgiveness Debt Relief Act, signed into law late last year, allows homeowners to avoid paying income taxes on any mortgage amount forgiven on a qualified principal residence. Other programs focus on freezing the interest rate on adjustable-rate mortgages for subprime borrowers for up to five years. Bernanke, in a speech to the banking community on March 4, urged lenders to consider principal reductions for at-risk borrowers who can afford their existing mortgage but who have seen their home prices decline and their equity reduced to a degree that voluntary foreclosure (or simply walking away from their mortgages) becomes a financially credible consideration. Bernanke’s recommendation holds some appeal but runs the risk of pushing future mortgage rates higher, as lenders seek to increase risk premiums and recoup losses on past loans—a less desirable byproduct for the housing market in the longer term.
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Legislative Bailout Possible
The longer the current credit problems persist, the louder will be the clamor for the government to step in and provide capital relief to stressed financial institutions. We are unenthusiastic about the prospect of taxpayer money potentially finding its way to bail out financial institutions that profited by first offering loans to unqualified borrowers and then creating a market of complex, securitized debt obligations around them. But the situation appears to be inching in that direction.
The most recent Fed step stops short of what many have already called for—that is, having the central bank begin to purchase illiquid, mortgage-related assets directly from the open market. Another possibility is for government to provide capital funding directly to weakened financial institutions, improving their balance sheet positions and allowing them to return to a more normal lending environment. While those options are likely viewed as a last resort by the Fed and federal legislators, their hand could be forced by the domino effect of the current economic reality.
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Disclosure: Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results.
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Andrew J. Barkley is a financial advisor practicing at HW Financial Advisors, 23240 Chagrin Blvd. Suite 700, Cleveland, OH 44122. He offers securities and advisory services as an investment adviser representative of Commonwealth Financial Network(R) - a member firm of FINRA/SIPC and a Registered Investment Adviser. Andy can be reached at (216) 378-7269 or at barkley@hwfa.com. Authored by John Blood, CFA, chief market strategist, at Commonwealth Financial Network.If you have questions on any of these or other planning opportunities please feel free to contact Andy or your HW Financial Advisors Professional.