The High Cost of Financial Paralysis

I recently wrote a five part series in which I noted that current economic data supports that

• We are likely in the “trough” of the current economic cycle

• Monetary policy is very accommodating

• Investor sentiment is lower than it has been in decades, and

• Valuation shows the equity market is trading under its historic P/E average.

From these data, I concluded that, based upon historic precedent, this may be the best equity and real estate buying opportunity in decades. Not everyone agrees. Let’s take a look at the other side of the argument.

1. This situation is not comparable to previous economic downturns, as a combination of the housing bubble, lax mortgage underwriting standards and securitization and sale of mortgage loans has produced an economic downturn with severity second only to the Great Depression.

This recession is the longest since 1932. Its root cause is the bursting of a housing bubble that affected a very significant percentage of the domestic and international financial markets. Unlike the “Internet bubble” in the late 1990’s that affected only investors in that sector, this crisis affects most homeowners, who are losing net worth in a market of declining property values, as well as most financial institutions that participated to one degree or another through ownership of some amount of poorly underwritten securitized mortgages.

In addition, this crisis affected both the growing number of persons who invest in domestic capital markets through their 401(k) and other investments, as well as global markets through purchase of packaged securitized mortgages.

Those who question the conclusion that this is a significant buying opportunity do not do so because they disagree with the opinion that we are in (or near) the “trough” of the current economic cycle; rather, that they postulate that the length of time necessary to correct the excesses in the housing market will be more than the timeline suggested by most economists. Since the details of the stimulus package are currently unavailable, that is an impossible question to answer.

What we do know are the “players” in the new administration’s economic team

• Federal Reserve Bank Chairman Ben Bernanke. Dr. Bernanke is a respected scholar in the causes of the Great Depression with recent, relevant economic policy experience

• Treasury Secretary Timothy Geithner is the president of the New York Federal Reserve Bank, and has extensive international and domestic economic policy experience

• Chairman of Economic Advisors Lawrence Summers stated in December, 2007, that is was “distinctly possible we’re headed into a period of the worst economic performance since the stagflation of the late 1970s and recessions of the early 1980s.” More recently, he predicted that the financial markets wouldn’t return to normal for a long time.

Based on their individual and collective expertise, I think it is reasonable to assume that this particular economic team will err on the side of over – not under – reaction to this crisis, and therefore the timeline for recovery may not be significantly longer than projected.

Further, at the recent equity market bottom, nearly 2/3 of the S&P 500 stocks were down more than 50% from their high. After hitting that bottom, the market began to recover, regardless of very bad news about unemployment, indicating signs of a more positive market.

2. Because of the significance of the factors which caused this recession, measurement systems are less relevant.

Every recession is different from another. The micro and macroeconomic contributing factors differ with respect to type and severity. There are, however, similarities which include

• High unemployment

While we current have an unemployment rate of 7.2%, we had an unemployment rate ranging from 7% to 7.8% in the period from October, 1991 to June, 1993. In May, 1980, the unemployment rate was 7.5% and rose to 10.8% in December, 1982, before falling back under 7% in January, 1986. Historically, this level of unemployment is not unusual in the domestic recessionary environment.

• Low investor sentiment

Investor sentiment is predictably lower during recessionary times. Last October, this measurement fell more (from 70.3 to 57.5) than it had since records began in 1978, signaling the severity of this particular recession.

• Accommodative Monetary Policy

Because poorly underwritten mortgage loans were packaged together with more traditional mortgages, securitized and sold to everyone from risk adverse individuals to financial institutions, there is an uncertainty as to how to price these packages. How many of these “bad” loans are in each package, and how many of these loans will actually go bad?

No one knows.

In the late 1980’s, the US faced the Savings and Loan Crisis, which was rooted in a regulatory tangle in which thrift institutions could pay high market rates for deposits, but were under regulatory constraints as to the rates they could charge for mortgages. The resulting earnings squeeze resulted in the combined closing of 1043 institutions with $519 billion in assets by the Federal Savings & Loan Insurance Corporation and the Resolution Trust Corporation. Approximately half the thrift industry did not survive.

This fact does not lessen the enormity of our current financial problems, but does show that pervasive difficulties in the financial markets are not unprecedented, and the US economy has overcome them in the past.

The current “TARP” (Troubled Assets Rescue Package) includes $700 billion in congressionally approved funding, about half of which has been allocated to assist in shoring up the capitalization on bank balance sheets containing securitized mortgages. While results may be currently limited to shoring up some financial service companies’ balance sheet, it is a stimulus of unprecedented size and will likely have a positive economic effect.

3. Why rely on Standard & Poor’s earnings projections, when it was one of the companies that rated “toxic” packaged mortgage securities as “AAA”?

Skepticism in this market environment is certainly understandable, and more than one source of information is desirable. Comparing S&P’s earnings projections to other 2009 S&P 500 earnings prognosticators, we find the following

• Richard Bernstein – Merrill Lynch

September, 2008 – $63