In the middle of the Great Depression, the famous economist John Maynard Keynes was asked if man had ever suffered through a worse experience in its history. "Yes," he allegedly replied. "It was called the Dark Ages and it lasted a thousand years."
Comparisons to more recent financial calamities, like the savings and loan crisis in 1990, ultimately may prove to be more relevant to today's predicament. But as the mushrooming subprime loan crisis enters its tenth month (taking last July 17 as the launch date), a growing list of questions begs answers. They include: 1) How serious is-or was-it; 2) How long will it last; 3) How could a meltdown in what is about 10% of a sector that is only 5% of the overall U.S. economy bring the global financial system to a virtual standstill; and 4) What will the shape of the recovery look like?
Several informed, well-situated observers, such as Alan Greenspan and George Soros, have described the subprime affair as the worst crisis they've ever seen. Of course, Greenspan said the same thing about the Long-Term Capital Management demise in 1998 and Soros described the 1987 stock market crash in the same terms.
Peter Fisher, a managing director at BlackRock, has seen his share of financial crises, first as an executive vice president at the New York Federal Reserve Bank resolving the Long-Term Capital crisis, and then as an undersecretary of the Treasury dealing with problems arising from 9/11 and the Enron and Arthur Andersen scandals. Without a doubt, the subprime tsunami dwarfs the other crises, in his view.
"This is clearly a lot worse than 1998, which also involved the Russian default," Fisher says. "It's gone on and on. Every time you get up off the mat, you get knocked down."
Nonetheless, light is flickering at the end of the tunnel. When asked approximately what inning the U.S. subprime crisis is entering, Fisher and his colleague, BlackRock Fixed-Income Chief Investment Officer Scott Amero, estimated that the financial part of the crisis is somewhere between the sixth and eighth innings.
That's the good news, though neither man expresses a high degree of certainty. "Infinity is always a possibility," Fisher jokes. Yet he thinks that the Bear Stearns collapse is looking like the proverbial burning comet that streaks across the sky shortly before a crisis subsides. "We've probably passed the maximum stress point," he continues.
Coming from Fisher and Amero, who both enjoy a heart surgeon's view of the current crisis, that's a significant statement. After all, BlackRock was retained by the Fed to manage-or liquidate-a big chunk of Bear Stearns' toxic mortgage-related assets that neither the Fed nor Bear's arranged marriage partner, JP Morgan, wanted any part of. BlackRock, whose founder and CEO, Laurence Fink, helped create the mortgage-backed securities market in the 1980s, reportedly could earn over $50 million for the assignment.
In addition to more than $45 billion in mortgage-backed securities that are hard to value, Bear Stearns' portfolio included $2.5 trillion in credit default swaps, equivalent to about 5% of the total credit default swap market. Until a year ago, few advisors had ever heard of the $50 billion credit default swap market which, at least in dollar value, amounts to more than three times the size of the entire U.S. economy. Swaps are private contracts between parties, and it's not clear government regulators possess any right to supervise them. So the prospect of a Bear Stearns bankruptcy resulting in years of litigation over the value of these instruments was enough to spook the Fed into arranging the so-called bailout.
Excessive use of leverage spawned the credit bubble. What the markets are dealing with today is the ongoing challenge of a rolling deleveraging and other circumstances that have extended the duration of this latest crisis du jour. The problem, in Fisher's view, is that if everyone is highly leveraged, then "how does everyone delever [themselves] at once?"
What seems to have caught the Fed off guard is that, as the crisis unfolded, the "whole system didn't seem like it had anyone [in the asset origination business] that was prepared to be countercyclical," he continues. "That's probably one reason why the Fed was so concerned and so aggressive." Indeed, well-capitalized banks like US Bancorp and Wells Fargo have passed on chances to buy distressed financial institutions until now. JP Morgan only agreed to buy Bear Stearns after laying off the risk, and Bank of America picked up Countrywide for a song.
Raising equity is a quicker way to deleverage than selling assets or paying down debt over time. Market conditions, coupled with the inability of companies to value impaired assets, are forcing companies seeking capital, like Washington Mutual, to accept a higher degree of equity dilution than they would like, but shareholders have little choice. In the current environment, unwinding the subprime problem has demanded that financial companies own up to their mistakes by bringing Structured Investment Vehicles (SIVs) back on their balance sheets. "It's hard to raise equity when you are running all those losses through your income statement," Fisher explains.
Placing a value on a variety of complex instruments has been a contentious process over the last nine months. Shareholders of both Countrywide and Bear Stearns have cried foul, as have critics of sovereign wealth funds in cash-rich emerging nations. Communist Party members in China turned a recent meeting into an event reminiscent of the last Enron shareholders meeting as they berated the executives of its sovereign fund for pouncing on U.S. financial assets last year only to find the worst was yet to come.
Signs are surfacing that players in several markets are starting to agree on prices for risky assets and markets can clear once again. Asset-backed commercial paper is enjoying a subdued mini-revival. In early April, a group of private equity firms agreed to buy just over $12 billion in junk-rated loans from Citigroup at what was estimated at 90 cents on the dollar.
The U.S. financial system appears to be regaining its footing, but the credit crisis is likely to exact a more far-reaching toll than it has to date on the real domestic economy and the rest of the global financial system. In the view of Fisher and Amero, the banking system in Europe and the rest of the developed world probably is "six to nine months behind ours." That is not a good place to be, and it helps explain why price-to-earnings ratios in many European equity markets are hovering around 10 or 11.
"The European banking system could be in worse trouble," Amero says. "They have less frequent financial reporting and less transparency. We exported a lot of subprime and I think they are just starting to confess."
Moreover, foreign banks face the dual problem of asset mismatches coupled with currency mismatches, and they are unlikely to find other lenders willing to fund them in dollars. These problems won't be just confined to Europe, which is starting to wrestle with its own housing bubble. "CDO [collateralized debt obligations] road shows were done in Japan and other countries, not here," Amero notes wryly.
Amero and Fisher are surprisingly upbeat about the long-term prospects for the U.S. dollar, at least against the euro and other developed nations' currencies. Part of their view is based on their belief that, at present, much of the bad news in the United States is already out there, while Europe is only starting that process. "It's a lead-lag story," Fisher explains.
Over time, they think currency rates will be driven by economic growth rates, which positions the greenback favorably against Europe and Japan but not against emerging market currencies. In the meantime, stories about the dollar's demise as a reserve currency are "a little ahead of themselves," he adds.
Just as the equity market sobered up after the tech bubble, with valuations and investor behavior returning to reasonable levels, the credit markets are about to enter an extended transition to normalcy. Unfortunately, the continuing boom in foreclosures reveals that after the binge comes the purge.
Over the next several years, Amero and Fisher expect to see dramatic declines in both the supply, and probably the demand, for credit. While the long-term implications for American consumers and the U.S. economy are positive, the process of adjustment will be accompanied by pain in lots of places.
Issues arising out of JP Morgan's takeover of Bear Stearns, and the role played by the Fed, may or may not change the regulatory landscape. At present, market conditions and fear of the fate that Bear Stearns met is forcing major financial institutions, and the rest of America, to behave more sensibly.
Consumer spending-which climbed from 66% of gross domestic product (GDP) in the 1980s to 71% of GDP in 2007 at the same time as the national savings rate fell by almost a commensurate percentage-is going to face severe headwinds in the next few years. Many ordinary Americans stopped saving in the late 1990s when the wealth effect from rising equity portfolios more than made up for any savings shortfall. Shortly after that piggy bank pooped out, the housing market took off and home equity loans emerged as an even fatter cow to milk in lieu of old-fashioned savings.
At least for now, neither of these convenient alternatives to saving are available. For the long term, structural changes forcing Americans to save would be a very positive development.
But if consumer products companies are facing increasingly stiff headwinds-even Procter & Gamble's first quarter earnings left investors disappointed-industrial manufacturers are benefiting from the cheap U.S. dollar and the global economic boom. Although worldwide economic growth is expected to moderate in 2008, the fundamental factors driving this boom remain intact. Exports around the globe have yet to decline the way one would expect in the wake of a U.S. slowdown, according to economist Ed Yardeni. Some other economists are even predicting that if the greenback remains weak, what's left of U.S. manufacturing could enjoy a surprising renaissance when a global recovery begins in 2009.
Commodities remain one of the only assets still appreciating, and if business activity slows in foreign markets, the bell could soon toll for hard assets as well. Amero points out that never before have hedge funds and pension funds allocated dollars to commodities the way they have today. Still, the economic logic underpinning the global boom is undeniable, so "the long-term trend is in place for commodities," he adds.
On the investment front, conventional wisdom may not play out like some professional investors expect. In particular, those who recall how well financial stocks performed in the early to mid-1990s as they emerged from the savings and loan crisis could find history doesn't repeat itself. So if, as many expect, capital requirements are rising for banks and other financial institutions, and if the business of debt creation slows down and lending margins narrow, those who have been loading up on what appear to be cheap financial stocks may find themselves waiting longer than they expected for a rebound.
The dividend yields on bank stocks have made them attractive alternatives to bonds, but it's not clear they are sustainable. After saying earlier this year that they had no plans to cut their dividend, Wachovia Corp. in early April followed Citigroup and did exactly that, slashing its payout 41%. "[Banks] may be good investments over the next 10 or 20 years," Amero says, but adds that the next two years could leave some of the bargain hunters disappointed.
Some fundamental statistics support this view. In 2007, the figures on financial concerns' share of both equity and debt market total capitalizations had became eerily reminiscent of energy stocks in the early 1980s and tech stocks in the late 1990s. Between 1980 and 2007, financial services' market-cap-weighted share of the S&P 500 rose from 5% to 28%, though it has recently fallen back to the 20% area. While Amero and Fisher don't see those numbers reverting to their 1980 levels, it's difficult to imagine that their share of these pies will grow going forward.
Three straight months of rising unemployment figures and disappointing profit reports from a diverse array of companies like UPS, General Electric and Alcoa point to a recession, which many financial professionals think is under way. But the economy is entering this current economic slowdown with unemployment at a low level and corporate profit margins at a record high, and therefore most economists believe the recession will be mild.
Much uncertainty surrounds the shape of an expected recovery in 2009. "It's a little surprising that [Fed Chairman Ben] Bernanke foresees a return to trend growth in 2009," Fisher says.
A prolonged period of stagnation may be unlikely, but this Fed, worried about a potential unleashing of inflation, probably will want to move faster to raise interest rates than the Greenspan Fed did earlier in this decade. Because many think Greenspan left rates low for too long, he is getting much of the blame for the housing bubble.
As the subprime crisis began to unravel exactly one year ago, experts tried to sooth the public, noting that the problem represented only 10% of the housing industry, which was 5% of the economy. Fisher notes that since then, "we've learned how dangerous this notion of decoupling is." The lesson is that linkages in a global economy are greater than anyone assumed.
Amero and Fisher don't share the optimism of professionals in the equity market. Amero points out that investors can earn 6% to 7% in some high-quality, fixed-income investments over the next two years, while some long-term muni bonds offer almost 5% on a tax-free basis. "That might be a really good return," Amero adds. At the same time, Amero expects that the origination of high-quality corporate bonds will decline dramatically over the next two years, so a supply squeeze could make them even more compelling.
With short-term Treasury issuance expected to climb as the federal budget picture worsens, the BlackRock experts think the rally in those securities is near an end. The big values that still await bond investors lie in illiquid securities, probably high-quality mortgage securities buried in some CDO that responsible advisors wouldn't recommend. "There will be fabulous returns available in fixed income for investors who are willing to be patient," Fisher says.
Perhaps the biggest surprise is that, despite the present budget deficit and the looming entitlements crisis, Amero says that "we're not worried about long-term inflation. The Fed believes that weaker growth will ultimately dampen inflation. I believe they will be right in the longer term, but there may be periods in the near term when the markets question them."
What Others Are Saying
Recessions and bear markets typically provoke a surfeit of wonderment about what's the same and what's different. While both the economic statistics and the equity market performance over the last 10 months fail to meet traditional definitions of either a recession (two consecutive quarters of declining GDP) or a bear market (a 20% decline in major stock market indexes), many observers are presuming we are already there.
Speaking in early April at Tiburon Strategic Advisors' annual CEO Summit in New York City, retired hedge fund manager Michael Steinhardt posed the question of whether history would repeat itself or whether we were in uncharted waters. The correction of the last six months was "enough to qualify as a bear market," in his view.
But there are some positive indicators. "Price-to-earnings ratios are moderate and stocks are cheap relative to bond yields," Steinhardt said. "We've had a headline-grabbing event at Bear Stearns and a new tax cut [rebate] is coming in May. We may bottom out near or slightly below recent lows."
But never has the entire nation been as leveraged as it was before this process began, which makes Steinhardt wonder if a perfect storm could be brewing. It's not all the fault of U.S. banks. "Chinese banks are more promiscuous than American banks," he noted. Still, one "can't help but be impressed" how many U.S. hedge funds have gone bankrupt, how many giant financial institutions have been "brought to their knees," and there's still "enormous liquidity" and a stable economy.
Loomis Sayles Vice Chairman Dan Fuss remarks that in March the bank loan market bottomed and municipal bonds "bottomed relative to Treasurys." One by one, other sectors of the fixed-income market are finding their own floors "as selling pressure subsides." While Fuss praises the supportive actions of the Federal Reserve, he worries about other central banks, notably Japan's, which has "no one in charge."
David Kelly, chief market strategist at JP Morgan Funds, believes we are in a short, mild recession. Why? "It's hard to find a boom-bust sector [besides housing] in the U.S. economy," he explains. Housing has been "in decline for two years" and has done "just about as much damage to the economy as it can."
Consumer spending is an area of worry, but Kelly notes the rise in unemployment claims has been modest, partly because businesses didn't "go out and overhire" in recent years. If unemployment doesn't trend up more than he expects, consumer spending should remain in positive territory.
Like Kelly, Bill Cheney, chief economist at John Hancock, thinks a serious recovery could start in the third quarter. "I don't see a dreadfully painful recovery like the last one," Cheney says. If the slowdown is contained, with unemployment peaking at about 5.5%, the U.S. economy could "experience several years of growth with [the possibility of] running room."