Since the housing industry first collapsed more than two years ago, there has been concern how widespread the effect would be on the economy.  While the economy has continued to grow at least as of the last quarter, the fear of a deep recession has resulted in a steep market decline despite continuing double-digit earnings growth of non-financial stocks.

The plummeting dollar has been a boon to exports - foreigners are buying our goods, our real estate and even our U.S. companies. Booming exports are offsetting the decline in the housing sector, but there is concern whether the housing market bust will result in a deeper decline in consumer spending.

The stock market is priced to anticipate an economic collapse! Sensitivity to signs of economic weakness has been magnified while evidence to the contrary is often ignored. It is as though we have been in a recession for some time. While first quarter 2008 GDP may turn negative, most economists expect it to head up again by the second half of 2008.

The extreme negative sentiment exhibited by many expecting and preparing for the worst has created an opportunity for investors who are willing to position portfolios for a possible far less than catastrophic outcome and the rebound. Whether or not a recession results, we have a “Fearsession”!

The Fearsession may actually be good. Businesses, thinking that a recession is imminent, significantly pared inventories in 2007 to their lowest levels since before the recovery began.

Based on fear, households have slowed spending and boosted liquid asset holdings (e.g., inflation-adjusted annual growth in household liquidity remains very strong and retail money market funds have exploded.)

Bond investors have already priced in a recession. Short-term Treasury bill yields are below 2 percent and the 30-year Treasury bond yield declined recently to an all-time record low! Finally, recession fears have brought forth massive economic policy stimulus including rapid money supply growth, a negative real Fed funds rate, an increasingly positively-sloped yield curve, a stimulative falling U.S. dollar and panicky fiscal policy moves to stimulate the economy. The Fed has made it clear it is going to fight with all its power the downturn and potential recession.

Credit Frozen Even for the Best Prime Borrowers

The credit markets even for prime loans and commercial paper are “frozen” because of massive write-downs in subprime loans.

The credit crisis is spreading to many financials and hedge funds such as Carlyle Group based in Guernsey, England. Like most hedge funds it is highly leveraged. For each $1 of mortgages it buys it borrowed $30+ against what its bank lenders considered very safe, U.S. prime mortgage-backed securities of Fannie Mae and Freddie Mac, which carry the implicit backing of the U.S. government. However even these prime mortgage securities lack buyers in the market; Carlyle failed to meet margin calls and it lenders seized its portfolio.

Accounting rules require that mortgage holdings be “marked to the market” in computing equity and for banks reserve requirements. But with the drastic write-downs of subprime loans, most financial institutions don’t have enough reserves or equity to buy even steeply discounted prime debt, or issue new loans to even prime borrows.  Therefore, the credit markets are “frozen” with only a few buyers at deeply depressed prices and little money to lend to anyone.

John Mauldin in 3/3/2008 article “Credit Crisis Presents a Great Buying Opportunity?” says that the credit markets are priced at values that would assume 50% of all loans will default over the next five years. He says, “A default rate of this magnitude suggests that we are approaching a recession of almost biblical proportions. The implied default rate is now three times higher than during the savings & loan crisis in the early 1990s…Do we subscribe to such a bleak view? Absolutely not.”

The Fed to the Rescue? – Creative Move

In a creative surgical strike to stabilize the global credit crisis, the Fed will lend $200 billion of U.S. Treasury bonds it already owns (not new issues) taking as collateral about 85% of the value of AAA rated, Fannie Mae, Freddie Mac and other prime mortgages.

The loans will be available for 28 days starting March 27^th.  In addition the Fed has made available $100 billion in loans to banks via its Term Auction Facility, $100 billion in 28-day money market loans to bond dealers, and $36 billion in swap lines to European Central Banks. It is hoped this will help stabilize credit markets and may be extended if needed. The next more controversial step would be for the Fed to buy the depressed mortgages – although that could result in eventual profit for the Fed/U.S. Government.

The welcomed Fed action does not directly help the subprime crisis except it could help make credit available for refinancing for borrowers that have subprime loans but qualified for lower- interest prime “conforming” loans. Its rescue of Bear Stearns shows further commitment to the financial markets in this time of a credit crisis.                

Ideas for Subprime Solutions

President Bush thinks rebates are the solution. While they may provide a small stimulus to retail spending rebates do nothing for the credit crisis.

Senator McCain who admits he has little knowledge of economics says the solution is for the wealthy to know that their small tax cut (which most didn’t even realize they got) will be made permanent so their taxes won’t go up in 2011!  We already have among the lowest individual tax rates in the world – along with a $9 trillion deficit having to be financed largely by foreigners such as China and Saudi Arabia!

I recall my CPA firm days when it was great to have earned income over $52,000 since that qualified for the 50% maximum tax rate on earned income instead of up to 70% rates on other income!  And the economy did very well.

McCain believes, as does President Bush, in the supply-side theories and trickle down of benefits from the rich to the middle class. Ironically George H.W. Bush derided Reagan's supply-side policies as "voodoo economics".

McCain also wants to decrease the corporate tax rate which is high compared to most of the world. When corporations have been enjoying years of huge profits this doesn’t seem very essential. He has no ideas I know of to help the subprime credit or housing crisis.

Hillary Clinton has some limited good ideas to establish funds to assist state programs to help those facing foreclosure and expand Fannie Mae’s and Freddie Mac’s foreclosure prevention programs.  But at most this only helps those with “conforming” loans and has only a minor effect on the credit crisis.

Barack Obama says the real victims of the subprime mortgage crisis are the borrowers who followed the rules and whose only crime was taking out mortgages that lenders told them they could afford. I tend to agree, but his solutions which are similar to Hillary’s, do not provide a rapid end to the credit crisis.

While some home buyers made bad decisions to buy more than they could afford and should not be rewarded, the issue is now far larger.  Many home buyers were “sold” bad deals and those sellers are long gone, leaving the investors and the credit markets to take all the losses.  Today we have to consider what is best for the entire U.S. economy -which has implications that spill over into other countries.

Remember the Resolution Trust Corporation (RTC)? 
It bailed out failing S&L’s to solve a similar credit freeze and potential economic disaster. Today we don’t have thousands of insolvent financial institutions to rescue. We have a stressed, but mostly solvent financial sector.

RTC had to move quickly to solve a major national financial crisis by combining public financing with private partnerships. It acted in a way that minimized taxpayer costs and avoided serious dislocation in markets. It accomplished its goal in less time than was expected.  RTC pioneered the use of so-called “equity partnerships” to help liquidate real estate which it inherited from insolvent thrift institutions. The equity partnerships involved private sector partners which benefited both the investors and the taxpayers.

Instead of buying up foreclosed real estate and selling it at a loss to investors, today a “Credit Crisis Corporation” (CCC) could potentially make money for the government. 

Equity partnerships could be created with both private and government financing.  Special bonds could be issued by the Treasury at today’s very low interest rates. Because there should be profits made from the mortgages the increased deficit of the bonds should be temporary and provide the solution to the downturn in parts of the economy.  It would be far more effective at going after the real issue rather than sending out rebates.  The resulting hopefully robust economy also brings in more tax revenues.  So the long-term effect could be positive for taxpayers and for the U.S. deficit.

“CCC” could buy mortgages from the financial institutions at more than the unrealistically low  current values, freeing up their capital and reducing their losses.  With more money to fund restructuring of loans, the result would be fewer foreclosures and the ultimate payback to “CCC” could be a profit split between the equity investors and the government. 

The worse the crisis gets, the more pressure there will be to solve the credit crisis.  An RTC type plan could speed up the turnaround, which would help the deeply troubled housing industry as well as homeowners and the financial sector. 

Good Time to BUY!!!?

With the steep decline in markets worldwide and with lots of solutions in the works, this seems like a great time to look at or maintain diversified investing opportunities!

The views and opinions expressed by Dave Hutchison, CFP are as of the date of the report, and are subject to change at any time based upon market or other conditions.  The material contained herein is for informational purposes only and should not be construed as investment advice since recommendations will vary based on a clients goals and objectives. Information is believed to be from reliable sources; however, no representation is made as to its accuracy.  All economic and performance information is historical and not indicative of future results.  Please consult one of our financial advisors for more information. Hutchison Investment Advisors, Inc., is a Arizona registered investment advisor. Part II of Form ADV (Disclosure Statement) has been given advisory clients and is available upon request.

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