Current Financial Conditions: Our View
Wall Street today is facing its worst crisis in decades. The bankruptcy of Lehman Brothers, the federal bailout of mortgage giants Fannie Mae and Freddie Mac, and the forced sale of Merrill Lynch to Bank of America are the most recent highlights in this ongoing tale of woe. We are monitoring this situation closely, and below we offer a brief account of this crisis and its implications for our clients’ portfolios.
At the center of the story is the housing market. As we have warned for three years, house prices in the US inflated dangerously through a toxic mixture of easy money and lax federal oversight. So-called “subprime” and other “creative” mortgage products flooded the housing market with new buyers, and many were unable to shoulder the debt they took on.
As the bubble in housing prices finally burst (as all bubbles do), many homeowners found themselves with mortgages they couldn’t afford and whose pay-off balances were greater than the reduced market value of their homes. The result was a sharp increase in mortgage defaults. Those that have been hurt the most are the newly unemployed workers, and the millions of middle-class borrowers who are now suffering from the financial stress and foreclosures that are the consequences of this glaring failure of private and public-sector governance.
Most of these dicey mortgages had been “securitized” by Wall Street, bundled and sold to investors as “high quality” mortgage-backed bonds. Lax regulation, greed, excessive risk taking and poor judgment by private rating agencies all contributed to the market failure. As mortgage defaults rose sharply, the bonds backed by the mortgages lost favor and, in fact, lost pricing altogether as potential buyers stepped away from the market, refusing to bid on the bonds at any price.
What we’ve seen increasingly over the past several months is a massive write-off of the value of these bonds by the banks, investment banks and hedge funds that owned them. To date it’s estimated that $600 billion of these securities have been written-off. When banks write off these assets it has two effects: first, the amount of the write-off is charged against profits and, second, it reduces the capital base of the bank and thus its ability to lend. This is where problems on Wall Street have an impact on Main Street.
Were this simply a problem isolated to Wall Street, many might be inclined to say, “You reap as you sow.” Excessive risk-taking often yields ruinous financial losses and the market teaches this lesson regularly. The problem for Main Street, however, arises when a shrinking capital base on Wall Street constricts lending in general.
The most recent moves by Treasury Secretary Henry Paulson and Fed Chair Ben Bernanke should prove to be helpful. After bailing out Bear Stearns to facilitate its purchase by J.P. Morgan, they are now trying to draw a clear line between Main Street and Wall Street through their interventions. They stepped in and took over Fannie Mae and Freddie Mac as these two institutions are essential to the US mortgage and housing markets. Maintaining liquidity in these markets is crucial to the overall economy and that’s what the US Treasury did in taking over these institutions. Lehman Brothers, on the other hand, was an independent investment bank that the government allowed to fail. They did this under the belief that the fallout from Lehman’s bankruptcy is unlikely to threaten the overall financial system. It’s a Wall Street disaster, not a Main Street disaster.
The global nature of financial markets may yet lead to coordinated interventions by governments and central banks from a number of countries. As a result of the recent interventions, there is some hope that the crisis may be entering its final stages. Already, government support for Fannie and Freddie has led to lower mortgage rates for qualified borrowers. This improved mortgage financing environment will provide critical support to the housing market. And a stabilization of housing prices is necessary to get the economy on a sounder footing.
Equally important, the problems at the heart of the Wall Street banking system have been exposed. There may be much more in write-offs ahead of us in the next few months. But unlike the case in Japan, where denial lasted for well over a decade, in this case losses are being realized now. This up-front pain, as difficult as it is, will hasten recovery. Banks will own most of the surviving Wall Street institutions (including Merrill Lynch, anticipated to be acquired by Bank of America). This is likely to make them better capitalized and able to operate from a position of strength.
For socially responsible investors, this crisis demonstrates once again that a sustainable economy requires a balance between free-market forces and vigorous regulatory oversight. The laissez-faire attitude of Congress and the executive branch towards Wall Street has clearly past its sell-by date. Treasury Secretary Paulson and Fed Chair Bernanke, along with both presidential candidates, have blamed this mess in part on a failure of adequate regulation of the financial system. As millions of Americans have been hurt by falling home prices and lost jobs, we and many others will be pushing the federal government to step up its oversight of investment banks and the mortgage market.
Responsible investing is patient and forward-looking, not panicked and reactive. We have made no major changes to client portfolios in response to the current crisis. We did de-emphasize the financial sector in our portfolios starting last year, however, in anticipation of the troubles to come, a move that has proven quite valuable. For the markets overall, while there is risk of further declines, there is also the prospect of meaningful recovery. The dramatic recent fall in energy prices will help lower inflation and increase consumers’ spending power.
In the context of diversified portfolios, many of our clients have held positions in a few of the blue-chip stocks and bonds now under great stress, including AIG. Like all insurers, AIG is not without its social issues, but we have been holders in part because of the strong sustainability profile adopted in recent years. AIG was the first major U.S. insurer to develop a climate change policy, which includes new climate-related products and investments in renewable energy. AIG has strengthened its climate change policies over time and increased its social and environmental reporting. The company reports to us regularly on its performance in social and environmental areas. There is some chance that AIG will pull through this crisis; if not, we will miss its leadership on sustainability issues.
No doubt, the financial and housing sectors are in recession, and Wall Street is in crisis. Other parts of the economy, however, are holding up surprisingly well, including many service industries and the export sector as a whole. The overall economy, in fact, has continued to expand modestly throughout this turmoil.
As long-term investors we try to keep in mind that the best returns are earned in the periods following financial crises. In 2003, following the epic bear market of 2000-2002, the S&P 500 gained 28%. For wealth building over a period of years, there are risks to being out of the markets, as well as to being in them.