Tuesday, September 9, 2008

The State of the Investment Markets

“There was an old lady who swallowed a fly.
I dunno why she swallowed that fly,
Perhaps she'll die.

There was an old lady who swallowed a spider,
That wriggled and jiggled and wiggled inside her.
She swallowed the spider to catch the fly.
But I dunno why she swallowed that fly -
Perhaps she'll die.”
- Folksong

I thought it would be a good time to offer some perspective on what we’re seeing in the investment markets.

It’s been a brutal year: the Standard & Poor’s 500 index is down -12.3% for the year – this after Monday’s (Sept 8th) increase of 2% (25.48 points). Markets in other countries have fared no better and many in fact are doing worse. A global economic slowdown seems to be underway.

By now, the story of the housing bubble fueled by easy credit should be familiar. Too much easy money ignited demand for houses (new and existing) and created an unsustainable rise in home prices. We are still dealing with the consequences. Home values are falling and borrowers who thought they would be able to re-finance their way out of trouble are finding they can’t and are abandoning their homes to the lender. Mortgage foreclosures are approaching numbers not seen in the U.S. since the Great Depression of the 1930s (9% of all residential mortgages in the U.S. are in late payment status or foreclosure proceedings). Lenders have tightened their credit requirements – which means they are making fewer loans – while their assets – mortgages and mortgage bonds – are declining in value. Banks large and small are finding themselves in the unenviable position of having to raise capital in this environment – sell stock or issue bonds – to shore up their balance sheets so they can remain in business. Many of the largest U.S. banks have turned to Sovereign Wealth Funds (SWF) for capital, effectively selling part of themselves to non-U.S. investors. Of course, the U.S. Government has been doing this for years for essentially the same reason.

Enter the U.S. Treasury (or “Treasure Island” as I’ve seen it referred to). The U.S. Government explicitly guarantees only certain debt issues: U.S. Treasury obligations (T-Bills, Notes and Bonds) and mortgage-backed bonds issued by the Government National Mortgage Association (Ginnie Mae) being prime examples. There are two major Government Sponsored Entities (GSE) that have enjoyed an implicit U.S. Treasury guarantee: Fannie Mae (FNMA - Federal National Mortgage Association) and Freddie Mac (FHLMC - Federal Home Loan Mortgage Corporation). Fannie and Freddie as they are known, provide about half of the financing for home mortgages in the U.S. and have used the implied government guarantee to finance their operations.

Monday’s takeover of Fannie and Freddie – changing the implied guarantee to an explicit guarantee - could go a long way in reducing mortgage interest rates for new borrowers, stabilizing U.S. housing prices, and perhaps help to free up the tight credit markets around the world. In fact, today (Sept 9th) 30 year mortgage rates are being quoted at a national average of ~5.9%, down 50 basis points (one-half of 1%) from levels one month ago. This is a huge drop. Lower rates may help stabilize housing prices and home buyers may decide to quit waiting for prices to fall further and return to the market. There is still a large housing inventory overhang, but reducing it to historical levels (about 6 months’ worth is considered “balanced”) would really help the current economic environment.

There is still a long way to go. One of the big questions concerns further write downs of bad loans by banks worldwide, recently passing $500 Billion. Many commentators expect bank losses to eventually exceed $1 TRILLION. Stabilized housing prices could help homeowners re-finance their mortgages to affordable loans and remain in their houses. This in turn could help “stop the bleeding” in the banking industry. This in turn could help loosen the tight credit markets. This in turn could help businesses expand, creating more jobs. All of this would be positive for stock markets around the world.

Hopefully, the takeover of Fannie and Freddie will be the action that stops the “old lady” from attempting to solve a series of problems with an action that creates a bigger problem:

“There was an old lady who swallowed a horse -
She's dead, of course.”

Questions? kimm@sweetwaterinv.com

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