January 2009

January 29, 2009 10:25 a.m.
Optimism Makes a Comeback

Financial stocks soared Wednesday. Wells Fargo alone gained over 30%.

Last week I discussed the sort of policies the government should implement to right the financial system and resolve the crisis. The recommendation involved having the government set up one or more bad banks to take over bad assets. Shortly after, there were reports the government is on the verge of setting up an “aggregator bank” to take bad assets from banks. This news prompted the surge in financial stocks.

But is this the solution? There are differences between the reported program and my recommendations, and there are a number of unknowns about the program. I don’t think it is the solution that should prompt the sharp recovery in financial stocks. Here are some concerns:

? How do assets get from the banks to the aggregator bank? The initial TARP program changed course because officials could not decide how much to pay for the assets. Pay too much, and bad bankers are rewarded, to say nothing of how taxpayers would react. But banks won’t sell at market prices. There are plenty of investors willing to buy the assets cheap, but banks think current market prices are low and temporary.

? The bad bank system worked in the S&L crisis of the 1980s because the banks already failed. The government took them over, segregated the bad assets, and sold the good assets to healthy banks, new banks, or investors. The aggregator bank proposal apparently would leave the good portion of failed banks alone and shift the bad portion to the taxpayers.

? The plan doesn’t really improve balance sheets of banks unless the government overpays for the assets.

? By not forcing the liquidation of mismanaged banks, the reckless riskt akers are rewarded. The boards of directors are in place; management is in place; and those who lent to and invested in them are saved. They are free to repeat their actions, and everyone else pays the losses.

? The banks still have to deleverage. They took on too much debt during the boom and are only beginning to reduce the leverage. So, taking bad assets off the books won’t necessarily make the institutions healthy.

? It doesn’t solve the fundamental problem of too much debt. Presumably the aggregator bank would work to renegotiate the debt owed on homes and other assets that have declined in value. But that isn’t clear so far.

Most importantly, the problems have grown far beyond the financial system and troubled banks. After the Lehman Brothers bankruptcy, the economy froze. Since then, consumers reduced spending; employers reduced jobs; and investors fled risky assets. We are now in a cycle of job cuts that lead to further reductions in consumer spending that lead to more job cuts. The aggregator bank does not end that cycle and won’t unless there is some form of debt reduction included.

The key data to watch now is unemployment. Banks generally have pared back their operations and shored up their balance sheets enough to handle an unemployment rate around 8%. If unemployment rises much above 8%, loan losses and other problems will exceed projections. We likely would see another round of banks on the brink. Unemployment has been rising rapidly since September, and there currently is no reason to believe the trend is ending.

The recent rise in stocks appears to be a short-covering rally. A lot of money has been lost by investors trying to call the bottom of this downturn. As I have said before, applying the lessons of the last 25 years does not work today. This is a different environment and requires a different analysis. For now, I continue to believe it is best for investors to stay with safe assets and wait before increasing the risk of a portfolio.

January 23, 2009 11:50 a.m.
So, It’s All Factored In?

Sometime last fall the market bulls were back on their feet with a simple argument: All the bad news is in market prices. Some of the bulls had economic forecasts, which ranged from a mild recession to a severe recession that would end by mid-2009. But all argued that however bad the economy would get, the worst possible depression already was factored into stock and bond prices. Such thinking spurred some of the rally that began around Thanksgiving and eventually generated a 25% rise from the market bottom.

The “it’s all factored in” argument took a big hit. Though forecasts for the fourth quarter were marked down substantially, a number of companies reported earnings below the forecasts and economic data is worse than expected. The worst news seemed to come to from the banks. Their problems seem far from over, and doubt is growing whether the government efforts will help at all, and there is a growing school of thought that the government is making things worse.

This past Tuesday an analysis in the Wall Street Journal said recent economic data suggest the recession will get worse until the third quarter of 2009. The consensus at the end of 2008 was that the fourth quarter of 2008 would be the worst, and recovery would begin in around mid-2009. That scenario is what was factored into market prices. With the scenario in doubt, investors are selling risk assets again.

We don’t know how bad things will get or when the economy will hit bottom. Anyone who uses long-term averages of economic downturns as a guide is in a lot of trouble, because the deleveraging process is different from typical downturns. We are watching market indicators for signs that the credit crisis and deleveraging are ending. Until then, we recommend keeping your portfolios in safe assets.

January 23, 2009 11:55 a.m.
What is the Way Out?

I don’t often make public policy recommendations on economic issues or say what I think the Federal Reserve should be doing. If they want my advice, they can ask for it. Until then, I’ll follow government actions and invest accordingly.

Since we have a new administration and no solutions are on the table, I will make an exception. Also, having an idea of how to solve the crisis will give you an idea of how to react to different actions the government takes. The ideas that follow are not original. A number of people have proposed solutions. I have read many of them and compiling those that seem sound to me.

Too many people are saying that the problem is lenders aren’t lending and borrowers aren’t borrowing. That is not the problem. There is plenty of credit and debt. There are two main problems. One is that people took on too much debt during the boom. They became too leveraged. The debt level was unsustainable. The other problem is that prices of many assets were bid to high, primarily because people were able to buy them with the abundance of cheap, low cost credit during the boom.

Many aspects of these two problems were or are self-corrected. Commodity prices boomed and fell. The same things happened to stocks and many business assets. The bankruptcy process is efficient in liquidating the related debts and reducing asset prices.

Residential real estate is the major sticking point. Because housing is an illiquid market, prices do not adjust as quickly. The default, foreclosure, and resale process is a long, grinding one. In addition, the process tends to feed on itself. Foreclosures drive down asset prices and force more foreclosures. The mortgages themselves are the other sticky side of the process. Lenders are slow to write down mortgages on their books and renegotiate them. With the many mortgages that have been packaged with other mortgages and sold as securities, it is difficult to renegotiate debt. There are many owners of a mortgage, and they are tough to find.

New borrowing and spending won’t help. Home prices in many areas were too high at the peak and could be too high now. The prices need to return to a sustainable level as quickly as possible. The real issue is: Who bears the loss? The mortgages were too high, because they reflected the high home prices. The prices of the homes have declined, but the mortgage balances remain. The debt has to be restructured. The current restructuring programs leave the mortgage principal balance unchanged. They offer to extend the payout period or reduce current payments, effectively deferring part of the debt.

The people and organizations that made the bad loans should bear most of the losses. The government, saying it is trying to save the financial system, actually is trying to save specific financial institutions. Instead, bad loans need to be written down to realistic values as quickly as possible.

One analysis I have seen argues that banks and other financial institutions are solvent if their bonds and other debt are converted to equity. The people who lent money to these institutions were part of the bad decisions, so they should bear the losses before taxpayers. Bondholders and stockholders should not be saved at the expense of taxpayers. The normal bankruptcy process would convert debt to equity and have a new company emerge. Banks must write down their assets to market values.

If the write downs make an institution insolvent, the government directly or through a “bad bank” it sets up should buy the assets at market values (not inflated values). Depositors and customers should be protected, which would protected the system. The good assets are managed to protect customers and establish a viable bank. The good bank now can be sold to the private sector. Over time, the bad assets can be sold to the extent they become viable or written off. When loans are marked down, the mortgage also should be renegotiated. The foreclosure process won’t stop until loans made near the peak are rewritten to reflect current market values. The lender should keep all or a portion of any appreciation going forward, so the borrower does not have a no risk benefit from the renegotiation.

There are many variations of this solution. The key elements are that loans based on inflated asset prices needs to be written down and renegotiated. The government needs to take over insolvent institutions, manage the bad assets, and return the good assets to the private sector (but different owners) as soon as possible.

Attempts to stimulate either the economy or credit markets without solving the excess debt problem won’t be effective. The guarantee programs used to date also won’t be effective. They simply encourage investors to buy only guaranteed assets and punish people and businesses outside the government’s protection.

January 16, 2009 11:45 a.m.
Rolling the Dice

The big boys rolled the dice and lost more of your money, whether you are an investor or taxpayer.

The bear market rally, or hope rally, that began around Thanksgiving came to an abrupt halt last week. This week, more bad news started to emerge from the financial sector. Bank of America said the assets it purchased in Merrill Lynch declined far more in value than it estimated. Citigroup continues to lose money and now is selling assets and splitting up. Other banks are cutting dividends, announcing losses, and laying off more employees. Almost across the board financial stocks are at their previous lows before the Thanksgiving rally.

In the cases of BOA, Citi, and a number of others, it appears that the leadership took gambles that the government programs would work, things would turn around quickly, and they would profit. They were wrong. Now, the original government investments have declined, their shareholders have lost more money, and the government thinks it needs to put more money into the same deals to keep the economy from collapsing. These large financial firms are rapidly becoming “zombie companies.” Their shareholder have lost most of their equity, and the total capitalization of the companies is about equal to what the government already has “invested” in them. The government now is deciding whether it should put capital in on the same terms or do something different such as formally wiping out existing shareholders. Other options are possible.

These are additional examples of people who bet that the economy and markets have not changed their structure and patterns of the last 25 years. During that period, the successful formula was to buy on the dips. The prices always bounce back sharply. Since June 2007, that has been a formula to lose a lot of money in a hurry.

Overall, the economy is doing poorly. But there are some small signs of improvement. Corporate bonds have had a good run, with both interest rates and the spread from treasuries declining. The same is true of high yield bonds. Values and spreads still are far from normal levels, but they have improved from the extreme number of last November. Again, this is an example of investors betting that things will turn around.

Another positive sign is a small amount of price appreciation in industrial commodities, as tracked by the Journal of Commerce index. This rise likely is due to increased demand. But the increase so far is too small to get excited. It is worth watching as an earlier indicator that the bottom might be in.

I still don’t think this is a good time to roll the dice, but a number of investors continue to do so.

January 5, 2009 05:00 p.m.
A Few Positive Signs, but are They Enough?

Most of us were happy to see 2008 fade into the past and hope that 2009 will be at least somewhat better. At the tail end of 2008 there were a few positive signs to give investors hope.

? Mortgage rates finally fell dramatically. The initial response of the Federal Reserve and Treasury to the credit crisis brought short-term rates lower, but mortgage rates and other long-term rates generally stayed the same or even increased at times. Since housing problems began the credit crisis, relatively high mortgages rates would not help bring a speedy conclusion. Government actions announced in early December helped bring the mortgage rates lower.

Yet, the effects of lower rates at this point will not be overwhelmingly positive.

The decline in mortgage rates did lead to a significant increase in applications to refinance. That is nice, but unlike in years past these refinancings are unlikely to be for more than the outstanding mortgage balances. Consumers will benefit from lower monthly payments, but they will not be taking out home equity to spend on new items. Indeed, many do not have much home equity to borrow against.

Also, so far the lower rates are not stimulating demand among home buyers. Prices continue to fall, and sales are tepid. Many sales around the country are distressed sellers or foreclosures. Finally, the lower rates apply only to mortgages that qualify for coverage from the FHA, Fannie Mae, or Freddie Mac. Nonconforming and jumbo mortgages have current rates around 7%.

? The spreads between yields on treasury debt and investment grade corporate bonds and high yield corporate bonds have lowered a bit. The spread on high yield bonds, for example, declined by two percentage points. Spreads are one of the signals I watch to monitor the health of the credit market and economy, and lower spreads are a helpful sign. The move generated about a 10% return in corporate bonds in the last month.

This improvement isn’t enough to make me positive for the next few months. The stock market, for example, has not responded in the same manner. Lower corporate yields should make stock investors optimistic. It could be that bond investors simply are ahead of stock investors by a few months. But there are less benign explanations.

The move in corporate bonds was triggered by the Fed’s announcement that it would increase the types of bonds it purchases. I would like to see a rally not triggered by government action. In the past two years, rallies following government actions or announcements proved to be false rallies that were followed by declines.

Also, even after the recent decline, yields on corporate and high yield bonds are high, especially if companies covered by the various government guarantees are separated from the others. Credit markets still are pricing in high default levels in 2009 and 2010.

I think bonds will provide higher returns than stocks for a while, even after the crisis ends. But it is too soon to be comfortable with the risks in the bond market. Unemployment is rising steadily, and companies are cutting back. While there are a few positive signs, the overwhelming data at this point still indicates we are in a deflationary decline. I want to see more evidence of a stabilizing credit market and some evidence that housing and the economy have stopped declining.

? The stock indexes went on a rally. They are about 24% above their recent lows and recorded a gain of almost 7% last week. But that those returns were achieved during a holiday period when trading volume was light. There are not enough signs that this is anything more than a bear market rally.

Jeffrey Gundlach, manager of the TCW Total Return Bond fund, has a new shareholder letter posted on the firm’s web site here. It is well worth reading. It gives a good summary of how we came to this current state of the credit markets and the economy, a review of the current status, and Gundlach’s outlook. He also gives general guidelines for how to invest in the current environment.