Issue 54 - June 24, 2009

Aftershocks

The second quarter of 2009 marked another remarkable period in financial history as the global economy moved from crisis mode to recession. Aftershocks of the credit crisis continued to ripple through the economy and resulted in the bankruptcy filings of numerous corporate icons – from auto makers to newspapers to retailers to real estate developers. The recent slowing pace of job losses is a welcome and necessary condition for recovery, but it is certainly not sufficient. Hiring is what is required and it is likely to be some time before businesses have the credit, visibility, and confidence to restart their engines of growth.

Equities rebounded sharply and certain credit markets saw substantial improvements in liquidity and spread premiums. As markets move away from panic and liquidity driven selling pressure, we must not become complacent and lose sight of the fact that we remain deep in the midst of a transformative period with rising unemployment, contracting leverage, and excess capacity. As we look to the future, the flow of the economic rebuilding process will be choppy, but we should draw lessons and encouragement by what has already been accomplished.

• Short-term corporate obligations supported through the Federal Reserve’s CPFF are down to $159BB from over $300BB and are in place with just 10 out of 57 eligible issuers. This program is scheduled to wind down this coming October 30th and will be a good test of any fledgling recovery.

• The market for conforming home mortgages ($417k or less in most markets) has also seen a revival, although recent rate increases brought refinancing inquiries down sharply. While the current conforming rate of 5.50% may sound appealing, rates below 5% stirred recent demand. There is no better way to get cash directly into consumer hands than through a meaningful lowering of what is typically the single largest monthly expense. In 2002-2003, 30% of the 50 million homeowners with mortgages were able to refinance.

• The Build America Bonds (BABs) program has provided needed liquidity to the municipal market by allowing issuers to issue taxable bonds where the majority of investor demand resides. The issuer is given a 35% tax credit as an offset to a slightly higher coupon and the net impact has been significantly lower costs of funding coupled with the ability to issue much larger supply. It has also created a strong underlying bid for traditional tax-exempt bonds as supply has been moderated as a result of the success of the BABs.
What all of these successful programs have in common is a targeted approach to a particular element of the credit spectrum.

While there is much discussion of the importance of employment in kick starting an economy much of it misses the point that employment is a function of credit and not vice versa. Credit is the life blood of business. Look no further than auto sales. In the past 27 years there have only been five months where vehicle sales were less than 10 million units –January, February, March, April and May of 2009. Is it any coincidence that the auto loan market was completely moribund through this time? No. Consumers have not had access to credit for major purchases, and as a result they are postponed. Could vehicle sales be substantially higher than the current pace as some suggest? This will remain largely a rhetorical question until the market which securitizes consumer credit is back on line.

It has become fashionable to blame the securitization process for much of what went wrong in 2008, however, securitization was a useful tool for decades before banks, brokers, and ratings agencies decided to ignore underwriting standards and effectively corrupt an entire system. The Federal Reserve addressed the collapse in consumer credit in April with its TALF program by providing credit enhancements to pools of credit card and auto loans but it has received slow initial acceptance. Here we have a classic case of catch 22 – investors are clearly wary of the consumer’s ability to repay debt which hampers lending which in turn hampers employment which in turn hurts the consumer’s ability to repay. Breaking this viscous cycle of unwanted deleveraging is the key to stabilizing employment and recent history shows us that this is best accomplished by re-establishing the integrity of each component of the credit complex.

Fragility

Suffice to say, the recovery path of recent “traditional” recessions has not included the rebuilding of the global credit infrastructure. A meaningful slowdown was more of an inventory correction than anything else. Our current situation is a very different animal. It requires that we renovate the foundations of credit with a simultaneous evolution of uncompetitive 20th century business models. We are likely to see a much longer and uneven recovery than has been our modern experience. Low rates will help nurse a fragile situation along, but it is not the panacea it has been in the past; acting as a rising tide for all boats – sea worthy and not. Much of the discipline that it being imposed by markets today will be welcome over the next business cycle. As investors, we need transparency and we deserve to know which of our financial institutions are solvent and which are impaired. The repayment of $68BB by ten former TARP recipients is a positive development and issuance of non guaranteed FDIC debt by banks is another step in the right direction.

Inflation and The Fed

Recent readings of inflation were startling not so much for their strength but for their weakness: Producer Prices, lowest since 1949; Consumer Prices, lowest since 1950; and Capacity Utilization, lowest ever recorded.

We have an economy in which consumer habits are evolving through a backdrop of deleveraging credit, increasing savings, and persistent unemployment. The vast expansion of the money supply would be the kindling for inflation in our more “traditional” recovery. But all this cash is essentially just sitting on the sidelines in banks and money funds. It is not being put to work with any sort of pace or “velocity”. If we believe that it is going to take quite some time for the economy to evolve to what is now referred to as the “new normal”, then we should also expect that it will also take at least that long to see the impacts of the “new normal” flow through into the velocity and any coincident inflation.

On June 24th, the Federal Reserve reiterated their concerns and their commitment to maintaining an accommodative stance. Specifically they said:

“In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.”

The economy will continue to heal itself over the balance of 2009 and markets will likely perform in fits and starts. Companies with strong balance sheets and access to credit will be highly advantaged over weaker competitors. Our allocations will favor the stability of income and predictability of earnings that higher quality investments can provide.

Patsy and Jen

• Aftershocks
• Fragility
• Inflation and The Fed