This is indeed the hurricane season; over the past weeks the world has watched a huge financial storm drive the grandest financial vessels in the U.S. fleet on the rocks. In response, the government has in effect nationalized Fannie and Freddie and AIG. We watched Lehman Brothers sink. A terrified Merrill Lynch ran into the arms of Bank of America. The storm battered mighty Morgan Stanley and Goldman Sachs; and Wachovia, with Citigroup for a couple of days, is now with Wells Fargo. The U.S. Congress hastily put together a $700 billion care package, but no one really knows if it’s a Band-Aid or a real cure. One thing is certain: This storm is far from over. What we have seen in recent days points to a flicker of light at the end of the tunnel. We are not certain what is coming, but based on recent developments, we are due some good news.
News reports about the global credit crisis have compared it to a hurricane. But the more appropriate analogy might be an ill-constructed levee, filled to the brim with bad debt and breaching under the pressure of massive over-leveraging.
What went wrong? How did so much go so badly so quickly? The answer is a long period of rapid growth, low inflation, low interest rates and macroeconomic stability, which bred complacency and increased the willingness to take risk. Stability led to instability. Innovation, securitization and off-balanced sheet financing was the story. Coupled with undue faith in unregulated markets, the result has been lethal.
A Housing-Driven Recession
America is in the throes of one of the most dire challenges we have seen. Yet the fact remains that this is a housing-driven crisis. Start with 900,000 vacant homes, a direct result of foreclosures. Housing starts have fallen by 50 percent, consumer demand has dropped by 60 percent, 6.4 percent of residential mortgage owners are behind by one or more payments, and 10 million homes are under water. The value of these homes has dropped below the value of their mortgage loans. There is a huge incentive for many homeowners to walk away from their mortgage obligations en masse.
Frankly, I am concerned that what lies ahead is more severe than what we’ve seen so far. The problem is a result of loose lending standards and the proliferation of teaser-rate mortgage products that artificially inflated the home-ownership rate to 69 percent. Many new homeowners were in over their heads from the start. They’d put little or no money down and thus had little incentive, and often little ability, to keep making their monthly payments when home prices started to fall and their teaser rates ran out and much higher interest rates kicked in. Low equity positions in their homes, high revolving-debt balances and high commodity prices made for the ingredients of a credit implosion. Rising foreclosures prevented a reduction in the inventories of unsold homes and fire sales continued to depress prices of homes across America.
What can we do to prevent this from happening again? Here are a few options to consider.
Option #1: Asset-Based Loans
Banks must consider asset-based loans as a good tool for managing working capital. These are not for everyone as it takes a certain toughness to manage assets with requisite rigor. But for those whose assets qualify and who don’t mind living up to a lender’s high standards, this type of financing will take a lot of the pain out of the present credit crunch.
Option #2: Capital Insurance
Capital insurance will require banks to buy policies in normal times that deliver an infusion of fresh equity during crises. This will reduce the adverse consequences of a crisis while ensuring that the private sector, not the government, picks up the bill.
Option #3: Shiller Continuous Workout Mortgage
Famed economist Robert Shiller, professor of economics at Yale University and co-creator of the Case-Shiller Index, has proposed a mortgage contract that makes steady adjustments to the balance of a payment schedule over the life of a mortgage. This enables most homeowners to continue payments and maintain some home equity even in harsh economic circumstances.
A Word of Advice for Investors
I believe stocks are still the best bet for long-term investors, offering better returns than bonds or cash. My advice is for small investors to stick with their long-term plan rather than pull money out in this downturn. Yes, the credit crunch could continue to drive stocks down, but those who move to the sidelines could risk waiting too long to get back in, likely missing the rebound. A long-term asset allocation will entail 50 percent stocks, 30 percent bonds and 20 percent cash. The best strategy is to stick with a diversified portfolio.
Investors should steer clear of illiquid assets right now; otherwise, they might not be able to get their money out if the investments turn out badly. If you think you are going to need cash, be careful to hold liquid assets.
Post script: The Paulson plan offers real hope for overcoming the crisis. The U.S. Treasury will buy stakes in nine large U.S. banks on terms that are open to other investors. In addition, new inter bank lending and all deposits will be guaranteed by the Federal Deposit Insurance Agency FDIC. Even though the $700 billion Bail Out Plan (BOP) has passed, the markets are still not convinced whether this is a long-term fix or an election year smoke-and-mirrors…This recovery will take a while.
A popular saying in the show-me state is even more appropriate in this instance; the government and the market must show us that the flicker of light at the end of the tunnel is really not another freight train carting more bad news. One thing is certain: American resiliency will eventually prevail, and you can take that to the bank.