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Tuesday, September 16, 2008

Comment on Crisis: Necessary Steps

by Calculated Risk on 9/16/2008 11:00:00 PM

With the DOW off over 500 points yesterday, Lehman in bankruptcy, the Fed rescuing A.I.G. tonight, the viability of WaMu and others institutions in doubt, Fannie and Freddie placed in conservatorship, a major money market fund halting redemptions, it might seem like the credit crisis is spiraling out of control.

And there are definitely more problems to come.

Many banks will fail - especially small and regional banks with excessive concentrations in construction & development (C&D) and commercial real estate (CRE) loans. And the recession is getting worse with rising unemployment, declining personal consumption expenditures, declining industrial production and falling business investment. Economies of many other countries are in or close to recession. The Fed even cautioned on slowing U.S. exports today for the first time.

Foreign stock markets are crashing: the Russian stock market was halted today after declining 17%. The Shanghai composite index is off about 2/3 from the peak.

The situation appears grim.

This crisis might have first become visible to Wall Street and the Federal Government in August 2007, but this crisis has been unavoidable for several years. If action had been taken in 2004 or 2005 to curtail the loose lending practices, the problem wouldn’t be so severe, but the crisis would have still occurred. The damage had already been done. Unfortunately the U.S. failed to prevent this crisis, and now we have no choice but to pay the price for the cleanup.

The good news is the U.S. is finally taking the necessary steps towards eventually resolving the crisis.

First, whether you agree or disagree with the FHFA and Treasury Secretary Paulson placing Fannie and Freddie in conservatorship, it has been obvious for some time that the U.S. Government had to explicitly guarantee the debt of Fannie and Freddie, or face a complete shutdown of the housing and mortgage markets. At least this guarantee was accomplished with the shareholders (both common and preferred) taking losses before the U.S. taxpayers. Since I have viewed a guarantee as inevitable, I consider this a necessary step toward the eventual resolution of the credit crisis.

Second, Secretary Paulson's no bailout approach to Lehman removes some moral hazard from the process. Although the fallout from Lehman's bankruptcy has just begun, this liquidation is probably a positive for the market. It appears this approach has already reaped some benefits with John Thain of Merrill Lynch calling Ken Lewis of BofA on Saturday morning to propose a buyout. Clearly Thain could read the writing on the NY Fed's wall.

BofA CEO Ken Lewis' self described "gamble" could fail, and BofA could find itself facing insolvency too. There are always risks in these situations.

It's true that the rescue tonight of A.I.G. suggests there are still moral hazard issues, but an A.I.G. collapse posed significant risks to the system, and the Fed was stuck with a dilemma and no good alternatives. I believe a collapse of A.I.G. would probably have been worse than the rescue.

Third, one of the reasons the credit crisis has lingered (in addition to house prices still being too high) is that a number of financial institutions have been unwilling to adequately mark down their assets. The reason for this reluctance is obvious as Lehman just discovered; too many write downs can lead to bankruptcy.

To Lehman's credit, they were getting close on their house price forecasts:

"[The Lehman] base case assumes national home prices drop 32% peak to trough, vs. 18% to date, with California down 50% vs 27% to date."
Ian T. Lowitt, Lehman CFO, Sept 10, 2008
I think Lehman's new house price forecast is probably in the ballpark. Analyst Meredith Whitney thinks prices will fall over 40% from peak to trough (see video):
"The underlying root of all evil, if you will, has been U.S. house prices. ... The futures market indicates that a peak to trough house decline will be somewhere 33%. I think it will be well north of 40% to 45%."
No one knows for sure how far prices will fall, but based on fundamentals, we can be pretty sure there is still a ways to go. (For a discussion of Price-to-rent, price-to-income, and real prices see: Housing: It's about prices ... ). Until the institutions get realistic on their house price forecasts, the write downs - and the credit crisis - will continue.

In addition, the economic problems will exacerbate the credit problems for some time - probably all through 2009 as Ken Lewis noted yesterday:
[A]ll of next year will be a relatively tough time for the financial services industry. ... I don't see the clouds parting as I would like them to in 2009.
And Lewis is probably overly optimistic.

But progress is being made.

Along these same lines, here is what Brian Horey, President of Aurelian Managment, LLC wrote to his partners Monday night (posted with permission):
While it is unsettling to watch a major broker dealer such as Lehman be liquidated, I am viewing the events of the weekend as a constructive development in the process of reestablishing equilibrium in the capital markets. The most encouraging aspect is that the Fed and Treasury have finally recognized the futility of trying to prop up asset prices and removed the "Fed/Treasury put" ... from the marketplace. (note: written before the A.I.G. rescue)
This change in approach will hasten the processes of deleveraging, capital raising and asset price discovery which are needed to stabilize financial institutions and get capital flowing back into the sector again. A large number of investors sat on the sidelines throughout the crisis as financial institutions have been unwilling to come clean about the value of their assets. I expect the liquidation and repricing process that Lehman's bankruptcy will catalyze should help facilitate the recapitalization process.
But even the A.I.G. rescue will help with price discovery since it appears A.I.G. is required to sell certain assets as part of the deal.

Clearly we are closer to the eventual bottom today, than say in 2005 when very few people believed a housing bust and credit crunch were on the horizon. Unfortunately the bottom still isn’t in sight.

Horey concluded his letter with:
[W]e should not expect smooth sailing from here ... [however] I believe we have taken the first concrete steps toward putting in a bottom in the financial sector and that is the first glimmer of light of a recovery that I have seen since the mortgage market started to deteriorate two years ago.
"The first glimmer of light" written by an investor who has been correct on the credit crisis. Just a glimmer ...

There will be more grim news, perhaps for another year or more. And there is definitely some possibility of a systemic financial collapse (see Professor Roubini’s excellent discussion of the downside risks). But unlike observers that believe this only marks the end of the beginning, I believe there is a chance that these events mark the beginning of the end of the crisis.