Mitigating Factors

Against this backdrop of impending resets and shrinking equity, a number of actions have been taken to address the crisis.  Understanding the stage of the crisis requires assessing the impact of these actions.

The Fed has implemented a number of measures to increase the borrowing ability of banks.  The goal of these measures is to provide liquidity, in part to restart the credit markets and the securitization process.  If successful, these actions will create options for some homeowners to refinance.  However, the likelihood of an underwater homeowner refinancing remains small.

The Fed has $800Bn on is balance sheet, with approximately one half of that committed.  The Fed is clearly preparing for more bad news, and recently announced a contingency plan, whereby the Treasury would sell securities to the Fed, which the Fed would fund through additional borrowing.  This would leverage the Fed, increasing both its assets and liabilities.  It allows the Fed to use these securities in programs where they would be swapped for AAA sub-prime debt. 

The Fed’s actions carry a cost.  They will work as long as the borrower (the bank) remains solvent.  In the event the borrower defaults, the Fed will need to borrow additional funds from sources such as sovereign wealth funds.  If that is not possible, the Fed must print more money, which would be highly inflationary and would likely be the downfall of the dollar as the reserve currency.  If we run out of lenders to the Treasury, we are in a doomsday scenario.

Congressional plans have been advanced to allow the FHA to provide refinancing assistance.  The FDIC has proposed a program to provide loans to troubled borrowers to reduce the principal of their loans.  These plans, if implemented, will provide relief for homeowners.  However, the size of these plans currently under discussion would cover only a small portion of the loans that will potentially default.  As with the Fed’s actions, as the size of these plans increases, so does the stress they place on the Federal budget and their inflationary impact.

As many as half of the condominiums on the market today are unoccupied.  Unoccupied properties are less likely to benefit from public policy measures.  But the effect of their foreclosures and defaults still impacts owners of CDOs containing these loans, placing strain on the financial services sector.

Another possible route for easing the credit crisis is through a number of funds that have been raised to purchase distressed loans.  We spoke with Cris Santa Ana, Managing Director of Mortgage Backed Securities for Trust Company of the West, about their fund and others like it.  Santa Ana notes that hedge funds and private equity firms are investing, but they are buying the better quality loans, mostly the senior tranches of Alt-A securities.  He estimates less than $10 billion in capital has been raised for such funds, and said that “a couple of billion is not going to make a dent in the sub-prime crisis.”

Santa Ana believes we are in the fourth or fifth inning, although he confessed that “nobody really knows what inning we are in.”

Banks may be unwilling to sell their most distressed assets because, by doing so, they would be forced to mark-to-market similar portions of their portfolios, creating large write-offs.  It is likely banks have hedged their default risk on distressed loans through credit default swaps and, by doing so, are able to carry these loans at an inflated value.

What Inning are we in, and why does it matter?

Banks have written off approximately $200 billion thus far, a little more than half of that by US banks.  This includes not just sub-prime mortgages; it includes Alt-A and other prime mortgages, leveraged loans, and consumer debt.  In April, the IMF estimated the ultimate cost of the sub-prime crisis to be $1 trillion, and we suspect even this estimate is conservative.  Hence, we believe we are in the first or second inning.

For advisors, the key question remains whether the market has already discounted the severity of these losses.  We doubt this is the case.  The 9.4% decline in US markets (the S&P 500) since their peak in October of last year does not reflect future sub-prime related write-offs and the inflationary pressures that will result from the proposed rescue measures.  At the very least, equity investors should look to be broadly diversified internationally.  The current environment also represents a once-in-a generation opportunity for value oriented investors.  Market volatility and distressed securities lead to under valuation, and we are confident that those opportunities exist in the equities market today.

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