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Is A Subprime Recession Inevitable? |
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FORECASTS & TRENDS E-LETTER IN THIS ISSUE: 1. Stocks – Correction Or New Bear Market? 2. Consumer Confidence & Spending Remain Key 3. A Look At Previous Credit Crunches 4. How Bad Is The Subprime Mortgage Problem? 5. Crisis In Confidence 6. Are Subprime Fears Overblown? 7. Fed To The Rescue? Introduction This week’s title above is indeed the question on the minds of investors around the world. In the wake of the market turmoil over the last six weeks and the troubles in the credit markets, it is certainly fair to say that the odds of a US recession later this year or early next year have increased. I find little disagreement on that point. Likewise, it is still uncertain just how bad the credit crunch will become. So, it is naïve to rule out the possibility of a recession in the months ahead. At the same time, I think it is equally naïve to assume that a recession is inevitable, just because of what’s happened in the markets over the last six weeks. There’s an old saying: The stock market has accurately predicted nine of the last three US recessions. Think about that. Along that line, might the latest plunge in the stock markets merely be the long overdue downward correction we have all been expecting, rather than a harbinger of recession? While it remains to be seen just how widespread the subprime and related problems are (although most estimates are still generally in the $50-$150 billion range) and how bad the credit crunch might become, we have been through several similar periods over the last 20 years. In the pages that follow, we’ll look back at those prior credit crunches and see what happened. We’ll also look at the estimates of the current subprime mortgage carnage. I will present some information you may not have seen elsewhere. For example, you may not know that mortgage lenders historically have assumed that 10-11% of all subprime mortgages granted will default. We don’t hear that in the media. Also, the Federal Reserve indicates that only about 30% of all subprime loans are of the type likely to experience a large increase in payments in the near future. The media doesn’t talk about that either. But we will in the pages that follow. Our review of the prior credit crunches over the last 20 years will only intensify the interest in the other question on investors’ minds: Will the Fed drop interest rates on September 18 at the next FOMC meeting (or even sooner)? The Fed did cut the discount rate from 6.25% to 5.75% on August 17, as I will discuss below, but it remains to be seen if the Fed funds rate will be cut on September 18. The markets certainly think it will happen, but remember, Alan Greenspan is no longer at the helm. We will talk about all these issues, and others, in this week’s E-Letter, so let’s get started. Stocks – Correction Or New Bear Market? Let’s begin this week with a look at what’s just happened in the US stock markets, since that’s on everyone’s mind. From its all-time peak in mid-July, the S&P 500 fell just under or just over 10% (depending on whether you use closing day prices or intra-day prices). Many analysts would say that the drop of only 10% is very impressive given all the extenuating circumstances and fear that have gripped the financial markets over the last six weeks.
A similar chart of the Dow Jones Industrials Average looks even more impressive than the S&P 500 chart above. The Dow did not correct down to its long-term trend line. Of course, we still do not know if the decline in equities is over. That remains to be seen. One positive development that has occurred while the equity markets sold off is in the area of earnings. While not all S&P 500 companies have reported their 2Q earnings, as this is written, over two-thirds have reported, and 2Q earnings look to have had average annual growth in the 5½-6% range. That is above expectations. Consumer Confidence & Spending Remain Key Actually, there has been quite a bit of good news that the equity markets seemed to ignore over the past six weeks. On July 27, we got the news that 2Q Gross Domestic Product surged by 3.4% (annual rate), well above most pre-report estimates. And the inflation figures in that same GDP report indicated that core inflation was finally down to near the Fed’s supposed comfort zone. Analysts agreed this meant no more interest rate hikes. Since then, the Index of Leading Economic Indicators for July rose 0.3%. Retail sales also rose 0.3% in July. Durable goods orders rose a surprising 5.9% in July following a 1.9% increase in June. Even new home sales rose modestly (2.8%) in July as compared to June. On July 31, the Conference Board reported that its Consumer Confidence Index surged from 105.3 in June to 112.6 in July, the highest level in almost six years. In its statement, the Conference Board noted the following: “An improvement in business conditions and the job market has lifted consumers’ spirits in July. This rebound in confidence suggests economic activity may gather a little momentum in the coming months.” There is evidence, however, that consumer confidence fell, perhaps sharply, in August. The University of Michigan’s preliminary Consumer Sentiment Index fell from 90.4 at the end of July to 83.3 by mid-August. The Consumer Confidence Index for August plunged from a revised 111.9 in July to 105, the lowest level since August 2006. What a difference one month of bad news can make! There is little doubt the combination of the stock market sell-off and continued bad news in the housing and credit markets has taken a toll on the exuberant confidence in July. The question is, how much more is to come? Obviously, we want to keep a close eye on consumer confidence and spending in the coming months, since consumer spending now accounts for 70% of GDP. The extent to which confidence and spending erode will be the main determinant as to whether we have 2-3 more quarters of modest growth in GDP or a recession. I continue to think we will avoid a recession (defined as two consecutive quarters of negative GDP) but as noted above, that depends how bad the credit crunch becomes, and what the Fed does about it. A Look At Previous Credit Crunches The latest sell-off in the stock markets and credit fears have prompted a new wave of recession forecasts. But as suggested in the Introduction, there have been several prior instances when we have had sharp declines in stocks and fears of a credit crunch that did not cause a recession. Let’s review three such scenarios over the last 20 years. Those include the stock market crash in October 1987, the credit crunch/Long-Term Capital Management fiasco in the fall of 1998, and the financial scare immediately after the 9/11 attacks in the fall of 2001. I remember well the stock market crash of October 1987. The S&P 500 plunged from above 330 to below 200, basically in a month, with the worst of it coming on “Black Monday,” October 19, 1987. There were widespread fears that the big banks might be in trouble, and that a credit crunch would follow. Predictions abounded that the economy was headed into a severe recession or a depression. In response, the Fed cut interest rates three times in six weeks. The US economy continued to grow over the next two years, stocks recovered to new highs, and the recession wasn’t until 1990. The 1998 stock market plunge saw the S&P 500 dive from 1,200 to below 1,000 in just seven weeks. This event was attributed to the Asian financial/currency crisis, which later spread to Russia and resulted in Russia defaulting on some of its bonds. This was also the time when Long-Term Capital Management Fund, a large hedge fund, went belly-up. As the US markets plunged, we heard the same things we do today – “credit crunch” and financial markets “seizing up.” And, of course, we were headed for a serious recession. In response, The Fed cut rates three times in seven weeks. So what actually happened? In 1999 and 2000, the US and global economies recorded their strongest growth in a decade, and stocks soared to all-time record highs. There was no recession until 2001. The 2001 recession, worsened by the 9/11 attacks, sparked many of the same concerns we are hearing today about a credit crunch. As a result, the Fed cut rates three times in seven weeks. There was no serious credit crunch. I revisited these three prior instances only to point out two things. First, whenever we get what many people believe are unprecedented downward actions in the equity markets, we almost invariably get predictions of a credit crunch and a recession. That is nothing new, despite the fact that the US economy has continuously surprised on the upside for the last 20 years or longer. Second, the Fed has demonstrated its willingness to act, repeatedly, in each of the examples above, and I see no reason that it would not do the same if financial conditions worsen in the weeks or months just ahead (more on the Fed below). How Bad Is The Subprime Mortgage Problem? As is usually the case with any real or perceived credit crunch, there are always those who spew fear, warn of calamity and inflate the estimates of potential losses. The gloom-and-doom crowd is having a field day with the subprime mess. Having said that, there is no question that the subprime and related mortgage dilemma is a serious problem that has negatively affected almost all areas of lending, and the equity markets as well. There is no shortage of market analysts and respected research groups that failed to see the magnitude of the subprime meltdown, including The Bank Credit Analyst. Many believed that the subprime problems would not spill over into the broader financial markets. But as we all know now, the subprime contagion has negatively affected not only the prime mortgage market but also the banking system and the US and global equity markets. Given the volumes of materials that have been written and disseminated on the subject of subprime mortgages (just Google it, and you’ll see), I will not attempt to go into detail on how the subprime train wreck developed. Not unlike some past credit crunches that involved real estate, the subprime problem is the result of greed on the part of mortgage lenders that offered home loans to people with weak (or no) credit history that could not qualify for a traditional mortgage. The default rates on subprime loans have always been higher than prime mortgages. Making matters worse, over the past couple of years, millions of these subprime loans were made with no down payments, and at very low “teaser” interest rates that were set to increase, in most cases significantly, after the first year or two. Add to that the fact that we entered a housing slump last year. As a result, delinquency rates on subprime mortgages began to skyrocket last year, as you can see in the chart below.
The question is, how big is the subprime dilemma? It is generally agreed that there are apprx. 50 million outstanding home mortgages in the US, and of that, apprx. 15% are subprime mortgages. What is not known for certain is what percentage of the outstanding subprime loans have defaulted already, and how many more will default in the near future. What we do know is that the numbers are large, but how you define “large” is a matter of great contention. To help us understand, let’s look at the graphic below which was produced by H&R Block.
There are countless ways to analyze and dissect the many different statistics surrounding the subprime meltdown. What the analysts at H&R Block point out, in a nutshell, is that there has always been an assumed delinquency/default rate with subprime loans, just as there is with prime mortgages. What the graph above illustrates is what the potential incremental losses would be if subprime defaults rise from 10-11% to 20%. If the subprime Adjustable Rate Mortgage (ARM) default rates rise to 20%, then the potential loan losses – in excess of those already planned for - would be in the neighborhood of $76.5 billion, as noted above. If the default rates for subprime ARMs and subprime fixed rate mortgages rise from 10-11% to 20%, then the potential loan losses – again, in excess of those already planned for – would be in the neighborhood of $136.2 billion. These are H&R Block’s numbers, but you can see their sources noted below the graph. It is also worth noting that not all mortgages that become delinquent end up defaulting. Estimates of the subprime carnage are all over the board, but most of the estimates I have seen are in the $50-$150 billion range. Granted, $50 billion or $150 billion is a big number. But either number is not enough to sink the mortgage industry at large, or the big banks, or the economy – in my opinion. Loan losses have sunk a lot of mortgage lenders, and others are likely to follow. However, an argument can be made that these entities needed to fail in light of their ridiculously lax lending policies. Fed Chairman Ben Bernanke estimated recently that subprime losses could be as much as $100 billion, the mid-point of the range noted above. $100 billion equates to apprx. 0.7% of GDP – not enough by itself to send the economy into a recession. By comparison, in the Savings and Loan debacle in the early 1990s, the total loss in bad debt was estimated to be around $185 billion, which equated to 3% of GDP at the time. Crisis In Confidence If we agree that subprime losses of $50-$150 billion are not life-threatening to the economy, then what is driving all the fear and heightened volatility in the marketplace? Basically, it is a crisis in confidence. Everyone is concerned with everyone else. Who is holding subprime debt? How much do they hold? We read that the big banks are reluctant to lend to each other. We also read that these same banks have sent “margin calls” to the many hedge funds they deal with. To meet margin calls, many hedge funds have been forced to sell their liquid securities because they can’t unload their subprime portfolios. Many hedge fund investors, understandably, have grown wary of their fund managers, fearing that the fund(s) they are in may be the next to blow up due to subprime issues. Some hedge funds have been forced to suspend redemptions. The Economist magazine described it as follows:
There has been a huge flight to safety over the last month as the crisis in confidence has grown more intense. People have flocked to the safety of US Treasuries. At the beginning of August, the 90-day T-bill rate was near 5%. But in the last half of the month, huge demand for Treasuries caused the 90-day T-bill rate to plunge to 2.6% at the low. It has since risen back to near 4.2%. Fortunately, confidence seems to be recovering, but no one knows if the worst is past. Are Subprime Fears Overblown? To hear the media reports and the gloom-and-doom crowd, you might assume that ALL subprime loans are in trouble. That is certainly not the case. Likewise, not all subprime loans were made with no money down. Not all subprime loans were interest-only loans. Not all subprime loans had “negative amortization,” which means the borrower paid even less that the stated interest rate. And not all subprime loans included “resets” to a substantially higher payment after the first 12-18 months. You might not be aware (because it is rarely pointed out) that there are “fixed rate” subprime mortgages that do not reset, and there are subprime mortgages of all types that are paying on time and may well continue to do so. I looked long and hard to find statistics on this issue, and finally found them at the Federal Reserve Bank of St. Louis. Read the following carefully. According to the St. Louis Fed, only apprx. 30% of the total subprime mortgages were of the riskiest type – interest only, negative amortization, etc. - based on data from 2004 through 2006. Of the remaining 70%, 45% are ARMs where both principal and interest are being paid. The other 25% of the subprime market are fixed-rate mortgages, which will experience no increase in payments at all over time. So, the biggest risk is in the 30% of subprime loans that may experience a significant increase in payments, not in the 70% that will either have no, or moderate, payment adjustments. Keep this information in mind as we are deluged daily with media reports that would have us believe that all, or substantially all, subprime mortgages are going to default. That is simply not the case. In fairness, the St. Louis Fed data above does not include the significant number of subprime loans that were made in 2007. The data above does not ignore the fact that large numbers of subprime mortgages will reset to higher (in some cases much higher) interest rates in the next 12-18 months. But remember, we are talking about only apprx. 30% of all outstanding subprime mortgages, plus whatever percentage of problem subprime loans that were added this year. The discussion and data noted above are not meant to minimize the problems that we will experience as a result of the subprime dilemma. The news cycle surrounding subprime debt, and especially increased numbers of defaults and foreclosures, will get worse before it gets better. And the reporting of the subprime problems will not go away anytime soon, especially when the interest rate resets kick in over the next 12-18 months or longer. I merely bring the data above to your attention because you are not likely to hear it elsewhere. Fed To The Rescue? In what was a surprise to many, the Fed cut its key “discount rate” from 6.25% to 5.75% on August 17. The discount rate is the interest rate charged to commercial banks and other financial institutions that borrow money from the Federal Reserve. The rate cut was welcomed in the financial markets, and stocks rebounded sharply. Now all eyes will be on the Fed on September 18 when the next FOMC meeting will occur. It is widely expected that the FOMC will vote to cut the Fed funds rate from 5.25% to 5.0%, or maybe even lower. Of course, there are those who stridently believe the Fed should not cut short-term rates next month, as they would view such a move as a bailout for hedge funds and wealthy investors that bought subprime debt. Let’s keep in mind that a Fed funds rate cut does not, by itself, bail out anyone. It merely reduces short-term interest rates, which is good for the economy. It is also generally bullish for the stock markets, as it signals that the Fed is taking an accommodating stance in regard to business activity overall. The Fed’s policy statements for the last couple of years have emphasized that the central bank’s focus has been on lowering US inflation rates. It is widely believed that the Fed focuses on the “core” CPI. The core CPI rose only 0.2% in June and July. Not since January has the monthly core rate been above 0.2%. For the 12 months ended July, the core CPI is up 2.2% and trending lower. Most analysts believe the Fed wants to see the core rate at 2% or less. However, with the year-over-year core rate trending toward 2%, and with all that’s happened in the markets in the last month or so, I think the Fed could feel more than justified in lowering the rate on September 18. The Bank Credit Analyst agrees and now feels the Fed will likely cut rates at least twice before the end of the year. Caution: I would expect another nasty sell-off in the equity markets if the Fed does not lower rates on September 18. Conclusions To answer my own question in the title of this E-Letter: No, I don’t believe a recession is inevitable in this cycle. While the subprime and related mortgage problems are very serious, I think the odds are relatively low that they will tank the economy, especially in light of the St. Louis Fed data I have presented above. The crisis in confidence seems to be getting better, especially with the cut in the discount rate and some encouraging language from the Fed, and it should improve even more if we get a Fed funds rate cut on September 18. If the US is to avoid a recession, US consumers have to remain reasonably confident. In July, consumer confidence hit a six-year high, but then took a major hit this month. It will probably take another hit in September before recovering. So we have to watch and see if consumer spending holds up reasonably well. The other thing we have to watch closely is the default rates on subprime and related mortgages. Loan losses in the $50-$150 billion range are bad, but are very likely manageable as discussed above. But if default rates more than double their historical norms, it not only increases the losses, but it also means many more homes on the market, which could depress home prices. And that puts us right back to consumer confidence. Needless to say, the next 2-3 months could be dicey. The markets will very likely continue to be very volatile just ahead, but hopefully we have seen the lows in the broad equity indexes. Now, more than ever, is a good time to think about adding actively managed strategies to your portfolio. Over the years, I have frequently mentioned how the investment programs we offer often seek the safety of cash or hedging during difficult market environments. Sure enough, many of our recommended Advisors are in defensive positions, waiting for the volatility to decrease and tradable trends to reappear. When the market trades on pure emotion, sometimes it’s best to be on the sidelines or hedged. However, it's also important to know when to get back into the market, and the Advisors we recommend all have sophisticated systems with the potential to do just that. If you’re tired of the wild daily swings in the market, I encourage you to give one of our Investment Consultants a call at 800-348-3601 and check out our actively managed investment alternatives. Remember, the fasten seatbelt light is still on. Wishing you profits,
Gary D. Halbert SPECIAL ARTICLES
Which way from sub-prime?
United States: Recession Risk? - reasons for optimism.
Chronology of the subprime meltdown.
Big Source of Clinton's Cash Is an Unlikely Address |
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