The credit crunch
While most of you have probably read way too much on the subject already, I thought you might like to hear my thoughts on the subject and how it might affect you. I don’t want to say “I told you” but, I told you a problem was coming. When my dog, Sadie, qualified for a “no document” loan to buy a condo in Phoenix a couple of years ago that gave me some hint that there could be some problems with the mortgage market. In all seriousness, I was joking, but starting about 2 ½ years ago many of you may remember me saying how crazy the mortgage market was because I really think Sadie (if she could get a social security number; oh wait, she didn’t need that either!) might have qualified for a loan to buy a house or condo. When I read a story in Money magazine about a single girl, just out of college earning $55,000 a year purchasing a $500,000 condo in downtown San Diego using a reverse amortizing, low introductory rate, 0% down loan, I knew we were in for trouble. Even worse than that was how Money lauded her for finding a roommate to help in the payments and saying she had a made a wise decision!
This one was easier to see coming that the tech bubble; unfortunately, other than ensuring that we use high quality investments there are much fewer avenues to make money and fewer investments that will remain unaffected by this mess. But really, how big is this problem?
Mortgage Market Estimates
· $56 trillion – total net wealth in America
· $24 trillion – value of U.S. bond market
· $18 trillion – value of U.S. stock market
· $10 trillion – value of U.S. home mortgages as of 3-31-07
· $1.1 trillion – value of sub-prime mortgage market
· $25-$100 billion – loss exposure in sub-prime mortgages (.25% - 1%)
· Overall mortgage foreclosure rate – recently increased from .5% to .6%
As can be seen above, the actual loss exposure in the sub-prime mortgages is very small as compared to America’s total net wealth. The “sub-prime” mortgage market has always been a non-traditional source of financing for a limited number of homeowners nationwide. These are loans where borrowers have less stringent requirements in exchange for a higher long term cost of the loan. The default rates have risen on these kinds of lower quality loans as the economy has slowed, home values have declined and short-term interest rates have risen over 2% in the last three years. This change has caused the bond markets to re-price these investments, something that is healthy for the long term soundness of our financial markets. In the short run, however, it can be stressful as volatility increases due to waves of emotion that determine pricing, rather than rational thought.
This repricing of assets and risk is a very good thing for the market from a long-term perspective. As many of you know, I have, along with many others, thought that risk has been severely under priced the last few years. One example of this is what is called the “spread” between the yield on high yield or “junk” bonds and U.S. Treasury bonds. The spread has been narrower than almost anytime in history. This means investors are buying junk bonds for their high yields, effectively pushing those yields down to where they are not much higher than what many consider the safest investment in the world today, U.S. Treasury bonds. This can also been seen in the run up in prices of low quality stocks.
However, I’ve stated above that the loss exposure in sub-prime mortgages is very small, so why the concern? My concern lies in the repricing of more risky assets all over the world and the coincidental effect this could have on higher quality assets. This repricing of assets is the main concern of Jeremy Grantham, a renowned money manager. Grantham got out of low quality U.S. stocks, including technology, and got into inflation protected bonds and emerging market stocks in 1997. Many of his clients left, unsatisfied with his middling returns in the late 90’s. He has since tripled the size of his firm. Our concern, to some extent, stems from a theory call “fingers of instability.” It focuses on how change occurs. We are in a transition in the world economy, and it sometimes helps to think about how these transitions take place. What is the mechanism for change? Can we see it coming soon enough to avoid the problems and take advantage of them? If you don’t want all the details you can skip to the last paragraph in the Mauldin excerpts, but for those who do:
The following is from an article by John Mauldin on 08/25/2006:
We are going to start our explorations with excerpts from a very important book by Mark Buchanan called Ubiquity, Why Catastrophes Happen. I HIGHLY recommend it to those of you who, like me, are trying to understand the complexity of the markets. Not directly about investing, although he touches on it, it is about chaos theory, complexity theory, and critical states. It is written in a manner any layman can understand. There are no equations, just easy to grasp well-written stories and analogies. www.amazom.com.
We have all had the fun as kids of going to the beach and playing in the sand. Remember taking your plastic buckets and making sand piles? Slowly pouring the sand into ever bigger piles, until one side of the pile started an avalanche?
Imagine, Buchanan says, dropping one grain of sand after another onto a table. A pile soon develops. Eventually, just one grain starts an avalanche. Most of the time it is a small one, but sometimes it builds up and it seems like one whole side of the pile slides down to the bottom.
Well, in 1987, three physicists named Per Bak, Chao Tang, and Kurt Weisenfeld began to play the sand pile game in their lab at Brookhaven National Laboratory in New York. Now, actually piling up one grain of sand at a time is a slow process, so they wrote a computer program to do it. Not as much fun, but a whole lot faster. Not that they really cared about sand piles. They were more interested in what are called nonequilibrium systems.
They learned some interesting things. What is the typical size of an avalanche? After a huge number of tests with millions of grains of sand, they found out that there is no typical number. "Some involved a single grain; others, ten, a hundred or a thousand. Still others were pile-wide cataclysms involving millions that brought nearly the whole mountain down. At any time, literally anything, it seemed, might be just about to occur."
It was indeed completely chaotic in its unpredictability. Now, let's read this next paragraph slowly. It is important, as it creates a mental image that may help us understand the organization of the financial markets and the world economy. (Emphasis mine.)
"To find out why [such unpredictability] should show up in their sand pile game, Bak and colleagues next played a trick with their computer. Imagine peering down on the pile from above, and coloring it in according to its steepness. Where it is relatively flat and stable, color it green; where steep and, in avalanche terms, 'ready to go,' color it red. What do you see? They found that at the outset the pile looked mostly green, but that, as the pile grew, the green became infiltrated with ever more red. With more grains, the scattering of red danger spots grew until a dense skeleton of instability ran through the pile. Here then was a clue to its peculiar behavior: a grain falling on a red spot can, by domino-like action, cause sliding at other nearby red spots. If the red network was sparse, and all trouble spots were well isolated one from the other, then a single grain could have only limited repercussions. But when the red spots come to riddle the pile, the consequences of the next grain become fiendishly unpredictable. It might trigger only a few tumblings, or it might instead set off a cataclysmic chain reaction involving millions. The sand pile seemed to have configured itself into a hypersensitive and peculiarly unstable condition in which the next falling grain could trigger a response of any size whatsoever."
Something only a math nerd could love? Scientists refer to this as a critical state. The term critical state can mean the point at which water would go to ice or steam, or the moment that critical mass induces a nuclear reaction, etc. It is the point at which something triggers a change in the basic nature or character of the object or group. Thus, (and very casually for all you physicists) we refer to something being in a critical state (or the term critical mass) when there is the opportunity for significant change.
"But to physicists, [the critical state] has always been seen as a kind of theoretical freak and sideshow, a devilishly unstable and unusual condition that arises only under the most exceptional circumstances [in highly controlled experiments]... In the sand pile game, however, a critical state seemed to arise naturally through the mindless sprinkling of grains."
Thus, they asked themselves, could this phenomenon show up elsewhere? In the earth's crust triggering earthquakes, wholesale changes in an ecosystem, or a stock market crash? "Could the special organization of the critical state explain why the world at large seems so susceptible to unpredictable upheavals?" Could it help us understand not just earthquakes, but why cartoons in a third-rate paper in Denmark could cause worldwide riots?
Continuing on to how this affects the economy, stock and world markets:
Now, let's couple this idea with a few other concepts. First, Nobel Laureate Hyman Minsky points out that stability leads to instability. The more comfortable we get with a given condition or trend, the longer it will persist; and then when the trend fails, the more dramatic is the correction. The problem with long-term macroeconomic stability is that it tends to produce unstable financial arrangements. If we believe that tomorrow and next year will be the same as last week and last year, we are more willing to add debt or postpone savings for current consumption. Thus, says Minsky, the longer the period of stability, the higher the potential risk for even greater instability when market participants must change their behavior.
Relating this to our sand pile, the longer that a critical state builds up in an economy, or in other words, the more "fingers of instability" that are allowed to develop a connection to other fingers of instability, the greater the potential for a serious "avalanche."
With the invention of literally thousands of financial instruments in the last few years the markets have been getting less, not more turbulent. However, no one ultimately knows if these “risk controlling” instruments will really work. Long Term Capital Management’s “risk free” 45% returns certainly did not. Thus, the build-up of critical states, those fingers of instability, is perpetuated even as, and precisely because, we (the “market we”) hedge risks. We try to "stabilize" the risks we see, shoring them up with derivatives, emergency plans, insurance, and all manner of risk-control procedures. By doing so, the economic system can absorb more body blows which would have been severe only a few decades ago. We distribute the risks and the effects of the risk throughout the system.
BOTTOM LINE
Based on daily closing prices, the S&P 500 has not even experienced a 10% correction, yet the recent decline has been characterized as if investors are acting “like the world is about to end.” This is not the pinnacle of human irrationality, but in fact, quite a shallow selloff from a historical standpoint. The fact that Wall Street is branding it otherwise is evidence that investors have completely forgotten how deep the market's losses can periodically become. We attempt to remind you of this constantly and is one (of a multitude) of reasons why we do not simply put your hard earned money “in the market.” We manage your money and your portfolios based on average historical outcomes and prevailing conditions, not by making predictions of specific future events in the hope that they will come true.
Our clients’ portfolios have held up fairly well over this time period. From its peak on 7/19/07 to its current low point on 8/15/07 the S&P 500’s performance (as well as for a couple of other indexes) was as follows:
· S&P 500 Index (i.e. Large Core): -9.43%
· Russell 1000 Value (i.e. Large Value): -10.49%
· Russell 1000 Growth (i.e. Large Growth): -8.93%
· Russell 2000 (i.e. Small Core): -11.77%
· Dow Jones Wilshire REIT (i.e. Real Estate): -13.86%
Obviously our less aggressive clients’ portfolio have held up the best as intermediate bonds, inflation protected bonds (TIPs), foreign bonds, non-traded REIT and alternative investments have held up fairly well; respectively up 1.41%, 1.33%, 1.10%, 0.00% and 2.60%). Our large cap, small cap, real estate, foreign real estate and international stock asset classes have all taken hits. Some have lost significantly less than their corresponding indexes (like Jensen) and some slightly more (like Keeley Small Cap Value). Overall, in large short term market gyrations like we have been having, all stock based mutual funds will be affected, that much we know. The key, however, is trying to find those that don’t mirror the market over longer sustained drops (such as 2000-2002).
Possible Changes
As many of you know we are reviewing a particular timber product to see if it warrants inclusion in your portfolio. We will probably complete our work in the upcoming couple of weeks and let you know the outcome. Additionally, one other change we are contemplating is increasing high quality large cap exposure while simultaneously decreasing small cap exposure. Over the past few years we have used anywhere from a 68/32 to a 75/25 ratio of large caps to small caps for the U.S. stock portion of our clients’ portfolios. Note: Our exposure to pure, non sector U.S. stocks ranges from 9% to 32% of total holdings. We are also considering lowering our exposure to real estate and small cap/diversified emerging market stocks. Both considerations are due to valuation and, as mentioned, risk issues.
Please call us at 713-827-8014 with any and all questions.
Paul Palmer, Jr. and Kurt L. Box are Investment Advisor Representatives with Cypress Advisory Services, Ltd., LLP, a Securities and Exchange Commission (SEC) Registered Investment Advisor.
