What the Markets Know Isn't Worth Knowing
...the best market calls/predictions are those that are early and usually not terribly popular at the time.
Editor's Note: This is the first part of a three part series looking ahead at what to expect from the economy in the coming months.
"An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative." -Benjamin Graham-legendary value investor.
"American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage. To the degree that households are driven by fears of payment shocks but are willing to manage their own interest rate risks, the traditional fixed-rate mortgage may be an expensive method of financing a home" -Alan Greenspan, 2/23/2004.
"With these advances in technology, lenders have taken advantage of credit-scoring models and other techniques for efficiently extending credit to a broader spectrum of consumers. The widespread adoption of these models has reduced the costs of evaluating the creditworthiness of borrowers, and in competitive markets, cost reductions tend to be passed through to the borrowers. Where once-marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately. These improvements have led to rapid growth in subprime mortgage lending; indeed, today subprime mortgages account for roughly 10 percent of the number of all mortgages outstanding, up from just 1 or 2 percent in the early 1990's." -Alan Greenspan, 4/08/2005.
Subprime Lending-"Containment or Contagion?"
One thing that I have learned (the hard way, let me assure you) is to never tempt the market Gods and beat your chest about a previous market call that turned out to be correct.
In my experience, it is better to learn from both our mistakes and successes. There are many market axioms that I live by, one of which is "what the markets know isn't worth knowing." What I mean by this is that the best market calls/predictions are those that are early and usually not terribly popular at the time. When the masses universally agree that "it is different this time" I usually duck for cover. In turn, once the masses embrace the now obvious (previously unpopular) issues it is time to put these facts into the rear-view mirror and focus on the future. Again, these issues are generally unpopular and early, but better to be slightly early and correct than to be slightly late and incorrect.
The last two quotations used at the beginning are in no way a detrimental view of former-Fed Chairman Greenspan. Rather, they are simply a view of how credit issues begin in the first place. Whether it is the banking system at large, the Federal Reserve, Foreign Central Banks or a combination thereof, that are easy with credit, a credit crisis usually looms on the horizon. Indeed, Greenspan's comments were a sign of the times and a warning sign that easy credit for low-end borrowers would eventually end in ruin. I have written about the low credit standards (and have been positioned for) particularly as it regards housing. Could I write endlessly about how Greenspan's statements were not the most prudent of commentaries that emboldened people with low credit scores to embrace adjustable rate mortgages with low teaser rates when fixed rate mortgages were at 30 year lows? I could write about all of the subprime lenders gone bust as monitored by the "implode-o-meter" at www.mortgageimplode.com, or the "no document" loans made, or the 10 pieces of "easy credit junk mailings" I get per day.
Rhetorically speaking, the answer is, of course we could, but there is no point in dwelling on the past. I have felt for the better part of a decade that the Federal Reserve has been targeting asset prices (stocks and real estate) in addition to the real economy, rather than just the real economy as it has done for many decades. This is a direct result of the monstrous amount of debt outstanding relative to the size of the economy. For further proof, please look at the chart below, courtesy of our friends at Ned Davis Research. Not only is the percentage of credit market debt relative to GDP important, but note the trajectory of the debt growth. What is important to me is that what accompanies debt is debt service, and that debt service requires ever-increasing asset prices to support the debt service.
I wrote recently about a concept called "zero hour" that was initially unveiled by Barry Bannister (who worked for Legg Mason at the time). Essentially, zero hour is defined loosely as the moment at which credit growth no longer has an impact on the real economy. While the US not yet there, I wonder aloud if it is not heading on a course towards zero hour, or as some call it, "the day of reckoning." I will say this. I do not know when and even if this is to occur. Frankly, for our children's sake, I hope that it does not. But to blindly ignore the mere possibility of this potential outcome is to be imprudent, particularly with other people's hard earned capital. If the US does not, as a nation, get its financial house in order (in a short time I may add), then the question becomes not if the US visits zero hour, but when it reaches zero hour.
This brings me to the title of this section. Will the sub-prime mess that has been well documented by the press remain contained, or will it spread to many other parts of the economy, world and credit markets (contagion defined)?
Generally speaking, I think that the answer of the contained versus contagion question is most likely to be contagion - or when "credit rot" spreads to other parts of the credit markets. It could spread to corporate bonds generally, emerging market debt, junk bonds, prime mortgages or a combination thereof. I have written at length recently how I was completely avoiding corporate bonds as I feel that I am not at all being compensated for the risk taken. Further, I have been quickly reducing my firm's holding in Government Sponsored Entities (GSE's) like Fannie Mae (FNM) and Freddie Mac (FRE) in favor of U.S. Treasury bills and notes and more importantly Ginnie Mae (Government National Mortgage Association). I would note a couple of reasons why. First, Fannie and Freddie have "implicit,' or implied guarantees of Uncle Sam, while Ginnie Mae has an "explicit" guarantee from the U.S. Government. What is amazing to me is that I have been executing these laborious swaps while barely, if at all, giving up any yield to do so. A friend e-mailed me and said, "Bennet, I cannot believe that the market is actually allowing you to execute this swap." My response was, "I am doing it while I can, not when I have to." In other words, I do not expect these relationships to last forever, and want to be on the other side of these trades when the crowd looks to execute the same trade.
While I do not believe that Fannie Mae or Freddie Mac will default, I do expect their securities to drastically under-perform "risk less securities." In other words, I expect their yields relative to "full faith and credit" instruments to widen along with corporate debt in the not too distant future. Being early is sometimes painful introspectively, but usually well compensated in the long run. "Sell when you can, not when you have to," as Toddo likes to say. So while this is not necessarily a prediction of a contagion, I recognize it is not worth the risk of being positioned otherwise. The day to take risk is certainly out there in front of us and at the moment I feel I am being properly compensated to do so, I shall take risk prudently.
Click here for What the Markets Know Isn't Worth Knowing: Part II.
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