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Jeff Saut: Too Big To Fail


The problem appears to have gotten beyond the ability of the private sector to solve.


Editor's Note: The following article was written by Raymond James Chief Investment Strategist Jeff Saut. It has been reproduced with permission for the benefit of the Minyanville community.

I first heard the phrase "too big to fail" in Washington, D.C. back in the 1980s. At the time the systemic risk fostered by the failure of over 1000 Savings and Loan institutions threatened to collapse the U.S.'s banking system. As one savvy seer exclaimed, "It was the largest and costliest venture in public malfeasance and larceny of all time." The ultimate cost of the S&L debacle was estimated to be roughly $160 billion, for which the American taxpayer eventually "footed" the bill. At the downside inflection point of the crisis, Citigroup's (C) stock was changing hands at single digits amid worries that it would go bankrupt. It was then I heard the term "too big to fail" and Saudi Arabian investor Prince Al-Waleed swooped "in" with a massive purchase of Citigroup's stock and the rest, as they say, is history.

Well, I'm in Washington, D.C. and once again have heard the term "too big to fail." Eerily, the reference was aimed at Citigroup as the poster child of the subprime/housing mess. Also déjà vu-ish is another huge purchase of Citi's stock by a Middle-Eastern entity, namely Abu Dhabi's Sovereign Wealth Fund (ADIA). It should be noted that the current crisis, at least in monetary terms, dwarfs the 1980/1990's S&L situation, which is why the politicians inside the "beltway" are worried. Using Washington, D.C. as a microcosm, it should be noted that mortgage lending standards continue to tighten. Meanwhile, housing sales for the region are down 58% from their peak in 2004 and "for sale" housing inventory represents 10.7 months of supply compared to 6.9 months at this time last year. Significantly, the most recent data from the Case-Shiller Home Price Index (which measures home prices given a constant level of quality) suggests that same home prices in the Washington, D.C. metro area are down 7% year-over-year (y/y).

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To understand how the era of low interest rates and fancy mortgages created the current housing bubble, one merely needs to look at the attendant chart of median house prices divided by median personal income as constructed by the brilliant money management organization Grantham, Mayo, Van Otterloo (GMO). To wit, the ratio of housing prices to income achieved nearly a four standard deviation (SD) reading. To put this in perspective, a one SD event occurs once every six years. A two SD event every 44 years. A three SD event every 740 years. And a four SD event every 31,575 years! Clearly, the United States is in the midst of a severe housing problem compounded by fancy mortgages that gave unqualified consumers the ability to buy houses they really could not afford. Now with housing prices falling and mortgages resetting at higher interest rates, defaults and foreclosures are rising. In fact, it is estimated that 30% of the $1.3 trillion in subprime mortgage debt will eventually default. While we have railed against government intervention, and over-regulation, the problem appears to have gotten beyond the ability of the private sector to solve.

New York University professor Nouriel Roubini said it best when he wrote:

"The main point is that – leaving aside important issues of moral hazard from fiscal bailouts – there is now a new and increasing recognition that severe credit and financial distress problems cannot be resolved with monetary policy alone. Thus, if a political consensus were to emerge that some financial support of distressed mortgage borrowers is fair and necessary, then fiscal – as opposed to monetary alone – solutions may have to be discussed and implemented. The prospect of home prices falling 10 to 15% and two million plus home owners losing their homes is – rightly – becoming a political issue. And political issues lead to fiscal solutions when there is a political consensus that the consequences of no action can be a severe economic and social fallout from the worst U.S. housing recession in decades."

Plainly, our country's inteligencia is worried as evidenced by the Herculean efforts to contain the mess. So far, the attempted solutions of freezing mortgage resets, creating a Super SIV (Structured Investment Vehicle), lowering interest rates, the TAF (Term Auction Facility), etc. appear to be both inflationary and potentially illegal. However, as we noted a few weeks ago, the verbiage imbedded in the Pooling and Servicing Agreements (PSA), which govern how securitized loans are handled, in many cases permit "adjustments" to the original contracts, causing one Wall Street wag to exclaim, "Can you spell estoppel?!"

Click to enlarge

By my pencil the main question going forward is, "Does the housing/mortgage induced credit crunch cause economic growth to collapse?" Clearly the economy is slowing as reflected by the recent Empire State Manufacturing Index, which fell to an alarming 10.3 from 27.4 versus expectations of a 20 reading. Moreover, the "new orders" component dropped to 14.3 from 24.5 and "shipments" declined to 21.1 from 32.1. However, if growth merely slows, and does not collapse, the liquidity the central banks are pumping into the system has got to be inflationary. Further, even though my firm has been bullish on the U.S. dollar for the past few months, the dollar's multi-year collapse has finally led to a boom in the tradable goods sectors, resulting in export growth that is currently three times greater than imports. This is not an unimportant point for the export sectors are almost three times larger than housing and therefore could more than offset the housing debacle.

In the past, whenever the U.S. trade deficit improved, the S&P 500 has tended to outperform the EAFA Index (Japan + Europe). As the good folks at GaveKal opine, "This make sense if one assumes that, instead of detracting from U.S. GDP, trade actually acts as a net-positive on growth and that the earnings of U.S. companies become supported by the undervaluation of the U.S. dollar." In the U.S. equity markets, the technology sector has the greatest exposure to foreign revenue. Consequently, is it any wonder technology stocks have been strong? We think "style cycles" last years, not months, and that select technology names should remain a primary focus. One such name is Strong Buy-rated Avnet (AVT), which is being valued as if there is going to be a 35% reduction in earnings that we don't think will happen. Another favored name would be Motorola (MOT), which appears to be just too cheap selling at one times revenues and one times enterprise value to sales with a product array that will be refreshed over the next 12 months.

As for the overall equity markets, for whatever the reason the indices seem to "think" things are going to get better as the dutiful Dow gained 111 points (+0.83%) last week, yet was totally eclipsed by the Russell 2000's surge of 4.20%. This strength is consistent with my "call," since the end of November, that the Santa Claus rally has begun. Sure, there are a number of things wrong with the rally: 1) Lowry's Buying Power Index fell to a new 11-month low last week indicating the rally is more about a lack of "sellers" rather than earnest buying; 2) the Operating Company Only (OCO) advance/decline is flirting with new 11-month lows; and 3) our Exchange Traded Funds (ETF) analysis is showing increasing signs of weakness. However, as often repeated in these missives, "We have learned the hard way NOT to be bearish in the ebullient month of December!"

The call for this week: Economist Hy Minsky stated, "All panics, manias and crises of a financial nature, have their roots in an abuse of credit." To which I would add, "True in the 1600s with Tulip Mania. True in the Dotcom bubble. And, true in today's housing/mortgage mess."

Still, my firm remains positive on select stocks/sectors, as we have been at the August 2007 "lows," yet cautious at the September/October "throwback" highs, and again aggressively bullish at the subsequent late-November downside retest of the mid-August "lows." Indeed, my firm is positive on stocks into year-end, emboldened by the "too big to fail" mantra and Canada's over the holiday solution to its Asset Backed Commercial Paper woes.

Happy New Year, everybody!

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