There are very few certainties in the financial markets, which is as good a reason as any for these commentaries to avoid making bold macro predictions. We therefore tend more toward observation rather than overconfidence, having experienced (humbly!) too many short-term surprises in our firm’s three decades of existence. But the disaster du jour, subprime mortgage lending, has represented to us for some time one of several overheated markets likely to correct sharply:

...The buyers of these instruments, by implication, forecast a continuation of smooth economic times as far as the eye can see….we can’t justify shouldering these risks without fair compensation (April 2006);

 ...In a post-9/11 world, many investors have tried to cope…by seeking more exposure to alternative assets such as…real estate…as this capital has sloshed its way into newer investment vehicles in search of a few extra basis points of return, it’s debatable whether investors…truly comprehend the risks….the use of exotic derivatives can be undone by temporarily illiquid markets and creditors who might force liquidation at an inopportune moment (October 2006);

 and finally

…we are instinctively wary of the seeming complacency of those who chase junk credits…there is likely to be a price to pay from the indigestion that is bound to follow (January 2007).

And so today, we see rising bankruptcies among the aggressive subprime lenders, meaningful pain among those who buy or sell the related exotic financial instruments, and distress among homeowners and speculators who failed to consider – or perhaps did not fully comprehend – the precariousness of these low-quality and explosive instruments. Yes, this was a train wreck waiting to happen (timing uncertain); now that the distress has arrived, we wonder about the potential for further distress and the prospects for our portfolios.

It’s important to note that the current mess is more a symptom of the general market environment rather than an isolated incident. As we’ve previously discussed, in the past five years market participants have increasingly sought to earn higher returns through more complex, non-traditional investments: equities lost their luster following the pop of the Technology Bubble in 2000, and growing economies and profits swelled cupboards with liquidity that stretched to generate high returns. In the real estate market in particular, rising demand for homes and low default rates encouraged lenders to accept more risk by offering loans to the shakiest borrowers. Wall Street banks greased the skids by extending generous credit terms to the lenders, further fueling the expansion of the boom. But this was an unstable equilibrium: as the real estate market slowed while teaser rates on these loans reset at higher levels, defaults mounted and the leverage (that had previously offered such attractive returns) worked in reverse as the flow of liquidity from Wall Street shut down. We have certainly seen this movie before: high expected returns and easy money encourage more participants to enter the market (utilizing more leverage) until the marginal borrower defaults, causing painful ripples for many others.

Interestingly, the subprime mess takes place today against the backdrop of a decent economy. While it’s true the U.S. economy has slowed in recent quarters – as would be expected for any economy in its sixth year of recovery – conditions remain supportive of growth. It’s worth noting that the world economy – driven primarily by the U.S. and China – grew more in the past five years than any five-year period since WWII. Today, inflation and interest rates are uncharacteristically below-average after such a strong period, and consumer spending continues to defy the naysayers who predicted disaster following the Tech Bubble, 9/11 and sharply higher gas prices. Admittedly, the subprime mess could prove to be the tipping point, but we’re not betting on that outcome: even former Fed Chairman Alan Greenspan – who has little reason to obfuscate anymore – has expressed an unusual amount of uncertainty and humility in his recent public comments on the topic.

It seems to us (non-economists!) that the key factor that will determine the outcome of this episode is confidence. Confidence drives companies to continue to invest in new opportunities and provide jobs (allowing consumers to meet their financial obligations); it encourages folks to continue to spend; and it persuades investors and speculators to provide liquidity to the market when there is none. In recent weeks, it has been heartening to see opportunistic investments by investment banks and private funds in the subprime mess, hoping to pick up the pieces to generate meaningful future profits. This activity is similar to the bailout of Long Term Capital Management (LTCM) in 1998, when the New York Fed formed a group to rescue the beleaguered hedge fund. This time, however, no “arm twisting” was required, which speaks to the ample liquidity now available.

But confidence is a tricky concept. We have noted in many of our commentaries the propensity of the media to emphasize the negative more than positive, and this can have an important impact on consumer and corporate actions, politics, and obviously, the markets. We continue to be struck by the dichotomy of the current environment: journalists cry disaster while the facts show substantially less real damage (some recent sales of subprime loan portfolios were described by CNBC as occurring at “cents on the dollar”, although, the deals were struck very close to par; the report was at least technically correct since there are, in fact, 100 cents in a dollar!). Another troubling aspect is the knee-jerk political response: several states are now threatening to halt all foreclosures or bail out borrowers. This would certainly not be the first example, unfortunately, of a legislative body responding to a financial crisis with policies likely to make things worse. In the long run, such government action runs the risk of undermining the market itself by driving away lenders and deserting countless families who may not enjoy the benefits of home ownership.

We always worry about what can go wrong, recognizing that the financial markets will often react in the most unlikely ways. As we said in 1998 after the market break associated with LTCM’s collapse, market declines are common and necessary events:

“A decline helps to wring out the excesses that have developed in the preceding period – too much credit, too much capacity, too much euphoria – in order to set the stage for the next cycle.”

Frankly, we worry a lot less about the ability of the market to handle the subprime issue than we do about the willingness of participants to do so. Hyped-up news reports and misguided government regulations are always present at these moments, but nonetheless, they make the ultimate scope and impact of this episode difficult to assess. The vast amounts of available capital, plus the initial willingness of some investors to act as buyers encourages us, similar to last year’s experience with the collapse of hedge fund Amaranth Advisors. But it would be arrogant to dismiss the risks of problems in related asset classes where leverage and risk taking have been high (and the margin for error and common sense have been low). As we said earlier, the subprime mess seems more like a symptom of a broader environment where credit spreads are tight and there is little perceived risk. The players in these markets have become less transparent while the financial engineering has become more complex. The uncertainties loom large.

As we have stated in recent commentaries, we remain positive in the face of such uncertainties because of the significant operating and financial strength of the securities in our portfolios. Our client accounts continue to reflect our own risk-related concerns through the ownership of unusually strong businesses priced attractively. We recognize that in recent years this class of assets has provided uninteresting performance while some peers took advantage of a more risk-loving market environment. The distress in the subprime market provides a healthy reminder of meaningful risks that lurk within the system, and we remain skeptical of related areas where enthusiastic and leveraged capital might have created similar problems. Even as perennial worriers, however, we view the current environment as one which is likely to reward our judgment, as well as offer the chance to opportunistically identify attractive businesses that meet our strict criteria.

Edward S. Loeb
quarterlynews@harrisassoc.com