In recent weeks, the investing atmosphere has become even more pessimistic, as pundits outbid each other in guessing the size of the next gigantic bank accounting write-off. Because of the nature of how many mortgage and related securities are valued, there is some circular feedback in this exercise, and so pessimism tends to be a self-fulfilling prophecy. But at some point, market prices begin to look silly. For instance, some now predict the cumulative losses from overzealous subprime mortgage lending to reach as much as $500 billion. That figure is statistically possible, but short of economic Armageddon, estimates in this range appear overly extreme: if one makes the seemingly conservative assumption that lenders recover only about 50% of the loan value of foreclosed properties, a $500 billion loss would require something like 75% of all subprime mortgages going bust (trust us: that is a huge percentage). But according to industry statistics as of September 30, 2007, only about 10% of all subprime mortgages are in foreclosure (and overall, only about 0.3% of American families have a home in foreclosure). While delinquencies are rising (and are likely to continue to rise), the economic impact of a housing bust should be limited: less than half of American families have a home with a mortgage (about one-third rent, and about one-quarter of homes are mortgage-free). Housing starts peaked over two years ago and the economy has exhibited very strong growth in recent quarters. And remember this: the vast majority of borrowers are current in their monthly payments and are likely to continue to remain so. We admit that certainty is impossible in these exercises, but the long-term pessimists rely on some very extreme math. It’s very important – yet increasingly difficult – to keep things in perspective.

The underlying causes of seizure in the U.S. mortgage market will be discussed for many years, but it’s pretty clear that several elements, including bonus-driven lenders and packagers, compliant credit rating agencies, impatient investors – and throw in a tax code that is biased toward home ownership regardless of economic means – conspired to create an unsustainable boom. The increasing complexity of the mortgage market, which at one point was viewed as a positive, is also now understood to have played a key role because of misaligned motivations and risks. The banks quickly packaged and sold mortgages too numerous to analyze, so they didn’t need to really care about underlying credit quality. As recent articles have highlighted, many of the newfangled mortgage products were designed more for investors than for borrowers. The rating agencies (compensated by issuers, not investors) then blessed deals they didn’t fully understand; even after the markets seized in July, one of the two major rating agencies predicted “stable” ratings for the soon to-be-beleaguered Structured Investment Vehicles used by various banks (the timing was about as perfect as Irving Fisher’s well-known prediction that stock prices had reached a “permanently high plateau” in 1929!) And deceit, as in past market cycles, also rose during the boom. Some lenders were undoubtedly too aggressive, but on the other hand, FBI reports of suspected fraud have increased eightfold in the past five years as predatory borrowers took advantage of a system that asked few questions and offered great rewards. Interestingly, the current political fallout directed at mortgage lenders is more than ironic given that until recently, many of these institutions were strongly criticized for failing to make loans available to the same marginal borrowers who are now defaulting! The current correction in the housing and mortgage markets will eventually eliminate the financial excesses, but in the long run, the U.S. mortgage market might benefit the greatest from improved transparency and a better understanding of how current structures can lead to unintended consequences.

But of course, the current credit troubles extend well beyond the mortgage and housing markets, as attested by the recent moves by the Fed and its foreign counterparts. With major financial institutions caught off balance by the swiftness of the mortgage crisis, the appetite for risk has evaporated: liquidity appears to be plentiful, yet there is little desire to transact with counterparties. Skepticism has replaced trust among institutions that typically trade regularly. So risk spreads have widened, partly due to the sting of the mortgage crisis but also because (as we have regularly noted) risk was severely underpriced. As a result, it is now a given among investors that recession is likely. We won’t quarrel too strongly with the idea of an economic slowdown, although as we said last quarter, the actual evidence of recession remains inconclusive. And to be clear, we view the current economic trends as cyclical and not secular: while the absolute magnitude of credit losses will undoubtedly be large, we believe the relative impact should be very manageable compared to the size of the economy and compared to previous financial market seizures (e.g. the S&L crisis of the early 1990s). While the current headlines offer plenty of doom-and-gloom pessimism, we recall too many episodes where the media’s tendency to highlight woe served only to sell more ads rather than provide helpful advice. Current credit/confidence problems are undoubtedly real, yet conventional wisdom rarely contemplates the variety of responses – market, fiscal and monetary – that generally come to bear in such periods of distress (e.g. S&L crisis, Long Term Capital Management). Rather than argue about a slowdown which most everyone already takes for granted, the more important issue is whether the current phase and magnitude of the economic cycle leads to a meaningful change in our own assessment of the long-term opportunities for our clients’ portfolios.

First, it’s worth reiterating that our own analytical assessment of business value always assumes cyclical ups and downs. While it always seems tempting to use the magic of a spreadsheet formula to project rising margins and profitability into the next century, our experience leads us to more sober predictions. In our view, the intrinsic value of a business is not dependent upon any particular economic condition; good businesses by definition have the wherewithal to survive stressful periods. Second, we reject the notion that there are meaningful stock market timing opportunities associated with the economic cycle. Stocks actually rose during the 1990-91 recession, and the market can fall even during strong economic times (e.g. 2000-01). With the average recession lasting only about 10 months anyway, the challenges of executing a well timed exit and re-entry to the market for any true long-term investor are daunting and, in our opinion, ill-advised. The economic outlook has certainly deteriorated in recent months, but the long-term backdrop remains impressive, with the increasing relevance and impact of developing nations, muted inflation and interest rates, large pools of available investment capital and plenty of economic momentum in recent quarters. Malthus, Marx and Ehrlich commanded great attention during global moments of stress, but their arguments of secular decline proved hollow. Scaremongers are occasionally right – the Trojans should have heeded Cassandra – but their track record is pretty dismal.

The market, however, has certainly been affected by the credit crisis and mounting fears of economic decline. While the broad market averages have held ground reasonably well, there is great turmoil beneath the surface, led mainly by price-momentum strategies that run counter to our successful long-term value approach. Today – after many years of modest price volatility, tight credit spreads and little differentiation among assets of various levels of quality – market prices are now breaking from their logjam. While the change has, as we detailed earlier, delivered some bruises, the good news is that risk is being repriced, and the benefits from accurate fundamental analysis should increasingly be rewarded. We remain quite comfortable with our current portfolio holdings, and rising volatility is likely to offer new opportunities to adjust and reshape our portfolios. We believe the current challenges will be overcome and opportunities remain bright.

Edward S. Loeb
quarterlynews@harrisassoc.com