Economic Commentary - April 2009   Christopher Bremer Senior Investment Consultant   Overview Stephen Crane’s literary style represented a deliberate attempt to create confusion, disconnection and disorder, and no, he was not writing about the current state of the economy and the federal government’s attempts at fixing the institutions deemed too big to fail. Recognizing fear, finding courage and confronting it are themes throughout Crane’s classic novel on the Civil War, “The Red Badge of Courage,” and many households are confronted with their own economic fears today. At one point, the main character, a young soldier named Henry Fleming, comes to the realization that turning away is even worse than confronting his fear. Crane writes:  “Since he had turned his back upon the fight his fears had been wondrously magnified. Death about to thrust him between the shoulder blades was far more dreadful than death about to smite him between the eyes. When he thought of it later, he conceived the impression that it is better to view the appalling than to be merely within hearing.”   Certainly, if Henry Fleming were here today, he might be tempted to turn and run from the current state of economic affairs. This year ushered in hopes of an economic and market recovery and vast amounts of policy effort led successfully by the new administration. Instead, the economic crisis continued with a new round of equity market lows, further declines in housing prices, weaker sales and consumer spending, unfavorable sentiment, spikes in unemployment, and uncertain futures for the banking and automotive industries. Fear, as expressed by the Chicago Board Options Exchange SPC Volatility Index (VIX), became rampant, and investors turned their backs from risky assets. (Figure 1.)   Since the signing of the $787 billion fiscal stimulus bill into law, there have been a number of new policy initiative discussions aimed at rescuing the economy. The administration’s lack of clarity on economic policy and stimulus measures, however, only served to create more anxiety and jeopardize any potential reversal in the intensity of the recession. Despite the market’s unfavorable opinion on the clarity of policy initiatives, the government’s ability to successfully promulgate monetary and fiscal stimulus remains critical to securing an economic upturn.   Enter the Federal Reserve (the Fed). Things suddenly heated up in the rather obscure area of “quantitative easing” when, on March 18, Fed Chairman Ben Bernanke unexpectedly announced the intention to purchase $300 billion in longer-term U.S. Treasuries over the next six months. In addition, the Fed pledged to increase the size of its balance sheet by scooping up $750 billion to $1.25 trillion in agency mortgage-backed securities (MBS). The Fed’s stated purpose is “to provide greater support to mortgage lending and housing markets and to help improve conditions in private credit markets.”   The same week, the Fed concurrently launched the long anticipated Term Asset-Backed Securities Loan Facility (TALF). That major economic institutions are in severe trouble is well documented on a daily basis. The Fed meeting on March 18, however, was more about public households and small business than about the big institutions. To understand the Fed’s initiatives, we must examine how household wealth has deteriorated and the importance of freeing up credit to those households.   Wealth Decline   The Fed’s Flow of Fund report for the fourth quarter of 2008 showed material erosion in U.S. household net worth. Household net worth fell by $11.2 trillion, or 18 percent, and erased more than five years of gains. The value lost equals the combined annual output of Germany, Japan and the United Kingdom. This represented the biggest annual decline since the start of records in 1952. Net worth is defined as all household assets – including housing, stocks and personal property – minus the total debts. (Figure 2.)   From the peak in household wealth, households’ net worth has dropped $12.8 trillion over five consecutive quarters. The decline almost matches the total size of the U.S. economy, which was $14.2 trillion in the last three months of 2008. At first, the decline in wealth stemmed from declining housing values. That was until the fourth quarter’s equity markets contributed $5.4 trillion of the total year’s drop in household net wealth.   Over a decade of the “wealth effect” has been reversed. In general, wealth effect means that as equity and housing prices increase, consumers feel more comfortable with their financial conditions and are inclined to spend more freely. Over the last decade, consistent increases in housing values enabled consumers to spend more relative to income. Net wealth accumulation or household savings was, in effect, accomplished through home equity increases. In this case, and in the aggregate, the housing bubble served as an enabler of future spending without the need for current savings. At the same time, the declining rate of personal savings indicated that, as housing prices increased during the early part of the decade, consumer spending grew faster than income. (Figure 3.)   When home prices started declining in 2006, many economists concluded that a stabilization or moderate decline in home prices would diminish consumer spending. The adverse impact of declining home and equity valuations would be dependent on the degree to which the asset declines were transitory. Like all other economic and market-related events over the past 18 months, those prognosticators that got it correct directionally, never imaged the magnitude of the declines. For example, 20 percent year-over-year housing price declines were so far outside the normal distribution of outcomes that virtually no one modeled for such a devastating “fat tail” event.   The global market dislocation of October and November of 2008 drove home to all households the intransient nature of the current economic crisis. Depending on one’s outlook, 2008 likely instilled or reinforced the notion that housing and net worth do not always go up.   Credit   Credit is essential for economic growth, as households and businesses alike depend on it for improvements in standards of living and profit growth. Indeed, credit is often required to support the ordinary operations of businesses—for example, to finance their inventories and to meet payrolls before payments are received. If the customary means of obtaining credit break down, the disruption to households’ and businesses’ spending can be severe.   High corporate spreads are indicative of economic uncertainty and a larger risk premium required by investors. The corporate spread is the increase in yield the market demands for buying corporate bonds instead of U.S. Treasuries. When the spread increases, investors are more fearful about a corporation’s ability to adequately cover debt payments. (Figure 4.)   Falling corporate spreads are only as good as the ability of companies to raise capital in the bond market – that is, to issue debt. As corporate spreads fall relative to U.S. Treasuries, the cost of issuing bonds declines and corporations have more incentive to raise capital this way.   The current economic decline is broad-based, and no part of the economy or geographic region has been insulated. Last October, banks stopped lending to one another. When credit markets break down, the line between savers and investors is severed. Without access to credit, economic producers cannot invest in capital projects, products, service offerings or employees. The result, as we have experienced, is a breakdown in the financial system and a severe decline in economic output.   Throughout the worst of the crisis, credit dried up for firms with lower credit ratings. In fact, there was virtually no issuance of debt for firms with less than the best credit rating; this meant expansion, growth and even fundamental business activities like payroll were difficult to meet. One measure of short-term confidence expressed through the “TED spread”, shown in the graph as the difference between the London Inter-Bank Offered Rate and the 3-month U.S. Treasury Bill. Simply stated, the higher the spread, the lower the degree of confidence banks have that other banks can pay them back. (Figure 5.)   As a sign of the turmoil in the credit markets, it is difficult to have imagined two years ago that bond markets today place a higher probability of Warren Buffett’s Berkshire Hathaway defaulting on its debt than the country of Vietnam. Or that after five decades of AAA ratings, General Electric’s (GE) debt would be downgraded, making GE a greater market risk than Russia.   Just like their corporate counterparts, securing credit (a loan) for those with lower credit ratings (credit score) is vastly more difficult than those with higher ratings. While this is the normal course of things in an average credit environment, the credit crisis resulted in historically high spreads between those with good credit and less than average credit.   In short, credit is the lubricant that makes the machinery of Wall Street and Main Street operate. When fear of defaults tick up, shockwaves spread through the system. Eventually, the machinery jams and moves into reverse with banks becoming unwilling to lend, even to each other, and economic activity grinds to a halt. As we can see, credit has an impact on business and households that is pervasive. Hence, credit spreads should provide some coincident or leading indication as to how smoothly the gears of commerce are working.   The key to gaining positive economic momentum is to reverse the credit crunch and provide the incentive for credit providers to transact with one another and engage the credit markets.   By buying up long-term U.S. Treasuries, the Fed hopes to depress rates, including mortgage rates, and create more affordable housing and refinancing opportunities. As homeowner equity is now below debt owed, refinancing at lower rates frees up funds for all home owners, not just the ones close to foreclosure. (Figure 6.)   Term Asset-backed Securities Loan Facility (TALF)   The U.S. Treasury and the Fed have initiated programs to provide funding and support for highly-rated securities with underlying loans for automobiles and college tuition, among others. Getting these credit lines open again is critical to achieving economic recovery.   In March, President Obama elaborated on plans to use capital injections as an incentive for investors to buy distressed securities from banks. This represents a change from the previous administration which considered the outright purchase of bad assets. The main problem is how to value such assets, and coming up with a fair market price agreeable to both banks and buyers, whether the buyers are the U.S. Government or private investors.   The Fed’s balance sheet has doubled in the past year, from about $860 billion to $1.8 trillion. Further expansion of the balance sheet is probable. While the issue of how to deal with toxic assets is still being debated, the Fed does have bad assets from Bear Stearns and AIG on its balance sheet. Most importantly for market psychology, the Fed consistently maintains there are few limits as to how far it will go in attempting to restore confidence and functionality to the financial markets.   According to the Fed’s term sheet, “the TALF is intended to assist the credit markets in accommodating the credit needs of consumers and small businesses by facilitating the issuance of asset-backed securities (ABS) and improving the market conditions for ABS more generally.” The TALF may lend as much as $1 trillion to investors to buy recent securities.   Asset-backed securities are investments based on an underlying loan. For example, a mortgage-backed security (MBS) is a way for smaller banks to facilitate mortgages to homeowners with the investment markets. ABS means that the underlying investments are backed by other kinds of loans, leases or credit card debt. Historically, the asset-backed markets have funded a significant share of consumer credit and small business loans. When these markets froze upon the Lehman Brothers bankruptcy, so did credit to households and small businesses.   Where We Are Headed   Does the erosion in household wealth mean we should turn our backs and run from the fight? Similar to “The Red Badge of Courage,” will economic death smite us between the eyes? In a word, no.   However tenuous the present circumstances seem, turning one’s back from the fight can be reckless with regard to one’s long-term financial interests. By definition, one cannot advance if one retreats.   The economy and markets are self-adjusting mechanisms. For sure, economic growth in the coming years is likely to come at a much more moderate pace than we have been used to during the debt and leverage years. There are still enormous amounts of leverage to unwind, earnings will be lower and consumer spending is likely to moderate. Likewise, household net worth will be adjusted. While the current debt deleveraging is painful, at some point households will compare their net wealth to the re-adjusted levels. This is not unlike the evaluation of the equity markets.   Investors and economists are scrutinizing all economic data for signs of stabilization or deceleration in the rate of decline. The Institute for Supply Management’s Manufacturing Index has had two monthly improvements following its worst readings in 30 years, and the Leading Economic Indicators Index has risen for two consecutive months. (Figure 7.)   As we have presented in recent months, economic data is only a part of the equation. Sentiment, psychology and expectations, while certainly harder to quantify, play a critical role in the health and vibrancy of our economic and security markets.   For example, while speculative excess is difficult to quantify, most observers agree it contributed to the rise in housing prices, making the ensuing revulsion all the more destructive. The perception that housing prices always go up has been transformed into the perception that we are in a prolonged and disruptive economic cycle. Home prices, however, do not have to again rise by double digits on an annualized basis or get back to previous levels for the economy to become healthier. The market has only to perceive that prices can once again rise. This applies not just to housing prices but all investment assets, especially those assets with risk premiums relative to U.S. Treasuries.   The Fed’s recent actions increase the probability that the economy will stabilize or begin to recover later this year. Just as excess consumer spending may have been positively influenced by expected gains in housing prices, an improvement in economic activity may be influenced by expected improvements in the health and vibrancy of the economy. At some point, the loop of negative feedback will be severed. And when it is, investors will be grateful that they “viewed the appalling” and came out of the economic crisis with their own badge of courage.

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