The successive moves by the Treasury and the Fed to restore confidence look increasingly panicky and desperate as they attempt to deal with the first credit crisis of the derivatives era. We have now witnessed three cuts in the fed funds and discount rates, extensive open market operations, an attempt to shore up the SIVs and a plan to freeze subprime mortgage rate resets. The latest action is a coordinated plan (the term auction facility) to induce banks to lend more readily to one another and overcome the atmosphere of fear that has upset the word’s credit markets since August. While the latest plan may help liquidity a bit it doesn’t get to the heart of the problem—insolvency, debt deleveraging, asset writeoffs, the continuing lack of transparency and the ongoing decline of the housing market. In addition the forces for recession have already been set in motion and are not likely to be stopped at this late date.
Despite the action of the various authorities, the fact remains that financial institutions still don’t know what securities other institutions own, what they are worth and how much more will be written down. In too many instances they don’t even know what securities they themselves own or what they are worth. Furthermore with the housing situation still deteriorating the situation is likely to get even worse.
The writedowns keep coming with no end in sight. This week Bank of America CEO Kenneth Lewis said that profits will be disappointing and that the bank will take a bigger writedown on CDOs than the $3 billion previously forecast. He added that the final writedown total is completely unknowable. Wachovia raised its provision for credit loss to $1 billion from a previous $500,000-to-$600,000, and a Merrill analyst said that Wachovia’s credit losses could rise significantly in 2008. PNC, thought to have minimal exposure to subprime mortgages, lowered its valuation of commercial loans by $1.5 billion and significantly increased their provision foe credit losses. This is only a small sample, and we can cite many more instances.
The situation will only get worse as more subprime-related securities are downgraded. A Wall Street Journal article indicates that in the year-to-date there have been 19,795 downgrades among securitized assets including multiple downgrades for the same bonds. Excluding double-counting, 11,817 securities worth $290 billion have been downgraded. Even more ominous, the ratings agencies indicate that there are thousands more securities, valued in hundreds of billions, under consideration for further downgrades.
While some insist that the credit market and housing turmoil has not and will not spread to the economy, significant softening is already evident as is conceded by the Fed itself. In addition a number of prominent economists, even those associated with Wall Street, are now forecasting recession. The main argument of the economic bulls is that employment remains "strong." However, if you hear anyone say that again—and you will—make them prove it. According to the BLS, the increase in monthly payroll employment averaged 189,000 in 2006 and fell to 118,000 in the first 11 months of this year. In the last six months the increase dropped to only 94,000. Furthermore, the so-called birth/death adjustment accounted for 87% of the average monthly increase in the current year. Since these jobs are probably non-existent, the actual increase in employment this year is minuscule.
In our view, therefore, the chances for recession are high. Bear in mind that preceding and coinciding with the last seven recessions, the S&P 500 declined by an average of 30%, and that at the most recent low was down only 10%. In addition the NYSE daily advance/decline line peaked in June and has since made a succession of lower highs, indicating serious technical deterioration. Overall, we think that the probability of a serious market decline is extremely high at this time.
