The Credit Crisis

The Credit Crisis: Just How Bad Is It?

by Alexander Green, Chairman, Investment U
Investment Director, The Oxford Club
Friday, March 14, 2008: Issue #774

We all know what’s been ailing the financial markets lately - record oil prices, the threat of recession and a stubborn liquidity crisis that refuses to go away.

What caused this credit crisis? What can be done about it? And how long is it likely to last? These are the questions investors everywhere are grappling with right now.

The answer to the first one, of course, is easy. In an effort to stave on a potentially debilitating Japan-style deflation, Greenspan took short-term rates all the way down to 1%.

Predictably, that stimulated the economy and the stock market. It also had unintended consequences. Borrowers were motivated to buy more home than they could afford. Lenders were motivated to make loans they shouldn’t have made. And Wall Street took these bad loans - along with some good ones - and turned them into publicly traded securities.

The real problem was masked as long as real estate prices kept rising. But when the housing market rolled over, the jig was up. As foreclosures rose - eventually hitting record levels - the market value of subprime mortgages plunged. Eventually they went “no-bid.” No one wanted them. And no one wanted the securitized mortgages that Wall Street created, either.

As the Housing Market Succumbs, The Credit Crisis Evolves

The end of the rising housing market has caused a severe liquidity crisis at the nation’s banks. And we’re now caught in a vicious circle. The value of home loans falls, forcing banks to take write-offs. That pushes the market lower, causing still more write-offs.

However, this week the Federal Reserve announced its intention to lend up to $200 billion of Treasury securities to primary dealers for a term of 28 days, rather than just overnight. The idea, of course, is to increase liquidity and ease the credit crunch.

Unfortunately, this is just a Band-Aid. The wound has still not been treated. And the credit crisis is likely to persist.

Bank Write-Offs Could Hit $600 Billion During the Credit Crunch

So far the total amount of bank write-offs comes to just over $150 billion in this continuing credit crunch. That is equal to only 1% of U.S. GDP. It is less than 1% of the market capitalization of U.S. stocks.

Two weeks ago, however, a report by UBS said losses among financial institutions could top $600 billion as world credit markets continue to freeze up. That’s a lot, even measured by the free-spending ways of Washington. Still, it’s not as if we haven’t been here before.

As Rich Karlgaard writes in the March 10 issue of Forbes, “The nearest historical comparison we have is the savings-and-loan crisis of 1986-95. On a constant dollar basis - so we can compare apples with apples - the S&L crisis saw $700 billion in bad loans… The S&L crisis caused some damage, to be sure. But during the 1986-95 period, the U.S. economy grew and stocks went up.”

Investor Tip: Don’t Shrug Off The Continuing Credit Crisis

Don’t get me wrong. I’m not suggesting that investors shrug off the credit crisis and get fully invested. Far from it. We’re likely to see plenty more market volatility in the weeks ahead.

But when some market commentators argue that “we’ve never seen anything like this before,” take it with a grain of salt. We have been here before. We have survived… and prospered.

Let me add one caveat, however. If housing prices continue to slide and Alt-A and prime mortgages start going the way of subprime debt, we’re likely to experience more difficult times than most investors are expecting. So keep your investment posture on the conservative side.

The burden right now is on the Federal Reserve and other central banks to do what they can to help guide the economy through this tough period.

The actions we saw this week were a good first step. But it will take more action - and clearly more time - before we’re able to sound the all-clear from the continuing credit crisis.

Good investing,

Alex

Today’s IU Crib Sheet

This morning, the credit crisis continued to blemish stocks… JPMorgan Chase, in conjunction with the Federal Reserve Bank of New York, said it would provide funding for Bear Stearns for up to 28 days. And it will also help Bear Stearns get permanent financing. According to The Associated Press, Bear Stearns’ liquidity “significantly deteriorated” over the past day and the temporary funding from JPMorgan will help it continue operating normally.
Stocks plunged early on Wall Street. The S&P fell more than 1.5%. At one point, shares of Bear Stearns (NYSE: BSC) dropped more than 35% on the news.
Meanwhile, oil prices remained steady at $110 a barrel. And gold hovered near the $1,000 mark.
Of course, as stocks move lower, the world’s best value investors begin to stir. Take a look at Investment U Issue #760, Warren Buffett: 3 Stocks on Berkshire’s “Buy List” and you’ll find the three companies Warren Buffett’s been loading up on.