Comments on the Financial Stability Plan

February 12, 2009

The first part of this article discusses the Financial Stability Plan presented by Treasury Secretary Geithner.  The second part of the article addresses our investment plans to adjust and benefit from today’s investment environment moving forward.

 

Comments on the Financial Stability Plan introduced February 10, 2009

Addressing the Problem

We commend the new administration’s efforts to turn the economy and our financial system around.  As Americans we all stand to benefit from our government succeeding in its efforts to guide and rejuvenate our economy.

As your investment advisors, our job is not (thankfully) one of making political judgments and national policy decisions.  Our job is to objectively assess the facts, make our own judgments concerning the implications of existing policies and their impact on investment markets, and determine the best way to invest under these circumstances.  

The plan presented earlier this week by Treasury Secretary Geithner did not identify the underlying root cause of today’s problems, nor did it propose an effective solution to addressing the root cause of today’s problems.  As investors, this was a disappointment.  The stock market concurred, greeting the announced plan with a sharp sell-off.  In the investment world, this is the equivalent of a vote of no-confidence.

Identify the Problem

Our government, including past and present administrations, is failing to grasp that the root cause of today’s economic problems can be stated in the simplest of terms; there is simply too much debt and an inability to meet the payment obligations on that debt.  A weakening economy further undermines the ability to meet those obligations.

It is a mistaken notion that encouraging lenders to extend more credit and create more debt will somehow fix the problem of too much debt and too little ability to support it. 

So let’s just come out and say it; Treasury Secretary Geithner’s proposed solution to the existence of too much debt and an inability to support it is… create more debt!  They are focused on the symptoms of the problem (reduction of new lending) instead of the source of the problem (too much existing debt). You cannot provide enough heroin (debt) to cure a heroin (debt) problem.

The Solution

If the problem is too much debt and an unmanageable burden it creates for the individuals and businesses that are responsible for the debt, then the solution is reducing the amount of debt.  Economists refer to this as “de-leveraging.”  Normal people refer to it as “getting out from under the debt.” 

This can be accomplished in one or more of four ways: 

  1. Higher incomes --- incomes need to rise to be able to meet current payment obligations.  Incomes are currently declining as unemployment rises and business owners see lower revenues and profits.
  2. Pay down debt --- debtors need to save and pay down their debts to a level that is manageable with their existing incomes and ability to service their debts.  In many instances their debts exceed the values of the underlying assets (e.g., a mortgage on a home exceeds the home’s value, or the loan balance on an automobile is more than the value of the automobile).  If someone can’t make the payments on their debt, they certainly don’t have any extra funds to pay down their debt. This is not a viable solution.
  3. Restructure debts -- debts that cannot be supported and are headed into default or foreclosure need to be restructured --- principal reduced or partially forgiven and/or payment terms modified --- to become manageable.  There has been some progress in this, albeit limited and slow in coming.
  4. Foreclosure --- the debt goes into default and the assets used as collateral for the debt are lost to foreclosure.  Homes are foreclosed and cars are repossessed.  This is the most painful of the four, but the most expedient.  

There are simply no other ways to reduce debt.  Until the debt is reduced and becomes manageable, today’s problems will not be resolved.

Some of the proposals unveiled by Treasury Secretary Geithner in the Financial Stability Plan will not help repair the problem of too much debt.  In fact some of these measures will be counterproductive and make the problem worse by creating even more debt of questionable creditworthiness.

The proposal of a “Public-Private Investment Fund” does not involve any of the four necessary events outlined above.  Instead, it proposes to lend money to private investors (e.g., hedge funds) to buy pools of bad loans from banks willing to sell them at heavily discounted (distressed) prices.  This does not magically make bad loans good.  It does not make the unmanageable debt burden facing debtors less burdensome.  It simply shuffles around who owns the bad loan.

The proposal of a “Consumer & Business Lending Initiative” seeks to buy up to $1 trillion of high quality AAA loans from banks, thereby putting fresh cash at the disposal of banks to make more loans.  Who exactly do they think the banks are going to lend to in their quest to create high quality loans?  Anyone that ever wanted to borrow money at next-to-nothing interest rates has already done so.  There may be an abundance of individuals and businesses that would like to borrow more, but unfortunately there is a scarcity of creditworthy borrowers among them. 

Creating more loans to borrowers with poor creditworthiness is not the solution to too many bad loans.  Of course, if banks could loosen their credit standards they might broaden their ability to generate more new loans, but wasn’t that what got us into this mess in the first place?  How could more of the same possibly resolve the credit mess we’re in?

Banks receiving “exceptional assistance” (translation: additional capital to avert insolvency and bankruptcy) will be required to (underlined emphasis was not added) “show how every dollar of capital they receive is enabling them to preserve or generate new lending compared to what would have been possible without government capital assistance.”  Capital infusions to banks teetering on the brink of insolvency are necessary so they can remain solvent.  That is not the same as providing funds to meet the demand for creditworthy loans.  Solvency is a necessity of continued existence.  Making more loans, regardless of the quality of those new loans, is not.  Banks will and are making loans to creditworthy customers.  They should not be encouraged to lower their lending standards just because they were rescued from bankruptcy.  Doing so would only make the problem worse.

The only area of the six part Financial Stability Plan that provides a partial remedy to the underlying problem of too much debt is the proposal under “Housing Support and Foreclosure Prevention.”   This proposal commits $50 billion to “prevent avoidable foreclosures of owner-occupied middle class homes.”  This helps a limited number of homeowners by making unmanageable debt obligations manageable, hopefully saving their homes from foreclosure. 

However, in a news release issued December 9, 2008, (http://www.occ.treas.gov/ftp/release/2008-142.htm)  the Comptroller of the Currency, the overseer of federally chartered banks, reported that more than half of loans modified in the first quarter of 2008 had defaulted again within six months.  Loan modification will help some, but a 50%+ failure rate is a stark reminder that not everyone will be saved through loan modification.

The second part of the Housing Support and Foreclosure Prevention section calls for spending as much as $600 billion to purchase mortgages and drive mortgage interest rates lower, thereby making homes more affordable.  Roughly 58 million homes have mortgages. According to Zillow.com (http://www.zillow.com/reports/RealEstateMarketReports.htm) by the end of 2008 one in six mortgage holders had negative equity, that is, they owed more than their house was worth.  That equates to around 10 million homes that are worth less than their mortgage balance.  Negative equity is the most common profile of homes slipping into foreclosure.  No one knows exactly how many of those homeowners will ride this slump through, and how many will go into foreclosure. 

However, pushing interest rates lower won’t help any of these homeowners.  Anyone that owes more on their home than the home is worth will not qualify for a new low interest rate loan.  Lenders have returned to normal lending practices, i.e., requiring the borrower to have some equity of their own in the property. 

The Financial Stability Plan will not produce an instant recovery in our financial system and economy.  But, regardless of how effective the Financial Stability Plan is or is not, there will be an economic recovery and the stock market will rise some months earlier in anticipation of the recovery.  Addressing the problem of too much debt and an inability to meet the obligations on that debt will bring this recession to an end.  It will require a restructuring of unmanageable debts and/or foreclosures.  The process of reconciling the debt with an ability to meet the payment obligations of the debt will take place with or without government programs.  Roughly two to three million homeowners went through this process last year with more to come this year.  The sooner this happens, the sooner we will see an end to today’s economic and financial problems.  

Moving Forward: Investing to Benefit in Today’s Financial Environment

Whenever there is economic turmoil it is accompanied by both peril and opportunity.  Our objective as your investment managers is to avoid the perils and seize the opportunities.

In the past few months, the nation has anxiously awaited a glimpse of the new administration’s plans to address the problems evolving from decades of government policies and business activities that culminated in today’s financial crisis.  Our collective hopes as individuals and as a nation have been exceedingly high.  Between the election and last week’s unveiling of the Financial Stability Plan, speculation about possible policies abounded, yet no one really knew or could count on the new administration’s unannounced policies. 

Now that we have a view of the programs and actions the administration will adopt, we have a clearer perspective of what we can expect their impact to be on financial markets. Now we can formulate our investment decisions to address the impact of these policies. 

The programs introduced by the Financial Stability Plan are costly and the Federal Reserve will need to print money, a lot of it, to finance these programs.  At first, this will not create a noticeable difference in interest rates or the rate of inflation.  However, it will be inflationary and investments that benefit from inflation will move higher in anticipation, perhaps significantly so, before the specter of inflation is widely seen and acknowledged. 

Bonds price adjustments will lag inflation sensitive investments.  We believe that quality short-term corporate bonds and U.S. Treasury Inflation-Protected Securities (“TIPs”) are attractive today.  We also think that inflation sensitive investments will fare well even though inflation has not yet picked up. 

These types of investments will serve us well as the economy works through its problems, but we do not view any of these investments as permanent core long-term holdings.

We remain pleased with our balanced investment strategy and our existing mutual fund selections.  They have collectively outperformed their peers and held up much better than the stock market.  However, we find it necessary to trim these positions in order to reallocate a portion of your investment capital to new investments that we believe will be beneficial in the coming months.  You will receive an Investment Bulletin for each fund purchased, fully describing each investment added to your portfolio and an explanation of how and why the fund is anticipated to profit from today’s investment environment.

We encourage you to call us if you have any questions or concerns about your portfolio.  As the saying goes, “we cannot direct the wind but we can adjust the sails.”  Navigating today’s troubled waters is a challenging task.  We appreciate the trust and confidence you have placed in us to guide your portfolio.  Together, we will press forward to the rewards that await those with discipline and patience.***

Greg Schultz & Bruce Grenke
© 2009 Asset Allocation Advisors, Inc.