Are we in a Depression? (Continued)

Written by Dave Young for Paragon's 2008 3rd quarter newsletter.

photo by hamed masoumi

The Problem and its Cause

At the epicenter of the current economic crisis is the subprime lending mess. Over the past few years banks began making loans to borrowers that normally wouldn't qualify for loans. Those loans were then repackaged in blocks by Wall Street and sold to banks to hold as investments. Banks are required to have capital reserves that equal about 10% of the amount that they make loans on. If their capital reserves fall below 10% then they either have to raise capital or liquidate holdings to bring their ratio back to 10%.

Initially, the subprime loans were assigned a value based on estimates of what the banks believed them to be worth. As our economy weakened and housing prices began to decline the actual value of these subprime loans were questioned.

In an effort to strengthen their balance sheets many financial institutions tried to sell their subprime loan portfolios. Because so many were up for sale at the same time and no one knew for certain what they were worth the value of portfolios of subprime loans began to plummet. Banks were stuck because they were being forced to sell these securities and since no one really knew what they were worth, they were assumed to be almost worthless. For example, when Merrill Lynch was forced into a merger it was assumed that their subprime debt was worth an absurd 22 cents on the dollar.

This evolved into a credit crunch.

Because of the subprime debt on their balance sheets banks weren't sure if their capital ratios were in line or not. If those ratios aren't in line then legally they aren't allowed to lend. If they can't lend then consumers can't buy cars and houses, businesses can't borrow to buy inventory or meet payroll, and local governments can't borrow to cover short term needs. In essence, everything comes grinding to a halt.

As a result of this credit crisis, the markets continued their sell off. By way of analogy, credit is to our economy what oil is to an automobile.

The essence of the federal bailout plan was that the government would buy the subprime mortgages from the financial institutions at a deep discount but for more than ridiculous fire sale prices. This in turn would alleviate the banks short term capital needs. Because the government doesn't have the same accounting requirements as the banks, they could hold the subprime mortgages “long term” giving them time to determine what they are really worth and allow the depressed real estate market time to recover. In reality, it is highly probable that the bailout won't cost 700 billion and that the government may actually make money. (That would be a first)

With all of the finger pointing who really is at fault in this mess?

The Clinton administration started it by making a politically popular decision and mandating that consumers all be treated equally regardless of whether or not they actually qualified for their loan. Banks were pressured to make loans that they had historically avoided. Republicans attempted to rein in the liberal lending practices with regulations in 2005 but were stonewalled by democrats.

Once the mandate occurred, then banks and mortgage brokers discovered that they could charge much higher fees if the quality of the loans were subprime. At this point they were incentivized to make the lower quality loans. Wall Street's role was to buy the loans from the banks, repackage them in blocks, and then resale them to other financial institutions. They were the delivery system. Because many of them held them on their books, the balance sheets of Bear Stearns, Fannie Mae and Freddie Mac, Lehman Brothers, AIG, Merrill Lynch and other major players were vaporized as the subprime mortgages became impossible to value.

The other guilty party was the consumer. Hundreds of thousands of loans were irresponsibly taken out by consumers that made purchases and then were unable to make their payments. Contrary to popular opinion there is plenty of blame to go around to all parties involved.

Where do we go from here?

Based on market history we know that this bear market has hit the median numbers in terms of time and decline. The previous 34 bear markets have lasted a median of 363 days and declined 26.9%. Through September 30^th, this current bear has gone on for 354 days and the S&P 500 has declined about 24%.

Unfortunately, even though many of our “bottom watch” indicators have triggered, we don't know for certain if we are at the bottom or not. What we do know is that previous bear markets have often reversed when the news has been the most dire.

We also know that some of the sharpest declines have been followed by the strongest rebounds.

Historically it has been a huge mistake to sell during the depths of a bear market.

As always, if you have any concerns about your investments, please call us at (801) 375-2500 and we will evaluate how your portfolio is invested versus your goals and individual risk tolerance.