April 2008
Investors fear a massive unwinding of debt will undermine the world’s economies. But the data indicates deleveraging doesn’t equal disaster.
A new fear has permeated conventional investment thinking: the massive leveraging-up of the recent past has gone too far and its unwinding will permanently hobble the global financial system. This view sees Bear Stearns as just one casualty in a gathering wave that has already claimed many U.S. subprime mortgage originators along with several non-U.S. financial institutions and will cause countless others to fail. And it sees the earnings power of those that survive as being permanently impaired.
The obvious question then is, which scenario is more logical: the extreme outlook described above, given the long period of easy credit extended to unqualified individuals? Or the scenario of a typical credit cycle that will work its way out as other post- excess crises have, and without impairing the long-term ROEs of the survivors? We believe the latter. Here’s why:
- During the previous period of consumer deleveraging, bot the broad market and beaten-down sectors continued to grow.
- Commercial banks and insurance companies are well-capitalized.
- Derivatives do not increase the underlying risk, though some of the excessively leveraged players (primarily unregulated hedge funds) will likely suffer.
- As in prior crises, the short-term issue is perception and fear.
Past Deleveraging Did Not Impair Growth
Consider private debt, i.e., total consumer plus non-financial company corporate borrowings. As investors look ahead to a period of deleveraging, they worry about its effect on the economy. Figure 1 looks at the last such episode, which began toward the end of 1990 and continued through late 1994. Of course, recession and the S&L and real estate crises at the opening of the decade were the context for underperformance by the broad market in general and financial stocks in particular. But as you can see, even as consumers and businesses shed debt over a four-year period, financial and consumer stocks were up sharply. Deleveraging did not impair the business opportunity.
Another significant comparison can be made between that period and this. In 1989, commercial real estate exposure for the banking industry was about 20% of GDP. In 2006, subprime and Alt-A loans combined equaled about 13% of GDP. Whether residential real estate loans continue their historic trend of greater safety than commercial loans remains to be seen, but at the very least the exposure prior to the current crisis is broadly comparable to that of the earlier period when it led to a recession but no systemic breakdown.
While historical patterns generally repeat, they are never identical. There already has been, and there will likely be more, real pain both for homeowners who can’t pay their mortgages and for businesses with weak balance sheets. Ultimately, the key is filling our portfolio with companies whose business franchises and balance sheets enable them to withstand the temporary pain and enjoy the long-term opportunity.
Financial Institutions’ Leverage Is Non-Historic
Of course, financial calamities could inflame the system further. Are financial institutions able to withstand the pain? I.e., are they really more levered than they used to be? Based on the data of both banks and insurance companies, the answer is no. Bank capital ratios are quite strong and insurance company premium-to-surplus statistics are even more robust (Figures 2 and 3). (Note that the premium-to-surplus ratio measures the ability of the insurer to absorb losses. Since the ratio is com- puted by dividing net premiums by the amount by which assets exceed liabilities, the lower the ratio the greater the company’s financial strength.)
Are Derivatives Dangerous?
The place where leverage truly has increased is among the brokerage firms and within hedge funds. The exploding derivatives market is closely associated with these leveraged entities. A hedge fund that has leveraged up AAA-rated CDOs 20:1 can be wiped out if the securities are downgraded. But do these structures create systemic risk? We think not. Derivatives are a zero-sum game. For every winner there is a loser. If the loser happens to be a highly leveraged hedge fund, it might fail. But derivatives do not increase systemic risk. They just apportion the loss to the losing bettor.
To understand this, we can compare a typical traditional prime mortgage with a subprime one created within the new paradigm of securitization (Figure 4). Senior debt is approximately the same in each case, but in a securitized mortgage, subordinated debt in the form of junior tranches of an MBS or CDO replaces some of the equity. While the structure does add leverage to the system, that leverage is at the subordinated level which earns much higher returns and allows the risk to be parceled out according to the risk-takers’ appetite. With appropriate lending standards, the structure enhances the system. But with lax standards, risk is increased.
So the question isn’t whether the structures are unsound. The question is whether they encouraged bad loans with inadequate down payments made at rates which were too low. And of course, the answer is yes. The true risk is that these loans go bad. But once the losses are flushed through the system and rates and terms return to more normal levels, there is no reason to believe that the availability of mortgage financing is permanently impaired.
A Crisis of Confidence
Of course, liquidity and confidence are another type of risk. That is what happened in the Bear Stearns case. When there is a run on the bank, all the risk analysis in the world is for naught.
The federal government has a crucial role to play in reducing the risk of a confidence-based failure and in ensuring a functioning marketplace. The Fed’s intervention with Bear Stearns and its decision to extend its role as “lender of last resort” to the investment banks helped prevent a crisis of confidence that could have had systemic effects.
Our conclusion then is straightforward:
- We are in a classic credit contraction, and while painful both to the financial companies and the overall economy, this cycle does not appear to be worse than the last several.
- The government and regulatory agencies are acting to soften the pain, as they generally do during periods leading up to recession and economic malaise.
- Businesses with solid franchises and adequate capital will be able to weather the storm and return to normal profitability.
- The timing of the turn as always is uncertain, but we believe the seeds have been sown for recovery.
The Opportunity Has Grown
What the current crisis has done is to propel what was a very attractive valuation opportunity in the financial sector to one of historic proportions. Financials are now about as inexpensive compared to the broad market as they have ever been (Figure 5). Early in the first quarter and even more recently, we may have seen the first indications that the market is recognizing the strength of these companies and the mispricings they’ve been dealt. Indeed, as we wrote about in last quarter’s Commentary, the momentum/value cycle has historically turned once the economy has entered a recession. The precise timing can never be predicted, but we’re carefully monitoring the events as they unfold. 
Disclosures
Past performance is no guarantee of future results. The historical returns of the specific portfolio securities mentioned in this commentary are not necessarily indicative of their future performance or the performance of any of our current or future investment strategies. The investment return and principal value of an investment will fluctuate over time. The specific portfolio securities discussed in this commentary were selected for inclusion based on their ability to help you understand our investment process. They do not represent all of the securities purchased, sold or recommended for our client accounts during any particular period, and it should not be assumed that investments in such securities were, or will be, profitable.