It's the (sub-prime) Economy, Stupid!

Some months ago, I wrote an article (published on this site) entitled "A Sub-Prime Economy" and I urge anyone reading the following piece to revisit that material, both to see what was wrong about it, and what was right. In it, I predicted that the trigger for financial trouble would come either in the form of an overheating economy, which would drive up interest rates and end the era of easy money, pushing marginal companies over the cliff, or, alternatively, that a weakening economy would tighten up lending standards, starving weak companies by blocking their resource to working capital, and increasing business failures. I was wrong.

While even the chronically optimistic must surely now admit that there is a problem in the capital markets, and that it has, in fact, spilled over into equities, the fuse has been lit not by either of the phenomena described, but rather, by the proverbial “tail wagging the dog.” That is to say that while the fundamentals of the “Global Economy”—more about that hackneyed phrase below—remain strong, they threaten to be compromised by an absence of access to credit, hitherto provided by hedge funds and private equity sources, with seemingly endless pools of easy money looking for a home.

Can it be only a few weeks ago that the indomitable cheerleaders for the markets (who, by some magical coincidence, are, for the most part, individuals engaged in the business of selling securities) were telling us that we need not fear, because the world was “awash in oceans of liquidity?” Now, central banks worldwide are intervening almost around the clock to provide needed liquidity to credit markets.

As for this author, I thought I saw the worm turn about two weeks ago, when, in the face of tremendous (and rather scary) volatility in both directions, the folks at Goldman Sachs trotted out Abby Joseph Cohen to tell us that the bull was alive and well, thank you very much. I had forgotten about Abby Joseph Cohen, and last remember her telling us in March, 2000 (the last hurrah for the internet bubble) that that, well, the bull was alive and well. Ms. Cohen has, to the best of my knowledge, never suggested publicly that the market might {gasp!} go down.

Further evidence of a change in mood can be found by anyone who is a regular watcher of CNBC. Gone are most of the smiles, jokes and general bonhomie that could always be found when the expectations were of an endlessly rising market. Gone is that most annoying "cowbell" signal which rang at CNBC to herald any announcement of note in the business world. And although CNBC is supposed to be a source of business and market news, any regular viewer of its programming can have no doubt about the inherent love for bulls and loathing of bears exhibited by its on-air talent. After all, just as sellers of securities want us to think that the markets will always go up, CNBC’s producers understand well that broad, general interest in the markets (and hence, higher ratings) increase dramatically when the markets are rising. But today, the featured guest of CNBC before the U.S. Markets opened for trading was none other than Wilbur Ross, the unchallenged Dean of Distress. Wilbur is an icon in the bankruptcy/restructuring/turnaround world, and, speaking for myself (I have spent over 25 years in this field), I readily acknowledge that Wilbur has probably forgotten more about this subject than I will ever know.

And yet, his observations on the current turmoil in the markets were succinct and remarkably simple. He noted that: “for the past two years, consumers have spent more than they have earned, and the government has spent more than it has earned (sic).” He pointed out the obvious: that such a situation cannot continue indefinitely. He attributed some of the recent difficulties to what he called the two most dangerous words in the English Language: “Financial Engineering,” which, according to Ross means that “someone has figured out a way to underprice risk.” Ross noted that many people had relied entirely, and to their detriment, on ratings agencies and bought products that were designed to sell a “risk ignorant rate of return.” According to him, such a practice “always has a bad end.”

Yet, the purveyors of promised profits will, undoubtedly, continue to tell us that this is a mere “blip on the radar screen,” and that the indestructible “Global Economy” will save the day. If one has a memory that reaches back to before yesterday afternoon (not such a given in an industry whose “captains” are often “twenty-somethings”), one might easily substitute the words “Global Economy” for the words “New Economy” that was so prevalent during the internet bubble. One might also easily realize that the recent and massive spate of private equity deals, in which funds acquire public companies, and finance their acquisitions with either low-cost loans or investor capital secured by assets of the target company are (not-so) strangely reminiscent of the leverage buy-out boom of the late 1980’s, so well-exhibited in the film Wall Street. Those deals certainly came to a bad end.

The difference now, the starry-eyed optimists tell us, is that the defaults in these deals are much more difficult to trigger. In fact, some of these private equity deals have provisions in which, if the borrower cannot pay, in cash, it has the option of merely issuing more stock to the lender. That system works fine, until and unless the borrower is in genuine difficulty. It may not be in default, because it retains the right to issue more stock (of ever-increasing worthlessness) to its lender. So what has been accomplished? The risk of financial disaster has merely been transferred from the borrower to the investors in the private equity deal. To my knowledge, nobody has, as yet, figured out a mechanism to generate “junk bond” level returns with “treasury instrument” credit quality. And yet, the investors in many of these vehicles have somehow allowed themselves to be bamboozled into thinking that someone had. And they were willing to pay astronomical fees for it. Now, of course, many investors are running for the exits, shocked at having actually lost capital! And the “Financial Engineers” are begging the Federal Reserve to ride in to the rescue and reduce the Fed Funds rate. Who would benefit by such action? Well, the stock market would likely go up, at least for awhile. Is the Fed supposed to be in the business of propping up the stock market? On the other hand, there would almost certainly be run on the already battered U.S. Dollar. The Sub-Prime mess would not be solved by any such action, as it represents much more than a problem of less than stellar borrowers. It is mostly a problem of declining housing values in a system where there was precious little equity from the buyers in the first place. Borrowers who could not afford conventional mortgages bought homes, upon which they put little or no money down, and took on mortgages at teaser rates, which are now adjusting to market.

So who are the victims? Not the lenders. They got their fees and their points. And they got paid again when they “securitized” their loan holdings and sold them on a market newly created and packaged by other “Financial Engineers.” Not really the borrowers, either, who got houses without having put up any equity, and paid (for awhile) low-interest mortgages instead of rent, for a place to live which they could not otherwise have afforded.

But if the Fed plays the role of the cavalry, or the Government embarks upon yet another bail-out plan (anyone remember the Savings and Loan crisis?), we KNOW who the victims will be: the taxpayers. We will be called upon to save the banks and the hedge funds from the consequences of their “Financial Engineering.”

The “Global Economy” may well be strong, but the U.S. Economy is two-thirds driven by the true American vice: rabid consumerism. Once the credit cards are nearly all maxed out (and accruing interest at, in some cases, over 30%), and the middle class is no longer able to access its non-existent home equity (whether because of declining values or tightening credit standards), consumer spending MUST suffer. The first hints of this are coming from profit warnings from Wal-Mart, Home Depot and Macy’s.

I am certainly a believer in the resilience and ultimate success of this Country, and we will somehow grow ourselves out of this mess, too, in the long run. But for the shorter term, all the protestations of Government spin doctors and Wall Street salesmen posing as analysts will not change the simple truth: The Sub-Prime Economy is upon us.

Warren R. Graham
Copyright 2007