Bad Assumptions, Bleak Reality

>From Drudge: FLASH: AMTRAK sets new record in May for number of passengers, revenues...

Passenger rail, folks. We need it.

Maybe we'll look back at June, 2008 as a peak in bearish sentiment, but at the moment if one were to make the claim, "There's a race to zero between the American auto industry, airline industry, banking industry, and mortgage finance industry" one would find a lot of believers. This doesn't mean that we're heading towards a future without cars, planes, banks, or mortgages any more than the fall of Rome meant the end of life in Italy. What it means is the institutions who currently control these industries are bleeding to death after making business decisions based upon key assumptions. These assumptions, for the moment anyway, look like bad ones. If the assumptions turn out to be reasonable again the institutions may survive, but if not then several if not all major players will fail.

What are these assumptions?

• Energy will forever be cheap and plentiful.
  
• Asset prices will always be stable and rising.
  
• Abundant credit will always be available at a reasonable cost.

Here's a gross oversimplification of how the American economy grew from 2001-2007. The Federal Reserve cuts the target rate to 1%. Borrowing costs for consumers and corporations fall. Consumers lever up -- because mortgage rates are lower than normal they can buy more house than before, or pay a higher asking price for a house since monthly payments will be lower due to lower borrowing costs. Corporations lever up too -- they issue debt to buy back stock.

A quick aside for readers who are more detached from financial markets wondering how this works. Let's say a company has 1,000 shares of stock outstanding, and the company earns $1/share annually (so annual profits for the company are $1,000). The market gives the company a P/E ratio of 20, so each share costs $20 and the company has a market cap of $20,000. Now let's say the company can borrow money at 4%/year. It decides to borrow $10,000 to buy back half its shares. Interest on the new debt is $400/year (4% of $10,000). But now there are only 500 shares outstanding with the company earning $600/year (the original $1,000 minus the $400 in annual interest payments on the new debt). Thanks to the debt for equity swap, earnings just rose to $1.20/share ($600 divided by 500 shares). So not only are EPS higher, but earnings growth rose as well, so maybe the company now gets a P/E ratio of 25. By issuing debt to buy back stock, the share price has risen from $20 to $30 ($1.20/share of earnings times the new P/E ratio of 25).

In aggregate this leads to higher stock prices. Lower mortgage rates also led to higher house prices, so the guy with a house and a stock portfolio is feeling rich -- his assets are rising in value. Those without houses see how much those with homes are "making" on their investment and want to get into the act. Demand for houses skyrockets, leading to a production boom of houses, furniture, TV, cars, and other products those with houses tend to buy. Due to a rise in asset prices, lowered borrowing costs, and strong business activity, default risk is low. The homeowner who loses his job can sell his house at a profit. Marginal producers are flush with orders and don't go out of business as they ordinarily would. As a result, credit spreads fall, meaning bondholders earn less and less on their money. In steps structured finance, promising higher returns with less perceived risk due to AAA stamps from S&P and Moody's with bond insurance from players like Ambac (ABK) and MBIA (MBI). Thanks to products like CDOs everyone gets what they want -- bondholders earn a higher yield with less perceived risk, borrowers get more and cheaper credit, the borrowed money makes its way into the economy and stimulates production, asset prices rise as a result, politicians get reelected on the back of a "strong economy," and Wall Street takes its cut all along the way.

Just like a Rube Goldberg machine, the system had a lot of fancy gears and cranks, but it was set in motion by a simple ball bearing, in this case artificially low interest rates and excess credit. The system worked as long as asset prices kept rising and credit was available, but now that it's not the case a lot of business models have been broken. If house prices are rising faster than the borrowing costs to finance them, it doesn't matter how big your mortgage is -- if you can't make payments you can always refinance or sell. Likewise, if nobody ever defaults on a mortgage, lenders can lend to whomever they want without risk.

If a bank or mortgage originator is earning more interest (from lending to homeowners) or fees than it's paying out in interest (from borrowing in the capital markets to finance loans) or taking writedowns, it can lever up as much as it wants. In the hypercompetitive, I-want-mine-now atmosphere of Wall Street, this is what happened, with almost every firm taking a fatal amount of leverage from home loans, structured finance products, and the like. If one saw Len Bias on a respirator after draft night in 1986, one might think his prognosis was good, as it would appear that he was breathing and he looked young and physically strong. Yet this wasn't the case -- his heart no longer functioned. Where do many financial institutions currently stand -- they're on life support via the Fed's lending facilities, but their balance sheets have crippled the firms and only a "heart transplant" (ie, taxpayer-funded bailout) can save them.

The auto industry and airline industries are suffering from these same issues -- cheap credit allowed both industries to borrow to stay alive by allowing them to finance themselves via the capital markets, and in the case of the auto industry allowed customers to buy cars they couldn't ordinarily afford. GM is also being strangled by its credit divisions, GMAC and RESCAP, both in tailspins due to the credit crunch and consumer/housing recessions. But they're also being done in by sky-high crude prices, as consumers struggle with $200 round-trip drives from LA to SF and $1,000 flights from Boston to Hawaii. Legacy costs don't help either, and the only debate now would seem to be whether the government picks up that tab or whether it doesn't get paid at all.

Ten years from now people will still be driving and flying (though perhaps at far lower rates than they are now), banks will be making loans and taking deposits, and mortgages will still be originated. But that doesn't mean that Ford, GM, Washington Mutual, Wachovia, Citigroup, Bank of America, American and United will be the ones providing those services. And it doesn't mean that there will be nearly as much credit to go around as there was in 2007. And it certainly doesn't mean $900 will buy an ounce of gold, or even a quarter of an ounce.

Good trading and great risk management to all.

Educational use only. Never intended as investment advice.