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Financial Markets Will Reset

The rolling credit crunch, which first struck the head pin, ill-conceived pools of subprime mortgages, quickly hit a second row of targets. It toppled the insurance companies that "guaranteed" the mortgages and the investment banks that held them. Fear of the unknown in terms of what banks owned what pools caused the near collapse of the bank commercial paper market, prompting the first 75-basis point drop in the Fed Funds Rate by the Federal Reserve.

The crunch then moved to other debt structures that relied on the AAA-ratings of the insurance companies as a precondition for ownership. Holders required to invest in only AAA-rated instruments were forced to sell the now downgraded securities. At the same time, investment banks forced to write down the value of some of their holdings, thus reducing their lending capacity, stopped buying certain debt structures. And, financial institutions, with lending capacity, have taken to the sidelines to wait until the dust settles. Supply swamped demand for many of these issues, causing prices to fall and yields to rise for row three - the auction debt market, insured municipal debt and financings for merger and acquisition activities.

Row 4. Delinquency rates in the Alt-A tier of mortgage market, one tier below the high-quality prime category, spiked in November to a record 5.7% up from 1.4% a year earlier, the most recent reporting period. The calendar is also adding energy to the roll. Financial institutions are required to mark their investments to the market. With quarter-end fast approaching, they are feeling the pressure. What price do you put on something that no one wants? Additional write-downs again mean less capital to lend. Regulatory requirements to maintain certain loan to capital ratios and an increased aversion to risk have caused the banking industry to call in some of their loans and to require other borrowers to put up more collateral. The credit crunch rolls a strike, as debtors across the board scramble to meet their margin calls.

Meanwhile, the stock market, down around 17% from its high, has woes of its own to handle. A non-existent housing market, a battered and bruised banking industry, and a record-setting low for the value of the U.S. dollar and high for the price of crude oil have all of us wondering if we are going to enjoy spring.

In thinking about what spring will bring, we must weigh the good and the bad. Rising mortgage delinquency rates and declining home values are certainly a concern. When we tack on peaking energy bills and spiking unemployment claims, it's a wonder the consumer doesn't head underground to nest with the groundhogs.

But, despite all the political rhetoric, much has been done to sow the seeds of a recovery. First and foremost is the accommodating yield curve. Banks can once again make money by simply borrowing short and lending long - a welcome source of new capital. Mortgage rates have also fallen, providing credit-worthy borrowers an opportunity to boost their cashflow by refinancing to lower their payments. The beleaguered bond insurers are also taking steps to shore up their balance sheets in an effort to reclaim their AAA-ratings. Manufacturers and retailers alike have seen the red flags and smartly trimmed their inventory production/purchasing plans, reducing the need for significant cutbacks later in the year.

How about inflation? What we are witnessing is strong global growth causing commodity inflation that spills over into our core inflation statistics. We believe the Fed correctly surmises that trying to control commodity inflation from strong global growth is a futile effort. Once the financial write-offs stabilize, the economy will be in a much stronger position for the Fed to reverse course on interest rates, if necessary. And lastly, the explosive growth overseas combined with cheap dollars have many of our companies searching for new capacity in the form of employees and equipment to meet the burgeoning demand.

So, while we fret over all the fallen markets, we should take solace in knowing there are forces working to reset the economy, and thus our credit and stock markets.