It may be years before financial stocks recover.
The deep rot in the U.S. financial system gives the impression that the fin de siecle is indeed upon the United States. There is no easy cure for what ails the U.S. housing market and U.S. financial institutions, and, at the very least, the near-term outlook is grim.
The latest panic point is regarding the solvency of the two biggest (government sponsored) mortgage finance enterprises (GSEs), affably named Fannie Mae and Freddie Mac. The market’s attitude to Fannie and Freddie has been anything but that, downright hostile in fact.
These two GSEs have exposure to half of all U.S. mortgages through either ownership or guarantee, and recent investor selling forced U.S. Treasury Secretary Henry Paulson to make explicit what was only assumed: that Fannie’s and Freddie’s debt would indeed be a liability of the U.S. government.
The failure of these two GSEs is not the crucial question for equity investors around the world. Fannie and Freddie are indeed too big to fail. The concern should really be over the ability of Fannie and Freddie to continue to provide mortgage guarantees and funding to the beleaguered U.S. housing market. On that front, the outlook remains bleak.
Fannie Mae and Freddie Macshare the same problem with many other U.S. and European financial institutions: they are inadequately capitalized because of writedowns on mortgage related securities. Without a second and major round of capital raising (investment banks have already raised well over US$200-billion in capital through equity issuance), lending will remain weak in the United States for the foreseeable future.
The data bears out this conclusion. U.S. bank loans have been falling recently. Over the four-week period ending July 2, U.S. bank loans showed the biggest decline since the beginning of 2002 when the U.S. economy was in recession.
This has major implications for U.S. house prices and the economy in general. Housing prices in the U.S. have declined 19% since the middle of 2006, according to the Case-Shiller index of 10 cities. Futures markets are pricing in a further 11% fall before the market bottoms. Falling house prices and rising mortgage defaults are causally related to write-downs at financial institutions, cementing a negative feedback loop between house prices and bank lending.
Tighter lending will lead to slower growth and lower profits for U.S. companies. Profit margins were well above average leading into the recent credit crisis last summer, and
those margins are declining in line with the slower growth.
Therefore, equity investors remain at risk. If we step back, it is highly conceivable, in fact, that U.S. equities are in a bear market that started in early 2000 when the first speculative bubble, in technology stocks burst.
The S&P 500 equity index failed to meaningfully hold new highs reached in August, 2000, when the index crested the 1500 level. The index briefly broke through that level in October, 2007, but this nominal high is really a case of price illusion given the 22% depreciation of the U.S. dollar (trade-weighted index) since February, 2002. The equity index has failed to reach new highs once translated or, more correctly, deflated by euros or the price of gold for example.
Compounding problems for the U.S. economy are high oil prices and inflation. The world finally awoken to the scarcity of oil, and oil prices recently closed in on US$150 per barrel before retreating on slower growth fears.
The rise in oil prices is contributing to rising inflation. Headline inflation in the month of June was 1.1%, rising at its fastest pace in 17 years. Rising prices are confounding Federal Reserve Bank policy of maintaining low interest rates and a weak dollar to combat weak economic growth.
There is no quick fix to the U.S. housing market, and investors should expect further write-downs from financial institutions as they come to grips with the extent of the housing crisis and the true value of the assets on their books.
As Wall Street’s problems spread to Main Street, writedowns on consumer credit will also rise further. House prices will need to fall further to clear the oversupply of housing, and any significant rebound in this market could take years.