From Uncertainty to Negativity
If we look at the period of May 1 to July 31 of this year, the Dow recorded fourteen days of minus 100 points or more...nine of those were over 200 points. The Dow moved from 13,010 to 11,378 over this period. Out of 65 trading days, nearly 22 percent had negative movements of more than 100 points. This is what happens when the market moves from the uncertainty phase, where we see dramatic market volatility in both directions, to a more consistent phase. In this case...consistently down. Are we in a recession? Will the housing market recover soon? How much more in write-downs will we see from financial institutions? Will the Government have to bail out more cash-strained banks? None of these questions can be answered definitively. More importantly, it's very difficult to grasp the full extent of possible repercussions of these and other issues.
The "Real" in Real Estate
Much of the talk regarding our current economic situation revolves around residential real estate. It's true that much wealth was created from 2002 through 2006 via residential housing price increases. Many homeowners borrowed against their home equity to fund their spending. Some upgraded their homes using attractive, low-interest, adjustable-rate mortgages (ARM's). I remember people saying their purchases made sense because "home prices never go down". That was my confirmation we were in a bubble. No asset class goes up indefinitely. Now, with home prices plummeting in some areas, consumer confidence is dropping in a similar fashion. Many feel they aren't as well off as they were two years ago. Economists and analysts are expecting this to reduce consumer spending and drive us into recession, if it hasn't already. The expected lower corporate profits are already discounted in the stock market. Foreclosures are trending upward. The inventory of homes for sale is rising.
Sub-Prime: A Fact-Free Media Blitz
Sub-prime mortgages are given to individuals with less than perfect credit. Alt-A mortgages are given to individuals who don't meet prime standards, but are better than sub-prime. Families used these products to purchase homes they couldn't afford while speculators bought homes hoping for a quick flip. Wall Street created and sold mortgage-backed securities as fast as investors could buy them. But then something unforeseen happened. Default rates started moving up as the economy slowed, unemployment rose and ARM interest rates adjusted. We now know that the mortgage-backed securities were sold as "safe" using historic default rates. But the default rates were wrong and the rating agencies that gave the securities "safe" ratings were wrong. Those securities became practically worthless overnight. The credit crisis we so frequently hear about is the affect of these worthless assets on the balance sheets of many banks. They don't have sufficient capital to operate. Without capital, banks don't make loans which exacerbates an already sluggish economy. While it is clear that the assumed default rates were wrong, we don't know what the actual default rates will be. Historic default rates offer no guidance due to the extremely relaxed lending practices of the last few years. If the expectation is that default rates will be very high, then many of those securities truly are worthless. If more moderate default rates are expected, than those securities might be worth more than their current value. But most banks can't afford to hold them until the dust settles and the value potentially moves in their favor. They need to sell them now and raise capital, hence the recent Merrill Lynch CDO sale at $0.22 on the dollar. On a positive note: we are holding short-term interest rates low and Congress has passed a mortgage relief bill to help struggling families.
|
