Robert Rodriguez is the guru that warned us about the credit problems through the past two years. He owns little financials and the current credit crunch provides him a lot of opportunities. Is the credit crisis over? We should certainly listen to what he says.
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It took years for the excesses in the credit system to develop. To think a few weeks of market decline and a 1/2 point cut in the Fed Fund's rate will solve our large and varied credit issues seems to us to be a bit unrealistic. This credit crisis, unlike earlier ones which were a function of Fed policy actions that led to higher interest rates and a lessening in credit availability, had its genesis from unsound underwriting and aggressive credit creation that was accommodated by the credit-rating agencies' use of faulty models. The basic problem is that borrowers took on more debt than they could handle and the rating agencies had faulty models that allowed large scale debt sales to buyers who had little understanding of what the risks were of the particular security they were buying. All that counted was that there was an appropriate credit grade that allowed the buyer to purchase a structured finance security at a yield substantially higher than what could have been attained with a similarly rated corporate bond. These ratings have been shown to be quite faulty, with Moody's, Standard & Poor's and Fitch trying to get ahead of this situation by announcing a multitude of credit downgrades. They all have said that they have modified their models in light of new information. As the old saying goes, “Fool me once, shame on you. Fool me twice, shame on me.” Many buyers worldwide were sold securities that were not what they thought they were. There was a scramble for yield, in a low interest-rate world, that allowed this mess to develop. To think that these buyers will return rapidly is, in our opinion, quite optimistic. It will take a revamping of the structured finance industry and a restructuring of the credit-rating agencies to re-establish confidence in the entire process. This will take time and, thus, structured finance credit creation should shrink in size for the foreseeable future.
Should we be correct in this assessment, a smaller potential structured finance market will lead to a large number of layoffs from those companies that specialize in this area. Unless a multitude of financial institutions are willing to grow their balance sheets and increase their leverage ratios, particularly banks, it would seem that we are in for a rough spell, regarding credit availability and growth, and this should have negative implications for economic growth. A contraction in structured finance originations will likely prolong the housing slump by further depressing home construction, turnover and prices, resulting in a further erosion of consumer confidence and spending. A cleansing of the credit system should and will have to take place. At this time, we have seen no material cleansing of toxic investment securities within the capital market. If any structured loans have traded, they have been of the higher-quality credit ratings. We believe most holders have not been able to or willing to take the appropriate price discounts to move these troubled securities off their books. These comments apply to other areas of the credit market such as high-yield and leveraged buyout loans. We do not believe these credit market issues will likely be resolved within the next twelve to eighteen months. Additional pain and fear must occur before this process can begin.
Outlook
In light of the above comments, we believe the odds of a 2008 recession have increased to at least 50%, or more. Given the growing credit contraction, oil prices approaching $90 per barrel and the dollar setting new alltime lows versus a basket of currencies; future Fed policy actions may prove rather ineffectual in dealing with these challenges. We are of the opinion that the Fed will lower the Fed Funds rate into the 3.75% to 4% range next year, or lower, as housing, capital markets and consumer issues negatively affect economic and corporate earnings growth. We view consensus earnings growth expectations as being too high and believe that they will have to be lowered. Only recently have various types of financial services companies begun to recognize their problem loans and investments, with charges and provisions for future losses. Some of these stocks have responded favorably, with the belief that these companies are getting their problems behind them. Again, we believe the consensus is being too optimistic. Generally, managements are always initially optimistic, until they have to face the grim reality of the situation, and this process should extend well into 2008. The stock market appears to be ignoring these various risks since there appears to be a general belief that lower interest rates will ride to the rescue to solve these credit problems and support stock prices. We do not agree with this optimistic view and, therefore, we will continue to deploy a highly defensive portfolio strategy since we do not believe we are being appropriately compensated for these risks.
Read the complete shareholder letter
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It took years for the excesses in the credit system to develop. To think a few weeks of market decline and a 1/2 point cut in the Fed Fund's rate will solve our large and varied credit issues seems to us to be a bit unrealistic. This credit crisis, unlike earlier ones which were a function of Fed policy actions that led to higher interest rates and a lessening in credit availability, had its genesis from unsound underwriting and aggressive credit creation that was accommodated by the credit-rating agencies' use of faulty models. The basic problem is that borrowers took on more debt than they could handle and the rating agencies had faulty models that allowed large scale debt sales to buyers who had little understanding of what the risks were of the particular security they were buying. All that counted was that there was an appropriate credit grade that allowed the buyer to purchase a structured finance security at a yield substantially higher than what could have been attained with a similarly rated corporate bond. These ratings have been shown to be quite faulty, with Moody's, Standard & Poor's and Fitch trying to get ahead of this situation by announcing a multitude of credit downgrades. They all have said that they have modified their models in light of new information. As the old saying goes, “Fool me once, shame on you. Fool me twice, shame on me.” Many buyers worldwide were sold securities that were not what they thought they were. There was a scramble for yield, in a low interest-rate world, that allowed this mess to develop. To think that these buyers will return rapidly is, in our opinion, quite optimistic. It will take a revamping of the structured finance industry and a restructuring of the credit-rating agencies to re-establish confidence in the entire process. This will take time and, thus, structured finance credit creation should shrink in size for the foreseeable future.
Should we be correct in this assessment, a smaller potential structured finance market will lead to a large number of layoffs from those companies that specialize in this area. Unless a multitude of financial institutions are willing to grow their balance sheets and increase their leverage ratios, particularly banks, it would seem that we are in for a rough spell, regarding credit availability and growth, and this should have negative implications for economic growth. A contraction in structured finance originations will likely prolong the housing slump by further depressing home construction, turnover and prices, resulting in a further erosion of consumer confidence and spending. A cleansing of the credit system should and will have to take place. At this time, we have seen no material cleansing of toxic investment securities within the capital market. If any structured loans have traded, they have been of the higher-quality credit ratings. We believe most holders have not been able to or willing to take the appropriate price discounts to move these troubled securities off their books. These comments apply to other areas of the credit market such as high-yield and leveraged buyout loans. We do not believe these credit market issues will likely be resolved within the next twelve to eighteen months. Additional pain and fear must occur before this process can begin.
Outlook
In light of the above comments, we believe the odds of a 2008 recession have increased to at least 50%, or more. Given the growing credit contraction, oil prices approaching $90 per barrel and the dollar setting new alltime lows versus a basket of currencies; future Fed policy actions may prove rather ineffectual in dealing with these challenges. We are of the opinion that the Fed will lower the Fed Funds rate into the 3.75% to 4% range next year, or lower, as housing, capital markets and consumer issues negatively affect economic and corporate earnings growth. We view consensus earnings growth expectations as being too high and believe that they will have to be lowered. Only recently have various types of financial services companies begun to recognize their problem loans and investments, with charges and provisions for future losses. Some of these stocks have responded favorably, with the belief that these companies are getting their problems behind them. Again, we believe the consensus is being too optimistic. Generally, managements are always initially optimistic, until they have to face the grim reality of the situation, and this process should extend well into 2008. The stock market appears to be ignoring these various risks since there appears to be a general belief that lower interest rates will ride to the rescue to solve these credit problems and support stock prices. We do not agree with this optimistic view and, therefore, we will continue to deploy a highly defensive portfolio strategy since we do not believe we are being appropriately compensated for these risks.
Read the complete shareholder letter
