The Uncertainty Continues

There is a lot riding on Tim Geithner’s speech next week. It seems that momentum for a new, large-scale bank bailout or implementation of a “bad bank” structure may be losing steam. Geithner and company could be favoring a bank bailout scheme that relies more heavily on providing government guarantees to banks holding bad assets (similar to the structure in place at Citigroup). With regard to the “bad bank” proposal, nobody can seem to come up with a good way to price the assets that are bought. Meanwhile, Republicans in Congress are trying to gain support for a stimulus package that relies more heavily on tax cuts.

We believe that those seeking to avoid another large-scale stimulus package are emboldened by some recent improvement in the credit markets, as well as some limited data suggesting housing may be closer to bottoming. Credit spreads have indeed tightened a bit in recent weeks and the December reading for existing home sales came in better than expected. We are not sure these very limited improvements suggest it is again safe to get back in the water. For our part, we believe the key issue may be the securitization market and the future of Freddie Mac and Fannie Mae. So much of the credit made available to consumers and businesses over the past decade has been financed through securitization and/or Freddie Mac and Fannie Mae. As long as these sources of funding are either absent or dramatically reduced, it doesn’t seem likely that a recovery can be imminent.

But the larger issue is really that the process of deleveraging and asset deflation (housing) must run its course. Consumers that had been living beyond their means must now begin to build their balance sheets again by saving more. Unfortunately, this process of deleveraging leads to a “paradox of thrift” – a scenario whereby what’s good for each individual consumer is not good for the economy at large. While government stimulus may be helpful in reducing the pain, we don’t believe the pain can be eliminated altogether. Recessions are a normal part of the business cycle, and policy responses to past economic slowdowns have served to exacerbate the situation we now find ourselves in now.

The market continues flirt with 8,000 on the Dow. There is much talk of a retest of the November lows. We suppose that the lows may be re-tested but don’t know that it will matter much. We are struck by the complexity of the TARP, and CEO pay restrictions, and the proposals to create a “bad bank” (as if we really need another one). We conclude that there are so many moving pieces to the current financial crisis and economic decline, with far-reaching implications, that our forecast of a prolonged recovery seems on the mark. A rigorous focus on balance sheets and earnings is the only reasonable approach to investing in this environment.
Do the work. There is money to be made. Hang in there!

Peace,

Michael