WHEN WILL IT END?

It seems as though the Federal government has been in the economic crisis mode for quite a while. Most of us are about “crisis’ed” out. We’re numb. Here is a list of current “crises”. I break them into two groups. First there is food, energy, inflation, and recession. The other crisis group is banking, credit/liquidity, and (sub prime) mortgage crises. The stock market is reacting as it always does during times of uncertainty. Welcome to bear country!

The first group of food, energy and inflation crises are inter-related functions of the global economic boom that has been on-going for a long time. Too much of a good thing. Since the world market is largely free and capitalistic, it will likely just unwind over time as free markets do, perhaps punctuated by a recession that is global in nature.

Recessions are a necessary evil in the free market. It is during recessions that businesses retool and become more productive. Dead wood is eliminated. People move to activities they are best at and away from activities in which the competition is besting them. Consumers pay down credit card debt. Oh, and gas and food prices come down. Recessions are hard on members of the work force, who may be laid off or work reduced hours. But recessions are great for retirees, who enjoy lower prices and lessening inflation.

The second group of banking, credit and mortgage crises are inter-related and are functions of the housing bubble that just burst. It is important to realize that the housing bubble was world wide. Here is how these crises came to be.

First, the central banks kept interest rates too low for too long. This over-stimulated demand. Soon everyone seemed to be neck-deep in debt yet buying new houses or trading up. House prices soared. Buyers were less concerned with the price of a house as they were the payment they could afford. So they would buy way too much house and pay way too much for it, borrowing excessively. We had a real estate bubble.

The banks and mortgage companies loaned the money necessary. Then the loans were re-packaged and sold to other financial institutions around the world. Naturally, the purchased real estate served as collateral. When the overheated real estate market cooled down, home prices started dropping. At the same time, the U.S. economy started dancing around the lip of a recession. Workers started to be laid off and paychecks cut off or cut back. Mortgage payments were missed.

In this environment, weaknesses in the mortgage market started to show themselves. There are mortgages extended to buyers who should never have been qualified. As home prices plunged, many mortgages became under-collaterized. By way of example, suppose you bought a home for a million dollars and had a $900,000 mortgage. But then your house value dropped to $700,000. The bank is stuck with a loan of $900,000 with only $700,000 of collateral. If you stop paying due to job loss, the bank can lose $200,000. Banks become very nervous in that situation. So do investors.

Returning to the title of this article, “When will it end?” I can’t give you a date. I can give you the conditions. In short, for group two, the housing market needs to stabilize. House prices must drop to their real value level. Only then will the extent of the bad and weak mortgages be evident. We will know which lending institutions are in bad shape. Then the Feds need to determine which to help and which to allow to fail. For group one, a recession, possibly global in nature, is likely required.

There has been one indication that the housing market may be approaching equilibrium. Real estate speculators are starting to buy distressed properties. They would not if they could not buy at what they perceive are good prices. They usually also are obtaining loans.

Used to be we could look to the Fed (short for Federal Reserve Board) to fix things…. However, the Fed is between the rock and the hard place. Inflation is threatening. The Fed should raise interest rates to head it off. A recession is also threatening. The Fed should lower interest rates to stimulate the economy. What’s a Fed to do? Answer: probably nothing. If the members of the Fed are religious, they might pray, abridging the separation of church and state. The Fed has recently received the good news that the dollar is strengthening after having fallen precipitously against the other major world currencies. This should take a little pressure off as our country’s borrowing power perks up and inflationary pressure drops. The downside is that every fund with a major international position has taken a hit.

There is another huge point concerning how deep an economic downturn we will have. It is the “people factor”. The biggest driver of our economy (about 75% or the gross domestic produce) is the American consumer. For about two years, high visibility politicians (I call them “bad news bears”) have been running around making speeches about how bad off the people are. How they are being victimized. After a while, they start to believe it and stop spending. As proof, let’s ask the question, “Have we been in a recession?” Most think we have. Big time and for a long time. We have not. The economy has slowed, but gross domestic product is still mildly expanding. Exports have been booming. The pessimism may end in November. If the people have confidence in whom they elect, they may start spending again. It depends on how badly the politicians have poisoned the well.

The other people factor concerns investors. They lead. If they think the downturn is ending, they rush to buy stocks, well before many economic numbers turn around. There may be some false starts as well. (Wall Streeters gruesomely refer to each of these little hiccups as a “dead cat bounce”.)

From an investment point of view, how should we react to this situation? Remember we want to buy low and sell high. The stock market is down. We prepare to buy. We try not to pay much attention to the numbers with dollar signs in front of them. We remember that we are trying to accumulate shares. Shares are cheap. They are “on sale”, but the price may come down some more. We prepare to buy.

Because we are diversified, we are able to buy. Some of the non-stock investments are at least holding value, if not increasing. U.S. bond funds are quite strong. We will sell some of them to buy more stock fund shares. We invest in mutual funds, so we don’t experience “specific company risk”. Unlike individual stock investors, we don’t have to worry about whether the company in which we have invested is going to regain its previous value. Each mutual fund owns securities from 50 to 500 companies.

All in all, I am sleeping well at night (SWAN).