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February 23, 2009

The Economy Needs Coordination, Not Money, From the Government

John P. Hussman, Ph.D.
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Last week, the market sent out another enormous vote of no-confidence in the notion that even nearly two trillion of government bailout money would materially ease the ongoing financial crisis. While the idea of mortgage principal reductions were part of the plan announced by the Obama administration, the idea of government having a major role in subsidizing this was predictably and correctly met with contempt (watch Rick Santelli of CNBC, for example).

The key issue is that in the final years of the housing bubble, home prices advanced more than 30% above their normal relationship with incomes. Unless we want the government to redistribute about 30% of the value of the U.S. housing stock either directly to struggling homeowners or indirectly to financial institutions, this problem will simply not be solved by government money.

What is needed is not government money, but government coordination. Government has the capacity to take actions in a large, coordinated way that private individuals cannot. Importantly, these actions need not involve enormous deficits or costs to taxpayers.

For example, throwing government money at financial institutions that are insolvent simply gives taxpayers a loss that should be borne by the bondholders of that financial institution. I can't stress emphatically enough that the largest bank failure in U.S. history – Washington Mutual – was arranged last year with absolutely NO cost to the government, and no loss to the bank's customers. What happened there was exactly what I've been advocating since the Bear Stearns crisis: the government took Wa-Mu into receivership, wiped out the stockholders and most of the bondholders, sold the bank's assets along with the customer liabilities to J.P. Morgan for $1.9 billion, and handed those proceeds over as partial recovery for the senior bondholders. For more details on this sort of transaction, see the March 31, 2008 comment What Congress should Understand About the Bear Stearns Deal, and the September 22, 2008 comment, An Open Letter to Congress Regarding the Current Financial Crisis.

Take a look at Citibank's balance sheet as of the third quarter of 2008. The company had about $2 trillion in assets, versus about $132 billion in shareholder equity, for a gross leverage ratio of about 16-to-1. That's not a comfortable figure, because it indicates that a decline of about 6% in those assets would wipe out Citibank's equity and make the bank technically insolvent. Unfortunately, we saw credit default spreads screaming higher last week, while the bank's stock dropped below $2 a share, so evidently the market is deeply concerned about the possible immediacy of that outcome.

But keep looking at the liability side of Citibank's balance sheet. There is over $360 billion in long-term debt to the company's bondholders, and another $200 billion in shorter term borrowings. None of that is customer money. That puts the total capital available to absorb losses at $132 + $360 + $200 = $692 billion, which is about 35% of the $2 trillion in assets carried by Citibank. That's a huge cushion for customers, who are unlikely to lose even if Citibank becomes insolvent. Should that occur, the proper response of government will not be to defend Citi's bondholders at taxpayer expense, but rather, to take Citi into receivership, wipe out the shareholders and most of the bondholders, and sell the assets along with the liabilities to customers to another institution.

Alternatively, the government could hold those assets in receivership, reappoint management in the interim, and eventually IPO the company - now stripped of debt obligations - as a new entity called, say, Citigroup. The proceeds of the issuance would be retained as statutory capital, and a small amount might be paid as a residual to the existing bondholders. That sort temporary "receivership" is the only sense in which the government response could be called “nationalization."

Simply put, institutions that are insolvent and would only avoid continued insolvency by large and continued infusions of taxpayer funds should be allowed to “fail” through the process of government receivership. It is wrong to squander the taxes of ordinary citizens and put a burden of indebtedness on our children in order to protect the bondholders of careless and poorly-managed financial institutions.

The other pressing need for government coordination is to address the foreclosure crisis. What policy-makers do not seem to understand is that the only appropriate way to restructure mortgages is to change the payment stream in a way that doesn't dramatically reduce its present value, and doesn't give away something for nothing.

If you simply let bankruptcy judges push down principal values with no other recourse to lenders, you undermine the basic principles of contract law that underpin our economy. If you provide government funds to reduce the mortgage principal of some homeowners, with nothing for those who have played by the rules, you create huge inequities and incentives for good homeowners to go delinquent.

No. There are essentially only two ways to restructure mortgages. First, if it were possible to collect all of the pieces of various securitized mortgage issuances at large discounts to face value (say 60 cents on the dollar), then the government could write down the mortgage principal by the same amount of that discount, with absolutely no cost to taxpayers. Essentially, the losses already taken by lenders and the owners of those mortgage securities would be “passed on” to the underlying homeowners in the form of mortgage principal reductions.

Aside from that, the most useful feature of government in resolving the foreclosure crisis is not its ability to squander taxpayer money, but its ability to provide coordinated action. I still believe that the best approach to foreclosure abatement would be for the Treasury to set up a special “conduit” fund to administer “property appreciation rights” or what I've called PARs.

Suppose a $300,000 mortgage is in foreclosure (or the homeowner and lender can agree to the following arrangement outside of foreclosure court). A reasonable mortgage restructuring might be to cut the principal of the mortgage to $200,000, and to create a $100,000 PAR. The homeowner would agree to pay off the PAR to the Treasury (and administered through the IRS) out of future price appreciation on the existing home or subsequent property. The homeowner would be excluded from taking on any home equity loans or executing any “cash out” refinancings until the PAR was satisfied. The maximum PAR obligation accepted by the Treasury would be based on the value of the home and the income of the homeowner.

The lender would receive not a direct claim on that homeowner, but a participation in the Treasury's “PAR fund” which would pay out proportionately out of all PAR proceeds received by the Treasury (technically, new shares in the PAR fund would be assigned based on a ratio reflecting the extent to which existing shareholders have already been paid off, so earlier shareholders don't receive more than they have coming to them).

Importantly, the Treasury would not guarantee repayment, but would simply serve as a conduit. There would be no “free lunch” at taxpayer expense. If the homeowner was to eventually sell the home and not purchase another, the obligation would become a low-interest loan obligation and would eventually be a claim on the estate of the homeowner, but with an initial exclusion at low income and a progressive recovery rate based on the size of the estate. The PARs would be tradeable, since they would be based on a single pool of cash flows, though they would almost certainly trade at a discount to face value. Assuming that the PAR obligations are fixed and don't increase at some rate of interest, then even if home prices were expected to take about 15 years to recover, the PARs would still trade at more than 50% of face. Given that recovery rates in foreclosure are running at only about 50% of the entire loan, it is clear that this sort of approach would be preferable to foreclosure in most cases. If it were available, lenders might agree to outright principal reductions as well in preference a costly foreclosure process.

This sort of approach would reduce foreclosures without relying on free money from the government, or violating contract law. The PARs would provide a legally enforceable, diversified stream of cash flows at far lower cost than individual lenders would have to spend to collect from individual homeowners. Since home sales are taxable events, the IRS would be in an ideal position to enforce these obligations.

Valuation Update

A number of shareholders have written to ask whether the current economic downturn will make it more difficult to achieve prior levels of peak earnings. The answer is most certainly yes, which is why despite the general usefulness of the price/peak-earnings ratio, I noted last September that “that multiple is somewhat misleading because those prior peak earnings reflected extremely elevated profit margins on a historical basis.” In order to get a useful sense of valuation, it is important to consider normal profit margins as well. Rather than the near 9% profit margins that we saw in the most recent market cycle, I believe that profit margins in the years ahead (particularly with a less leveraged economy) are likely to be closer to their long-term norm of about 5-6% of revenues.

The most recent trailing earnings figure for the S&P 500 was a disaster. The 12-month trailing number is now $28.75, down from $78.60 a year ago. The following chart gives an idea of how far earnings have declined. Note that the recent plunge has taken earnings far below the lower channel line. Bill Hester notes that the trailing 12-month earnings figure for the S&P 500 by the second quarter of this year is estimated to be just $15.

From a long-term perspective, the recent plunge in earnings is likely to be followed by an eventual recovery, so it is important that investors not put too much weight on P/E multiples based on prevailing, depressed earnings. Since the top-channel and bottom-channel earnings lines provide a “smooth fundamental” that is closely related to long-term (if not short-term) cash flows, these earnings figures offer useful insights into the typical valuation multiples that investors have placed on stocks.

Note that except during the past 15 years or so (a period over which stocks have now returned next to nothing), multiples of even 13 times top-channel earnings were actually quite expensive. Multiples of 20 or more were decidedly reserved for bottom-channel earnings, where a multiple of 25 times bottom-channel would be easily considered to represent rich valuations.

Presently, top-channel earnings for the S&P 500 are about 90, and bottom-channel earnings are about 50. That puts “rich valuations” at about the 1200 level. At the 2007 peak, stocks were about 30% above what would be considered historical overvaluation.

In contrast, to match the worst historical troughs of market valuations, the S&P 500 would have to decline to between 10 and 11 times bottom-channel earnings, and between 5.5 and 6 times top-channel earnings. That would currently translate to somewhere between 500 and 550 on the S&P 500 Index. These levels are emphatically not forecasts – they represent extreme outcomes. Unfortunately, they also cannot be ruled out in the context of a deleveraging cycle plagued by utterly misguided policy responses.

It is essential to understand, however, that at those levels on the S&P 500, stocks would be priced to deliver total returns over the following decade in the likely range of 14-17% annually. The current economic downturn requires us to suspend any optimism that earnings will recover quickly in the coming years, but the iron law of finance – that lower valuations imply higher long-term returns – is likely to endure, as it did even during the Great Depression.

Though current earnings are well below the bottom-channel here, there is a very durable tendency for profit margins to normalize – which we even saw following the Great Depression. Since stocks are a claim on a very, very long-term stream of cash flows, I strongly believe that short-term earnings figures should not be the basis for valuation analysis.

Even at current levels, I do believe that stocks are priced to deliver reasonable long-term returns, most probably in the 9-11% range over the coming decade. The problem is that the risk aversion of investors shows every indication of increasing. In the context of an ongoing and worsening economic downturn, investor psychology often reaches the point of “revulsion,” so that stocks are abandoned by the public at very low prices, and must offer even higher potential long-term returns in order to induce value investors to absorb them.

Our 10-year total return projections for the S&P 500 Index ( standard methodology ) are presented below. The heavy line tracks actual 10-year total returns since 1950 (that line ends a decade ago for obvious reasons). The green, orange, yellow, and red lines represent the projected total returns for the S&P 500 assuming terminal valuation multiples of 20, 14 (average), 11 (median) and 7 times normalized earnings.

Note that this chart is not based on price/peak-earnings, but on earnings figures closer to what might be called “mid-channel earnings,” or “earnings on normalized profit margins.”

You'll notice when the extreme (green) projections spike as they did in 1974 and 1982, the actual total return of the market rarely achieves those levels, which require extreme movements in valuations from historically low multiples to historically high multiples within a decade. As Bill Hester noted last week, the greater the recent experience of investors with recession or inflation, the more reluctant they are to drive multiples to the upper ranges. So while there is a somewhat outside possibility that the S&P 500 will deliver 15% annual total returns over the next decade from current levels, I would view that outcome as improbable. More likely, total returns for passive, buy-and-hold equity investors from current levels will be near the middle range of projected outcomes, or about 9-11% annually.

In short, stocks are priced to deliver reasonable, though not outstanding probable returns for passive, long-term investors. Unfortunately, current valuations provide little support for the belief that stocks have “hit bottom” or that they could not decline considerably more. To achieve a valuation trough similar to deep historical extremes, the S&P 500 would have to approach the 500 level. If the market was to decline to that extent, I believe that stocks would be priced to achieve extraordinarily high subsequent returns. Unfortunately, with investors becoming palpably averse to risk and susceptible to “revulsion,” the prospect of such high returns may be necessary to induce value investors to absorb the supply from skittish investors.

Frankly, I have no opinion about “where the market is headed” or “where the bottom is.” What I know at present is that valuations are generally favorable, while market action suggests increasing skittishness of investors. While I expect to gradually increase our exposure to market risk on weakness (as well as on measurable improvement in market action), our responses continue to be gradual and very measured.

Market Climate

As of last week, the Market Climate for stocks was characterized by favorable valuations and unfavorable market action. The Strategic Growth Fund remained largely, though not entirely hedged. Still, the primary source of the Fund's day-to-day returns continues to be the difference in performance between the stocks the Fund holds and the indices we use to hedge (primarily the S&P 500, Russell 2000 and Nasdaq 100).

In bonds, the Market Climate was characterized by moderately unfavorable yield levels and relatively neutral yield trends. The Strategic Total Return Fund remains primarily invested in Treasury Inflation Protected Securities, with about 12% of assets in precious metals shares, about 12% of assets in foreign currencies, and about 6% of assets in utility shares.

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