Market Update – Concerns over credit

Ted Truscott, Chief Investment Officer
September 23, 2008

More than 25 years ago when I first joined the financial services industry as a commercial banker, the venerable commercial bank of JP Morgan was seriously considering giving up its commercial banking license and the regulation that went along with it. Unlike my employer, Chemical Bank, Morgan had no retail deposits. It thought that the disintermediation of commercial banks brought about by years of deregulation placed the institution at a competitive disadvantage vis a vis the emerging power of investment banks such as Lehman Brothers and Goldman Sachs. Morgan, of course, never gave up its commercial banking license and ultimately merged with multiple commercial banks (Chemical being one of them) and today has a formidable advantage in the market place.

Goldman Sachs and Morgan Stanley have now announced that they wish to convert to bank holding companies in order to access the so-called stable funding base of retail deposits. This is, however, a regulatory illusion and one poorly reported by the financial media. What the pundits have not told you is that investment banks and commercial banks have never and would never be allowed to use retail deposits to fund the operations of their broker-dealer subsidiaries. The presence of FDIC insurance precludes this.

These companies and a misinformed financial media blame investment bank reliance on short-term funding (some of it known as “repos”) for the collapse of some and pressure on other institutions. Short-term funding is not the problem. Investment banks have always had the choice to use long-term debt to fund a portion of their operations. They chose not to do this because overnight funding is cheaper and the profits, therefore, were greater until overnight funding dried up.

Character, capacity and collateral

As young commercial bankers, we learned a lot of lessons about credit from demanding, and not particularly polite, bosses. It was boot camp, and I am afraid that a whole generation of today's bankers are about to go back to boot camp themselves. We learned that borrowing short and lending/investing long was an eventual recipe for disaster at any corporation, and particularly banks. We also learned the “C's” of credit, which included character, capacity and collateral.

A borrower had to be of sound character or perhaps a loan might not be repaid. The capacity to repay, including the ability of an individual to remain employed or a company to generate free cash had to be present; otherwise the loan was too risky. Finally, there was collateral. A home could secure a mortgage, a plant could secure a long-term loan and receivables could secure a short-term loan. The collateral had to be substantive because falling prices could render the collateral worth less than its stated value.

The last 25 years, particularly the last five, have seen all the rules of credit cast aside. Our nation has feasted on credit in order to live beyond our means and to create higher investment returns than could be sustained. Character has mattered all too little, capacity has been imagined rather than real, and collateral (particularly homes that secure mortgages) has fallen deeply in value.

The government bailout and market response

The piper is now being paid and we are witnessing a massive deleveraging of the financial system. This is long overdue and policy makers will analyze for years how debt was able to be accumulated on such a massive scale both here and in other countries such as the United Kingdom. The U.S. Treasury and our legislators are riding to the rescue with a massive bailout package worth an estimated $700 billion. Only time will tell how much the taxpayer actually has to pay and whether a more orderly unwind of the accumulated debt will result in improved or more liquid markets.

In the meantime, the U.S. dollar has resumed its fall as foreign investors mark down our country's credit standing due to the projected increase in federal debt. Federal debt substituting the debts of the U.S. financial system may seem counter-intuitive but there really is no other choice. Fear and panic in the marketplace has caused confidence and, therefore, liquidity to plummet. Time and an orderly liquidation to the debts is the better solution, and while it may not prevent additional losses, at least the proposed solution creates the hope of confidence and, in turn, liquidity and price discovery returning to the markets.

In the meantime, there has been a massive flight to safety in the financial markets. At one point last week, U.S. one-month treasury bills yielded one basis point (.01%). Some large and stable banks were turning away deposits as they could not find places to invest the money. People are concerned about insurance and the safety and soundness of institutions. Risk is to be avoided at all costs whereas just over 14 months ago risk was all that mattered.

What's next and how to be prepared

It is hard not to comment on the extremities here. The axiomatic law of finance is that risk and return are related — the higher the projected return, the higher the risk. It's quite simple and yet this law is forgotten if not derided constantly. We now live in a world where risk is being shunned and as a result opportunity is likely to emerge. The absence of risk seekers and the flight to safety will create opportunities but there will be no instant gratification in the months ahead. Too much leverage still needs to be shed and housing prices will have to bottom out before markets improve on a sustained basis. Timing is uncertain and that is why dollar-cost averaging into this market is a good idea.

This is also an excellent time to review your long-term financial plan with your advisor. Money has been lost in the markets and while time may erase those losses during an eventual recovery, it is likely that we all need to make adjustments to our short-term plans and spending habits. Most important, it's time to engage in a thoughtful discussion about the balance of risk and reward in a portfolio and to remember the essential role diversification plays not only across asset classes but in the products you own as well.

I am deeply concerned that investors might compromise their financial future by completely shunning risk and accepting mediocre returns, which would eventually be eroded even if inflation levels are historically low. At the same time, the last year has been a stark reminder that too much risk in a portfolio can result in big losses that might be permanent. Only you and your advisor can agree upon the right mix of risk and return and the right mix of products that have the features that will balance out that mix. At the end of the day, we continue to encourage investors to stay invested, be disciplined and resist the urge to let emotions drive their decisions — even during difficult times like these.