Summer Rerun: The Tinkerbell Market

This post first appeared on March 14, 2007

One of today’s lessons is to have greater courage in my convictions. In a number of earlier posts (such as “The Rising Tide of Liquidity,” part 2 and part 3 of the same, “Where Has the (Perception of) Risk Gone“) I pointed to how toppy the markets have been, and how much capital has flowed into risky assets, particularly in the credit markets. I’ve also lived through several bad times in the securities markets (1980-81, the 1987 and 1989 crashes, which preceded the nasty 1990-1991 recession, and the unwinding of the bubble in Japan) so I have seen how rapidly sentiment can shift.

I’ve also been struck by the generally grim tone of reporting in the Financial Times for the last few months. The Brits have a higher tolerance for bad news than we do.

Commentary in the US has gone from a Pollyanna market to a Tinkerbell market. If enough people believe in it, the markets, or in this case, market valuations, won’t perish. And in fact, confidence is a heady elixir. Look how long the dot com mania persisted, despite the patent lack of grounding in reality and positive cash flow.

The optimistic commentators here have stressed how the economy is strong, the subprime market is a just a sector of the overall mortgage market, concentrated in lower-priced housing. Any damage, they argue, will be localized. Default rates are a function of employment, and unemployment is low.

One can make a counterargument around particulars, for example, that latest job additions were weak, which doesn’t bode well for unemployment. But the fundamentals aren’t really what is driving this correction. They may appear to be the cause, but are merely triggers. A different mechanism is at work.

As John Authers pointed out in the FT last weekend, credit is overvalued. Lenders have given borrowers way too generous terms, and not just in the subprime market, but in junk bonds, emerging markets, and so on. And even equities are overvauled, just not to the same degree.

So this correction is really about valuations. Investors are realizing that the prices that assets have been trading at are high, systemically high. That knowledge will precipitate a rush for the exits, since investors that can realize these unduly high prices will. That’s why the price drops in equities and riskier fixed income instruments have seemed out of proportion to events.

Let us not forget that more stringent lending will be a damper on growth, and may finally put a crimp in the free-spending ways of US consumers, who have been the engine of growth for the US and an important contributor internationally. So the change in the financial markets doesn’t simply anticipate worsening fundamentals; it will feed them. That’s why the Tinkerbell crowd is so eager to keep belief going any way they can.

The Tinkerbell fans do have a case, that in the long run, investors have to put their funds to work, that most of the time markets go up, because most of the time we have economic growth. So if and when confidence returns, the markets will resume their general march upwards.

The problem, of course, is when confidence is shaken, it can take a while for it to return. And the latest reports aren’t very cheery.

The much decried New York Time story by Gretchen Morgenson, “Crisis Looms in Mortgages” doesn’t appear as overblown as it did two days ago. The front page of this morning’s Financial Times, “Fears of subprime fallout escalate,” had a paragraph that fit the thesis, if not the overwrought style, of her piece:

The rapid decline of New Century, the latest in a wave of problems at US subprime lenders, raised concerns that problems could spread in the $8,000bn (£4,000bn) mortgage industry and other parts of the capital markets.

The FT gave this recap of today’s events, “Markets slide as subprime woes escalate:”

A steep sell-off swept through global stock markets on Tuesday as investor confidence was hit by the escalating woes of the US subprime mortgage market and weak US retail sales data.

Stocks began the day on a bearish note but selling pressure intensified after the Mortgage Bankers Association said that the rate of late payments and defaults on US home loans hit 4.95 per cent in the fourth quarter, up from 4.67 per cent for the prior quarter.

The problems were particularly severe among subprime borrowers – people with patchy credit histories. Delinquencies for subprime adjustable rate mortgages rose to 14.4 per cent, up from the third quarter’s 13.2 per cent…

GMAC, a financial services group 49 per cent owned by General Motors, said subprime lending woes contributed to a $651m fourth-quarter loss at its home lending arm.

Sentiment across markets was driven by fears that subprime problems will slow consumer spending and hamper economic growth, leading investors to sell risky assets and seek the safe haven of government bonds.

The S&P 500 tumbled 1.6 per cent, while the yield on the 10-year Treasury note fell below 4.50 per cent. The Dow Jones Industrial Average was trading more than 1.7 per cent lower in afternoon trading, having fallen 200 points earlier. London’s FTSE 100 and France’s CAC 40 both closed more than 1 per cent lower…..

An odd news item on the Wall Street Journal’s website, and it looks to be the lead item in their news summary for the print edition: “Goldman Goes Hunting in Battered Loan Sector After a Record Quarter.”

Seeing growing turmoil in the market for risky home loans as an opportunity, Goldman Sachs Group Inc. is looking at pushing deeper into the business, ramping up its own subprime-lending operation and pondering the purchase of another.

Although David Rothschild attributed his wealth to buying a little early and selling a little early, this appears to be more than a bit early. There are going to be more subprime failures, and more important, Congress has taken interest in the question of regulating lending practices. Capacity clearly needs to leave the subprime sector; it’s never going to be as big as it was. Failures of originators like New Century are part of this process. But the market, even in its reconstituted form, will be much smaller, and could be less attractive if new rules are imposed. Goldman appears willing to take that chance.

Or could Goldman have a completely different set of motivations? Could this be a cheap way to show confidence the subprime market to help calm investors? After all, this is a mere announcement of an intent to look, nothing more.

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