Market update — Lessons in lending and the role trust plays in the markets

Ted Truscott, Chief Investment Officer — RiverSource Investments, LLC
Nov. 18, 2008

"Shocking as the current stock-market drops have been, the freezing up of the flow of credit is far more damaging to the health of the U.S. economy … the problem with an impersonal [lending] system is that when the models fail and when companies' ratings become suspect, everything is called into question. Lenders can't fall back on their own judgments of a specific company or individual because such judgments aren't part of the typical decision-making process. Instead, they've adopted a deep-seated distrust of all borrowers, even financially secure ones."
"The Trust Crunch," The New Yorker, Oct. 20, 2008, p. 36

The changing dynamics of lending

Lots of people are asking me when things are going to get better. I have a two-part answer that is somewhat contradictory. I generally tell people things will get better when banks start lending again and when all the debt that needs to be paid back or written off is paid back or written off. The problem, of course, is that banks fear additional write-offs and, therefore, are unwilling to lend money except to those who do not need it. There is an old joke that a banker is the type of person who will lend you an umbrella when the sun is shining. These days that feels all too true.

I remember when I was a kid and my parents needed to borrow money, they would head down to the local bank branch to see Florence. Florence knew my parents and took care of their mortgage, car loans and other banking needs. Essential to their relationship was trust. Florence trusted my parents to pay back the bank and my parents trusted her to provide the credit they needed to raise a young family. I was too young to understand much, but I knew Florence was an extremely important woman!

The quote above from The New Yorker explores the paradox of lending relationships that has evolved in the great democratization of credit over the last 25 years. In essence, the act of lending money has become depersonalized. This is surprising given the trust-based nature of any financial relationship — but this evolution of the credit system had its merits. Credit became easier to obtain beginning in the late 1970s, allowing an improvement in most people's standard of living. For consumers, credit cards allowed them to borrow money without seeking approval from the loan officer at the local branch.

Computer models, which became increasingly sophisticated and complex, have made credit decisions en masse for the credit card industry. These are also the very models that offer predictions about default rates, which are beginning to lead to all kinds of stories about consumers losing their credit cards or having credit lines cut. Today's computer models are powerful and necessary, but in some ways are no replacement for Florence.

At the institutional level, banks originated loans for customers they knew, but in general these loans were sold off to investors — thus banks had less responsibility for completely evaluating the borrower. The mortgage industry became completely depersonalized. Loans were originated by brokers for banks and banks packaged the loans and then sold them off as securities to investors. Nobody knew the borrower along the way. Is it any wonder that some of these borrowers were either naïve or unscrupulous?

Trust, confidence and liquidity

Naturally the deregulation of the financial system also played a role in the evolution of credit as did a host of other factors. Credit expanded rapidly for both consumers and corporations until finally we all had too much of a good thing. Now comes the hard part — deleveraging. Some of the debt needs to be paid back and banks lack the personal relationships necessary to distinguish between bad and good borrowers. Trust has almost completely evaporated. Along with trust, confidence has disappeared. When confidence goes, so does liquidity. When liquidity disappears, we experience the market volatility seen during the last two months.

Trust, confidence and liquidity all go hand in hand. This is why our current financial woes seem so devilishly complicated to sort out and why this has become a global problem. You cannot build trust or confidence through legislation. Trust is earned and confidence results from faith that the financial system is working. Despite the government's best efforts to shore up confidence and renew trust, the old remedies are not working. Once confidence has been shaken, it is very hard to restore. I am afraid that a fair amount of damage has been done to the economy given the epic breakdown in trust and confidence. It is certain that Japan and the United Kingdom are in a recession and it's highly likely we are in one here in the U.S. as well. As one of our retail analysts noted to me the other day, "it feels like the economy just stopped in October."

What we expect going forward

So we are headed for a pretty nasty recession if we are not in one already. It has been a long time since we experienced something like the 1981–1982 recession. Many people were not alive or do not remember those painful times. The cries of panic are partly the result of poor memory and we need to remain vigilant in not responding to the current markets emotionally.

As discussed in our last market update, I continue to place a 30% probability on the economy slipping into disinflation/deflation and suffering the additional burden that falling prices would place on those who are indebted. This is not a pretty scenario and we should all be aware that Japan was the last country to experience disinflation/deflation. While plenty of policy mistakes were made, the country experienced 10 years of sub-par economic growth.

As noted in The Economist, "A deadly mix of falling prices and high leverage could foment a ‘debt-deflation' of the type first described by Irving Fisher … In this schema, debt-laden firms and consumers rush to repay loans as credit dries up. That hurts demand and leads to price cuts."¹ The problem is that this can become a self-reinforcing downward spiral and our policymakers are well aware of this. The government is doing everything it can to ward off deflation.

The other 70% probability is placed on a reflation scenario where the economy starts growing again in the second half of 2009, according to our Chief Economist Dan Laufenberg's forecast. What will cause the reflation scenario to emerge? I believe it will be a mixture of government policy, sharp investing and an eventual restoration of confidence. Beyond the government programs already in place, it is likely that additional fiscal stimulus will be enacted by the U.S. and other governments. The Chinese have already launched a large stimulus program that is, according to The Economist, four times the size of the U.S. program enacted earlier this year. Investors will begin to believe that these programs can work and take advantage of bargain prices in the stock and bond markets. Renewed confidence will bring people back into the markets and liquidity will improve.

Relative value

I believe that there is more value in the bond market than the stock market, particularly in corporate bonds, high-yield bonds and high-yield loans. As noted in past market updates, corporate and high-yield bond spreads are the widest we have ever seen. The "spread" is the number of percentage points over U.S. Treasury notes/bonds that an investor is paid for taking on extra risk. When bond prices fall, yields or the "spread" over treasuries widens to create extra compensation for risk.

Many investors think that purchasing bonds automatically connotes a conservative investment strategy. This is not true. The purchase of corporate and high-yield bonds entails the risk of default. When a bond defaults, interest is no longer paid and investors then become part of a bankruptcy process where they attempt to recover as much lost interest and principal as is possible. This is known as a "recovery rate." Our investment professionals believe that bond defaults will increase markedly in 2009 and that recoveries will be much lower than in past recessions. That said, they are also quick to note that bond prices have fallen to such an extent that the yields or spreads over treasuries compensate for the risks incurred. Indeed a recent report by the Bank Credit Analyst suggested that total returns in corporate bonds may range from a pessimistic 5% to a more optimistic 7.3%. In high yield, the same study suggests return ranges from 6.8% to 14.8%. The lower returns are based on higher defaults and lower recovery rates.² Our "Paid to Wait List" published a few weeks ago provides examples of corporate debt that offers good value.

Conclusion

A restoration of confidence is needed. Renewed confidence in government policy, markets and the economy will lead to greater liquidity in markets and less volatility. The battle underway is a massive attempt by governments to restore confidence and ward off the deflationary threat. There is a definite balance here. We all need to carry less debt and save more, but at the same time we need to have confidence that the economy will recover and not shut down our spending entirely.

It is possible that individual investors lack confidence in these tough times and this is completely understandable. Consult your financial advisor and either initiate a financial plan or make changes to your existing plan, if necessary. Here is some additional advice to consider:

• Avoid the fear mongers in the media. These are the same people that talked up the market in past periods of excess.
• If you are retired, our retirement income framework suggests that you keep two years' living expenses in cash or near cash. If you are not retired, keep three to six months living expenses in cash as an emergency fund.
• Cut back on spending. Everyone needs to make adjustments in this environment and will have to save more. This should be done analytically and not emotionally. Remember that part of the road to recovery is based on the consumer spending wisely and not stopping their spending entirely.
• Remember that there is always opportunity in financial markets. Money can be made in good and bad markets. Have confidence in the ability of most companies to make the necessary adjustments to respond to the new environment and prosper again.