Ray Unger: Are subprime woes ending or just beginning?
The Army has a way of teaching -- or should I say bludgeoning -- troopers into learning things. I can still recall the mind numbing first-aid classes I endured during basic training: stop the bleeding; clear the air passage; bandage the wound; treat for shock.
Today, our global markets have been badly mauled, and I'm reminded of those four steps. The question is, where are we in the wound treating process?
Are we at the beginning -- stop the bleeding -- or are we at the end -- treat for shock?
Last week the Federal Reserve staunched the bleeding with an interest rate cut and by injecting billions of dollars into the financial system. That helped prevent a free-fall in the market. Last Friday, the Dow Jones Industrial Average gyrated 442 points, ending up 233 points. A welcome change from the steep declines of late.
As we all know, free market economies can be messy. There have been many financial panics in our economic history, but the one best known to us is the Great Depression of the 1930s. Since then, we've beefed up the Federal Reserve's ability to combat such events and for the most part they've worked. Our down cycles have been shorter and less severe. Nonetheless, recessions have occurred in every decade, including the recession in 2001.
Are we about to enter another such recession and is this latest up move in the market a mere feint on the way down?
If you've watched any of the business-oriented TV programs you've heard predictions of an economic meltdown. That's not very comforting, but economic forecasts are what they are. It's up to us to adjust to the changing economic climate.
It's a shame this subprime fiasco exposed the failure of our government's noble experiment of encouraging low-income home ownership. For many in that category, the purchase of a home has backfired.
According to a study released in 2004 by Carolina Katz Reid, a graduate student at the University of Washington, between 1977 and 1993, 36 percent of low-income home buyers returned to renting after just two years of home ownership. In five years that number rose to 53 percent.
Sadly, low-income homeowners often spend half of their incomes on mortgage payments, and when mortgage payments go up with interest rates, defaults are almost inevitable. Unlike previous interest rate cycles, however, today's mortgage market includes more subprime loans than ever.
But is this deja vu all over again? Remember the savings and loan crisis in the late 1980s? That prompted the formation of the Resolution Trust Corporation, the government-owned real estate company that was charged with liquidating the assets of failed S&Ls. The tab on that little excursion was well over $200 billion.
Could we see a similar government bailout? In a manner of speaking, we're already witnessing a makeshift bailout. But according to Homan Jenkins Jr. of the Wall Street Journal, the bill for patching up this mess should be considerably lower. In an article on Wednesday, "Payback" he noted that subprime loans account for around 15 percent of all home mortgages, and $90 billion of that could go into foreclosure.
Is $90 billion the right figure? And would $90 billion in defaulted mortgages bring about an economic meltdown?
Remember the scene in the movie "It's a Wonderful Life" when Jimmy Stewart vainly tries to convince his depositors to keep their shares in the Bailey Building and Loan? They thought their savings were in jeopardy so they demanded cash. That same thing is happening on a global scale. That's why the Fed stepped in with billions to provide liquidity. So has the bloodletting ended? For the moment, yes.
A major bank, however, sees opportunity. Bank of America just announced it acquired a $2 billion equity interest in Countrywide Financial, one of the largest mortgage-lending firms in the U.S. that's hemorrhaging foreclosed loans. Its stock is rallying on the news.
Such news could be signaling that we're in stage 4 -- treat for shock. The recent news that foreclosures jumped 93 percent year-over-year, and that 24,000 finance related jobs have been lost to the subprime slump were certainly shocks. But the market didn't react negatively.
Bottom line, don't make any major asset allocation changes because we just might be in the "treat for shock" phase of dealing with this problem. If that's the case, the market could gyrate, but not go much lower. For the full year, however, we may have to tone down our previous performance expectations.
Ray Unger is president of Unger Capital Management in Madison. He can be reached at 833-9400; e-mail: rayu@ungercap.com
Traders and specialists work the trading floor of the New York Stock Exchange.
