by Ron Muhlenkamp   

We may have passed the point of maximum pain in the debt and equity markets.

From an economic point of view, the questions concern recession:

 

• Are we in a recession?
• When will we know?
• What shape will it take?
• How long will it last?
• How deep will it be?
  
  

But, from an investment point of view, these questions may no longer matter because by the time we know for sure, it’s too late to do anything about it.

In the U.S., we’ve had ten recessions since WWII. In each case, the slowdown was triggered on purpose by the Fed, which acted according to its charter in containing inflation. But they also squeeze out the excesses of the prior expansion.

If we review our economic history, we note that prior to the 2001 recession, there were excesses in the technology and “dot-com” sectors. Looking back at the 1990 recession, the excesses were in the real estate and energy sectors, resulting in several banks and S&Ls going out of business. What we are learning this time is the excesses have been in the financing of real estate and other assets.

A soft landing was the Fed’s goal each time it slowed down the economy. In ten cases, the result was recession. In most cases, the Fed squeezed until something broke. (Translation: a major firm went bankrupt.)

This time, the Fed quit squeezing two years ago which is why we were expecting a soft landing. But participants in the credit markets (including mortgages) didn’t get the message. As short-term rates moved up, Adjustable Rate Mortgages (ARMs) became less attractive to the borrower and less profitable to the underwriter and lender. This should have resulted in fewer ARMs being written. Instead, the underwriters changed their terms. They allowed lower down payments, less documentation, or used greater leverage to try to improve their profits. In short, they pushed the limit until they broke themselves.

At the individual level, if you have a three-year ARM written in 2005, it’s up for renewal in 2008. A year ago, short-term interest rates were well above the rates in 2005 and many feared that borrowers wouldn’t be able to afford the rates being charged at renewal. Since then, the Fed has lowered rates to nearly the level of 2005, so the rate shock at the time of renewal wouldn’t be huge. But if the original mortgage exceeded 80% of the value of the home, or the current balance exceeds 80% of the current value (because the value of the house has declined), the borrower may need to make up the difference between the current mortgage and 80% of the current value of the house. It depends on the original terms of the mortgage.

Obviously this can make it tough on the borrower. But it also makes it tough on the lender, which results in declines in the market value of existing mortgages.

To understand how this impacts a business, let’s look at Carlyle Capital Corp. This was a fund which functioned as both a borrower and a lender. It lent money into the mortgage market by buying mortgage-backed securities, and borrowed money from other sources to fund their purchases. (This model only works if the returns from lending exceed the cost of borrowing by more than the expenses of running the business.) What happened was, as spreads narrowed, Carlyle should have backed away from the business. Instead, they increased their borrowing until it exceeded 30 times the equity in the business. The result was it went bankrupt — defaulting on $17 billion worth of debt and ceding the collateral to their lenders. The lenders, in turn, sold this collateral in the open market, resulting in the decline in the market value of existing mortgages.

Given this environment, other primary lenders have become less willing to lend to intermediate lenders like Carlyle. The result has been some forced selling, leading to a decline in the market value of existing mortgages.
The primary lenders, who plan on holding their mortgages and bonds to maturity, have seen the current market bids for such bonds fall far below what they believe is the long-term value of the securities. And their accountants have interpreted the accounting rules to say that at year-end 2007, they must value these assets on their books at current market bids.
(For this discussion, I’m defining primary lenders as those who lend but don’t borrow; e.g., pension funds and life insurance companies. I’m defining primary borrowers as those who borrow but don’t lend; e.g., the homeowner with a mortgage, but no bonds. I’m defining intermediate lenders/borrowers as those who do both, such as banks, Carlyle Capital, some hedge funds, and brokers including…Bear Stearns. Note that although the media has been discussing a federal “bailout” of Bear Stearns, what the Fed really did was provide a location for Bear Stearns clients and customers to continue doing business. The shareholders of Bear Stearns will receive less than 10 cents on the dollar.)
Another example of the current environment involves AIG (an insurance company we own). The company believes the value of their holdings has declined by $1 billion. Their auditors, however, have said that, reflecting current market bids, AIG must devalue their holdings by over $10 billion.
Over the past month, three things happened which we think are sufficient to break these trends:

1. For companies reporting on a calendar year, the end of February was the deadline to satisfy the auditors for the annual report. This means that these assets have been appraised at the current bids (which we believe may be well below economic values).
2. In response to the above, the SEC has clarified their rules on “Fair Value” reporting, implying that the “marked to market” many auditors required at year end may have been overdone. This should help to alleviate the markdowns.
3. In response to the insolvency of Bear Stearns, the Fed has made it clear that while they’ll allow a major firm to go out of business, they’ll support the assets (and the customers) of the major brokerage firms as well as the banks.

These actions may well be sufficient to bring some liquidity and stability to the credit markets. If so, we may have passed the point of maximum pain in the debt and equity markets.

The comments made by Ron Muhlenkamp in this article are his opinion and are not intended to be investment advice or a forecast of future events. Copies of past newsletters are available at www.muhlenkamp.com.

As of March 31, 2008 Carlyle Capital Corp. and Bear Stearns were not holdings of the Muhlenkamp Fund.

As of March 31, 2008 the Muhlenkamp Fund held 4.11% of AIG.

As with all mutual funds, the Securities and Exchange Commission (“SEC”) does not approve or disapprove these securities, or pass upon the accuracy or adequacy of this article. Any representation to the contrary is a criminal offense.

The comments made by Ron Muhlenkamp in this article are his opinion and are not intended to be investment advice or a forecast of future events. Copies of past newsletters are available on our web site at www.muhlenkamp.com.