recession? What is missing

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Fast! Why should we believe that we are approaching (or already in) a recession? No, negative real GDP isn’t it. Neither does inflation itself. Fed interest rates are also not rising. And no, consumer confidence and spending are not weak.

Giving up? Fortunately, the answer is clearly visible. It can be seen by examining past recessions. Recession causes are the ‘overs’. The exaggerated, overwrought, over-optimistic, and exaggerated beliefs and actions that produce an unsustainable and unbalanced environment.

Most importantly, the “overs” are rarely repeated, so looking for rules of thumb isn’t rewarding. So, to understand how recessions come about, let’s look at the last three episodes.

Episode 1990: The S&L Recession and the Banking Crisis

High interest rates in the late 1980s helped save and borrow and banks break out of government-imposed controls. The release enabled them to pursue comprehensive business strategies. However, weighed down by low-income, fixed-rate mortgage portfolios with the need to compete for high-interest deposits created a lose-lose endgame. Result… A wave of bank and S&L closings leading to a general recession.

Note: Recessions are reversals to heal the “overs”, but they don’t have to topple everything else. During this financial recession, in which value investors continued to hope for a bottom in bank stocks, growth investors had a field day with an excellent three-year run (1989-1991).

Episode 2000: The Internet Bubble Recession

The excitement on the Internet increased from fall 1999 to mid-March 2000 – the new millennium. The famous Nasdaq valley has been explained as undoing the insane and the greedy. However, that is incorrect.

This was a time of unique internet-based innovations that could topple physical and “old economy” businesses. The problem was that the excitement (and the rush to be the first) didn’t leave enough time to complete the tasks needed to develop the Internet-based services and be accepted, trusted and adopted by potential customers. (A prime example is the many bursts of businesses focused on ordering food and other goods for takeout and delivery.)

So when the boom, valuations and investor growth peaked, the failure happened. (In addition, the “old economy” companies regained status and their “value” stocks delivered good returns.)

Episode 2008: The “Great Recession” burst from the housing and financial bubble

To earn the “Great” descriptor, you need a village of actors. In this case, the players were the Federal Reserve, banks, mortgage brokers, Wall Street bond divisions, bond rating agencies, accountants, and again banks. Then there was the critical need: loads of excited homebuyers and investors who wanted to buy new homes, not to live in, but to sell at higher prices later.

Let’s start with the Federal Reserve. Fed head Alan Greenspan experimented with keeping money easy by keeping Federal Funds interest rates abnormally low at about 1% until mid-2004. He then slowly raised the rate to about 3.25% in mid-2005, when new home sales peaked. He would later be criticized for paving the way for the bubble and its aftermath.

This recession came from two ‘overs’. The first was an abundance of new homes because so many were bought to be sold at a higher price. The inflated supply/inventory required a flood of new home buyers to stabilize the market, and that would take a few years to achieve. The second was a continued massive supply of funds seeking mortgage investments that kept the urge for new mortgages alive.

The banks and mortgage brokers had a field day, enticing new buyers with friendlier terms. They even started easing their credit quality requirements for borrowers. As in the past, good, competitive times led to the need for smaller down payments and the provision of adjustable-rate mortgages (ARMs) that started below market rates (reducing initial payments allowing for more expensive homes to be purchased). The next easing was offering a temporary zero rate. That usually meant the end of easy terms. This time, however, the game moved into new, more risky territory…

Wall Street bankers had come up with a way to make pig-eared partial silk wallets: multi-tranche mortgage bonds. Working with the rating agencies, they obtained approval for AAA ratings on the highest, most protected tranches, then downgraded, but still investment grade, ratings as they progressed up the tranche ladder. Most importantly, Wall Street convinced others that the strategy worked even on low-credit-risk mortgage portfolios. With the less harsh-sounding “subprime” credit rating (think “high yield” rather than “junk” bonds), the door of the homebuyer’s prospect burst open.

Note: The main flaw in this development is that this tranche build-up of poorly rated mortgages has never been done before. While Wall Street said it “proved” the structure through “back-testing,” it was actually a huge experiment that would eventually explode.

But wait… it’s not over yet. The banks had put on their innovative hats and created ‘option ARMs’. This nonsensical design of making borrowers pay any amount they wanted was the kiss of death. The banks said everything was fine. They just added the underpayments to the mortgage balance. And they had a stopgap solution – If the mortgage reached a higher limit, the borrower would “just” have to start paying off in full. Of course, the subprimers were over their heads in the beginning, and the speculators weren’t about to stick around.

So, what could go wrong? First, demand for homes could decline, meaning excess homes will enter the market and house price increases may slow down or even reverse. Second, the subprime tranche bond experiment could fail as delinquencies increased. Both did. Hence… the Great Recession.

Recommendation: An excellent film is “Margin Callwith Jeremy Irons. It shows both the operation of a Wall Street firm and how the flawed financial innovation in the subprime tranche could have been reversed.

Bottom line: the next boom has yet to happen

What will the next boom be like? There is nothing to tell. What it won’t be is something like the past three. The next bull market in the stock market now seems to be settling in, so it could be many months, even years, before we enter an exciting “over” time that will have to be corrected by a recession.

So the best strategy is to invest in stocks. As I mentioned before, I now prefer a diversified portfolio of actively managed mutual funds.

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