Our Updated Take on Financial Stocks
We still see opportunities amid the turmoil.
In the wake of the current credit crisis, we have spent a good deal of time examining and reassessing how we value financial stocks. This article offers an encapsulation of much of the work we have done so far.
We begin our discussion with a brief history of the lending bubble and its fallout, as well as a description of the players and the funding mechanisms. We have also outlined some mitigating factors and potential outcomes; specifically, we lay out three broad possible scenarios for the economy. Of course, there are myriad imaginable outcomes and we continue to incorporate new evidence into our models; however, the three broad scenarios outlined here form a starting point for further analysis.
Finally, we turn our focus from the big-picture economic issues to explain how we have adjusted our process and methodology in covering financial stocks. Specifically, we have reassessed our economic moat and business risk ratings for the firms most impacted by the credit crunch and initial stages of asset deflation, especially those with concentrated exposure to riskier bond holdings and residential properties. We've also moved to an expected value methodology (instead of simply base case valuation) when we think a company could potentially face liquidity issues between now and the long run. Even after taking this more strict approach to valuation, however, we still see a tremendous amount of opportunities where we think the market has overreacted to the current environment.
Origins of the Asset/Lending Bubble
The current mess in the credit markets had its beginnings early this decade. The Fed took aggressive action to fight perceived deflation risk with sharply lower rates during the previous downturn, while at the same time the twin deficits--trade and government spending--swelled. Because many of our trade partners were attempting to keep their currency pegs more or less in place, recycled oil and Asian export profits found their way back to our shores. This vast and rapidly growing inflow of wealth pressured rates lower, especially for securities backed by the government--or implicitly so in the case of GSE-backed mortgage bonds--or similarly blessed securities rated AAA by the major rating agencies. With negative real Fed funds rates (lower interest rates than inflation) put in place following the bursting of the Internet-fueled stock bubble, and the additional downward pressure on base market rates from overseas investors, many bond investors began stretching further and further in search of additional yield without properly accounting for risk--either to meet a funding mandate or in a simple attempt to boost real returns for those funds cordoned off specifically to invest in the credit markets.
The result of this cheap money stimulus: Assets began appreciating across most every category, to varying degrees. While commercial real estate, stocks, and commodities all moved higher, the most impactful asset bubble from the U.S. consumer's perspective was the doubling of home prices in some large population centers over the past several years. As with most asset bubbles, the initial price increases were based on rational economic decisions. Lower mortgage rates meant that new home buyers could get more house for the same monthly payment. Or for those already in a home, a simple refinancing could free up cash, either through lower monthly payments or more immediately with a cash-out refinancing. Barring any additional supply or demand disruption, one would expect home prices to move higher, which is precisely what happened, despite weakness in the broader economy early in the decade.
As home prices moved higher and interest rates eventually clawed their way back from the cellar, affordability began to suffer mightily in some regions. The mortgage industry responded with more and more affordability products, which took many forms. In order to keep monthly payments from skyrocketing, the broader market moved from fixed-rate fully amortizing loans toward adjustable-rate mortgages and eventually into teaser-rate, interest-only, and even negative-amortization loans. Lenders also raced each other to the bottom with their underwriting standards, eschewing the most basic principles of sound lending such as requiring documentation of income to ensure that the borrower would in fact be able to repay the loan. This layering of risks was remarkable by historical standards and the boost to home prices and the level of homeownership was equally unprecedented. In fact, the housing boom helped offset the fallout from the stock bubble and associated overinvestment in technology-related capital goods. Ironically, however, the new housing/credit bubbles merely led to overinvestment in a different segment of the economy. At present, there are roughly a million additional empty homes for sale than would be expected from normal market friction.