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Stock Strategist

Our Updated Take on Financial Stocks--Page 4

We still see opportunities amid the turmoil.

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Potential Outcomes
With all of the countervailing forces currently at play in the marketplace, handicapping the outcome from here is a fluid and dynamic endeavor to say the least. We choose to look at multiple possible scenarios, and incorporate new evidence as it arrives to reweight the probability of each potential outcome. Although there are truly a multitude of imaginable outcomes, let's lay out three broad scenarios in an attempt to form a starting point for further analysis.

Don't Fight the Fed
Let's begin with the most benign possible outcome. If the Federal Reserve is able to employ lower rates to shore up asset prices and provide better spread income to lenders in order to offset mounting losses, all players involved (overleveraged borrowers and lenders with questionable loans) should be able to work through troubled loans given sufficient time. While some marginal owners of assets will be separated from their purchases (think condo flippers in Miami or homeowners barely making the minimum payment on negative amortization loans on overpriced homes in California) and some banks will take hits against earnings on poorly underwritten loans, growing employment, higher earnings, and rising asset prices would smooth out much of the pain. There are several limiting factors that could potentially derail this scenario. Runaway inflation or a precipitous dollar decline could prevent the Federal Reserve from keeping rates low enough for long enough to help out the wounded parties seeking help.

Asset Deflation Spiral
Next, let's examine the worst possible outcome. It's possible that the Fed might prove impotent in its efforts to break the asset deflation spiral, either because it's unable to keep rates low enough due to the other half of its dual mandate (inflation control), or because ultra-cautious lenders could largely offset the stimulus by demanding larger credit spreads and tighter underwriting standards. Although low rates mean lower monthly payments for prime customers shopping for a home or investors with reasonable amounts of equity capital looking to invest in commercial real estate, the question becomes whether this is enough to bridge the current supply and demand imbalance. The other question lies in always-dubious-to-interpret buyer psychology. Will prime borrowers armed with lower rates be willing to step in front of the freight train of rapidly declining home prices in California? Although this troubled regional market is clearly one of the most extreme examples, price bubbles that were pushed to unreasonable levels by marginal buyers and ridiculous lending standards--predicated on ever-higher assets prices--usually don't end well. Normally, simple gravity pulls price bubbles back to earth. There are several factors that could add fuel to this fire. A severe or prolonged recession, accompanied by significant job loss, would amplify the pain for marginal asset "owners" and lenders alike. Lost cash flow and additional forced sales of assets would push prices down even further, putting more homeowners underwater on their largest investment. As we've already witnessed in California and Florida, upside-down homeowners are more likely to default and are apt to reduce spending levels in general, furthering the downward spiral in the economy.

The Big Middle
At this juncture, we are expecting an outcome somewhere between the two extremes discussed above, and we will continue to weigh incoming evidence as to whether it pushes the environment more toward one end of the spectrum or the other. In our judgment, there are certain variables that will be highly impactful in tipping the scales. Of utmost importance, the magnitude and timing of ongoing Federal Reserve rate cuts and the degree to which these lower short-term rates translate into market-driven risk-free rates like the 10-year U.S. Treasury will be critical in terms of setting the overall discount rate applied to various asset classes for valuation purposes. Aside from the base level of interest rates, the credit spreads and underwriting standards required by banks and other lenders will also be critically important in driving asset valuations going forward. The overall health of the economy, especially employment levels, will be another determining factor in terms of the ultimate magnitude and severity of credit losses faced by lenders. And finally, more concretely, we think that the upcoming spring selling season for residential homes will provide a critical data point. If the current large inventory overhang begins to be worked off and the broad decline in home prices eases, we would expect fewer bad loans and less severity of loss as well as improved consumer confidence regarding such large levered purchases. If, on the other hand, buyers don't show up and home price declines accelerate, we would expect a further pullback from the market on the part of both buyers and lenders, and for the downward spiral to build momentum.

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