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Credit Crisis Conundrum

By, 07/12/2007

If media headlines are to be believed (hint: they're not) the era of cheap, easy money is over. Apparently, we're facing a subprime-implosion-induced credit crisis doomed to tank the economy and stock market. (Note: When companies are borrowing apace, busily driving earnings higher, companies are "too leveraged" and we're "over-indebted." But when the media sees credit drying up, that's bad too. We can't keep it straight. But we digress.)

Subprime fallout fears are punctuated repeatedly in headlines. For example, this story links subprime woes to the downfall of two hedge funds and implies the entire sector is thus infected.

Credit Crisis to Worsen as Banks Cut and Run
By Paul J. Davies, The Financial Times
http://www.ft.com/cms/s/21a226ac-2b1f-11dc-85f9-000b5df10621.html

And this news story warns the private equity boom is over for want of easy credit:

End of the Private Equity Party?
By Steve Rosenbush, BusinessWeek
http://businessweek.com/bwdaily/dnflash/content/jul2007/db2007079_282879.htm?chan=top+news_top+news+inpex_best+of+bw

A true credit crisis could be very bad, particularly since major drivers of this current bull market include the historically unique earnings yield-bond yield gap and benign interest rates. (For more, see past MarketMinder commentary "Buyback Bonanza," "If CEOs Don't, Investors Will Do It for Them," or "Smart, Smarter, Smartest.")

Are we facing a credit crisis? More important—how would we know? Easy—check credit spreads.

A "credit spread" is the rate difference between lower-quality and risk-free bonds of similar maturity. Think of this as the premium corporations must pay to borrow money. When investors perceive more risk, they demand more in return for lending money—sending interest rates higher and widening credit spreads. When the spreads are wide, money's more expensive and companies are less interested in borrowing. Narrower spreads signal cheap and easy money. Therefore, wider spreads signal companies will be out one important source of expansion capital, potentially hampering earnings growth and the market and economy in turn.

Spiking credit spreads in recent history have been fairly reliable indicators of coming trouble. In 1998, spreads spiked on Long Term Capital Management's infamous implosion and the market corrected a massive 20% that year. The spike was short-lived, but so was the correction. Credit spreads also warned of coming trouble in 2000—quickly widening over 500 basis points during the year. Credit spreads remained historically wide nearly the entire bear market, narrowing briefly post-9/11 as the stock market rallied and the US recession ended. Rapidly narrowing spreads in 2003 heralded the bear's exit. Since then, spreads have remained in a narrow band—if anything, trending lower with some volatility.

What are credit spreads up to lately? Credit spreads today are about where they were a year ago, and pretty much in the same place, if not a touch skinnier, than when subprime headlines emerged earlier this year. So where's the crisis? Maybe we're confused—maybe "credit crisis" means "figuring out the myriad ways to spend this here cheap and easy money." That can be hard to do. So many options! Which to choose?

Fear-mongering headlines about a coming credit crunch simply aren't true. There's no evidence of such a thing at this point—no matter how much the media squawks to the contrary. Sure, banks are tightening standards on subprime lending, and a handful of narrowly-focused hedge funds investing primarily in subprime mortgage securities are in trouble. But what does the failure of two hedge funds out of the entire hedge fund galaxy in the wider investment vehicle universe tell you? Nothing—except hedge funds are typically murky and you cannot be certain they manage risk properly.

Could a crisis develop? We suppose—but the way you'd know is by watching credit spreads. If they start widening rapidly, you know something's awry. But until then, no need to fret a coming credit crunch. In fact, fears of a false factor are very bullish! When the gloomy outcome credit cowards fear fails to materialize, the positive surprise should boost stock prices.

Another bullish false factor for this year? The "subprime implosion" itself. This scary article warns quality ratings were slashed on $17.2 billion out of $2.3 trillion subprime loans issued between 2002 and 2006:

Ratings Cut By S&P, Moody's Rattle Investors
By Serena Ng and Ruth Simon, The Wall Street Journal (*site requires registration)
http://online.wsj.com/article/SB118408289722162161.html?mod=home_whats_news_us

This is truly terrifying . . . to anyone lacking a working knowledge of long division. Our handy calculator tells ratings were cut on a grand total of 0.7% (not 7% . . . zero point seven percent) of the subprime loans—itself a small portion of the much more massive mortgage market.

We're relatively well assured subprime isn't the major market negative the media insists (0.7% . . . are they kidding?), and a credit crunch isn't looming. Look for stock buyback and M&A activity to accelerate from here—driving earnings-per-share higher and stock supply lower. Both are bullish. It's a beautiful market.

*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.

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