- Last summer, sub-prime mortgage default concerns sparked significant de-leveraging in the financial system.
- To reduce leverage, financial institutions pay down existing debt.
- Stocks are highly liquid and not terribly useful to meet certain capital requirements.
- While not immaterial, such action is likely short-term.
Picture your average musician shuffling into a pawn shop with guitar in hand (maybe that prized sunburst Les Paul), taking a short-term loan to pay the rent when the credit card is maxed out and the paycheck from the last big gig is still in the mail. It's not fun to have to trade the trusty axe for cash, but the bills must be paid.
It's easy to imagine some financial institutions in the same situation.
You may have recently heard the term "de-leveraging." What exactly is de-leveraging? It's the process undertaken to reduce a company's financial leverage. Financial leverage (aka debt relative to equity) is the very basis for a financial institution to generate profits, but if it falls outside certain bounds set by regulators, it needs to be reduced back to "acceptable" levels in short order.
Many big financial institutions invested heavily in relatively obscure vehicles like mortgage-backed securities in recent years. Following deterioration in their creditworthiness, the market for these securities is almost barren today. Even small amounts of selling have lead to massive price drops due to a scarcity of bidders. As the market value (marked-to-market sometimes based on guesswork) of these instruments decline, the leverage ratio of the investor goes up. In the case of banks, brokers and insurance companies, regulatory requirements mandate leverage be reduced, forcing them to sell any available liquid assets. In the case of hedge funds, margin calls or investor withdrawals can force the same. In many instances, stocks have been the best candidate for selling, since they're more liquid and less useful for capital adequacy requirements than other securities. The titans of Wall Street pawning their stocks to pay the rent! How sad.
These leveraged financial players also must have a certain ratio of "high quality" reserves relative to total liabilities. Securities previously considered very high grade investments have either lost market value or suffered credit downgrades. To satisfy industry regulations, these securities are being replaced with the safest in town—US Treasuries.
These combined events have caused three notable results. First, investors have flocked to Treasuries. They are the most valuable security of all for capital adequacy measures because they don't require any meaningful "haircut" in the calculations. This has caused their yields to plummet. Secondly, exotic debt and anything else smelling of potential credit problems have become extremely illiquid and dropped further in value because of a lack of buyers. Lastly, and obviously, stocks have sold off—not so much due to bad fundamentals or scary economic news, but because of their relative liquidity as a source of needed cash to satisfy those capital requirements or margin calls.
It's similar to pawning a guitar in desperate times. The musician might prefer to sell his Sha Na Na record collection (mortgage bonds), but the pawn broker considers that toxic. Instead, he is forced to pawn his only valuable asset, the guitar (stocks). The musician is in no position to bargain and is willing to take less than the guitar's true value in exchange for the ability to pay what is owed immediately. Once things improve, the pawned guitar can be reclaimed by paying more than what was lent. Disciplined investors will benefit from today's environment if they think of themselves as a pawn shop owner and buy stocks now from the selling brokers.
The Fed announced another initiative to provide liquidity to banks—Term Securities Lending Facility (TSLF). The TSLF will lend up to $200 billion of Treasury Securities to "Primary Dealers" (banks and broker-dealers) for a term of 28 days via an auction similar to the Term Auction Facility (TAF) increased last week. (For more on the TAF, see "Going Once, Going Twice," 3/10/08.) The unique aspect of the TSLF is the Fed will deal directly with primary dealers, otherwise called brokers, whereas in the past liquidity injections were focused on banks. While $200 billion doesn't offset the entirety of the exotic debt market, it's a big step towards improving both the primary and secondary market for such debt and gives the primary dealers on the front lines some much needed capital to meet liquidity requirements, therefore avoiding the need to liquidate otherwise attractive securities like stocks. To boot, the Fed is accepting as collateral the very securities the masses would prefer to see burned at the stake—mortgage backed securities (MBS). The gall!
While this is a short-term phenomenon, it doesn't necessarily mean the selling will end immediately. Central banks' recent innovative steps to inject liquidity into the system are positive, but they shouldn't be viewed as an ultimate solution. But we applaud these actions and view them as more effective than simply lowering interest rates.
Sometimes stocks go down in the short-term simply because there is a need for investors to sell them—not because they're a bad investment or a signal of economic malaise. When will the forced selling end? It's darn near impossible to predict. But at some point the selling abates when there is sufficient de-leveraging and/or when central banks adjust the terms of how institutions achieve an acceptable level of leverage.
The end of the forced selling seems much closer to an end than a beginning. Many disagree with us on this last point, but that is just as well. The majority invariably don't predict the end of corrections.
S.J. Perelman said of Groucho Marx, "He had the compassion of an icicle, and the generosity of a pawnbroker." In this environment, investors shouldn't pawn their stocks. Instead, be a pawnbroker and hoard the stocks these leveraged players are pawning.