Recession? What’s Missing

Quick! What’s the reason we should believe we are approaching (or already in) a recession? No, negative real GDP isn’t it. Nor is inflation, itself. Neither is the Fed’s interest rates raising. And, no, consumer sentiment and spending are not weak.

Give up? Fortunately, the answer is clearly visible. It can be seen by examining previous recessions. Recession causes are the “overs.” The overdone, overwrought, overoptimistic, and overblown beliefs and actions that produce an untenable and imbalanced environment.

Very importantly, the “overs” rarely repeat, so looking for rules of thumb is unrewarding. So, to understand how recessions occur, let’s look at the last three episodes.

Episode 1990: The S&L and bank crisis recession

The high interest rates in the late 1980s helped savings & loans and banks break the government’s regulatory controls. The release allowed them to pursue expanded business strategies. However, weighed down by low earning, fixed interest-rate mortgage portfolios with the need to compete for high interest-rate deposits created a lose-lose end game. Result… A wave of bank and S&L closures, leading to a general recession.

Note: Recessions are reversals to cure the “overs,” but they need not knock down everything else. During this financial recession, in which value investors kept hoping for a bottom in bank stocks, growth investors had a field day with an excellent 3-year (1989-1991) run-up.

Episode 2000: The internet bubble-burst recession

The internet excitement increased through fall 1999 through mid-March 2000 – the new millennium. The well-known Nasdaq plummet has been explaining as the undoing of the crazed and the greedy. However, that’s inaccurate.

This was a time of unique internet-based innovations that could overthrow brick-and-mortar and “old economy” companies. The problem was the excitement (and the rush to be first) didn’t allow for the time necessary to accomplish the tasks needed for developing the internet-based services and for becoming accepted, trusted and adopted by potential customers. (A good example is the many flameouts of ventures focused on ordering food and other goods for pickup and delivery.)

So, when the boom excitement, valuations and investor growth peaked, the bust happened. (Moreover, the “old economy” companies regained stature, and their “value” stocks delivered good returns.)

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

To earn the descriptor, “Great,” it takes a village of actors. In this case, the players were the Federal Reserve, banks, mortgage bakers, Wall Street bond departments, bond credit rating companies, auditors and banks again. Then, there was the critical need: loads of excited home buyers and investors willing to buy new homes, not to live in, but to sell later at higher prices.

Let’s start with Federal Reserve. Fed head Alan Greenspan was experimenting at keeping money easy the Federal Funds rate 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 hit their peak. He would later be criticized for helping set the stage for the bubble and its aftermath.

This recession came from two “overs.” The first was an overabundance of new homes because so many being bought simply to be sold at a higher price. The bloated supply/inventory required a flood of new homebuyers to stabilize the market, and that would take a few years to accomplish. The second was a continuing huge supply of funds looking for mortgage investments that kept the push for new mortgages alive.

The banks and mortgage bankers were having a field day enticing new buyers with friendlier terms. They even began easing up their borrower credit quality requirements. As in the past, good, competitive times led to requiring smaller down payments and providing adjustable-rate mortgages (ARMs) that started at below-market rates (reducing initial payments that allowed for buying higher priced houses). The next easing was offering a temporary zero-rate. That usually signaled the end of easy terms. However, this time the game moved into new, riskier territory…

Wall Street bankers had devised a way to make partial silk purses out of pigs’ ears: Mortgage bonds with multiple tranches. Working with the credit rating companies, they got approval for AAA ratings on the highest, most protected tranches, and then reduced, but still investment grade, ratings as they moved down the tranche ladder. Most importantly, Wall Street convinced others that the strategy worked even on portfolios of mortgages made to poor credit risks. With the less harsh sounding “subprime” credit rating (think “high yield” instead of “junk” bonds), the homebuyer prospect door burst open.

Note: The major flaw in this development is that this tranche building of poorly rated creditor mortgages had never been done before. While Wall Street said it “proved” the structure through “back-testing, what it actually created was a huge experiment that would blow up in the end.

But wait… it’s not over yet. The banks had donned their innovative hats and created “option ARMs.” This nonsensical design of allowing borrowers to pay whatever amount they wanted was the kiss of death. The banks said all was fine. They simply added the underpayments to the mortgage balance. And they had a stopgap – If the mortgage hit some higher limit, the borrower “simply” would need to start making full payments. Of course, the sub-primers were in over their heads to begin with, and the speculators had no intention of sticking around.

So, what could go wrong? First, house demand could lessen, meaning excess homes on the market with house price rises lessening or even reversing. Second, the subprime tranche bonds experiment could come unglued as delinquencies rose. Both did. Hence… the Great Recession.

Recommendation: An excellent movie is “Margin Call” with Jeremy Irons. It shows well both a Wall Street firm’s operation and how the flawed subprime-tranche financial innovation could have come undone.

The bottom line – The next boom has yet to materialize

What will the next boom be like? There is no telling. What it won’t be is anything like the past three. The next stock bull market looks to be establishing itself now, so it could be many months, even years, before we enter an exciting “over” time that will need to be corrected by a recession.

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