Tuesday, July 21, 2009

The Panic is Over, The Crisis is Not

With the S & P 500 up nearly 40% from its March lows and volatility way down, it appears the Panic of 08-09 is over (or at least in hibernation), however the crisis is not over and there is no real light at the end of the tunnel - despite what you hear. Don't get me wrong, we very well may have a recovery that appears to be real and solid over the next 18 months, but don't be fooled, the underlying structure is such that it can only be temporary.

I am not pessismistic on America in the long run, but for the short-term I remain uneasy. The basic structure of our system is in peril, though it is masked by government bailouts and more importantly - accounting rules. How a company like Citibank can be allowed to continue operations is beyond comprehension. To be clear, the structural underpinnings I'm referring to are almost all debt-based. Our country as a whole is consumed by debt, from the consumer to the government and unless and until that issue is resolved, we will continue to put our economic future in peril.

Last October the United States was held hostage by Hank Paulson (at Treasury), a gun was put to our head and we were told that if we don't spend a trillion dollars on "toxic assets" the world will fall apart. The Congress and the President acquiesced and gave the Treasury the money, much of which has been spent (yet no one knows quite where) and none of it to buy "toxic assets". Kind of funny that the world didn't fall apart, it did fall off a cliff in October, but perhaps that had something to do with the fear that was instilled in everybody - psychology drives markets.

The funny thing is that Paulson had it right, "toxic assets" were a problem, but buying them was impossible and he had to have known that from the beginning - the only thing that could temporary stop the toxic asset problem was a change in accounting rules (which for some reason didn't come till the end of March). The accounting rules changes finally went through and this has covered up the problems, instead of actually dealing with them. It seems the course of action to be taken with the toxic assets is to simply wait them out and hope banks can "earn their way out" of the crisis. I don't think the financial institutions can earn their way out this (I include the GSE's - Fannie and Freddie) as the potential losses are astronomical.

Banks have written down about $400 billion (see Seeking Alpha story), but they've raised over $300 billion in capital. On the surface, this sounds great, the banks will basically make up their losses by raising more money and earning enough profits to get them out of the mess. This will work for some banks, but not all and not for the financial system (GSE's included) as a whole.

Why am I so sure? I happen to live in one of the hardest hit area code's in the country (Murrieta, 92563) in terms of Real Estate price crashes. My house has an original Tax Assessment base of $521,000 and a similar home two doors down just sold at auction three weeks ago for $190,000. Ignoring the bogus appraisal I got in 2007 for $555,000, my house has dropped in value by about 60% (50% if you solely use tax assessor data). That is a huge and unprecedented drop in value. Neighbors are starting to wonder wether its just best to leave, this is a dangerous psychology.

The next wave of foreclosures is going to be crushing and this represents a major systemic problem to our financial system. Imagine putting 50% down on your home and still being underwater substantially. When good credit and large down payment buyers have substantial incentive to walk away, there is going to be problems. Within a one mile radius of my house (according to RealtyTrac) there are 190 homes in some stage of foreclosure, another 102 that are bank-owned and 34 homes for resale. This doesn't count the people who are now making payments but haven't been placed into the "pre-foreclosure" category yet.
While this may be an extreme, its not uncommon in many parts of California, Nevada, Arizona and Florida - if not dealt with it, it will spread (it already is).

My point, the panic appears to be over (but could easily return), but the crisis is not even close to being over.

Scott Dauenhauer CFP, MSFP, AIF