NEW REGULATION AND DELEVERAGING OF THE FINANCIAL INDUSTRY INEVITABLE, SAYS MECHANICS BANK INVESTMENT CHIEF
"It's different this time"
Richmond, CA, April 10, 2008--The US is moving toward much greater regulation of its financial system, and a prolonged and painful period of deleveraging by financial institutions, businesses and individuals, predicted Brian Pretti, head of Investment Management for The Mechanics Bank, in his second quarterly economic forecast for 2008.
"With the collapse of 85-year-old Bear Stearns, we are seeing the end of an economic era and fundamental changes to how we will move forward," Pretti said. "It's different this time, and we probably won't see a return in our lifetime of the conditions that prevailed recently."
Pretti said the deterioration in the credit markets has moved far beyond subprime mortgages to envelope a broad array of assets on the balance sheets of the major U.S. financial institutions, forcing the Federal Reserve and US Treasury into a series of "lesser of evils" choices. "They cannot allow the economy to collapse," Pretti said, "but they cannot avoid the crippling side-effects of their preventive measures--including escalating inflation and exposing US taxpayers to the big financial risks of bailing out Wall Street."
Pretti believes that few people recognize the profound nature of the change undergone by the US financial system over the last few decades--and the effect it has had on economic behavior and character at all levels.
"The act of lending, once the province primarily of the US banking system, found its way onto Wall Street starting in the 1980s," he said. "In essence, it evolved into a free-wheeling shadow banking system that was unregulated and not required to hold reserves. Securitization was the key to this dramatic transformation, and one of its worst aspects was that it separated the borrower from the lender as never before. Wall Street owned many of the loan origination companies directly involved in subprime and Alt-A lending--for mortgages, autos, credit cards and more--but they didn't retain the credit risk (or so they thought.) That's when the US credit cycle began running amuck--there were simply no adults in the room to supervise these seductively profitable, inherently risky activities."
End of an era
The Bear Stearns meltdown, said Pretti, brought this debacle to a close. "From now on we will see a much more heavily regulated financial environment," Pretti said. "That includes the brokerage firms that were left to wheel and deal in days gone by. Now that the Federal Reserve has for the first time in its existence begun an emergency bailout of non-banking financial institutions--which is simply without precedent--those institutions will have to come out of the shadows into the light of regulatory scrutiny."
By using a Depression era clause in the Federal Reserve Act to guarantee $30 billion of potential Bear Stearns-related losses, and through a series of financing actions over the past month, the Fed has swapped about half of its internal balance sheet of Treasuries to the big banks for collateral that includes subprime mortgage loans and other questionable securitized debt. That fundamental and profound change in Federal Reserve policy must ultimately be accompanied by increased regulatory oversight, Pretti says.
But the impact will be felt far beyond Wall Street. The end of haphazard credit availability and lending (securitization) practices will have an important influence on credit-dependent US consumers, Pretti predicted. "Hurt by a tightening credit environment, declines in major household asset values and skyrocketing increases in energy and food price inflation, consumption trends will have to moderate."
"Even if the positive stimulus from tax rebates and Fed and Treasury-related monetary actions allow the economy to sidestep an official recession for a quarter or two the US economy is going to have to stand on its own two feet without being held up," Pretti said. "It's not at all clear that will be easy."
Interest rates will continue to decline
Even as the Fed Funds rate continues to decline--most likely to 2% in late April--the real action in interest rates will be driven by the financial markets themselves, Pretti said.
"When the credit market began to unravel late last summer, an institutional investment stampede into the Treasury market began," he said. "Many of these entities are required to invest only in AAA-rated securities, and when the dubious nature of the AAA ratings on US mortgage securities was exposed, the subsequent move into the US Treasury market began driving bond prices up and yield levels down. In recent months, three-month Treasury Bills have yielded as little as .5%. The fact that investors will accept that level of yield when headline inflation is running near 4% reveals nothing less than blatant fear."
Hard choices
Bond investors will be caught in a bind, Pretti said, because even good quality bond yields will be decimated by inflation. "The flood of liquidity the Fed is pumping into Wall Street and the large US banks, as well as the new guarantees it is providing virtually insure a rise in loose monetary policy over the longer term," Pretti said, "and while the Fed is stoking monetary inflation Stateside, the pressures of continually rising commodity prices in the global economy have been unrelenting--especially on energy and food-related costs. It won't stop any time soon--and doesn't bode well for long maturity bond investments."
Pretti suggests the bright spot in bonds may be a select few tax-free municipal bond categories--but only those of the highest quality. "There is more in this market to avoid than to invest," he said. "Municipalities will be under extraordinary pressure due to declining property and sales tax receipts while costs will be increasing, especially for public safety salaries and pensions as the boomers age. Just look at Vallejo for illustration. And don't depend on muni bond insurance agencies, many of which may not survive financially. In short, selection is the key, but don't try this at home. It is best left to seasoned investment professionals."
Deleveraging-- the new economic reality
Driven by fear, the stock market racked up the worst quarterly performance in five years. But the Fed's unprecedented monetary action to shore up the greater US financial system has brought some relief as the second quarter debuts.
"However, don't think you can relax," Pretti advised. "Investors will now have to discount and start to take into account the likely direction of consumer spending and corporate earnings. Across the board we will see a new economic theme: deleveraging. From banking institutions and Wall Street brokers to individual households, the dependence on credit will have to be broken. Successful investment outcomes in the future will depend on recognizing this reality."
Pretti said investors must continue to focus on globalized sectors of the economy--energy, agriculture, precious metals, large blue chip companies with worldwide revenue growth and select foreign and yield-oriented equities. He emphasized picking investment opportunities in companies and sectors with strong internal cash flow generation to fund their ongoing operating needs independent of the dramatically changing US credit cycle.
"Deleveraging will be a reality for the US economy for the foreseeable future," Pretti said. "It will require a change in investment thinking and actions--and purposeful avoidance of those sectors of the economy that have been prior beneficiaries of the credit cycle mania. Instead of crying over 'spilt milk' those who are flexible and adjust their courses can still profit.".
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Contacts:
Carleton Prince
The Mechanics Bank
(510) 741-3328
Hatti Hamlin
925.872.4328
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