Yesterday American Home Mortgage, a specialized mortgage company, lost 90% of its value, when its lenders refused to advance the company more funds to meet its reserve requirements and lending demands. When the news was announced, the Dow Jones was higher by over 100 points, after the news hit, the market immediately turned lower and finished down over 100 points, wiping out hundreds of billions of stock market value.
The question that everyone is asking is how much more bad news are we likely to get from the mortgage and real estate businesses, and do their problems have the potential to endanger the banking systems and the economy?
Here’s my short answer. From what I read, American Home Mortgage’s –AHM -- biggest problem was that their banks pulled the plug on them because of the falling values of AHM’s underlying collateral, so it was not necessarily a case of them being swallowed up in sea of bad loans.
The big banks and investment banks in the US, in an effort to protect their own assets, have begun to cut off additional loans to all but prime mortgage credits. This will likely lead to more headlines for specialized mortgage lenders who are forced into bankruptcy because of being cut off by their lenders. So the answer to the first part of the question is the mortgage mess will be with us for a while, yet.
Having said this, I do not believe the odds are very high that the problems of the subprime and specialized mortgage lenders will cause severe damage to the major banks in this country or to our overall economy. My reason for saying this is that the banks in this country entered the year 2007 in as a good a financial position as they have been in 20 years. The best way to look at this is to compare the cumulative financial condition of the major banks at the beginning of 2007 with their condition when they entered the last period of financial stress, which was in the late 1980s—to early 1990s, resulting from the S&L debacle and a severe pull back in corporate profitability.
The table shows that there is little comparison between the financial position of the major banks today and that of 1989.
Today the banks’ equity capital as a % of assets is 60% higher than it was in 1989; non-accrual loans (loans on which the bank is not receiving
The question that everyone is asking is how much more bad news are we likely to get from the mortgage and real estate businesses, and do their problems have the potential to endanger the banking systems and the economy?
Here’s my short answer. From what I read, American Home Mortgage’s –AHM -- biggest problem was that their banks pulled the plug on them because of the falling values of AHM’s underlying collateral, so it was not necessarily a case of them being swallowed up in sea of bad loans.
The big banks and investment banks in the US, in an effort to protect their own assets, have begun to cut off additional loans to all but prime mortgage credits. This will likely lead to more headlines for specialized mortgage lenders who are forced into bankruptcy because of being cut off by their lenders. So the answer to the first part of the question is the mortgage mess will be with us for a while, yet.
Having said this, I do not believe the odds are very high that the problems of the subprime and specialized mortgage lenders will cause severe damage to the major banks in this country or to our overall economy. My reason for saying this is that the banks in this country entered the year 2007 in as a good a financial position as they have been in 20 years. The best way to look at this is to compare the cumulative financial condition of the major banks at the beginning of 2007 with their condition when they entered the last period of financial stress, which was in the late 1980s—to early 1990s, resulting from the S&L debacle and a severe pull back in corporate profitability.
The table shows that there is little comparison between the financial position of the major banks today and that of 1989.Today the banks’ equity capital as a % of assets is 60% higher than it was in 1989; non-accrual loans (loans on which the bank is not receiving
payment), at 0.5% of total loans are only about 20% of what they were in 1989; the banks’ current loan loss reserves (money that is set aside to cover potential losses) is 274% of their actual loan losses, compared to 1989, when loan loss reserves were only fractionally higher than actual losses at 102.5%. Finally, At the beginning of 2007, actual loan losses were only 2.3% of equity capital compared to an 11.2% rate in 1989.
The bottom line is the banking system is strong, and I believe it can withstand the current real estate and mortgage problems very well.
The stock market is retreating because of fears that the banking system will be threatened by the current mortgage mess, which will result in a recession for the whole economy.
The best argument against that line of thinking is the aforementioned strength of the banks, but beyond that is recent US economic data. US Gross Domestic Product was just reported to have grown 3.4% (annualized) in the second quarter and the US unemployment rate has remained steady at only 4.5% of the workforce. Remember these data occurred simultaneous with the bad news in real estate and mortgage lending. Finally, if a recession were imminent, the Federal Reserve would have an obligation to start cutting rates.
The bottom line is the banking system is strong, and I believe it can withstand the current real estate and mortgage problems very well.
The stock market is retreating because of fears that the banking system will be threatened by the current mortgage mess, which will result in a recession for the whole economy.
The best argument against that line of thinking is the aforementioned strength of the banks, but beyond that is recent US economic data. US Gross Domestic Product was just reported to have grown 3.4% (annualized) in the second quarter and the US unemployment rate has remained steady at only 4.5% of the workforce. Remember these data occurred simultaneous with the bad news in real estate and mortgage lending. Finally, if a recession were imminent, the Federal Reserve would have an obligation to start cutting rates.
As I mentioned in my last blog, I listened to the quarterly earnings reports of three of the biggest banks in the country. None of the three reported big jumps in loan charge offs, or greatly increased their loan loss reserves. And, to remind you, two of the three increased their dividends more than we were predicting.
Gyrating markets are not much fun for most people, and they always raise the question: “What are these stock worth, anyway?” If all you are only looking at prices, you might decide that stocks aren’t worth very much, but when you look at companies from the perspective of the cash dividend they are paying and the dividend's rate of growth over the long-term, another picture becomes clear. Many companies are veritable cash flow machines and will be worth more in 10 years than you can imagine.
Cash dividends are real money and determining the value of companies that have long histories of raising their dividends is much easier than it is for companies who must be valued on earnings alone.
As I have said in these blogs before (see my series on The Rising Dividend Story on the side bar)[from the beginning], it was during the severe market correction of October 1987 that our Rising Dividend investment style was born. I knew those dark days would pass because I was convinced the selloff was not fundamentally driven, but I did not know what to buy, and so I sat on the sidelines and let one of the best buying opportunities in the history of the capital markets go by. Now 20 years later, we have a few pretty good valuation tools, and they are signaling that some truly wonderful companies are being put on sale (some of which we already own). I don’t think we need to be in a big hurry, but there are a few that I have been trying to buy for a long time. I’ll be discussing some of those companies in the days and weeks ahead.
Gyrating markets are not much fun for most people, and they always raise the question: “What are these stock worth, anyway?” If all you are only looking at prices, you might decide that stocks aren’t worth very much, but when you look at companies from the perspective of the cash dividend they are paying and the dividend's rate of growth over the long-term, another picture becomes clear. Many companies are veritable cash flow machines and will be worth more in 10 years than you can imagine.
Cash dividends are real money and determining the value of companies that have long histories of raising their dividends is much easier than it is for companies who must be valued on earnings alone.
As I have said in these blogs before (see my series on The Rising Dividend Story on the side bar)[from the beginning], it was during the severe market correction of October 1987 that our Rising Dividend investment style was born. I knew those dark days would pass because I was convinced the selloff was not fundamentally driven, but I did not know what to buy, and so I sat on the sidelines and let one of the best buying opportunities in the history of the capital markets go by. Now 20 years later, we have a few pretty good valuation tools, and they are signaling that some truly wonderful companies are being put on sale (some of which we already own). I don’t think we need to be in a big hurry, but there are a few that I have been trying to buy for a long time. I’ll be discussing some of those companies in the days and weeks ahead.
Table and data from BCAresearch.com and FDIC
