Subprime Mess, Credit Excess - This Ain’t My American Dream!

Aug.22.07 | About: ProShares UltraShort (SCC)

The title for this article comes from a line from the song American Dream by Switchfoot. The song tells a story about a young American who has a wake up call about living excessively. The song lyrics are an excellent metaphor for the state of the United States financial system and economy brought on by the subprime mortgage mess and credit excesses of the past decade.

When success is equated with excess
The ambition for excess wrecks us
As the top of the mind there becomes a bottom line
Where success is equated with excess

Despite early Federal Reserve assurances that the subprime mortgage troubles would be contained and not cause significant spillover into the financial system and economy, it has occurred. A comprehensive summary of the subprime crisis mess is available here on Wikipedia.

As a result of this spillover, the risks of continued market adjustments and adverse economic fallout have increased significantly as past excesses are removed from the housing, credit and equity markets. The contraction of credit in the subprime and prime mortgage markets has already led to downward pricing pressure in housing in certain real estate markets and the dramatic repricing of mortgage backed securities. Similar debt deflation may also continue to play out in the debt and equity markets.

Like a puppet on a monetary string
Maybe we've been caught singing
Red white blue and green

But the Federal Reserve does not control the United States economy or its citizens as if they were puppets on a string. At most, the Fed can promote a monetary environment conducive to stable prices, employment and growth and hope that the public responds appropriately.
The following considerations signal the great difficulty of the subprime financial crisis facing Federal Reserve Chairman Bernanke:

• The Federal Reserve Chairman’s view of severity of the subprime troubles and its potential impact on the financial system and the economy has deteriorated rapidly.

• Federal Reserve regulatory framework places considerable emphasis on market discipline. Therefore, the stability of the financial system depends on adequate risk measurement and management by market participants. Recent events raise questions about the adequacy of the risk controls by several market participants. This was particularly evident in financial industries that experienced rapid growth such as non-bank mortgage lenders (several have filed for bankruptcy) and hedge funds (bankruptcy of two Bear Stearns hedge funds and a large capital infusion to one Goldman Sachs hedge fund). In addition to their rapid growth, these industries are characterized by the use of sophisticated financial instruments such as asset securitizations, leverage and derivatives.

• Note that unlike their bank and mutual fund/investment company brethren, non-bank lenders and hedge funds are lightly regulated.

When success is equated with excess
When you're fighting for the beamer, the lexus
As the heart and soul breathe in the company goals
Where success is equated with excess

We have witnessed an out-of-control credit expansion with company profits of the financial innovators - non-bank lenders and their financiers - taking precedence over the public good. These financial innovators created new financial products (eg. subprime mortgages and consumer loans, asset backed securities and related securitizations, credit derivatives, interest-only mortgages, negative-amortization mortgages) whose risks were not well understood by consumers and investors. The long term nature of these instruments makes the estimation of expected profits/losses and their valuation subject to considerable judgment since the economic outcome is contingent on future events. These valuation difficulties are usually accompanied by enormous incentives to cheat in accounting because employee compensation is tied to reported company profits. Such features may allow profits to be initially reported when the actual underlying transactions will be unprofitable at the end of the day as occurred in the underwriting of subprime mortgages.

This quote from Warren Buffett in Berkshire Hathaway's 2004 annual report (.pdf) appropriately summarizes the situation of the financial innovators.

Investors should understand that in all types of financial institutions, rapid growth sometimes masks major underlying problems (and occasionally fraud). The real test of a derivatives operation is what it achieves after operating for an extended period in a no-growth mode. You only learn who has been swimming naked when the tide goes out.

With the tide receding, our economic tale arrives at the consumer - the linchpin to the United States economy.

• Most American consumers are tapped out after a credit financed spending boom. Many do not know it yet, but their sources of credit have dried up.

• 70% of US GDP is tied to consumer spending. Arguably the boom in real estate and credit resulted in an increase in consumer spending, which has fueled economic growth. Now that the United States real estate and credit markets have cooled off and are contracting, one might reasonably expect a decline in consumer spending and hence a decline in economic growth.

• According to a Beacon Economics study entitled "Savings and Asset Accumulation Among Americans 25 – 34"

Savings rates in the United States began to drop in early 1980s, from 11 percent of disposable income to 2 percent in 2000. Savings rates dipped into negative territory in 2005 and the first half of 2006. People are literally spending more than they are earning after taxes for the first time since the Great Depression.

• The net worth of most Americans has declined from 1985 to 2004, particularly among 25 – 34 year olds. This latter group likely represents a good cohort for the subprime and non-prime mortgage borrowers.

The mean net worth for all American households 25 to 34 increased from $25,000 in 1985 to $26,000 in 2004. However, the median of all households declined from $7,000 in 1985 to $4,000 in 2004. While the median for married households declined from $13,000 in 1985 to $9,000 in 2004.

Many of these young Americans will wake up some morning to find that their irresponsibly financed excesses of recent years have left them with no equity in their homes, no liquidity and limited access to credit. How these young Americans and other citizens in similar situations respond will likely be a key determinant of the future direction of the United States economy and government leadership.

I want out of this machine
It doesn't feel like freedom
This ain't my American dream!

With few good choices, many of these young Americans will cut back on their discretionary spending. One way to play this potential consumer spending fallout from the subprime fiasco within broadly diversified portfolios with moderate to aggressive risk tolerance is with an investment in the ProShares UltraShort Consumer Services ETF (NYSEARCA:SCC). The Ultra Consumer Services seeks daily investment results, before fees and expenses, that correspond to twice (200%) the inverse (opposite) of the daily performance of the Dow Jones U.S. Consumer Services IndexSM. The Index includes companies sectors of food and drug retailers, general retailers, media, travel and leisure. The top ten companies represent 34% of the portfolio and include broadline and home improvement retailers Wal-Mart, Home Depot, Target and Lowe’s and broadcast and entertainment companies Time Warner, Walt Disney and Comcast.

Fuel up the helicopter Ben!

(Refers to a 2002 speech in which Bernanke referred to a statement made by famed economist Milton Friedman about using a "helicopter drop" of money into the economy to fight deflation. Bernanke's critics have since referred to him as "Helicopter Ben.")

Full disclosure: Long SCC (a short ETF) in diversified, more risk tolerant client and personal portfolios.