Why Stocks That Have Nothing To Do With Mortgage Lending Are Falling

One need only look back at the experiences of 1987 to 1991, to determine what is likely to happen in the credit markets over the next few weeks. In that earlier period, it was widely believed that banking institutions were overstating the value of their assets. No one believed that the Latin American, LBO, and commercial real estate loans of the period could be sold at anywhere near the values listed on bank balance sheets.

Therefore, the market began to test the credibility of the banking industry’s liabilities. The biggest banks funded themselves daily in the credit markets. The lenders to these banks were going to determine whether these banks could pay down their debts or not. The way this was done was simple:

• First, assume that a given bank had to rollover a $50 million note.

• The lender would immediately raise the rate on the rollover.

• If the bank paid the higher rate, then the lender knew the bank was in trouble.

• If the bank said instead that it only wanted to roll over $25 million and it would pay down $25 million, the lender knew that the bank was money good.

• The only way the bank could pay down the note on the rollover was to have sold its best assets into the markets to raise funds (it could not sell its Latin American loans, for example).

• This meant that the financial markets across all spectrums had to absorb billions of dollars of high quality assets and this drove the prices of all financial assets lower.

• It also created a credit crunch because no bank was able to fund new commitments when it was trying to prove its own financial credibility.

This is now about to happen again. Bear Stearns (BSC/$108.35/Sell) has already raised questions as whether the company is valuing its mortgage holdings appropriately. It did this when it refused to sell mortgages at one of its “healthier” funds in order to meet investors’ requests for redemptions. Thus, the battle shifted from whether the assets are valued properly or not to whether the company can defend its liabilities.

To defend its liabilities, the company must pay down its debt. To do this it cannot sell mortgages; it must sell its highest quality assets into those markets that are most liquid. It will do this. It simply cannot show weakness in face of lenders’ demands for satisfaction.

The issues raised by Bear Stearns will be visited upon every major brokerage firm and every major bank. The market will test their ability to defend their balance sheets. This means these companies must pay down their debts. To do this, of course, means selling top quality assets.

While this is happening, all major lending activities to questionable markets will be curtailed. The deal market will stop functioning. Sub-prime borrowers will leave the market. Only the highest quality credits will be funded. The earnings of financial companies will fall. The economy will slow. The stock market will decline.

In time all of this passes as the Federal Reserve moves in to the markets with greater liquidity. However, one must experience the bad before it is time for the good.

It’s very important for both traders and long term investors to understand this concept.  This is just part of the process in cleansing the credit system.  It is and could continue to be very painful.  But once confidence is restored in the financial system, it could mean a broad rally like after the 1998 resolution to the Long Term Capital debacle. 

So in the near term, remain defensive.  Sell if you can’t stand another 10% – 20% correction from here.  But don’t get too bearish after prices have fallen that amount.  At some point, the Fed will step in to restore liquidity and the bad lenders will have been wiped out.  And that will be the time to step in and buy.