The bursting of the housing bubble and subsequent credit crisis have done considerable damage to the U.S. economy, and despite reports to the contrary, I believe that we’re in a recession. I think we are likely to see its bottom in the fourth quarter of this year or the first quarter of next year, but it’s going to be a “V” recovery. It will take at least two years to recover because the causes and consequences of the current slowdown will require lots of time to heal. A lower Federal Reserve funds rate will not make 2,000,000 excess homes go away or stop the flood of foreclosures. The improvement in the economy is likely to be slow and steady as we work our way through the serious problems we’ve created for ourselves, and 2009 is likely to be a repeat of the Muddle Through Economy of this year.
First, we have to work our way through almost two years of excess housing inventory. Sometime in 2010, the housing market should begin to pick back up.
Second, we’re going to have to develop new ways to securitize and lend money because we have vaporized 40% to 60% of the credit market that used to buy securitized debt and because we severely wounded those left standing. We are watching banking institutions close their doors or be taken over. It is likely that more than 100 banks, some of them quite large, will no longer be with us by this time next year. The government had to—in effect, if not in actuality—nationalize Fannie Mae and Freddie Mac. There are private shareholders who will benefit from the guarantees, but it’s going to cost the taxpayers, which is grossly inappropriate. The worst part is that we didn’t even get better regulation or a solution to the original problem. And the management that created the problem is still in place. But that’s another story for another column.
Right now, we need to focus on problems with the credit markets. Commercial mortgages are getting tougher to get. Commercial lending dropped off for the first time last month. Student loans? Credit cards? Auto leasing? Home equity lines? Corporate loans? Commercial real estate? Every area that touches on the credit markets is suffering and will continue to do so as banks need to raise more capital and reduce their leverage and exposure. That is not a recipe for a quick recovery.
As a result, I believe we’re going to see the development of a new asset class in the coming years. That new asset class is going to be what I call private credit, in which much of the credit traditionally done by banks or by other commercial institutions will be done by absolute return funds.
These funds will offer to supply credit to various markets. They’ll be leveraged at two to three times, not 20 or 30 times, and as we will see below, will offer adequate returns. It’s going to be a huge new source of lending for the domestic and global economy.
Initially, high net-worth investors, pension and insurance companies, along with sovereign wealth funds will form the initial supply for these markets. Pension funds, insurance funds, and investors all need something more than they’re getting out of the stock market today. The reality is that we’ve gone 10 years and are still roughly where we were in the broad market. On the NASDAQ, we’re half of where we were. We really haven’t made any gains, but our valuations haven’t come down.
There is a high correlation between long-term stock market returns and the valuations at the beginning of any given period. (To see this in detail, visit www.frontlinethoughts.com and click on the stock market charts.) You can look at the valuation of the stock market and ask yourself, “What are the likely returns that I will get over the next 10 years based on current valuations?” The answer is a very disappointing return in the 4% to 5% range. That isn’t enough to get the pension funds and insurance companies the returns they need for the obligations they have. To get equitylike returns of 9% to 11%, they’re going to start looking for alternative forms of investment, and I think private credit is going to be one of the places they turn.
You might not be familiar with the concept of private credit because it’s relatively new. Twenty years ago, nobody was familiar with the concept of private equity, and we’ve seen that develop over the years as a significant investment vehicle.
The similarity will be that the private-credit funds will ask for longer lockup periods like their private-equity brethren. That means they will be able to match the duration of their loans to the duration of the investor capital.
Your underlying investors don’t have liquidity, but they’ll get the returns based on the loans that are made. Part of the problem in today’s credit crisis is that funds or structured investment vehicles lent money long term but borrowed money in the short-term market. When the faith in asset-backed securities died, the ability to borrow short term went away. Couple that with the silly use of leverage, ridiculous ratings on patently bad assets and you have a credit crisis.
The managers of a private-credit fund will lend in markets where they have expertise. If they keep their leverage low, they will be able to borrow about 200% on the equity capital. Depending on the target credit market, you can make high single-digit or low double-digit returns.
And that’s going to be enough. You don’t have to try to go out and leverage yourself 10 times trying to be a hero and make 25% or 30%. That’s what got people in trouble. Ten percent will sound very good to pension funds, insurance companies, and investors who want steady returns. If the price is a three- to five-year lockup, I think they will pay that.
Private investors and hedge funds are doing it now, but institutions are jumping in. We’re seeing the whole asset class of asset-based lending, credit lending, and private credit grow rapidly. Further, it’s growing because it has to. People are always going to need to borrow money, and people are always going to need steadier long-term returns. Those two needs are going to come together.
Within a few years, banks will be some of the largest players in this market. Rather than fight the competition, they will see it for what it is: a brand-new profit and revenue-stream model that fits like a glove with their current business model. Just a few tweaks, add in a guarantee here and there, and it will look like the old model of originate a loan and sell it off, but on a much more solid basis. It will be easier for the banks to raise money. And the world credit markets will go back to being normal. The more things change, the more they stay the same.
John Mauldin is a financial expert, best-selling
author, and editor of Thoughts From the Frontline, which goes to more than one million readers weekly. He is also the president of Millennium Wave Investments.
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