Subprime mess: what the financial press might have missed

What has struck me about the recent decline in the financials relative to the subprime mess, and the comparisons to both the 1990 commercial real estate crunch and the October, 1998 Long-Term Capital mess is that credit cycle is different, and could very well be worse.

In the late 1980's and early 1990's our banking system was choked with bad commercial real estate loans sitting on bank and insurance company balance sheets as a result of the passive income tax loss deduction that was eliminated by then President Reagan in the 1986 Omnibus Budget Reconciliation Bill. Banks, insurance companies, brokerage houses and other financial intermediaries bought these illiquid commercial real estate mortgages and then watched as they went belly up, and put banks in particular in a bad capital position. (10% of all banks and S&L's were declared insolvent in 1988.)

However in the early 1990's, the RTC bailed out the banking system as did the new financial engineering tool known as securitization. Securitization was in its infancy in the late 1980's and the subsequent explosion of credit-cards, auto loans, home mortgages and any other asset that could be wrapped into a pool and dropped into a trust allowed financial institutions to rebuild capital. The positively sloped yield curve, the easing of monetary policy by then Chairman Greenspan from 1990 - 1993 and the rebuilding of consumer balance sheets all contributed to the regeneration of the banking and financial system, all of which helped as we moved therough the 1990's...

Now fast-forward to 1998: LongTerm Capital blows sky highs thanks to leverage and bad risk arb bets, and our capital markets seize up, as evidenced by Chairman Greenspan noting the difference in spread between on the run and off-the-run Treasuries that occurred in August and September, 1998. Chairman Greenspan reduced the fed funds rate in October, 1998 to take pressure off of the capital markets as he arranged a bailout by the then very healthy and well capitalized banking system. What exacerbated this seizing of the capital markets was that many brokerage firms had emulated or replicated the LongTerm Capital positions on their own balance sheets, thus you had many major Wall Street players leaning the same way as a global run on credit started.

The point being that in the early 1990's, the capital markets were the relief valve to rebuild and recapitalize the banking system, and the banking system was the relief valve or safety net for the capital markets during the 1998 LongTerm Capital crisis.

Today, with high yield spreads so tight and the private equity market choking, and now the banks hindered by rising single-family mortgage delinquencies both the capital markets and the banking system are hindered.

Even the consumer is feeling the pinch as mortgage refi's from the earlier part of this decade have flowed through spending already.

Still, our Thomson Financial market timing model (see earlier posts to this blog) rose to over 9% this past weekend thanks to the lower 10-year bond yield and the fact that forward 4-quarter earnings continue to rise. At just over 9%, the equity market timing model, particularly the S&P 500 looks very attractive relative to bond yields and earnings. The Thomson market timing model hit a high of 9.8% in October, 2005, and a low of 4% in the spring of 2000.

This credit cycle might not end until we get a bankruptcy or financial failure of enough size for the market and the Fed to take notice.

position in spy, S&P 500 index funds