The Quiet Facts

The "quiet facts" are those without buzz or hype, foisted to the last page by their odd misalignment with the themes of the day. Peter Lynch, the legendary former manager of Fidelity's Magellan Fund, coined this term to describe the investment ideas forsaken by Wall Street, usually in favor of the conventional wisdom and emotion. Lynch said it was by paying attention to the quiet facts -- not to the noise -- that the real money could be made over the long term.

Today, the loud facts are ones of credit turmoil, relentless deleveraging, and staggering losses. Of course, the bulk of these losses are non-cash write-downs of derivatives, not real cash money, but that's all lost in Wall Street's rush for the exits -- just as the absurdity of lax lending and foolish financing was the quiet, unheard fact during the real estate boom. The Financial Accounting Standards Board (FASB) rules that became law last year are the culprits. These new FASB standards mandate market-value accounting, forcing firms to take mammoth write-downs on derivative positions that may or may not foretell real losses. Given the collapse of the credit house of cards that is the housing market, it's true that there will be huge hemorrhaging of real dollars in the end. But the mark-to-market accounting is exaggerating the fallout like never before. AIG for example, just booked $11.1 billion in losses on credit default swaps and other derivatives when actual default rates, even adjusted for future expected misery, suggest that actual losses on swaps may only be a fraction of that.

Never before has the damage been so front and center, so front-loaded, and so in your face. It used to take years for banks to even realize the extent of their bad loans, let alone write them off or deal with them. In the early nineties, when banks were failing by the dozen, non-performing loans took several quarters to show up on the books and be marked down. Now a hedge fund blows up and seconds later, a bank has to write-off a whole year's vintage of mortgage-backed securities. In Japan, until recently, non-performing loans still didn't get dealt with, just reclassified or refinanced. But we are an impatient people -- and with mark-to-market accounting, we reap what our impatience (and securitization) has wrought: an orgy of write-downs that makes us treat nearly every loan as in default, well in advance of any missed payment. In the end, this impatience will serve us well. It leaves no room for denial or delay. Financial firms will take their lumps early, allowing a quicker recovery.

But the quiet story -- the one Peter Lynch would point to -- is the way this front-loaded process is exaggerating the declines, forcing financial firms to possibly exaggerate their end-losses. If the losses turn out to be even 75% as bad as the tea leaves of derivative prices suggest, then this could turn out to be the biggest buying opportunity in the history of financial assets.

There are still many shoes to drop in this great deleveraging: commercial real estate, consumer credit, and more credit default swaps. But in many cases the fundamentals will trump the write-downs. Take leveraged loans, for example, which were trading at 87 cents on the dollar despite past maximum recession default rates of 10% and pessimistic recovery rates on collateral of 70%. This should imply trades at 97 cents on the dollar, but many margin calls have forced hedge funds to sell, creating an unprecedented buying opportunity -- especially since leveraged loans, unlike junk bonds, are collateralized senior debt positions that are first in line on default. These leveraged loans have now started to rise in price in the past week, as savvy buyers look at the reality. At some point, banks will be able to write up these positions, as prices rise to meet actual loss statistics. The cataclysmic estimates are already out there. Some economists say $600 billion in write-downs, some even say a trillion. But these numbers are hardly secrets. Equities are pricing in at least $400 billion in write-downs, if not more. As renowned value manager Bill Miller said in his last annual report: "If it's in the papers, it's priced in."

The other quiet fact is the yield curve, which has steepened so dramatically in recent months, as the Fed has cut short-term rates while long rates have risen on inflation fears. Some say the Fed looks foolish, with long rates going in the opposite direction of their intended policy. But it's quite possible that the Fed knew long rates would move inversely to short rates, thus steepening the curve and giving banks the gift of a lifetime. Yes, that's the other quiet fact: banks are able to recapitalize their balance sheets -- as they haven't been for years -- now that the spread between T-bills and the 30-yr bond is over 250 basis points. This spread represents the gross margin for bank lending and drops right to the bottom line.

In times of pessimism, like today, the quiet facts are the optimistic ones. In times of optimism, the quiet facts are the ones foretelling grim realities: like the reality that real estate prices don't go up forever. No one wanted to listen to that quiet fact until it got deafeningly loud -- but by then, it was too late. The quiet facts are the ones to listen for. The loud ones are already priced in.