Tag Archives: credit

The Hidden Cost of Credit Ratings

justice

The NY Times’ “The Hidden Cost of Trading Stocks” paints a concise and damning picture of yet another malpractice in financial services.  This has been a recurring theme.   

Another storm may be brewing – this time for the credit ratings industry.  

It is standard practice for issuers to hire ratings agencies to rate their securities.  This practice has lead to incentives to give higher ratings when trying to get business from securities issuers, putting the ratings agencies in the position of representing the issuers when they are given special status to serve and protect investors.  They are not even required to disclose the conflict of interest.  The closest we get to protection is a lawsuit when they explicitly advertise objectivity.

It now looks like 16 states will each get their chance to sue individually.  This may be the beginning of a big and positive change.  If conflicts of interest did influence credit ratings, it would shift capital and damage economic efficiency even when it is not misdirecting pension money into a mortgage bubble.  I wonder if we will see a social media movement to influence reform like we are seeing with network neutrality and “common carrier” status.  I hope so.

 

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Planning and Investing for the Long Term

2 Great articles quickly tell the story of global trends, risks, and strategies:

The 1st, by McKinsey & Company, focuses on Globalization’s critical imbalances:

Globalization’s critical imbalances

The 2nd, by Investors Insight, talks about how to use global macroeconomic issues like these in your investment decisions:
What’s the point of macro?

Not Investment Advice

Dear Friends,

First

No Liability. This is not advice for any specific person. Everything here could be wrong; think for yourself. Only you are responsible for your behavior. If you accept these terms, you may continue reading.

I get asked for financial and investment advice a lot, and want to help. There has been tremendous public attention aimed at complicated financial and economic issues, and I’m happy to give my perspective on planning and investing.

Cash Flow and your House

First of all, as always, never maintain a balance on your credit cards from month to month. For those who maintain big savings accounts and a mortgage, make extra principal payments now. Savings accounts earn much less than mortgage interest, so use some of that savings to reduce the interest you pay. By law there is no penalty for making extra principal payments.

The Planning Mindset

Economic risk is high right now. We could recover with strong employment and growing prosperity. We could have a run on US Dollar debt and fall into an inflationary and humanitarian collapse. The likely future is somewhere in between. Our future course is unknowable, and anyone who tells you otherwise is overconfident. Instead, try to be aware of the range of possibilities and strike a balance that leaves you well prepared.

The biggest reason for high risk right now is the fragile confidence in the long term solvency of debtor nations. The shaken confidence is rational because it remains unclear if global debt and trade imbalances can come back into balance smoothly – or only through national default.

Making Investments

Stocks look pretty reasonable right now. In the US, dividends and earnings look good from a historical perspective. In a lot of emerging markets, stocks have big discounts because of perceived risk — but how much riskier is it for an emerging business to imitate existing efficiency, compared to a developed business improving through R&D? Owning stocks now looks better than usual, and diversifying globally seems as important and attractive as ever.

Bonds look bad. They may be in a bubble. If the Federal Reserve and the banks can not work together to maintain a stable monetary base, we risk high inflation. Monetary policy has eased in an attempt to offset the shrinking bank leverage, but history suggests that reversing this situation will not go smoothly. The recent financial reform included some good ideas, but does not protect against re-leveraging the banks.

Assets are the opposite of bonds; the same thinking above applies in reverse to assets. If bank lending recovers while monetary policy is still generous, then inflation can raise the price of real estate, gold, and everything else.

Overall, pay down your mortgage and use credit as little as possible – interest rates are high for people and companies. Don’t loan the government money by buying bonds — money has flooded in and they pay a low interest. Focus on global equities and real assets, especially emerging markets and commodities that are supply-constrained.

Economics and Trends

In the modern adult lifetime, emerging markets look poised to fully emerge. Investing globally looks wise. As global production enables global consumers to behave more like US consumers, there will not be enough raw materials. The constraining factors are the commodities used in production, so owning those looks wise. There is plenty of low skill labor in the world, so education will become increasingly important. The most educated nations likely have better 10-40 year outlooks than the less educated nations.

Finally, innovation has been lowering prices and improving products at an ~increasing~ rate, so save your money and delay your gratification because products in the future are going to be much better than what you can buy today.

Hope that helps.

Happy to discuss,

Dan

Failure, Contagion, Panic, … and the Future

The original article is available in PDF format here: Failure, Contagion, Panic, … and the Future


Failure

“This is a once in a half century, probably once in a century type of event”
– Alan Greenspan, September 15, 2008

Failures of judgment appear to have been epidemic in the US economy. A brief summary of major failures includes:

  • Insufficient regulation of banking system leverage,
  • Lack of regulation in mortgage origination,
  • Low interest rates and too much borrowing
  • Indiscriminate purchase and bundling of imprudent mortgages,
  • Public mania in real estate,
  • Insufficient enforcement of existing securities regulation
  • Institutional competition toward unlimited investment leverage,
  • Accounting rules that unfairly punish illiquid securities,
  • Concentration of credit risk within AIG,
  • No prepared means to resolve a breakdown in interbank lending.

These failures revealed themselves like layers in an onion as credit became unavailable and investors sold into falling prices.


Contagion

Bad mortgages are generally blamed for causing this crisis, but they were just the trigger. Think of them as the match that lit the bomb that caused the crash. Fundamentally reasonable declines in mortgage securities were magnified many times by fundamentally unreasonable leverage in the banking system. These magnified losses drove a small number of financial institutions toward insolvency, so they were forced to unwind their investments. The contagion had begun.

Selling became a race because as selling drove down prices, overleveraged institutional investors lost their collateral to support their portfolios. So selling begat selling. Because falling prices and a lack of buyers drove companies like Bear Stearns, Merrill Lynch, and Lehman Brothers into collapse, a new kind of risk was exposed: counterparty risk.

Counterparty risk is generally ignored in securities valuation, but if the party that owes you money (or oil, or stocks) fails, then counterparty risk becomes important. People stopped trusting their counterparties so lending and trading between banks slowed way down. Some markets had “no bid” and stopped trading entirely.

When your investments have lost money and you are forced to reduce your leverage, you hope for a liquid market with ample buyers. But with counterparty risk seizing the markets, there were only vultures to be found.

Panic

Large institutional investors could not sell because trading had seized. The few transactions that occurred were at desperation prices. Meanwhile, new laws requiring institutions to quote their assets using “mark to market,” as if all similar securities should be priced like the few transactions taking place, added further chaos. The paper losses from a small number of desperate sales multiplied against the entire asset base of the banks. On paper, many banks instantly became insolvent. Counterparty risk suddenly became the priority and credit markets failed to operate. Prices plunged, fear spread to the public, and mutual fund redemptions jumped to $75 billion in September (3 times the previous record set in 2001).

All manias and all crashes are, at their core, psychological. But psychology is very real, and in crowds it drives society and the economy. Free markets are subject to free fall when everyone wants to sell and there is nobody willing to buy.

With a somewhat dispassionate perspective, it’s curious to watch the public enthusiastically follow momentum: euphorically buying high and fearfully selling low.

The Future

The Valuable US Dollar

The collapse of the credit system is (or was) highly deflationary. As the volume of credit declines, so does the money supply, and with less money each dollar is worth more. That is why commodity prices fell in half, stocks crashed, and home prices declined. On the flip side of the coin, the recovery of the credit system is (or will be) highly inflationary. In addition to recovering toward the reasonable availability of credit, the government has also pumped a lot of new money into the system. While the short-term may be deflationary, the longer-term appears to hold significant risk of a US dollar that is declining in value.

Leverage in the banking system directly reflects the debt of companies and of people. Debt is one side of the leverage ratio, with reserves on the other side. As leverage is brought down to more reasonable levels, the overall level of debt must, by definition, be reduced. That means that corporations and people must pay down debts in order to deleverage the banking system. If leverage ratios are cut from 20x to 10x, then we must all (on average) pay off half of our debts. This will have a depressive impact on consumer spending and economic growth and could lead to big problems if it is done too quickly.

Many companies finance their operations using debt, and many will fail. Profitable companies often finance their growth using debt, using their operating profits to pay bigger salaries and bonuses and if this debt is cut in half then there will be less investment to grow companies, and less money for salaries and bonuses. People who are in debt will have to consume much less because consumer credit could be cut in half. Dollars become scarce and the value of the dollar goes up. In summary: deflation and depression. The government is going to great lengths to avoid this!

“There are risks and costs to a program of action. But they are far less
than the long-range risks and costs of comfortable inaction.”
– John F. Kennedy (1917 – 1963)

1. Bailout – Government can provide banks with additional reserves.

If the Federal Reserve or the Treasury buys debt or equity in banks, it can have the proceeds used as reserves and go directly into the Federal Reserve as “high powered money”. This would reduce the leverage of the banks and allow them to continue operating as usual. Because of the reserve ratio, every dollar invested into a bank’s reserves has many times as much impact on credit and the money supply. If the reserve ratio is 9:1, for example, then, because of interbank lending, the impact on credit and the money supply can be as much as 99 times. That is why it is called high power money, and this would be a very potent way to fix the credit markets in the short term. In the long term, the banks would have lost some of their own equity, and would work to avoid such a loss in the future.

The downside of this form of bailout is that the government would own part of the banking system, spend taxpayer money to do it, increase the money supply, increase debt, and not do anything to fix the structural problems that led to so much leverage.

2. Regulatory Overhaul – Government can change the system to engineer a soft landing.

New regulation of reserve ratios, credit, and securities markets are probably required to reduce the chances of systemic failure in the future. We think there should be a target reserve ratio just as there is a target fed funds rate. Credit regulation should include minimum collateral limits for derivative securities such as mortgage backed securities, credit default swaps, and other derivatives linked to a credit spread. Securities brokers would be responsible for reporting aggregated (clients remain anonymous) positions and collateral by security type.

The dollar has been strengthening lately as an anomaly within a long downtrend. This is no coincidence: the strength of the dollar reflects big investors reducing their leverage, repatriating US cash, selling down leveraged international investments, and generally holding more cash. As banks reduce their leverage, the money supply shrinks, so each dollar is worth more. The dollar was falling in value for years as leverage increased (money supply increased) and now, very quickly, the opposite has happened.

“Decoupling”

We have heard the argument that decoupling is dead: that international trade has brought every market into shared economic cycles. We don’t see it as a question of “either/or”, but rather as a continuum. Global growth is diverse and strong. There are certainly correlations caused by shared trends (such as trade, technology, cultures, etc.) and shared sources of capital, but these have been exaggerated in the past few years by excessive leverage that has given excessive influence to global institutional investors.

As the world economies emerge from the current financial crisis, expect lower correlations. In other words, expect some countries to emerge very strong and others to remain depressed for much longer. Countries with healthy political and economic foundations, along with abundant natural resources, are in the best positions. Brazil, Canada, India, Mexico, and China may be very strong.

The Fundamentals of the World Economy are Better than you might Expect

This is true whether you are talking about the American workforce or global economic statistics: the fundamentals are generally fine. Some of the statistics are clearly not strong but the overall picture is far from a disaster.

Gross World Product (GWP) growth has slowed from a 5% rate in mid-2007 to an estimated 3.7% in 2Q 2008, with 3% growth projected for the second half of this year. International liquidity growth slowed from 12% to 1.6% and global capital investment growth slowed from 6.5% to 3% over the same period. GWP, liquidity, and capital investment are all still growing. Liquidity growth has slowed from an unsustainable pace (more than double the growth rate of GWP), but it is still growing. This is far from a global contraction, and growth is more globally diverse and inclusive than in any previous time in economic history.

World trade volume growth has also been slowing significantly, declining from 9.3% in 2006 to 7.1% in 2007. This year, world trade volume growth has slowed to zero in May/June according to the latest official data. This is not world production, but world trade. World trade puts downward pressure on prices so a slowdown in World trade is inflationary.

Global inflation (CPI) rose from 2.2% in mid-2007 to 7.8% in 2Q 2008. Headline inflation in the industrial economies has risen from 1.4% to 4.2% in the past year, and is at double-digit levels in many emerging markets, the Middle East, South Asia, and Africa.

Global industrial output growth has slowed from 4.4% in mid-2007 to 1.6% in 2Q 2008. In the OECD, which accounts for 73% of world production, output growth has slowed from 3.4% to 0.7% in this period. In non-OECD, industrial output growth has slowed from 8.4% to 4.7%. The OECD represents a shrinking proportion of a growing global demand for resources for industrial output.

In the U.S, Q2 U.S. real GDP grew at 3.3% up from the 0.3% average growth of the prior two quarters.

GDP growth came mostly from export growth. Consumer confidence is at 30-year lows. Disposable personal income in the US rose $596 billion in May from the Economic Stimulus Plan, and consumers saved 84% of that. July data on consumer spending and personal incomes showed contractions in both areas. US Consumers are building up cash and righting their financial positions.

How you Invest

First things first: pay down debts or be ready to do so. We’ve been calling for readers to lock in interest rates on mortgages since July ’06. Credit may be more expensive and more difficult to obtain in the next few years. Companies that rely on credit to finance continuing operations will suffer.

Don’t let fear control you. Buy low. The dollar is strong and securities are cheap. Hoarding cash at a time like this is folly. Invest and diversify into Assets, Commodities, and International Equities. Companies that have international demand or that earn foreign profits may be particularly undervalued. Missing even a few days or weeks of equity or commodity price recovery might mean missing 20% or more in returns. Maintaining your strategic asset allocation balance is more important now than ever, and the dramatic volatility means rebalancing often.

Divest of long term US Treasuries, fixed income securities, and companies that require debt financing to survive. Investments that pay you back as a fixed number of future US Dollars may be eroded by inflation. In the short term, credit markets are essentially seized. In the longer run, it may be decades before debt financing becomes this easy again.

We are in the midst of major global shifts toward free societies, fair markets, growing consumption, and the magnetic attraction of purchasing-price-parity. The biggest drivers of global growth are unshaken:

  1. Expanding production into international (including developing) markets,
  2. Rapid global sharing of social systems and technologies that improve production,
  3. Expanding global trade in both goods and services,
  4. Improving alignment of tax codes and central banking policy in line with global best-practices,

Global investing appears fundamentally very strong, probably more so than at any other time in human history. The current financial crisis should be seen as an opportunity to use strong dollars to buy global investments.

Good luck,

Dan Von Kohorn

More on Money

“The process by which banks create money is so simple that the mind is repelled.”

– John Kenneth Galbraith

“That is what our money system is. If there were no debts in our money system, there wouldn’t be any money.”

– Marriner S. Eccles, Former Chairman of the Federal Reserve Board

“Whoever controls the volume of money in our country is absolute master of all industry and commerce…and when you realize that the entire system is very easily controlled, one way or another, by a few powerful men at the top, you will not have to be told how periods of inflation and depression originate.”

– James A. Garfield, assassinated President of the United States

“The Government should create, issue, and circulate all the currency and credits needed to satisfy the spending power of the Government and the buying power of consumers. By the adoption of these principles, the taxpayers will be saved immense sums of interest. The privilege of creating and issuing money is not only the supreme prerogative of government, but it is the government’s greatest creative opportunity.”

– Abraham Lincoln, assassinated President of the United States

“Until the control of the issue of currency and credit is restored to government and recognized as its most conspicuous and sacred responsibility, all talk of sovereignty of Parliament and of democracy is idle and futile…Once a nation parts with its control of its credit, it matters not who makes the nation’s laws…Usury once in control will wreck any nation.”

– William Lyon Mackenzie King, former Prime Minister of Canada

A cartoon explanation of the banking system:
http://video.google.com/videoplay?docid=-9050474362583451279

The Credit Crunch and the Market

[Download the complete article in PDF format, with charts and better formatting]

The past month has been a roller-coaster in the financial markets.

At the first hints of falling prices in the mortgage backed securities markets, Bear Sterns announced the bankruptcy of two large hedge funds, and 90% losses in a third fund which had $850 million invested in highly rated mortgage-backed securities. In the following weeks, other major funds also announced losses. Goldman Sachs’ Global Alpha hedge fund fell 27% this year through Aug. 13, prompting clients to ask for $1.6 billion in redemptions, investors told Bloomberg. DE Shaw, a pioneer of quantitative investing based on complex mathematical and computer techniques, has been hit hard in August. DE Shaw’s Valence fund is down more than 20% through August 24th, according to a fund of hedge fund manager.

These high-profile losses are prompting redemptions, and as cash flows out of hedge funds, managers must sell. Around the world, leveraged funds anticipate redemptions and are deleveraging (selling).

“When you can’t sell what you want, you sell what you can.”

Because the markets for mortgage-backed securities dried up so completely and so quickly, managers began selling positions that remained liquid and well-priced. In a sense, they had to sell good investments because they couldn’t sell the bad ones. What started as a series of collapsing mortgage strategies has spread into just about every other market that hedge funds touch. Prices fell in investments ranging from emerging market bonds to the price of hogs. In all, more than $1 trillion in value has been lost in US stock markets, alone. Many foreign markets and alternative asset classes suffered worse declines.

The trigger event is a credit tightening: mortgage issuers extended too much credit, were too loose with their lending standards, and may not have adequately communicated their loan terms. In response, lending standards have been increased and credit is tighter. US consumers might slow their spending, which might trigger a broader slowdown in the US economy, which might have implications for global growth. Uncertainty and fear prevail.

We view this fear as primarily psychological, wildly overestimated, and only loosely related to market fundamentals (See Figure 1). But that may not matter.

Contagion

The pricing of risk is driven by psychology. Investors require compensation for the possibility of loss and also for the inconvenience of uncertainty. So rising risk can cause capital to become scarce, lending rates to go up, and spending to slow. In this sense, the psychology can impact the fundamentals in what is sometimes called a “contagion”.

The “Greenspan put” was like a safety net, providing the comfort that credit would be made available on those occasions when it was needed. Bernanke has reiterated this strategy, but it remains to be seen if he has the same appreciation for what Keynes called the “animal spirits” of the market. Contagion is a real phenomenon, generally starting with a crisis in one market or a large fund, then spreading to other asset classes as volatility rises and investors require higher premiums for risky investments.

In our view, the excessive lending in the mortgage industry could trigger a contagion in a variety of ways, such as:

  • Rising rates and tightening lending standards leads to a contraction in home prices, reducing consumer spending and slowing economic growth.
  • A new awareness for the risk of debt investments causes borrowing costs for corporations and governments to rise, reducing investment and slowing economic growth.

These risks can be self-reinforcing, and could change the fundamental characteristics of the economy. These are the type of events that could change our investment strategies if they appear to develop out of control.

So far, these contagions have not caused a significant slowdown in economic activity. Volatility triggered by major hedge fund failures is different; it generally causes sharp declines in recently popular asset classes followed by recovery. These declines can proceed in unexpected ways, and can continue for some time because each price shock runs the risk of triggering another failure. It is surprising how many hedge funds use leverage sufficient to make them incompatible with price shocks. As months pass, however, these shocks can be a blessing because they offer rare value opportunities.

We should all hope that a full-fledged contagion does not develop, and be thankful that the world’s central banks are standing guard.

The Federal Reserve

It is important for the government to intervene if a contagion might damage the economy in fundamental ways, but also important for the government to avoid interfering otherwise. The Federal Reserve and foreign central banks play an important role in managing the stability of economic growth by changing the availability of capital at money-center banks, but interventions can also cause distortions in currency exchange rates, changes in the money supply affect inflation expectations, and reliance upon government intervention can lead investors take excessive risks.

On the 17th, the Federal Reserve followed several foreign central banks (European Central Bank, Australia, Japan, and others) by pumping capital into their nations’ banking systems in response to the recent volatility. This intervention increases the monetary supply, but the psychology of selling is still driving down many market prices as global investors reduce their exposure to risk and shift their portfolios to hold more cash and US Treasury Bonds.

Credit tightening is a reasonable response to excessive lending, but the signal from global central banks is that they are ready to smooth the volatility, even if it means increasing the money supply. This indicates that they may intend to inflate their way out of potential economic pain. As a result, we are less concerned about a recession, but our long-term expectations for inflation have risen. This combination makes stocks and real assets more attractive because they are better hedges against inflation, and reduces the value of fixed income instruments (such as US Treasury Bonds). Meanwhile, the global investor crowd has been doing the opposite. If higher inflation will be the ultimate outcome of this recent roller coaster, then the massive global shift toward cash and fixed income may ultimately be reversed.

America’s addiction to oil

PDF VERSION WITH GRAPHICS

Every time oil prices pull back, the financial press repeats the misguided mantra that crude inventories are too high. The fact is, inventories are far from excessive. Rather, they reflect the strategic importance of oil and America’s increasing dependence on foreign sources. Indeed, we believe that investors should expect crude oil inventories to continue rising along with prices. The higher inventories shield the economy from unexpected and uncontrollable disruptions in crude oil supply.

Oil inventories are strategic

As the chart below indicates, following the 1973 oil embargo, US crude oil inventories began rising steadily. Companies and the US Government correctly understood that maintaining larger inventories would help to avoid risks from further supply disruptions caused by OPEC. The increase in inventories continued for more than 16 years before stabilizing.

The attacks on September 11, 2001, triggered a similar change in perception – this time, the widespread recognition that inventories should be maintained to protect against supply disruptions resulting from terrorism or other political volatility. It is impossible to predict whether the current increasing trend of inventories will last as long or push as high as the previous one, but the increase appears ongoing.

CHART

Crude inventories in terms of months of supply

The slow-moving trends shown above may give false confidence in US crude oil inventory management. A more important measure of inventories is how long inventories would last during a supply disruption. Inventories would provide about two months’ supply at the current pace of consumption. This two-month period is up only slightly since September 11, 2001.

CHART

The US is increasingly dependent on foreign sources of oil

US oil production peaked in 1971. Since that time, growing demand for crude oil in the US has been satisfied by rapidly increasing imports. In 1991, imports surpassed domestic production, and since that time imports have grown to two-thirds of the total US crude oil supply.

CHART

In today’s world, the disruption of imports is a distinct risk. In the event of a war, embargo, or terrorist act, imports could be interrupted while domestic production might continue. Current US crude oil inventories would replace about 100 days of imports. This 100-day period has essentially remained the same since September 11, 2001.

If inventories do not grow in pace with demand, the period of protection against import disruptions will decline. As inventories shrink relative to imports, the US becomes increasingly vulnerable to import disruptions that could adversely affect the labor and lifestyles of Americans. By this measure, inventories have rarely been lower.

CHART

It is probably no coincidence that the|1973 oil embargo was triggered by OPEC when US inventories had fallen to less than three months of imports. A period of low inventories causes prices to respond dramatically to disruption. The oil crisis of 1979 resulted in long lines for scarce gasoline. Solar panels were actually installed on the roof of the White House.

In order to provide for the equivalent of six months of imports, inventories would have to rise by 79% over their current level.

Almost every aspect of modern living is tied to consumption of crude oil, directly or indirectly. The economy relies on the oil industry for gasoline, diesel, jet fuel, heating oil, natural gas, propane, asphalt, lubricants, fertilizers, antifreeze, pesticides, synthetic rubber, pharmaceuticals, and plastics. It is hard to imagine a functioning economy without these products.

Even the most optimistic experts anticipate that world crude oil production can only grow for a few more decades. After that time, production would decline as remaining sources became more difficult to recover from depleting reserves. Most prominent experts anticipate that global production will peak sooner; some even believe it peaked in 2005.

Already, energy efficiency is on the rise. We are increasingly using crude oil for applications that are best served specifically by crude oil. Other sources of energy are being exploited whenever possible and whenever the cost can be justified. The US economy has been growing faster than its rate of consumption of oil, but it is still highly dependent on crude.

CHART

In sum, America began coping with its dangerous dependency on oil after the Arab oil embargo of 1973. But management of this dependency is ongoing. War and terrorism, increasingly scarce supplies, and changing standards in the transportation industries are likely to lead to rising energy prices as America continues to struggle with its addiction to oil.

PDF VERSION WITH GRAPHICS