Tag Archives: credit

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

Historic Debt will lead to Inflation

I’ve talked about the debt and inflation before, but the following might scare you:

Although the level of deficit is the largest in history, it is not the largest when measured as a percentage of GDP. The current deficit is about 4.3% of GDP. This is high by historic standards, but has been exceeded in 6 of the fiscal years since 1962. BUT the private sector is larger than it has ever been, and issuing more debt than ever before. Total $US debt when combining private and public debt is about $35 trillion, or 300% of GDP.

Don’t think that inflation is soley a function of public debt. No, foreign investment is a competition among all capital securities, and it is net US debt interest owed as a percentage of GDP (as well as US GDP as a percentage of global production, and other factors) that underly inflation.

The Unhappy Recovery

Economists identify our economic recovery by the positive growth rate in GDP, but this may be an unhappy recovery as unemployment may remain too high, inflation too low, and wealth concentrated too much at the top.

GDP growth reflects productivity growth and employment growth. In America’s current condition, GDP growth has remained positive because productivity has risen faster than unemployment.

Productivity gains often lead to unemployment because companies can produce more with less. But in most cases, the benefit eventually transitions into falling prices. Competition and consumer choice, especially now that information flows so freely, has led to much more competitive markets. Competitors imitate productive strategies, prices fall, and consumers ultimately benefit. Falling prices is called deflation, and that is where the economy sits today. We have seen strong enough improvements in productivity to impact both unemployment and inflation.

Some industries are effected differently than others, and those with the highest productivity growth tend to also have the most rapid price deflation and largest layoffs. We can look to the past to understanding the relationship between productivity, employment, and inflation, but as we look to the future, it is hard to imagine that productivity growth will slow down. How will we cope with the unemployment and deflation pressures that will naturally arise?

The overall inflation rate is being held up by the fiscal debt of the nation, and we are almost forced to be fiscally irresponsible for fear of deflation. Deflation is an ugly beast. It concentrates wealth by increasing the buying power of those with money, and deepening the debts of those who owe. It also reduces investment because your cash grows in value. Your investments will have to appear very strong before you will be willing to part with cash that grows by itself.

What can we do to achieve a happy recovery?

Targeting a low stable inflation rate will help to achieve a low stable unemployment rate and more broadly distributed wealth. Low stable inflation helps to maintain employment levels by encouraging investment, and to a small degree encourages the creation of new wealth by slowly discounting the existing wealth.

But we can do more!

The total percentage of people in poverty increased to 12.4 percent from 12.1 percent in 2001 and totaled 34.8 million. The adjusted poverty line figures for 2002 have yet to be released, but the poverty line in 2001 for a single person under the age of 65 was roughly $9,200 a year.

More broadly distributed wealth is morally important, but this tends not to be a compelling argument these days. Let me appeal to more base instincts:

More broadly distributed wealth leads to increased and more stable consumer spending levels, more rapid innovation and productivity growth, lower crime rates, lower dependency on social safety nets, increased levels of home ownership and real estate prices, more stable economic growth, and lower risks for equity investments and the economy overall. Falling equity risks leads to ratio expansion and rising values. This combination will make for a very happy recovery.

To achieve these worthy goals, simply eliminate federal taxes on income up to the amount earned by the lowest 20% of earners. The money could be returned annually after April 15th, once the demarcation of the 20% income level is calculated. The tax revenue impact would be negligible, but the impact on our economy would be tremendous. A more aggressive (read politically dangerous) recommendation would be to make rent payments on primary residences tax deductible, just as home mortgage interest payments already are.