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WHAT CREATED THIS MONSTER?
Now that the credit crunch/crisis is too obvious for anyone to ignore, the search for culprits is on. Unlike the creatures questioned in "Who killed Cock Robin?", who all willingly confessed or volunteered, the involved will be busy deflecting blame. We can expect to see "deregulation", "greed", securitization, and perhaps the policies of Alan Greenspan to be among those fingered by the conventional financial press. It is doubtful we will see the Fed itself given a show trial, Ron Paul's call for its abolishment notwithstanding.
The article from the New York Times mostly concentrates on the investment banking industry -- which is certainly not blameless. It is really pretty standard stuff. Expect to see more of it.
Like Noah building his ark as thunderheads gathered, Bill Gross has spent the last two years anticipating the flood that swamped Bear Stearns about 10 days ago. As manager of the world's biggest bond fund and custodian of nearly a trillion dollars in assets, Mr. Gross amassed a cash hoard of $50 billion in case trading partners suddenly demanded payment from his firm, Pimco. ...
Even though Mr. Gross, 63, is a market veteran who has lived through the collapse of other banks and brokerage firms, the 1987 stock market crash, and the near meltdown of the Long-Term Capital Management hedge fund a decade ago, he says the current crisis feels different -- in both size and significance.
The Federal Reserve not only taken has action unprecedented since the Great Depression -- by lending money directly to major investment banks -- but also has put taxpayers on the hook for billions of dollars in questionable trades these same bankers made when the good times were rolling.
"Bear Stearns has made it obvious that things have gone too far," says Mr. Gross, who plans to use some of his cash to bargain-shop. "The investment community has morphed into something beyond banks and something beyond regulation. We call it the shadow banking system."
It is the private trading of complex instruments that lurk in the financial shadows that worries regulators and Wall Street and that have created stresses in the broader economy. Economic downturns and panics have occurred before, of course. Few, however, have posed such a serious threat to the entire financial system that regulators have responded as if they were confronting a potential epidemic.
As Congress and Republican and Democratic presidential administrations pushed for financial deregulation over the last decade, the biggest banks and brokerage firms created a dizzying array of innovative products that experts now acknowledge are hard to understand and even harder to value
On Wall Street, of course, what you do not see can hurt you. In the past decade, there has been an explosion in complex derivative instruments, such as collateralized debt obligations and credit default swaps, which were intended primarily to transfer risk.
These products are virtually hidden from investors, analysts and regulators, even though they have emerged as one of Wall Street's most outsized profit engines. They do not trade openly on public exchanges, and financial services firms disclose few details about them.
Used judiciously, derivatives can limit the damage from financial miscues and uncertainty, greasing the wheels of commerce. Used unwisely -- when greed and the urge to gamble with borrowed money overtake sensible risk-taking -- derivatives can become Wall Street's version of nitroglycerin.
So simple question: Who were the, well, morons who loaned out the funds used to indulge the "urge to gamble"? Lenders who were indulging their own urges to gamble, we suppose, even if they may have deceived themselves about whether what they were doing was gambling. And where did the lenders get the funds to lend out? There is no universal answer, but a lot came from the credit creation engine whose spark plugs are the central banks.
Bear Stearns's vast portfolio of these instruments was among the main reasons for the bank's collapse, but derivatives are buried in the accounts of just about every Wall Street firm, as well as major commercial banks like Citigroup and JPMorgan Chase. What is more, these exotic investments have been exported all over the globe, causing losses in places as distant from Wall Street as a small Norwegian town north of the Arctic Circle.
With Bear Stearns forced into a sale and the entire financial system still under the threat of further losses, Wall Street executives, regulators and politicians are scrambling to figure out just what went wrong and how it can be fixed. But because the forces that have collided in recent weeks were set in motion long before the subprime mortgage mess first made news last year, solutions will not come easily or quickly, analysts say.
In fact, while home loans to risky borrowers were among the first to go bad, analysts say that the crisis did not stem from the housing market alone and that it certainly will not end there. "The problem has been spreading its wings and taking in markets very far afield from mortgages," says Alan S. Blinder, former vice chairman of the Federal Reserve and now an economics professor at Princeton. "It is a failure at a lot of levels. It is hard to find a piece of the system that actually worked well in the lead-up to the bust."
Another simple question: Would it have been so all-fired hard to have surmised that what has happened could happen, at least in part, before the fact? It is not like there have not been plenty of Jeremiahs and Casandras out there warning of exactly what is now happening for years. But no one who was benefiting or enabling the bubble seemed to want to take such warnings seriously, until it was too late.
Stung by the new focus on their complex products, advocates of the derivatives trade say they are unfairly being made a scapegoat for the recent panic on Wall Street. "Some people want to blame our industry because they have a vested interest in doing so, either by making a name for themselves or by hampering the adaptability and usefulness of our products for competitive purposes," said Robert G. Pickel, chief executive of the International Swaps and Derivatives Association, a trade group. "We believe that there are good investment decisions and bad investment decisions. We do not decry motor vehicles because some have been involved in accidents."
Already, legislators in Washington are offering detailed plans for new regulations, including ones to treat Wall Street banks like their more heavily regulated commercial brethren. At the same time, normally wary corporate leaders like James Dimon, the chief executive of JPMorgan Chase, are beginning to acknowledge that maybe, just maybe, new regulations are necessary. ...
Two months before he resigned as chief executive of Citigroup last year amid nearly $20 billion in write-downs, Charles O. Prince III sat down in Washington with Representative Barney Frank, the chairman of the House Financial Services Committee. Among the topics they discussed were investment vehicles that allowed Citigroup and other banks to keep billions of dollars in potential liabilities off of their balance sheets -- and away from the scrutiny of investors and analysts.
"Why aren't they on your balance sheet?" asked Mr. Frank, Democrat of Massachusetts. The congressman recalled that Mr. Prince said doing so would have put Citigroup at a disadvantage with Wall Street investment banks that were more loosely regulated and were allowed to take far greater risks. (A spokeswoman for Mr. Prince confirmed the conversation.)
It was at that moment, Mr. Frank says, that he first realized just how much freedom Wall Street firms had, and how lightly regulated they were in comparison with commercial banks, which have to answer to an alphabet soup of government agencies like the Federal Reserve and the comptroller of the currency. ... In fact, Washington has long followed the financial industry's lead in supporting deregulation, even as newly minted but little-understood products like derivatives proliferated. ...
[I]n March 1999, Alan Greenspan, then the Fed chairman, told the Futures Industry Association, a Wall Street trade group, that "[derivatives] enhance the ability to differentiate risk and allocate it to those investors most able and willing to take it." Although Mr. Greenspan acknowledged that the "possibility of increased systemic risk does appear to be an issue that requires fuller understanding," he argued that ... "Regulatory risk measurement schemes ... are simpler and much less accurate than banks' risk measurement models." ...
A milestone in the deregulation effort came in the fall of 2000, when a lame-duck session of Congress passed a little-noticed piece of legislation called the Commodity Futures Modernization Act. The bill effectively kept much of the market for derivatives and other exotic instruments off-limits to agencies that regulate more conventional assets like stocks, bonds and futures contracts. ...
By the beginning of this decade, according to Mr. Frank and Mr. Blinder, Mr. Greenspan resisted suggestions that the Fed use its powers to regulate the mortgage market or to crack down on practices like providing loans to borrowers with little, if any, documentation. "Greenspan specifically refused to act," Mr. Frank says. "He had the authority, but he did not use it." ...
Regardless, with profit margins shrinking in traditional businesses like underwriting and trading, Wall Street firms rushed into the new frontier of lucrative financial products like derivatives. Students with doctorates in physics and other mathematical disciplines were hired directly out of graduate school to design them, and Wall Street firms increasingly made big bets on derivatives linked to mortgages and other products.
Three years ago, many of Wall Street's best and brightest gathered to assess the landscape of financial risk. Top executives from firms like Goldman Sachs, Lehman Brothers and Citigroup -- calling themselves the Counterparty Risk Management Policy Group II -- debated the likelihood of an event that could send a seismic wave across financial markets.
The group's conclusion, detailed in a 153-page report, was that the chances of a systemic upheaval had declined sharply after the Long-Term Capital bailout. Members recommended some nips and tucks around the market's edges, to ensure that trades were cleared and settled more efficiently. They also recommended that secretive hedge funds volunteer more information about their activities. Yet, over all, they concluded that financial markets were more stable than they had been just a few years earlier.
Few could argue. Wall Street banks were fat and happy. They were posting record profits and had healthy capital cushions. Money flowed easily as corporate default rates were practically nil and the few bumps and bruises that occurred in the market were readily absorbed. More important, innovative products designed to mitigate risk were seen as having reduced the likelihood that a financial cataclysm could put the entire system at risk. ...
One of the fastest-growing and most lucrative businesses on Wall Street in the past decade has been in derivatives -- a sector that boomed after the near collapse of Long-Term Capital. It is a stealth market that relies on trades conducted by phone between Wall Street dealer desks, away from open securities exchanges. How much changes hands or who holds what is ultimately unknown to analysts, investors and regulators.
Credit rating agencies, which banks paid to grade some of the new products, slapped high ratings on many of them, despite having only a loose familiarity with the quality of the assets behind these instruments. Even the people running Wall Street firms did not really understand what they were buying and selling, says Byron Wien, a 40-year veteran of the stock market who is now the chief investment strategist of Pequot Capital, a hedge fund. ...
Mr. Blinder, the former Fed vice chairman, holds a doctorate in economics from M.I.T. but says he has only a "modest understanding" of complex derivatives. "I know the basic understanding of how they work," he said, "but if you presented me with one and asked me to put a market value on it, I'd be guessing."
Such uncertainty led some to single out derivatives for greater scrutiny and caution. Most famous, perhaps, was Warren E. Buffett, the legendary investor and chairman of Berkshire Hathaway, who in 2003 said derivatives were potential "weapons of mass destruction."
Behind the scenes, however, there was another player who was scrambling to assess the growing power, use and dangers of derivatives. Timothy F. Geithner, a career civil servant who took over as president of the New York Fed in 2003, was trying to solve a variety of global crises while at the Treasury Department. As a Fed president, he tried to get a handle on hedge fund activities and the use of leverage on Wall Street, and he zeroed in on the credit derivatives market. ...
Mr. Geithner declined an interview request for this article. In a May 2006 speech about credit derivatives, Mr. Geithner praised the benefits of the products ... [H]e also warned that the "formidable complexity of measuring the scale of potential exposure" to derivatives made it hard to monitor the products and to gauge the financial vulnerability of individual banks, brokerage firms and other institutions.
"Perhaps the more difficult challenge is to capture the broader risks the institution might confront in conditions of a general deterioration in confidence in credit and an erosion in liquidity," Mr. Geithner said in the speech. "Most crises come from the unanticipated."
When increased defaults in subprime mortgages began crushing mortgage-linked securities last summer, several credit markets and many firms that play substantial roles in those markets were sideswiped because of a rapid loss of faith in the value of the products. Two large Bear Stearns hedge funds collapsed because of bad subprime mortgage bets. The losses were amplified by a hefty dollop of borrowed money that was used to try to juice returns in one of the funds.
All around the Street, dealers were having trouble moving exotic securities linked to subprime mortgages, particularly collateralized debt obligations, which were backed by pools of bonds. Within days, the once-booming and actively traded C.D.O. market -- which in three short years had seen issues triple in size, to $486 billion -- ground to a halt.
Jeremy Grantham, chairman and chief investment strategist at GMO, a Boston investment firm, said: "When we had the shot across the bow and people realized something was going wrong with subprime, I said: 'Treat this as a dress rehearsal. Stress-test your portfolios because the next time or the time after, the shot won't be across the bow.'"
In the fall, the Treasury Department and several Wall Street banks scrambled to try to put together a bailout plan to save up to $80 billion in troubled securities. The bailout fell apart, quickly replaced by another aimed at major bond guarantors. That crisis was averted after the guarantors raised fresh capital.
Yet each near miss brought with it growing fears that the stakes were growing bigger and the risks more dangerous. Wall Street banks, as well as banks abroad, took billions of dollars in write-downs, and the chiefs of UBS, Merrill Lynch and Citigroup were all ousted because of huge losses. "It was like watching a slow-motion train wreck," Mr. Grantham says. "After all of the write-downs at the banks in June, July and August, we were in a full-fledged credit crisis with C.E.O.'s of top banks running around like headless chickens. And the U.S. equity market's peak in October? What sort of denial were they in?"
Finally, last week, with Wall Street about to take a direct hit, the Fed stepped in and bailed out Bear Stearns. ... "The rescue was absolutely all about counterparty risk. If Bear went under, everyone's solvency was going to be thrown into question. There could have been a systematic run on counterparties in general," said Meredith Whitney, a bank analyst at Oppenheimer. "It was 100 percent related to credit default swaps." ...
It is still too early to assess whether the Federal Reserve's actions have succeeded in protecting the broader economic system. And experts are debating whether the government's intervention in the Bear Stearns debacle will ultimately encourage riskier behavior on the Street. ...
Mr. Frank [has] offered up a raft of suggestions, including requiring investment banks to disclose off-balance-sheet risks while also making the firms subject to audits -- much like commercial banks are now. He also wants investment banks to set aside reserves for potential losses to provide a greater cushion during financial panics. ...
But broad new rules aimed at systemic risk are likely to face strong opposition from both the industry and others traditionally wary of regulation. Analysts expect new, smaller-bore laws aimed at the mortgage industry in particular, which was the first sector hit in the squeeze and which affected Wall Street millionaires as well as millions of ordinary American homeowners.
There is an emerging consensus that the ability of mortgage lenders to package their loans as securities that were then sold off to other parties played a key role in allowing borrowing standards to plummet. Mr. Blinder suggests that mortgage originators be required to hold onto a portion of the loans they make, with the investment banks who securitize them also retaining a chunk. "That way, they don't simply play hot potato," he says.
Mr. Grantham agrees. "There is just a terrible risk created when you can underwrite a piece of junk and simply pass it along to someone else," he says. Ratings agencies have similarly been under fire ever since the credit crisis began to unfold, and new regulations may force them to distance themselves from the investment banks whose products they were paid to rate.
In the meantime, analysts say, a broader reconsideration of derivatives and the shadow banking system is also in order. "Not all innovation is good," says Mr. Whalen of Institutional Risk Analytics. "If it is too complicated for most of us to understand in 10 to 15 minutes, then we probably shouldn't be doing it."
Any suggestions that a credit-based monetary system is inherently prone to high leverage and the propogation of risk? Thought not.
VIVE LA FRANCE – THE ROAD TO HYPERINFLATION
As Peter Schiff, author of Crash-Proof: How to Profit From the Coming Economic Collapse, notes, with the Fed-engineered bailouts of Bear Stearns, just where does it all end? Carlyle Capital Corp. collapsed due the depreciating value of its AAA-rated MBSs guaranteed by Fannie Mae and Freddie Mac. Fannie and Freddie are "government-sponsored enterprises" that are considered to be backed by the U.S. government, but are not actually legally guaranteed. The market evidently no longer considers that backing a guarantee.
A bailout of the GSEs would take an inconceivably large amount of money. Schiff notes that the mechanism of in effect issuing worthless mortgage-backed notes has all been tried before, and the result was hyperinflation. Those who do not learn from history are doomed to repeat it. Moreover, as Cicero is quoted in Orator, "He who knows only his own generation Remains always a child." It seems we have a financial system run by children.
This week, as the financial sector began to give way under the unbearable weight of bad mortgage debt, the Federal Reserve stepped in to save the day. At least that is what it says in the script.
In a surprise move, the Federal Reserve announced its intention to swap $200 billion of treasury debt for $200 billion of potentially worthless mortgage-backed securities. The Fed may have been partially spurred to take the step as a result of the rapid collapse of Carlyle Capital Corp. a publicly traded private equity firm that is a subsidiary of the Carlyle Group. The Dutch firm could not meet margin calls on its depreciating collateral of AAA-rated mortgaged-backed securities guaranteed by Fannie Mae and Freddie Mac. On Friday, the Fed then took the unusual step of providing emergency "non-recourse" funding to Bear Stearns, collateralized by that firm's similarly worthless mortgage debt. Apparently the Fed now stands willing to assume any mortgage-related risk that no other private entity would touch.
That the Fed would take such extreme measures, which would have been considered unthinkable even a few months ago, followed a few notable media events that may have affected their thinking. On Monday [March 10], Wall Street was rocked by an article in Barron's that suggested that government sponsored lenders Fannie Mae and Freddie Mac lacked sufficient capital to cover the likely losses on the $5 trillion in mortgages they insure (a position that I have taken for years) and raised the possibility of either bankruptcy or a government bailout. On CNBC the next day, Paul McCulley, the managing director at Pimco, the world's largest bond fund, publicly called for the Fed to use it balance sheet and its printing press to buy mortgages.
According to the Fed, its new plan does not amount to buying mortgages but simply accepting them as collateral for 28-day loans. However, will the Fed really return these ticking time bombs to their true owners in 28 days, inciting the very collapse its actions were originally designed to postpone? Why does the Fed believe that the mortgages will be marketable next month; or the month after that? Nor can we believe that such "loans" will be restricted to only $200 billion. Bear Stearns and Carlyle are certainly not alone in massive exposure to bad debt. Given the unprecedented leverage that many of the biggest financial firms used to play in this market, there will be many more failures to come. Does the Fed stand ready to bail out all comers? Based on this course of action, the Fed, or more precisely American citizens, will end up with trillions, not billions, of such securities on its books.
The problem with these mortgages (other than the borrowers lacking any means or desire to repay them) is that the underlying collateral is worth a fraction of the face amount. With recent foreclosure recovery rates amounting to less than 50 cents on the dollar, it is no wonder that no one wants them. The real estate bubble allowed borrowers to leverage themselves to the hilt using inflated home values as collateral. However, now that the bubble has burst, mortgage balances far exceed current property values. It is a trillion dollar time bomb that no one can possibly defuse.
Paper dollars are technically Federal Reserve Notes, which means they are liabilities of the Fed. When it puts newly minted notes into circulation it does so by buying assets, usually U.S. treasuries, which it then holds on its balance sheet to offset that liability. By swapping treasuries for mortgages, the Fed effectively alters the compilation of its balance sheet and the backing of its notes.
However, backing paper money with mortgages is nothing new. The French tried it in the late 18th Century, and it lead to hyperinflation. Assignats, which were first issued in 1790 to help finance the French revolution, were backed by mortgages on confiscated church properties. Although the stolen underlying collateral did have some value, the revolutionaries saw no reason to limit how many Assignats were printed, which resulted in massive depreciation. Within three years, price controls were introduced and failure to accept Assignats, initially an offence subject to six years in prison, was made a capital crime. By 1799 the currency was completely worthless.
If even the threat of death could not prop up the Assignat, does anyone believe that the currency could have been saved if Robespierre had forcefully mouthed a "strong Assignat policy" as President Bush is now doing with the dollar? Rather than repeating the mistakes of history we should learn from them. Our own failed experiment with the Continental currency as well as the Great Depression should prove conclusively that it is Austrian, and not French, economics we should be following.
SORRY, I WASN’T PESSIMISTIC ENOUGH!
PrudentBear.com's Martin Hutchinson revises his forecast for how far housing prices could fall, and what the related bad debt losses and financial institution fallout will look like. He then goes beyond that to look at implications for the whole economic system itself. The article title indicates which direction his revisions have gone. The piece also includes a useful discussion about credit derivatives that is accessible to most everyone.
On August 27, 2006 this column suggested that U.S. house prices would fall by 15% nationwide, peak to trough. On March 11, 2007 this column suggested that the total bad debt loss from the mortgage crisis would be about $1 trillion. At a meeting at the American Enterprise Institute [March 12], it became clear that in both cases I was not pessimistic enough. Sorry!
I was probably closer on the bad debt loss. At AEI, Nouriel Roubini suggested that the total credit losses from the housing meltdown would be about $3 trillion, but on inspection his figure included credit cards, credit default swaps and a whole host of other non-housing items. From housing alone, Standard and Poors has now admitted to $285 billion among financial institutions (plus untold amounts among investors such as pension funds that are not financial institutions) while Goldman Sachs, generally somewhat optimistic, has proposed a figure of about $500 billion. I believe that both those figures are low, but that my original $1 trillion figure, which included losses to investors of all types, may be only modestly low. The final figure might be closer to $1.5 trillion, or about 13.5% of the $11 trillion pool of mortgage loans.
The house price decline from top to bottom will now pretty clearly be larger than I predicted. The decline in 2007, according to the Case-Shiller index, was almost 10%. More ominously, in Q4 2007, prices were dropping at a 20% annual rate. It thus seems unlikely that the overall decline in house prices will be limited to 20%, and more probable that when prices finally turn, they will have dropped 25-30%, with drops of as much as 50% in some heavily speculative markets such as much of California. This is an exceptional outcome by U.S. standards, ranking with the 1930s as a house price downturn, but it must be remembered that in Japan Tokyo house prices dropped by over 70% from their 1990 peak before stabilizing.
The depth of house price declines has a near-exponential effect on mortgage defaults, since a borrower can walk away from a home mortgage without declaring bankruptcy -- the transactions are generally non-recourse. Roubini estimates that if house prices decline 20%, 16 million mortgages would be "under water" with principal amount greater than the value of the underlying asset, and that 50% of those underwater mortgages will default. If house prices decline 30%, 21 million mortgages will be underwater, with the same percentage defaulting.
At the lower price decline, that seems to me a little pessimistic. A borrower who can make payments on his mortgage, and whose house is temporarily worth 5% or even 10% less than the mortgage is unlikely to default, if only because he has to live somewhere and moving costs, let alone real estate brokerage are substantial (he would also damage his credit rating.) Thus once we get beyond the universe of people who should never have had a mortgage in the first place, a moderate decline in house prices does not necessarily hugely increase defaults. However as price declines approach the 25-30% level, let alone the 50% that is possible in California, the percentage of mortgages defaulting is likely to rise sharply.
It is clearer now than it was a year ago that losses in housing debt will not be isolated. They will lead to losses in credit cards, leveraged corporate loans, automobile loans and most areas of the credit economy. Even emerging market debt, at first sight insulated from the problem, is in practice endangered by its concentration in Latin America and Russia, both dependent either on the U.S. economy itself or on the high oil prices to which U.S. easy money policies have led. Finally credit default swaps, with an outstanding volume of an extraordinary $50 trillion, appear to be an accident waiting to happen. Thus a mere $1.5 trillion in housing debt losses may indeed produce total losses of $3 trillion or more when collateral damage is included.
Not all of those losses will be felt by financial institutions, although the extraordinary appetite for risk that such institutions have exhibited over the past decade suggests that a high proportion of them may indeed come to rest in the financial area. If that is the case, we have a problem: the total capitalization of the U.S. banking and brokerage system is only about $1 trillion.
Yes Houston, we do have a problem.
The Bear Stearns intervention ... was a first symptom of what we can expect. (The Northern Rock disaster in London was a case simply of appallingly inept regulation of a bunch of hyper-aggressive used car salesmen who moved into the home mortgage business.) Bear Stearns, while not without its reputation for sharp elbows, is a major house with an important market position. Bear Stearns was more concentrated in the mortgage business than several of its competitors, but that may simply have led the tsunami now approaching the world's financial system to reach Bear Stearns first.
If Roubini is anything close to right as to the total size of the disaster, and it spreads as appears likely to areas beyond mortgages, then there is no reason to believe that any of the world's major financial institutions is exempt, although in practice some of them will have been exceptionally conservative in their adoption of new financial techniques or will have concentrated their business in areas such as emerging markets that are relatively less affected.
As the mortgage blow-up has shown, many of the "modern finance" techniques that have been designed in the last 30 years have shown themselves fatally flawed. Of all such innovations, probably the one posing most current danger for the world's financial system is the credit derivatives market.
Like most modern finance products, credit derivatives were marketed as hedges. A bank could reduce its credit exposure to a particular borrower by entering into a contract whereby another bank would make payments to it if the borrower fell into bankruptcy.
Needless to say, once Wall Street's trading desks got hold of credit derivatives, all thought of hedging was lost. Instead of selling a credit exposure once, banks sold it 10 times, or even 20. Instead of selling credit exposure to another bank or an insurance company, who would be able to handle the credit exposure and could be relied upon to pay up in case of trouble, credit derivatives traders sold credit derivatives to hedge funds, private equity funds and any riff-raff that walked in off the street.
As a result, the credit derivatives market is a time-bomb waiting to explode. ... [A]t some point rising credit losses on the underlying loans will be multiplied by the credit default swap mechanism to produce a payment requirement that is several times the size of the underlying defaulted loans. ... In practice, the losses are likely to be large enough to cause counterparties to default, particularly if they are "men of straw" such as hedge funds, so the profits will prove ephemeral while the losses prove all too real. Losses of even a modest fraction of a $50 trillion principal amount would bring down most of the banking system.
It is in this context that the Bear Stearns crisis must be viewed. When the Knickerbocker Trust went bankrupt in 1907, J.P. Morgan was able to bail out the banking system because the Knickerbocker had limited relationships with other banks. Even when Drexel Burnham went bankrupt, the authorities were able to solve the problem by allowing a two-stage process ... [which] was hard on Drexel's shareholders, who might well have salvaged something substantial from the wreckage if Drexel had been forced into Chapter 11 early enough, but it was good for Drexel's network of counterparties, who were given time to get out.
As the above discussion has shown, the network of counterparties for a major house such as Bear Stearns is now many times the size and complexity of that constructed by Drexel and poses huge systemic risk. Bear Stearns may not be too large to fail, and it has no depositors requiring insurance of their money, but its network of interlocking obligations is far too complex and extensive to allow it to cease payments.
The Fed is doing everything it can to stave off disaster, but frankly, it is not rich enough. With assets of about $800 billion, having instituted $400 billion of rescue programs in the last week plus unspecified intervention with Bear Stearns, it is pretty nearly tapped out. It does of course have available a further source of liquidity, the Federal printing press. With inflation already moving at a brisk trot, use of that source will replace an incipient recession with a deeper and highly inflationary recession.
Thus the participants in the AEI seminar were misguided in touting Treasury bonds as the last safe haven. In an era of inflation, long term Treasury bonds yielding less than 4% are not a safe haven, they are a guaranteed route to loss, particularly for any investor so unfortunate as to pay tax. The fact that 5-year Treasury Inflation Protected Securities now yield less than zero, even though the inflation figures on which they are based are comprehensively fiddled, is a sufficient indication of the incredible laxity of current monetary policy. Of course, since house prices peaked at about 45% above their equilibrium level, a 30-40% burst of consumer price and wage rises, perhaps two years at 15% inflation, may be just what is needed to bring house prices and incomes back into balance. In an era of very cheap money, all investments are overvalued (the stock market still has much further to fall) but Treasury bonds are perhaps the poorest buy of all.
This is not a pretty picture. The losses to come are probably large enough to wipe out the banking system, and the interconnected network caused by modern finance is sufficiently fragile that the failure of any one major house, if carried out through normal bankruptcy processes, would be sufficient to bring down the world economy as a whole.
It is as if the U.S. power grid had been installed without fail-safe mechanisms, so that a local outage caused by a snowstorm in Vermont or a hurricane in Florida could cascade through the whole system and wipe out power service for the entire U.S. Needless to say, failsafe mechanisms have been put in place precisely to prevent such an occurrence. When we dig ourselves out from what seems likely to be an unprecedented banking system catastrophe, we will no doubt design similar mechanisms to prevent contagion throughout the banking system. They will destroy much legitimate business, just as did the 1933 Glass-Steagall Act, which decapitalized the investment banks, making it almost impossible for companies to raise debt and equity capital for the remainder of the 1930s.
The barriers to new business caused by the new control regulations will be the last but by no means the least of the enormous costs imposed on mankind by the crack-brained alchemists of modern finance.
4 RECOMMENDATIONS TO DEFEND AGAINST A FINANCIAL ARMAGEDDON
This piece, from "award-winning" blogger Bill Cara writing on the Seeking Alpha website, is an excellent introduction to today's financial crunch -- for laypeople and professionals who need a little regrounding alike. He then goes on the advise how to deal with the crunch.
Mr. Cara believes we are headed for a deflationary credit contraction rather than a hyperinflationary crack-up, so his recommendations are accordingly based on that scenario. The bottom line is that he recommends pulling funds from the financial system and putting it in various safe places. However, he thinks gold is trading at "adrenalin driven" manic prices right now, so one should await a pullback before seriously investing there.
Another week of all-time record high commodity prices and a fresh record low U.S. dollar has had the expected result in U.S. equity markets: the stocks of the commodity producers and export manufacturing sectors have led the way to a week over week gain in the broad indexes, but traders are focused on the macro picture and remain nervous.
Capital markets are operating in a stagflationary environment, similar to the 1970's. The combined impact of slowing or receding economies and rising costs is that equity prices, which are based on inflation-adjusted corporate revenue, cash flow and earnings growth, are under pressure. Should inflation worsen, interest rates will rise, with further damage to economic growth and corporate earnings and net cash flow.
The problem has been caused by the massive increase in debt, on the one hand, without a counter-balancing increase in economically-based sustainable asset prices. Phony asset prices, which had been used to support the debt bubble, were discovered as banks tried to rein in credit that had been expanding at rates that were out of control. In the typical credit contraction cycle, the parties that suffer most are business corporations and real estate developers that are over-leveraged, which did not happen in this cycle. This time, it was the banks and brokers that were over-leveraged on the basis of these phony assets they carried on their books.
This succinctly lays out the issue that ails us: debt increase while economically sustainable asset prices did not. The flip side of that same coin is that the payments owed on the debt incurred continue while receipts from the unviable assets do not.
A proper write-down of those assets to economic reality means that many of the financial institutions have capital reserves below the ratios permitted by regulators. In fact, there are concerns that should all banks write off these dubious assets, the result would be insolvency, which is to say a complete elimination of equity, and worse.
So, the big picture is looking bleak, and it is not one that can be fixed overnight or even in a month or a quarter. This problem will probably take a few years to resolve.
As the credit contraction cycle works itself through the economy, cash and unencumbered assets will continue to be king. Periodically, there are injections of liquidity by central bankers and by sovereign wealth funds, but these are mostly based on new debt, which is like pouring fuel onto the fire, stealing from the children and grandchildren of the future, and the elderly and others who are presently or soon to be in need of social assistance, all done with the intent that vested interests among bankers can be protected today.
At the heart of today's economic and capital market woes is the unnecessary Iraq War. Nobel laureate economist Joseph Stiglitz and his associate sum up the issues in their book, The Three Trillion Dollar War. ...
As long as there was a conspiracy among bankers to price these real estate assets on fiction, backed by so-called insurance programs that work only as long as the credit ring remains intact, the beneficiaries of a strong U.S. dollar, and low interest rates, such as the bankers, telcos and regulated utilities were able to lead equity market indexes higher. But as the real estate market peaked and headed south, and higher inflation set in, the U.S. dollar started to plunge. Capital markets remained stable only as long as bankers could continue to sell their fiction-based assets, and the available excess capital went into bonds.
In other words, the Ponzi scheme only worked as long as new suckers could be found and not too many existing investors asked to cash in their pot.
That process started to come to a conclusion in June 2007, and the big capital pools started to switch from equities to the most risk-free bonds, the U.S. Treasuries. Now, even that safety valve has come to the end as the yields have collapsed on short-dated U.S. Treasuries to the point where in just four weeks, the yield on 2-year T-Notes has plunged from 1.90% to 1.48% and on the 3-month T-Bills from 2.17% to 1.06%. ... [T]raders are simply prepared to earn little to nothing if their capital base is preserved at this point, and the T-Bill rate proves just how negative is the market reality.
These yields are massively under the inflation rate, so wealth is rapidly being destroyed. As soon as the commodity price bubble bursts (and it will since record high oil and precious metal prices are economically unsustainable and will crack, just like real estate prices cracked in the summer of 2005), a huge deflationary wave will engulf the world.
So Mr. Cara is not a member of the hyperinflationist denouement school. He does not explain whether this is because he believes the central banks will eventually decide to not put themselves completely out of business, or whether it is simply not possible on the theory that hyperinflation ultimately would destroy more credit than could be created.
Writing his syndicated column Global Issues Sunday, David Crane points to the red flags waving when the International Monetary Fund warns that governments need to "think the unthinkable." He opines, "Indeed, we could be headed for the worst financial crisis since the 1929 stock market crash and the Great Depression of the 1930's." Negative I might be, but not nearly that much so.
And he is also not of the "Great Depression all over again" belief. Again, no explanation -- but presumably he thinks the mistakes of the 1930s will not be repeated. (Perhaps they will come up with new mistakes that are not as bad?)
Where I see the credit crunch has hit home the most -- the banks and telcos -- traders have been selling to raise cash. In fact over the past 6 and 12 months the price performance in these sectors is the worst across the broad market: down over 3, 6 and 12 months -18.7%, -29.2%, and -31.3% for Financials (XLF) and -24.6%, -32.0%, and -26.6% for Telcos (IYZ), respectively. [These are ETFs for the sectors.] How can anybody be positive with such a disaster?
A week ago I asked rhetorically, "As a trader you have to ask yourself if conditions are likely to change in the next three to six months to where Mom & Pop start getting ahead financially, start spending again, and start saving and buying equities. You want to ask how the Telcos (and other financial income sources) are going to pay out high returns on capital without it being a return of capital. In addition, you want to know how the Banks can recapitalize their balance sheets without traders somewhere in the world taking on huge debt. Debt inspired by greed, after all, is the cause of the problems today."
I am asked every day what my recommendation would be to defend against a financial Armageddon, and I will sum it up here:
These are tough times. It will pay to keep cool. ... There is very little rigorous analysis being done today. It is mostly synthesis (i.e., storytelling) by people who really do not know from nothing. The trouble is that transparency in the global financial system is not what those in control crack it up to be, and now that those persons are in deep financial trouble themselves, the public is being left even further in the dark.
- Go temporarily to a combination of cash, in the form of U.S. Dollars held with the most secure financial institutions (preferably a Swiss bank outside UBS and Credit Suisse, which are international investment banks), and 3-month T-Bills, regardless of how low the yield is. (The minimum account size for private banking with Swiss banks is about $250,000 for those who are interested.) In the meantime, maintain small loans at various financial institutions -- if the interest rate is low -- because your continued payment of the principal and interest will put you into the most valued client category when the global financial crisis is ended and banks are seeking to issue new loans.
- Then wait for the crack in the precious metals market, which will come as most of these record high commodity prices are futures contracts based, which will fall apart when the credit ring snaps and counter-parties are unable to pay off. I am now looking at $780-$800 gold, possibly lower, for example, in the months ahead. Yes, gold prices may go higher than Friday's high of $1009 for $GOLD because the market is adrenalin driven at the moment, but if you are not a day-trader with your finger on the buy/sell button, it is best you stay away.
- When precious metal prices, after the peak, spike down on the extreme sell-off days that I see upcoming, use that low price to buy physical bullion bars and coins for safekeeping, preferably in a private Swiss bank. For those who want the least exposure to the current financial crisis, I would not hesitate to put 90% of the cash into a variety of precious metals bullion holdings in safekeeping because even during the Depression era of the 1930s, physical gold was the best performing asset class.
- After the global bankers appear to be resolving their crisis, and real estate prices and equity market prices have sunk to ultra long-term lows, which may take six months to two or three years to unfold, I would begin a program of selectively selling the precious metals and buying real property with rock-solid mortgages, probably in Emerging Markets, plus the stocks of Cara 100 companies that managed to survive the difficult economic period ahead. With that in mind, I would start to narrow the Cara Global 100 down to one in each sector, like: Exxon (XOM), Goldcorp (GG), ABB (ABB), Toyota (TM), Diageo (DEO), Glaxosmithkline (GSK), ICICI Bank (IBN), Google (GOOG), Nokia (NOK) and EXC, as examples. That list would give a global balance of very strong companies, and I would probably weight the holdings on average with the S&P Global 1200 sector weightings at the point of entry.
As I wrote this week, the global liquidity crisis was brought on by bankers and the public ought to protect themselves by pulling their capital out of the market, which would send the system into crisis, forcing these bankers to sort out their various conflicts of interest and return us a legitimate capital market that is not controlled by debt market dependent financial services companies.
These are pretty hardcore recommendations, one step above the "buy gold and bury it" approach of the so-labeled survivalists. Note that physical gold stored in bank safe deposit boxes may not be such a great idea. If the bankers game plan is to save their hides at all costs, they will be tempted to grab anything they can get their hands on.
Post-Bear Stearns Bankruptcy Commentary
After noting that the collapse of Bear Stearns, heretofore the 5th largest Wall Street investment bank, and its fire-sale take-over by JP Morgan, was the "biggest news of at least the past year", Bill Cara added this commentary:
Had the Federal Reserve Bank not intervened, what [Cara calls] the credit ring of the global financial services industry would have failed, leading to a collapse of the capital market as one bank after another would have reneged on payments to others, causing a domino effect of bank failures. The concept of financial Armageddon almost became reality.
History is being made in the capital markets. It is prudent for the owners of capital to now stand aside, i.e., to withdraw all liquidity, to cause enough of a run on banks that the bottom line is that the weakest financial services companies fail and the strongest return to us, the owners of capital, a market that is free of the most basic conflicts of interest that have existed since the 1933 and 1934 U.S. Securities Act and Regulations that permitted such behavior.
In effect, Wall Street has been hoisted on their own petard.
[From the urban dictionary] Petard: a device contrived to hurt another person; boobytrap; an explosive contraption used in warfare to blow in a door or form a breach in a wall.
To "hoist by one's own petard" means you have been hurt or caught by the very device that you intended to hurt someone else. This phrase is often used mockingly, as if to say that you stepped in your own mess.
The revolution in the financial services industry has begun. Should we join it, the victors will enjoy the spoils, with not much changed. But, if we decide to step back and force their hand, i.e., let these banks destroy themselves, the victors will have to return to us with a new and much improved capital market, one that works for us and not against us.
It is time for those who provide services to be the servants and for the owners of capital to be the masters. A simple philosophy in life, yes, but we all need to get back to the basics.
So there is a moral component to Bill Cara's advice as well. Withdrawl capital from the system not just to preserve your wealth, but to bring the immoral system down.
COMMODITIES: IS IT ALL OVER?
No sooner had Bill Cara, in the entry immediately above, warned that the commodities bubble would burst than the complex sustained at least a major short-term correction. Roger Nusbaum -- financial advisor who writes a blog which focuses on "top down" asset allocation -- gives his take on what that might mean going forward.
Has the entire commodities theme broken down by the side of the road like an old car driving up a mountain in the summer? You know, 'cause it overheated? If you read enough articles or watch enough stock market television you will probably be able to come up with an explanation that makes sense to you (regardless of whether it is correct or not), but maybe there is no real reason other than one-way trades reverse course eventually, regardless of the fundamentals or anything else.
I have been a believer in commodity exposure since before I started my blog (back then there were far fewer choices), but I always repeat my belief in having moderate exposure. My thoughts about my commodity exposure is not that I am "going long commodities," but that I am adding in a little zig to my stock market zag (to be clear, I do have long exposure -- I just do not view it as a "bet on commodities").
There is plenty of research that compellingly argues for 20%, give or take, in commodities and some readers subscribe to that line of thinking, but I have never been comfortable with a number anywhere close to that.
In buying gold, I hope I am buying a little something what will go up if there is an external event that crushes the market so in a way the price does not matter. No matter where gold is today or where it was yesterday if there is a terror attack tomorrow, I think gold would go up.
Another aspect about small commodity exposure versus large is how levered you are to one theme. If you were 20% yesterday you really need to decide what you think the Wednesday selloff means and whether or not you need to do anything about it. With a 3 or 4 or 5% weighting the consequences for being wrong are much less which makes managing a portfolio much easier.
As this has played out over the last few months I have not sold any streetTRACKS Gold Shares (GLD). A couple of my clients have PowerShares DB Agriculture (DBA) and I sold 1/3 of that in late Febrary, right around $40, and I have also disclosed selling some Vale (RIO) at around $35 and then later at $30.
The sales were not about trying to make big changes or time anything, but one sort of exit strategy is partial sales after a huge run. There is no right or wrong with this - if something grows faster than the portfolio there is logic in reducing, and if something gets too frothy there is logic in reducing (or maybe selling out).
Commodities Experiencing a Record Selloff
While investors have spent the last few days focusing on the events in the financial services sector, commodities have been under heavy pressure. Much of the focus Wednesday was centered on the declines in gold and oil, which fell $59 (5.9%) and $4.94 (4.5%), respectively. Taken as a whole though, the entire sector has experienced a sell-off of record proportions.
As measured by the CRB Index, the two largest one-day 10 largest one-day declines in the index, as well as the performance of the index going forward. Fortunately, for commodity bulls, the average return going forward has generally been positive. At the same time, however, investors who are bearish on the sector are likely to compare the sharp swings to the Nasdaq back in early 2000 (or the equity markets now).
Even after experiencing its two largest one-day sell-offs on record, the CRB Index still remains well above its recently surpassed highs from 2006, and year to date the index is up over 8%.
BURST BUBBLE? COMMODITIES’ LONG-TERM STORY REMAINS INTACT
Another blogger from Seeking Alphay, Davy Bui, thinks the recent pullback in commodities -- however sudden and sharp it may have been -- is just a correction in a secular bull market.
[T]he last two days have been absolutely brutal for the commodities side of our portfolio and Wednesday, the energy stocks also got whacked. And I do not know about you folks but I have not reached that zen, Buffett-like state where falling prices do not faze me. They faze me. A lot. In my experience, the periods in which my self-doubts peak are honestly the times I should have been buying. Even in the short time since this website/blog has been up (since January 2007), the market has already tested me many times and I cannot profess to have bought every time at that bottom. I have regretted it every time. ...
I have my doubts. Every day, I question my theses, analysis, picks, etc. Especially on a day like yesterday. That said, I just cannot buy into this commodities "bubble" story ...
Obviously, we are in a corrective phase of the commodities bull run but I think any characterization of the run in hard assets as a bubble is absurd. We know what bubbles look like -- they leave indices like the NASDAQ or the Nikkei ravaged years/decades after the fact, they devastate whole industries and professions like realtors and Wall Street financiers, they transform thriving municipalities into ghost towns and retirement accounts into part-time work well into your 70's -- basically an awful lot like what is happening today in real estate and Wall Street. Just study previous oil busts -- we are obviously nowhere near that phase with commodities.
If you are a nimble trader, I am sure there is a lot of money to be made in this correction as well as the run back up. I cannot handle trading so I remain committed to my discipline of long-term investing.
I do not know where the story goes next from here. Maybe, some of the commodities will drop another 20% from here. And I will cringe every step of the way. But I know where this story must end -- with higher inflation, strained energy supplies and a burgeoning emerging rest of the world who will not continue to foot the bill for Americans living large. The long-term fundamentals dictate that any major corrections remain buying opportunities for long-term investors.
As Hot Money Flees Commodities, Picking Up a Little EOG Resources
"Trader Mark" recommends we use the correction in commodities to buy some natural gas exploration and development stocks. Cabot Oil & Gas and EOG Resource head his list. He expects commodities to correct further as the "hot money" retrenches -- for those who want to get cute.
I am adding a second name to my mini natural gas basket, which I started Monday with Cabot Oil & Gas (COG) ... I am beginning a small stake in my #1 target EOG Resources (EOG), which has some very impressive new expansion opportunities recently announced. ... Much like the fertilizer stocks which have been impervious to meaningful slowdown it has finally taken some hit ... down to its 20 day moving average of $115. I am starting small since I think more downside to go, and am targetting $106-$108 (which is just above the 50 day moving average). There is a "gap" in the chart around $108 which almost surely will get filled.
It appears the commodity trade is being abandoned by hot money so I will be waiting at lower prices to scoop these guys up when/if they get to my targets. In the meantime we will take the body blows as positions dominating the fund falter (temporarily). But we are only in day 2 of what could be a longer pullback in these hot money groups, so I am not jumping in too aggressively yet. I started a small stake of 0.5% of fund at $115. Looking to add significantly at lower prices.
CREDIT CRUNCH? WHAT ABOUT THE “TRUST” CRUNCH?
The creation of credit implies a confidence on the part of the creditor in the borrower at the time of the debt's creation. Of course later it may be revealed that the borrower misrepresented his or her position and the lender's confidence was therefore misplaced. When the loans are short-term in nature and the borrower's continued viability depends on being able to roll the loans over, the borrower has every incentive to maintain the appearance of confidence-worthiness, whether or not it is backed by substance.
Looking at statements emanating from Bear Stearns and its supporters and regulators a mere week or two before Bear's complete collapse, Elliott Wave International's Bob Folsom notes a massive effort that went towards maintaining an appearance utterly at odds with reality. If that just discredited the players in the immediate orbit of Bear Stearns that would be one thing. But, as Folsom, notes the "entire financial establishment" was wanton with its reassurances about Bear Stearns's viability. So how much stock do we put in future reassurances from the same sources?
Whether they were being dishonest or were very misinformed is really not the point. One just should not place much confidence in them the next time.
Every new revelation in the subprime debacle has turned out to be far worse than initially reported. That much is obvious to anyone who has followed the thing closely. But that is not to say that what happened with Bear Stearns over the past week fits the "worse than it looks" pattern. No indeed. In fact, the disintegration of Bear Stearns has moved the subprime debacle from "worse than it looks" to the level of "we cannot trust anything that the corporations, media, and government are saying about the crisis."
Yes, that may seem like an extreme remark. But read these comments. Then let us consider if my conclusion seems "extreme".
“There is absolutely no truth to the rumors of liquidity problems that circulated in the market.”
Public statement by Bear Stearns on March 10, 2008, as reported by The Wall Street Journal.
Question from viewer to Jim Cramer, host of CNBC's Mad Money:
“Should I be worried about Bear Stearns in terms of liquidity and get my money out of there?”
Answer from Cramer on March 11, 2008:
“No! No! No! Bear Stearns is not in trouble. If anything, they're more likely to be taken over. Don't move your money from Bear.”
“U.S. Securities and Exchange Chairman Christopher Cox told reporters on Tuesday [March 11, 2008] that capital adequacy at the five largest U.S. investment banks was being closely watched. 'We are reviewing the adequacy of capital at the holding company level on a constant basis, daily in some cases,' Cox said. 'We have a good deal of comfort about the capital cushions at these firms at the moment,' he said, including Bear.”
~~ Reuters news, March 11, 2008.
Okay, so does my conclusion still seem "extreme"? The entire financial establishment went on the record regarding Bear Stearns, and unanimously declared "No Problem." Within one week the firm was so bankrupt that it was bought out for $2 per share. Others folks may have a different standard than mine about "credible" sources -- I have drawn my conclusion.
Mind you, I am not saying that the people and sources above were being knowingly dishonest. What I am saying is that, in practical terms, honesty is less relevant than credibility. For all I know, a lot of smart people really did believe that Bear Stearns's $33 billion securities portfolio was sufficient collateral to meet any liquidity demands. Problem is, if lenders will not accept your collateral, and buyers will not purchase your assets ... well, your collateral and assets have no monetary value.
Now those assets -- the mortgages, mortgage-backed securities, etc., etc. -- have been nationalized. Here again, "nationalized" is a strong word. But to see what I mean, you need only read as much fine print as you can get your eyes on regarding the Federal Reserve's $30 billion pledge to J.P. Morgan Chase, which took over Bear Stearns' securities. According to The Wall Street Journal:
“Fed officials wouldn't describe the exact financing terms or assets involved. But if those assets decline in value, the Fed would bear any loss, not J.P. Morgan.”
And if the Fed bears a loss, guess who gets handed the bill: That would be you (and me), Mr. & Mrs. Taxpayer. Welcome to the subprime debacle.
THIS YEAR’S BERKSHIRE HATHAWAY SHAREHOLDER LETTER DOES NOT DISAPPOINT
For value investors and students of business alike, Warren Buffett's annual letter to shareholders of Berkshire Hathaway is an eagerly awaited diversion during the waning months of winter. The folks at The Motley Fool have conveniently summarized the contents of this year's letter. The complete letter, for fiscal year 2007 as well as those going all the way back to 1977, is available here.
[T]he investor letter from ... Berkshire Hathaway (NYSE: BRK-A and BRK-B) is an annual treat for lovers of business and investing. It remains one of the most readable pieces of literature released by any company, and gives tremendous insight into not only Berkshire Hathaway itself, but the way that Warren Buffett and Charlie Munger -- arguably two of the greatest investment minds out there -- think about their field of expertise.
Of course, the letter is not just for the initiated, nor just for shareholders. Anyone can access the annual letter on Berkshire Hathaway's website. For that matter, you can access the annual Berkshire letter going back to 1977. And for those who do not feel like weeding through every letter online, George Washington University professor Lawrence Cunningham has done a great job of compiling salient commentary from the letters, in his book The Essays of Warren Buffett: Lessons for Corporate America.
Although the annual letter has taken on an even greater significance than talking about the results of Berkshire Hathaway itself, the primary purpose is, of course, to talk about the results of Berkshire Hathaway. Based on the measure deemed most important by Buffett -- gain in book value -- 2007 was a good year for Berkshire. Book value increased by $12.3 billion, or 11%, besting the 5.5% gain that the S&P 500 posted.
As laid out in the letter, Berkshire has two main areas of value -- its investments in stocks, bonds, and cash equivalents, and its operating businesses. Over the years, as Berkshire has grown to its current impressive size, the whole- or majority-owned operating businesses have had an increasingly important role in Berkshire's growth.
On that note, 2007 brought positive results from most of the company's operating businesses. Insurance, its largest area, had an impressive year, helped greatly by a lack of disasters that would cause major payouts. Buffett, however, did warn that the coming years likely will not be so kind. Competition has already heated up, driving premiums down, and sooner or later there will be major disasters for Berkshire to cover.
For anyone who has been following business news, the results for the rest of Berkshire's operating businesses probably are not too surprising. Its manufactured housing and financing business, as well as its other housing-linked businesses, suffered during the year as the U.S. housing market continued to slump. The expectation, though, is that the businesses themselves are fine and will recover when the rest of the industry does. Berkshire's retail businesses likewise faced headwinds, but many of these -- notably See's Candies, Borsheims, and Nebraska Furniture Mart -- fought the tide and posted very positive results.
Buffett and Munger have always expressed a strong interest in owning truly great businesses, and if it is impractical to own the whole business, they are happy to own a portion of it. As Buffett states in this year's letter, "It's better to have a part interest in the Hope Diamond than to own all of a rhinestone."
Although the company's size has increasingly forced it to acquire entire businesses, Berkshire does still lean heavily on its marketable investment portfolio, which totals a massive $141 billion. ($75 billion of that is in common stocks.) Although Buffett is notoriously secretive about his investments, SEC regulations require that he reveal all positions over a certain size.
Berkshire's common stock holdings are the same market-traded stocks that individual investors hold, but you typically will not find Buffett equating the success or failure of one of these companies with the rise or fall of its stock price. In that vein, it is noted in this year's letter that three out of Berkshire's four largest holdings -- American Express, Coca-Cola, and Procter & Gamble -- all saw double-digit per-share earnings increases in 2007. The other of the "big four," Wells Fargo, had a small drop in earnings because of the problems surrounding the real estate bubble. In Buffett's estimation, though, this masked a slight increase in Wells Fargo's intrinsic value during the year.
Wells Fargo appears to be outperforming its peers in the industry by a noticeable margin. However, this is not saying much. Quoting directly from the letter to shareholders:
Some major financial institutions have, however, experienced staggering problems because they engaged in the "weakened lending practices" I described in last year's letter. John Stumpf, CEO of Wells Fargo, aptly dissected the recent behavior of many lenders: "It is interesting that the industry has invented new ways to lose money when the old ways seemed to work just fine."
You may recall a 2003 Silicon Valley bumper sticker that implored, "Please, God, Just One More Bubble." Unfortunately, this wish was promptly granted, as just about all Americans came to believe that house prices would forever rise. That conviction made a borrower's income and cash equity seem unimportant to lenders, who shoveled out money, confident that HPA -- house price appreciation -- would cure all problems. Today, our country is experiencing widespread pain because of that erroneous belief.
As house prices fall, a huge amount of financial folly is being exposed. You only learn who has been swimming naked when the tide goes out -- and what we are witnessing at some of our largest financial institutions is an ugly sight.
Wells Fargo (WFC) is down from a 52 week high of about 38 to around 30 as this is written, so it is off 20% or so where many of its peers are down 50% or more from their highs. Dividend yield is 4.40%, trailing P/E is 12.6, and price/book is about 2. Bank stocks have been much cheaper than this in times past, but Wells Fargo generally gets rewarded with a (deserved) quality premium.
Berkshire's one large sale of the year was to clear out its holdings of PetroChina. Berkshire had actually come under fire from many groups, based on the political view of the company, but the sell decision was ultimately based on PetroChina shares' climb to a price that well exceeded Buffett and Munger's estimated intrinsic value.
"Businesses -- The Great, the Good, and the Gruesome" is the title of one of the investing lessons that Buffett baked into his letter this year. The lesson deals with the dynamics of a business's "moat". A moat is any factor that protects a business earning higher-than-average returns from the onslaught of competition that would otherwise eat away at those returns. Buffett's love of moats can be seen clearly in Berkshire's investment portfolio, with companies like Coca-Cola, American Express, and Kraft Foods possessing significant sustainable advantages that are nearly impossible for competitors to overcome.
Using the example of See's Candies, Buffett further demonstrates how beneficial it can be to own a business that has enduring competitive advantages and does not require a tremendous amount of invested capital to produce outsized returns. He also points to the publicly traded examples of Microsoft and Google as similar examples of companies that have been able to grow and produce impressive results with a relative minimum of capital investment.
Not as impressive to Buffett, but still often worthy of investment, are companies that have a strong competitive position but require a significant amount of investment to earn their returns. He cites Berkshire company FlightSafety -- a flight training school -- as an example of this type of business. Berkshire has had to invest a significant amount back into the company to generate its continued earnings growth. Mr. Buffett referred to this as the "put-up-more-to-earn-more experience [that is] faced by most corporations."
The final business category is what Buffett calls the "gruesome" businesses. These are companies that require constant and significant investment and reward the investor with subpar returns. Where could such a lousy business exist? Look no further than the airlines. Buffett describes airlines' appetite for capital as "insatiable" and notes that the reward for all that capital investment has been a history of lousy -- and sometimes nonexistent -- earnings.
On the airline industry, he wrote in the letter, "If a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down."
Buffett concludes the letter by noting how grateful he and Munger are to be doing what they are doing, and to be as successful as they are. "We have long had jobs that we love ... Every day is exciting to us; no wonder we tap-dance to work." If you ask me, this could be one of the greatest nuggets on investing success that could be pulled from Buffett's vast collection of investing nuggets. Investing success has been linked to a lot of things, many of them contradictory. All that aside though, if you find it truly exciting to open up a 10-K to learn about a business, it is going to be a lot easier to get the rest of the pieces to fall into place.
One distillation of Buffett's investing approach is: (1) Understand what you are buying. (2) Do not overpay for it. (3) As long as the case for the investment remains intact, hold on. For those working with smaller amounts of capital, and thus have some maneuvering room, an addendum to rule #3 might be that if a better use of your capital comes along it is OK to redeploy it -- just do not fool yourself.
WHAT MORTGAGE MESS?
The big brokerage firms skewered themselves on fancy mortgage derivatives. TD Ameritrade sticks to stocks and bonds.
Keeping your head while all around you are losing theirs is not just a challenge for financial market investors (or clothing buyers). Fads and fashions and the siren call of the quick buck await business owners as well.
Especially, it seems, finance-related business owners. And in the case of finance, successfully keeping one's head pays off in spades once the fashions of the day run their course. With clothing, when the fever breaks you are just left with a pile of largely worthless junk -- not fatal as long as it was not purchased using heavy credit. In finance, buying on credit is part and parcel of the business plan. Once the fever breaks you may well be bankrupt.
Discount brokerage Ameritrade could have leveraged up their balance sheet with all manner of exotic loans and derivatives thereof, or reached for extra yield by increasing the riskiness of their asset profile, or invested in a lot of infrastructure to originate and service such loans. Wall Street analysts were evidently profligate with their advice to do exactly that. Ameritrade instead stuck to their business plan of being a low cost provider of trading services, augmented by higher margin fee businesses that logically fit with the main business. Too simple for derivative-addled Wall Street minds. Now that the exotic loan business has imploded, "We haven't had to dodge any bullets because we didn't get in front of them to begin with," says Ameritrade's CEO.
Implementing the plan has not been a risk-free undertaking, and there have been some bumps in the road. But it is an interesting story, and most everyone could find some lessons in it.
A year ago the guys at TD Ameritrade (AMTD) were catching a load of grief on Wall Street. Analysts took them to task for not expanding the discount brokerage into red-hot retail markets like mortgages and boat loans. Hedge funds SAC Capital and Jana Partners bought 8% of the firm and then slammed it for squandering a chance to merge with rival E-Trade Financial Corp.
These days it is the chief executive, Joseph Moglia, and his low-key staff who look like the sly ones. As E-Trade struggles to recover from a near-death brush with the mortgage meltdown, and big wirehouses oust their bosses for losing billions, TD Ameritrade is basking in the glow of a share price up 14% over the past year. "We haven't had to dodge any bullets because we didn't get in front of them to begin with," says Moglia, a brusque 58-year-old Bronx native with an unwavering faith in his unadorned game plan.
Ameritrade's financial results would make Goldman Sachs proud. Revenue (net of interest expense) rose 20% from a year earlier in the December quarter to $642 million. The $357 million pretax net gave TD Ameritrade an industry-leading profit margin of 56% and a return on equity of 42%. The company has a solid balance sheet with $1.5 billion in low-interest debt and a half-billion dollars in cash, which could come in handy for acquisitions -- perhaps even of E-Trade's brokerage business. Analysts at Credit Suisse expect Ameritrade to earn $1.5 billion before interest and taxes this year.
Client balances recently topped $300 billion, thanks in part to $9 billion in inflows last quarter. That included $2 billion the firm lured from E-Trade with cheeky ads stating, "The markets may be volatile. Your brokerage doesn't need to be."
TD Ameritrade is a well-oiled machine for a simple reason: Trading is a game of scale in which the company is now the online leader, handling 346,000 transactions a day in January. ... Once Ameritrade covers its fixed costs, it pays only pennies to handle additional orders, which bring in $12.84 each. The other, fee-based side of its business involves managing long-term investor assets in exchange-traded funds, mutual funds and money market accounts. This lucrative business throws in 58% of revenues.
Rather than launch risky or far-flung ventures, management has used its excess cash to reward shareholders with a special $6 dividend and share buybacks. "We're not willing to let a small group leverage our balance sheet or take big proprietary risks that can blow up the franchise," says Moglia. "We're happy to make a reasonable spread."
Moglia and his staff wear their midwestern persona as a source of pride and competitive advantage. Their headquarters are on the outskirts of Omaha [Nebraska, Warren Buffett's home town], sandwiched between a nursery and a Kellogg's cereal factory that permeates the area with the aroma of Cocoa Krispies. A few miles away 1,000 people work at a call center in a former Younkers store inside a shuttered mall. At $5 per square foot annually, the rent is 1/6 of what such space fetches in costlier cities.
The name of the company's founder, J. Joseph Ricketts, shows up in this [Forbes annual billionaire's] issue on page 156. The native Nebraskan founded Ameritrade in Omaha in 1971 and began offering discount trades a few years later when commissions were deregulated. He launched online trading two decades later, took his firm public in 1997 and built a national name during the dot-com boom by offering cut rates, bare-bones service and Stuart, a ponytailed spokesman who taught his boss how cool it was to trade online.
As investors fled e-brokerages amid the tech bust, trading volumes evaporated, along with 87% of Ameritrade's market value. Ricketts recruited Moglia in early 2001, at a time when the company was losing money and many analysts figured it would go the way of eToys. ... Moglia began by cutting 450 jobs and shutting losing operations in Korea, Germany and elsewhere. He also began scavenging the bombed-out landscape for acquisitions that would add trading volume. The first big one came four months after he arrived, when Moglia agreed to pay $154 million in stock for National Discount Brokers, an outfit Deutsche Bank had paid $823 million for 80% of eight months earlier.
The following spring he won a bidding war for Datek, raising fears that he'd overpaid. As the stock market began to recover later that year, however, Datek's software for active traders began to garner a new following with its streaming data, the same bleeps and bongs as on institutional trading screens and best-execution order-routing software.
After spurning a hostile bid from E-Trade in 2005, Moglia did his biggest deal yet, agreeing to buy online brokerage TD Waterhouse. The deal left former parent Toronto-Dominion Bank with a 33% stake (it has since increased that to a predetermined maximum of 39.9%).
It did not all go smoothly. TD Ameritrade's most moneyed clients are the 4,300 registered investment advisers who control $76 billion and clear millions of dollars of their clients' trades at a pop through the firm. Following the TD merger, the advisers' clients began receiving Ameritrade statements showing zero balances. Swamped with calls, the company's phone reps left many advisers waiting hours to get through and clear up the mess. ...
These days the boss is big on beefing up account sizes and wallet share. Ameritrade's own clients entrust a mere 12% of their investable assets to the firm, versus 60% claimed by Schwab. The average $50,000 account balance among TD Ameritrade's 6.5 million accounts compares with Schwab's roughly $300,000. "Eighteen months ago we didn't ask customers, 'Are you okay with your retirement plan? Your fixed income?' Now we ask those questions," he says.
Moglia, who shares the occasional steak dinner or poker game with fellow Omahan Warren Buffett, is rolling out investment tools like WealthRuler for retirement planning. He is also making a bigger push into the adviser market. He paid $225 million in February for a Fiserve unit that brought in $25 billion in assets held by investment advisers and retirement plan administrators.
So what could go wrong? A plunge in the stock market that drove down trading volume. Or an acquisition gone bad. With its solid performance and middling market cap of $11 billion, TD Ameritrade could also become buyout bait one day. But given how things might have turned out that is not a bad problem to have.
TAIWAN ETF: A BET ON IMPROVED CHINA RELATIONS
Taiwan's stock market has lagged the bubble-like returns of its fellow Asian stock markets this decade. There are a variety of good "reasons" for this, but the upshot is that the market looks relatively (not absolutely) cheap. A pending presidential election could bring in a new administration that favors a more conciliatory approach to mainland China, which in turn could be a catalyst for a revalution of the Taiwanese market. This is not a no-downside bet by any means. For example, the iShares Taiwan ETF -- an easy way to exposure to the market as a whole -- is heavily exposed to the capital-intensive, cyclical semiconductor chip business.
Global markets shuddered on Monday, as Asian stocks plunged after the Federal Reserve's emergency-meeting rate cut and the sale of Bear Stearns (BSC). Taiwan was no exception, with the country's Taiex index falling almost 2%, bringing it down nearly 8% since March 6. Prior to the most recent crisis ... Taiwan's markets were in relative rally mode compared to much of the rest of the world.
When trading closed on March 14, iShares MSCI Taiwan Index ETF (EWT) was down 0.8% year to date, still remaining more than 10 percentage points above the MSCI EAFE index. It was also the best performer for one month, three months, and year to date among Pacific ex-Japan ETFs tracked by Morningstar. Through March 14, EWT held a 17.9% year-to-date advantage over the category average and was nearly 12 percentage points better than the next best fund, iShares MSCI Australia (EWA). ...
Like Taiwan's markets, EWT's 126-stock portfolio is heavy on information technology, with nearly 55% of the fund's holdings allocated to that sector. Top holding Taiwan Semiconductor (TSM), consumer electronics maker Hon Hai Precision Industry (HNHAF.PK), and LCD screenmaker AU Optronics (AUO) make up 22.7% of the portfolio, sandwiched around the country's top financial holding company, Cathay Financial, and a few materials companies, including China Steel and two plastics makers.
Taiwan took a nasty beating when the tech bubble burst early in the decade, and it has lagged Asian and emerging markets ever since, in part because the 8-year leadership of Chen Shui-bian, whose term will end this week, saw the country pull further and further away from China just as the Asian giant's economy and markets skyrocketed.
Taiwan's presidential election will be held on March 22, and Ying-jeou Ma, a pro-business candidate with a more favorable view of China than the current regime has, is expected to win. That has brought new hope -- and new money -- to Taiwan's markets. ...
Last week, the Wall Street Journal also posited that Taiwanese stocks may be cheap, trading at 16 times reported earnings vs. 19 times for Hong Kong shares and 22 times for overseas-listed China stocks. The Taiwan dollar has been gaining since legislative elections in January and has hit a series of 8-year highs against the weakening U.S. dollar.
The Journal quoted several analysts bullish on Taiwan, including Andrew Foster of Matthews International Capital Management, a San Francisco firm specializing in Asia. "I've always seen Taiwan as a peripheral market if you're trying to invest in the China story," he said. "And Taiwan clearly hasn't met its long-term potential in terms of economic development."
At the moment, many Taiwanese firms—including Cathay and Taiwan Semiconductor -- are heavily invested in China, but the Taiwanese government limits what they can do there and essentially bars Chinese investment on the island. Whether Ying-jeou Ma will be able to change that is unknown, but if he does, Taiwanese stocks could benefit.
All that said, EWT carries plenty of risk, as evidenced by a three-year standard deviation of 20.49. The fund's heavy exposure to single-country risk, highly cyclical chip stocks, and other tech names warrants caution. ...
Should Taiwan indeed get a bounce from improved relations with China, or from lower valuations after trailing many markets for much of the decade, EWT could be the place to be. The fund holds more than 70% of assets in large- and medium-cap stocks, according to Morningstar, giving it much deeper exposure to Taiwan.
For now, EWT looks like a bet on improved relations between the two countries and on a market that has not kept up with its red-hot neighbors during the long post-2000 rally. There are some signs that is a possibility, but as the last few months -- and even the last week -- show, investors should not expect the ride to be a smooth one.
TIMBER REIT POTLATCH CAN HELP GROW YOUR PORTFOLIO
For not so obscure reasons (think "housing"), lumber-related stocks have not performed very well over the last year. But several studies have indicated that timberland is an asset that has generated returns over time comparable or superior to stocks, while the returns have been almost totally uncorrelated with those of equities. One might well consign this later point to the realm of strictly academic theoretical concerns -- until stocks tumble 25%.
The timberland REITs are an interesting way to play the asset class. The major ones sport 4%+ yields while their principle assets are a classic inflation hedge. Jonathan Callahan, editor of The Cheap Stock Hunter blog (he appears to post about as frequently as Terrence Malick directs a movie), makes the case that Potlach Corp. is the best value among the timber REITs.
If a tree falls in the woods, does Wall Street hear it? Clearly not, judging by the wide discounts to intrinsic value being awarded to names in the Timber REIT sector. Based on my analysis of private market value, the three largest timber REITs, Plum Creek (PCL), Rayonier (RYN), and particularly Potlatch Corp. (PCH) offer investors a wide margin of safety, relatively stable cash flows, and a healthy dividend yield.
Perhaps the most compelling argument for an investment in timber lies in the risk reduction benefits that timber can add to a growth focused portfolio. Backtesting 20 years of data from the NAREIT Timberland Index, in addition to a portfolio of U.S. stocks, international developed, emerging markets, and bonds reveals remarkably low correlation, while generating long-term returns of almost 14%. The correlation with equities was less than 10%, providing "bond-like" diversification, with returns that would be expected from smallcap or emerging markets. ...
Many highly regarded asset allocation gurus, such as David Swensen, who manages the Yale endowment, have been long time proponents of adding real assets, such as timber, to a well diversified portfolio. That said, as of this past December, the average institutional portfolio only held about 1% of their assets in timber, a far lower allocation than the efficient frontier would suggest as optimal.
Within the Timber REIT sector, one of the more attractive companies is Potlatch Industries. Potlatch owns about 1.7 million acres of timberland in Arkansas, Minnesota, and Idaho. The company is vertically integrated with higher margin businesses such as resources (timber harvesting) and real estate sales, offset by its lower margin, downstream businesses such as wood products (lumber), pulp/paperboard manufacturing, and consumer products (off-label tissues). This provides the company with numerous growth levers and allows them to more effectively manage volatility in its business. For example if timber pricing is weak, the company may delay its harvesting activities, choosing instead to generate cash with its manufacturing operations and real estate sales. Importantly, there is minimal opportunity cost when the company delays its timber harvest as trees continue to grow biologically. On average, trees grow between 3-6% per year.
After recently filling the CFO post with Eric Cremers, who recently orchestrated the split-up of Albertsons, it is clear that the company is focused on creating value for shareholders. Based on my analysis, there is plenty of value that can be monetized. Based on about 30 private market value transactions over the last 5 years, U.S. timberlands have been sold at roughly $800 per acre. The most recent data, published by industry journal, Timber Mart South, indicates timberland transactions have been averaging $1400 per acre.
Lets be conservative and use the 5 year average. The company also has 225,000 acres of HBU land (or higher or better use land) that the company conservatively believes can be sold at $2,000 to $4,000. After conferring with industry sources, and considering that competitors Plum Creek and Rayonier value their comparable HBU land at $4,000 to $10,000, using $2000 per acre as a base-case scenario should provide a margin a safety in the analysis. Assigning these values to the 1.5 million timberland acres and the 225,000 HBU acres, subtracting debt, and applying a trough 6x EBITDA multiple to the the manufacturing businesses implies a total enterprise value of about $56 per share for Potlatch. At its current $40 stock price, the risk/reward is quite favorable. Furthermore, a dividend yield of 5% should offer investors a healthy stream of income as we patiently await for catalysts to develop and the intrinsic value to be realized.
The stock is closer to $43 than $40 as this is written, with a yield of 4.8%, but nevertheless remains an interesting inflation hedge and yield play -- not your typical combination. The $56 a share valuation looks relatively conservative, i.e., not based on the pumped-up, pre-credit crunch valuations ca. 2005-06. Ideal would be to be able to buy in at 2/3 of that value, or around $38 -- which it did reach early this year. Worth watching.
MONEY MANAGEMENT FIRM ALLIANCEBERNSTEIN’S M.L.P. A HIGH YIELD IDEA
The money management business becomes a nice business once assets under management (AUM) are high enough to cover overhead and salaries. Capital investment requirements are negligible, there is no inventory to speak of, and receivables are of high quality and are paid off quickly, ergo most net income shows up as free cash flow. Fee income is proportional to AUM, so some care should be exercised in one's timing and assumptions when buying into the money management business. For example, a money management firm whose reputation depended on its expertise in technology stocks in the late 1990s would have seen AUM subsequently plunge, both as the share values of its accounts' assets fell and as clients fled due to the poor performance.
AllianceBernstein is a major institutional money management firm with assets under management (AUM) of around $750 billion of late -- exact amount depending on market fluctuations. Its master limited partnership units (symbol: AB) trade on the NYSE, and yield around 6.6% as this is written. The units trade $30 off their high at around $65 as investors have evidently worried that net income will fall with the stock market. This may well be true, but as usual a good question is whether things have been taken too far on the downside. This article argues that this was indeed the case at a $5/unit lower price.
A word on MLPs: Their units trade like shares on stock markets. Like any limited partnership, they pass their income directly through to the unit holders, avoiding tax at the company level. Come tax reporting time this can be a pain, depending on how complicated the K-1 form is. If you fill out your own forms expect to spend some extra time figuring it out. (Holding the units in a tax-deferred account like an IRA does not necessarily avoid the problem, due to the "unrelated business income" rules.) Because money management firms have so little need for retaining their earnings, for reasons explained above, the MLP structure makes economic sense as a way of avoiding the double taxation that would occur under a corporate structure.
The recent market turmoil has hit shares of financial services firms very hard. As such, many fine stocks are back "on sale" right now. ... AB is one of the largest institutional money management firms with year-end 2007 Assets Under Management [AUM] of $800.4 Billion. With the crappy market action to start this year AUM dipped to $751 Billion as of February 29, 2008.
Alliance Bernstein is not Bear Sterns. They do not hold any bad paper, they do not own a bank or make mortgage loans. They strictly run money. About 25% of their assets are in fixed income management of customer funds. Total debt stood at $163 million as of last September against over $1.9 billion in treasury cash. Earnings and distributions to unit-holders fluctuate with AUM changes and market performance.
AB has shown excellent long-term results. Earnings/unit were $1.66 in 1998 and grew to $4.32 in 2007. Distributions per unit went from $1.60 to $4.75 during that 10-year span. Revenues per unit kept pace going from $5.77 to $17.25. Value Line gives AllianceBernstein a financial strength rating of $B++ and an earnings predictability score of 75th percentile [very high for this industry].
With market conditions bad right now the AUM figure has regressed and the expected distribution for 2008 is estimated to be $4.45 versus last year's $4.75. At Wednesday's $59.53 price [$64.44 at Thursday's close] that provides a current yield of 7.47% [down to 6.9%] -- about double the best CD rates available today. Even if the units stayed unchanged in price this could be a reasonable return within a tax-sheltered account.
I think the underlying value is much higher. AB units have had a very steady normalized P/E of around 15. In hot markets it can go higher and in bear markets it sometimes goes lower. At present, AB's P/E is just 13.8 times trailing earnings -- its lowest level since the horrible bear market of 2002. At the exact lows in 2002, AB units were 11 times earnings and yielding 9.9%. Buyers back then saw their units go from $23.20 to $94.90 in under 5 years -- this on top of AB's excellent annual cash payouts.
If the markets continue to deteriorate AB units may well go lower. Whenever the markets pick up these units have good upside. The yield makes the waiting easier. ... A company director thought AB cheap enough to buy 5000 units in the open market on March 10, 2008 at $58.10 for a $290,500 investment. ... AXA Financial holds around 60% of the units and is a 1% General Partner.
The price is not a "wade in with both feet" bargain, especially after the $5 rebound, but it certainly is worth putting on one's watch list.
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