|W.I.L. Home Page||Offshore News Digest Home|
|Sign Up||Finance Digest Home|
CONFESSIONS OF A SHORT SELLER
Barron's interviewed successful short seller Douglas Kass. More interesting than the short ideas themselves is his approach, in effect the mirror image of a Graham and Dodd value buyer: (1) Know what you are selling, i.e., do your research; (2) diversify; (3) be a contrarian, which in this case means avoid stocks where short sellers are already heavily involved; (4) avoid leverage; and (5) be disciplined. Finally, one needs to be cognizant of the unique demands of short selling. Shorting requires a different skill set than buying, says Kass.
Douglas A. Kass occupies a special niche in Wall Street's pantheon of brains and wit. He is a short seller, and an outspoken one, at a time when most investors have abandoned the business of betting against stocks. After all, it is a tough way to make a living, and a short seller -- who sells borrowed shares in the hope of buying them back later at a lower price -- can get wiped out quickly, especially if there is leverage involved. Which there usually is.
Kass, 58, is founder and president of Seabreeze Partners Management in Palm Beach, Florida, a hedge-fund firm overseeing about $200 million in short positions. A veteran investor with a research background, he headed institutional equities at First Albany and later, JW Charles/CSG, in the early to mid-1990s.
So far, Kass and his crew have made good on their goal of providing returns that are not highly correlated to the stock market, while eschewing leverage has helped to reduce the firm's investment risk. As of April 30, flagship Seabreeze Partners Short fund was up 16.5%, excluding fees, versus a 5.6% loss for the S&P 500. Since inception in January 2005, the fund is up 40.7%, versus a 15% gain for the S&P. For more about how Kass shorts -- and what -- please read on.
Barron’s: Why short, Doug? What got you interested in that line of work?
Kass: Short sellers are an endangered species, like the dodo bird. The dedicated short pool totals about $5.4 billion, according to Knowledge@Wharton, a Website. That is roughly one-seventh the size of the Fidelity Magellan Fund. It is also a tiny sliver of the approximately $1.9 trillion of hedge-fund assets. But it provides a huge business opportunity for Seabreeze. My friend Jim Cramer's mantra is that there is always a bull market somewhere. At Seabreeze we consider ourselves the anti-Cramers. We say there is always a bear market somewhere, and it is our job to find it.
In the past two decades of the bull market, on average about 58% of the issues on the New York Stock Exchange have advanced and roughly 42% have declined every year. The 42% provides us with fertile opportunities for secular, cyclical and thematic shorts. Short selling is the least served and most uncrowded hedge-fund strategy out there.
Kass’s Pans Company Ticker Recent Price Berkshire Hathaway BRK.A $121,510 Colgate-Palmolive CL 72.30 Kellogg K 51.53 General Mills GIS 62.08 Danaher DHR 80.07 Henry Schein HSIC 56.21 Patterson Cos. PDCO 36.09 Fastenal FAST 51.66
What makes short selling so difficult to do effectively over a long period?
The objectives of a long buyer and a short seller are similar. Both want to produce uncommon returns by taking common risk -- typically by developing a variant view. Many believe short selling is a mug's game, but I do not, and thus far our results at Seabreeze have supported our opinion. But it is essential to maintain a disciplined short-selling strategy because, remember, risk and reward are asymmetric in selling stocks short. An investor can make only 100% if correct -- that is, if the stock sold short goes to zero. But you can lose an infinite amount if you are wrong as the stock keeps appreciating. And there is a gravitational pull of stocks higher over longer periods of time. So we use a very conservative approach to shorting.
Explain it, please.
First, we are diversified across company and industry lines. No individual security exceeds 2.5% of our partnership's assets and no industry sector exceeds 20% of the assets. We will have 35 to 40 holdings at any given time. Second, "Wee Willie" Keeler, a .341 lifetime hitter who played in the early part of the 20th century, liked to say he "tried to hit 'em where they ain't." We try to do the same by being creative in our stock-selection process.
In what ways are you creative?
We strenuously avoid stocks whose short interest is high relative to the float, or companies whose shares have large short positions relative to their average daily trading volumes. Many short sellers have made the mistake of shorting valuation and have blown up during short squeezes. Avoiding them allows us to sleep at night and allows time for our negative fundamental catalysts to develop.
We also mitigate risk by avoiding leverage [borrowing to enhance the size of a position]. Historically, short sellers have taken concentrated positions, often in companies with small to medium capitalizations, and then used -- and abused -- leverage. That is a recipe for disaster, particularly when they select investments with too many shorts. The average market capitalization of our holdings is more than $10 billion. Shorting large-caps is another way to control risk.
One of the latest trends in asset management is 130-30 funds, in which the manager shorts 30% of the portfolio and uses the proceeds to buy more long positions. What do you make of this idea?
These funds are a silly gimmick and their half-life will be short. Nearly every long/short manager thinks he is equally facile on the short side as the long. Shorting requires a different skill set; you have to have the mindset of an investigative reporter and be a skeptic at the core. Also, many 130-30 funds use exchange-traded funds [ETFs] as a proxy to short. That is a cop-out and a poor way to produce excess returns.
What are your current investment themes?
Right now our emphasis is on the consumer sector. We have found an undiscovered sector that has limited short interest, namely the dental industry. We would not look at traditional retailers like Target or Kohl's, or short the Retail Holdrs [Merrill Lynch Retail HLDRs [RTH], a retailing ETF. ETFs are the opium of the hedge-fund community because they are an excuse for lazy hedge-fund managers not to go belly to belly with companies and their managements. A dependency on ETFs as a shorting tool is simply an excuse for not doing hard-hitting and creative research.
But why are you so bearish on the U.S. consumer?
The consumer is spent up, not pent up, and more levered than during any period in history. That is one of the structural problems facing the economy. At the same time, job growth is declining and real disposable incomes are pressured as inflation literally is eating away at the consumer's buying power. It is frightening that the consumer has entered this economic downturn with the most levered position in history. On top of that, we are facing four consecutive months of job losses. We have seen the depreciation of the two most important assets, home prices and equities. Consumer confidence is at a 26-year low. The availability of credit continues to be a problem that will plague the economy for a while. Inflation, the cruelest tax of all, is rising as energy and food prices, in particular, are soaring. And the first-quarter GDP report contained a number of ominous signs that the consumer is spent up while the housing depression continues apace.
So, which consumer stocks are you shorting?
Colgate-Palmolive, Kellogg and General Mills, which are trading at 17 to 18 times earnings, but have secular earnings-growth rates of 7% to 10%. These companies historically are seen as recession-resistant, but we doubt it. All three are aggressively lifting their selling prices in response to huge cost increases, but demand is starting to suffer as private-label companies and generics gain market share. Demand elasticity, or sensitivity to changes in prices, in toothpaste, soaps and other consumer products has begun to surface in the current recession, as consumers trade down to private-label products.
You are short Berkshire Hathaway [BRK.A]. Betting against Warren Buffett in the past was a costly move, as evidenced by Berkshire's stellar performance since the 1960s. Why do so now?
This recommendation is sure to be controversial. For a counter-opinion, see the next posting below.
No. 1, there will never be another Warren Buffett. I respect and admire him considerably, but in part because of the lucrative compensation set-up in the hedge-fund industry, the investment landscape now is inhabited by a lot more smart and aggressive managers who comb for value -- far more than there were 10, 20 or 30 years ago. Berkshire Hathaway's outperformance versus the market has been narrowing in the last decade, and I expect that will continue. Investors are going to dump the shares if Buffett is no longer at the helm, though I am not signaling that he plans to step down anytime soon.
What else concerns you about Berkshire?
More than anything, I am short Berkshire because of Buffett's recent investment-style drift. In the past five years, Buffett frequently called derivatives "financial weapons of mass destruction." Yet, very much out of character, he immersed himself in several large and thus far unprofitable derivative transactions, leading to an unrealized $1.6 billion pretax loss in the first quarter. I am also short Berkshire because the salad days for insurance, which is the cornerstone of Berkshire's business, are over. Also, Berkshire's premium valuation seemingly has been a byproduct of the credit crisis, and the perception of the company as a safe haven. Berkshire's shares might underperform as some of the deflated financial companies regain their footing. And Buffett is substantially exposed not only to financials -- he owns large positions in Wells Fargo, Bank of America and American Express -- but also to a weakening housing market through his ownership of Clayton Homes.
You mentioned one of your short themes is the dental industry. What is behind that?
We are short three companies in that space: Danaher, Henry Schein and Patterson Cos. The sector is exposed to a weakening consumer and it is not heavily shorted, something we look for. My father was a dentist, and through him I know a great many dentists and CPAs whose clientele consists of dentists and doctors. We have made extensive channel checks of practitioners around the country. One thing we have learned is that elective cosmetic dental procedures are starting to tail off dramatically.
What was the bullish case on these stocks?
Dental distributors and original-equipment manufacturers are seen by many as defensive investments with minimal exposure to recessionary pressures and health-care reimbursement risk. The reality is that nearly half of the roughly $96 billion in annual dental spending -- which is basic dental care and cosmetic dental surgery in the U.S. -- is paid out of pocket. What is more, there are substantive signs that a slowdown in dental care has begun, especially in weak housing markets around the country. And there are signs that third-party financing is becoming generally less available. At the same time, there is evidence dental consumables and dental equipment like chairs and X-ray machines are tailing off as dentists have begun to cut back.
Do you have a favorite dental short?
Yes, it is Danaher, which is not typically thought of as a dental company. It is actually a diversified industrial company, but dental products account for roughly 25% of revenue. What caught my eye in Danaher's latest quarter was that they reported flat core dental equipment and consumable sales. Danaher has a trailing 12-month price/earnings ratio of about 20. In contrast, the P/E ratio of General Electric [GE], another diversified industrial company, is under 15. This is surprising since GE consistently has had more rapid organic growth overall than Danaher, and organic growth is the key sentiment driver and metric that moves the diversified-stock group.
How about one more short idea?
Fastenal [FAST], whose stock has risen from 33 in late January to around 50. They operate about 2,200 stores in nonmetropolitan areas selling an array of services and industrial supplies, including threaded fasteners. What intrigues me about this company, in looking at the second half of the year, is that their sales growth is going to be increasingly difficult to sustain, and a profit miss will likely follow. Earlier this month, Fastenal announced its daily sales in April dropped by half a percentage point on a sequential basis. That compares to an 11-year average gain of 0.5%. Companywide sales in May could be several percentage points lower than the typical seasonal growth.
Thanks very much, Doug.
BERKSHIRE COULD HIT $200K WITHIN TWO YEARS, SAYS ALAN ABELSON
Anyone recommending the sale, never mind the short sale, of Berkshire Hathaway -- as Doug Kass does in the piece immediately above -- is sure to draw out a contrary recommendation from the large crowd of Warren Buffett adulators. When the opposing opinion comes from legendary Barron's front page editor Alan Abelson, however, one had best at least give it a good read. And if you are reading Abelson's "Up and Down Wall Street" column anyway, you may as well read his skeptically-inclined market commentary as well.
Don't look now, because you don't want to frighten her. But unless these rheumy eyes deceive us, Goldilocks is back, big as life and wearing that same goofy smile.
No, we have not been drinking; honestly, not a drop. And, of course, like every other sentient being, we were sure the bears had finished her off. But, obviously, she is made of sterner stuff than we gave her credit for. Either that, or the bears have gotten finicky about what they eat.
And we are not alone. A whole host of happy people have spotted her recently, and they have been greeting her in the customary fashion by which natives in these parts celebrate good news -- by staging whacky little stock-buying sprees.
On the face of it, this would not seem the most propitious time for someone of Goldilocks's rather repugnantly cheerful disposition to return. Even a flighty bird as innately upbeat as she needs some stimulus to engage in serious chirping. And frankly, a glance at the sere economic landscape reveals zilch excuse for even a tentative positive peep, much less a joyous fusillade of chirps.
Manufacturing, supposedly reviving after all these mournful years of decline, thanks to the elixir of a weak dollar, instead is still tanking, with industrial production tumbling 0.7% in April. Consumer confidence, meanwhile, gives an impressive imitation of being in free fall. The latest reading of the good old U. of Michigan survey hit a 28-year low, while also indicating, we suspect to Ben Bernanke's horror, that expectations for inflation are briskly on the rise. Funny, isn't it, how $128-a-barrel oil, $4-a-gallon gasoline and a most unappetizing spiral in food prices will get people a tad antsy.
And although a thoughtful lad or lassie conjured up some suspiciously improved numbers in housing, we would suggest waiting for the inevitable revisions, which somehow these days tend to be downward, and often viciously so. Foreclosures, at last count, were up a tidy 65% compared to a year ago; home prices continued their downward spiral, while inventories bulge afresh.
To top it all off, Standard & Poor's reported that first-quarter earnings of the 500 companies that make up its index were down an awesome 25.9% from the like three months last year.
OK, then, but how come all of a sudden so many people are whooping up the return of Goldilocks? Maybe it is something in the water. Or, perhaps, it is a touch of mass delusion. Careful, though, it could be catching.
Or maybe with credit availability on the rise and the "Bernanke Put" firmly -- if delusionally -- providing downside protection, speculators figure there is no harm in buying.
A perennial favorite among the many delights this estimable publication serves up to its voracious readers week in, week out, is the Q&A with an investment luminary or some earnest aspirant who seems to have all the makings necessary to achieve that eminent state. The relentless questioner prepares for the grueling session by having her or his usual breakfast of a keg of nails with strawberries, and then digesting every key fact that can be discovered about the lucky soul chosen to occupy the hot seat, ranging from the personal (is he kind to animals -- the four-legged kind, that is?) to the professional (is he really the ace stock picker he is reputed to be, or does he get his ideas from some twisted genius he keeps chained in the attic, supplied only with scraps of food and The Wall Street Journal?).
These interviews are intended to give the skinny on how the investment pro sizes up the markets and how he is committing the capital entrusted to his tender, loving care, in hopes of enhancing our readers' knowledge and possibly (but not guaranteed) their material well-being. For enduring the ordeal and fielding a relentless torrent of questions -- including more than one he really does not want to answer -- said pro, besides sheer altruism and a natural desire to show the world how smart he is, hopes to corral a few more investors, while doing something nice for his best friend, which happens to be his portfolio.
After dutifully filling you in on the back story (journalese for the real poop) of our question-and-answer features, we urge you, if you have not already done so, to be sure to peruse this week's Interview with Doug Kass [posting above], an old friend and reliable source (we trust that noun will not immediately trigger a subpoena). Doug, as you no doubt know, but we will tell you anyway, works the dark side of the Street. Even worse, his hedge fund restricts itself exclusively to selling stocks short. Despite that, he is a very amiable sort, quite bright and with a sunny disposition (a description that is bound to get him in Dutch with his fellow bears, but our job is to out the truth).
As the piece demonstrates clearly, Doug brings a sharp eye and reasoned analysis to his negative view of this or that company and its stock. Most of the time, being partial to the ursine [bearish] view, we found ourselves in harmonious sympathy with his take. But most does not mean all, and among our rare dissents is to his thumbs-down verdict on Berkshire Hathaway.
It is not that we think there is anything sacrilegious about shorting Berkshire or, for that matter, taking issue with Warren Buffett. And Doug raises some intriguing demurs. Indeed, Barron's ran a negative piece on the company back in December that expressed a number of the same reservations. There is, however, a bullish case for Berkshire (all things considered, the wonder would be if there weren't), and we find it more persuasive than the bearish one.
That case is succinctly and graphically (literally, with nifty charts and tables) laid out in a recent report by T2 Partners [report summary here], a hedge fund we took flattering note of a couple of months ago [interview here].
The authors do not blink the risks -- an absence of catalysts to spark a rise in the price of the shares, the ever-present bugaboo for any insurance company, no matter how well-run, of a major catastrophe, made by man or Mother Nature in one of her less benign moods; that Buffett is getting on in years (who isn't?); or, heaven forbid, that the company will not be able to find a suitable place or places in which to deposit its enormous cache of cash.
None of these do they find extraordinarily daunting. Warren Buffett, they believe, is in good health and the company, in any event, has a strong board and a succession plan in place. Moreover, at current prices, they reckon, there is little "Buffett premium" in the stock.
Even absent a particular catalyst, T2 argues, Berkshire's intrinsic value will continue to grow nicely. And, as to a possible dearth of inviting investments, that hardly strikes them as a permanent or terribly serious impediment. "There are worse things," as the report wryly observes, "than sitting on a lot of cash," and, it points out, Buffett has said that he will distribute the loot to shareholders if he does not think he can make fruitful use of it.
Meanwhile, for a truly big company -- with a market cap of $190 billion, total assets at last count of $281 billion, total equity of $119 billion and book value per share of $77,014 -- it has been enjoying quite impressive growth, especially where it really counts. ... [I]ntrinsic value -- which T2 calculates as investments per share, plus 12 times earnings per share excluding investment income -- at the end of last year ran somewhere between $156,300 and $158,700 a share, or comfortably more than double 2002's $70,000.
The bottom line, to invent a cliché, is that Berkshire Hathaway, by T2's reckoning, is roughly 20% undervalued. Assuming 10% growth in the intrinsic value of the business and a cash buildup of $6,000 per share over the next 12 months, they are looking for total intrinsic value of $178,700 per share, or a 46% premium to today's price of the stock. And peering further out, within two years, based on the same reasonable assumptions of growth and cash additions, the magic number could rise to over $200,000.
The defense rests.
Fair enough. If you can buy a stock run by one of the best money managers and businessmen in history at a 20% discount to intrinsic value, and that value is growing at 10% a year, then it is a limited risk buy.
As a postscript to the above, we should take due note that the upbeat assessment on Berkshire Hathaway is nestled in a follow-up by T2 to the masterful analysis of the collapse of housing and credit we cited back in March. ...
The current report is more an extension, update and elaboration than a mere follow-up to the earlier version, as you might infer from the fact that it's twice as long as its predecessor. The basic, stark theme remains unchanged, as evidenced by the title peremptorily declaring in big, boldface letters: "We are still in the early innings of the bursting of the housing and credit bubbles -- and how to profit from it." As well as, it might be added, not get killed by it.
Once again its chilling and informative message strikes us as well worth heeding, and we fully intend to provide some of the fascinating details in which the report abounds as soon as space and time permit. We can tell you, in case you are in a bottom-fishing mood, that the folks at T2 still think Ambac and MBIA are in deep doo-doo and Washington Mutual is decidedly not in good shape. At the very least, their cogent concerns are likely to make you put off fishing for another day.
WHERE THE FINANCIAL CRISIS IS HEADED NEXT
Barron's follows up its interview with short seller Douglas Kass, covered above, with an interview with hedge fund manager Sy Jacobs, who specializes in financial stocks -- a source of short sale ideas right now, Jacobs thinks. He believes the recent rally in financial stocks and the whole market is "a bit of a head fake that will prove to be a bear-market rally." But he has some interesting long ideas as well from the financial sector, including MGIC, the mortgage insurer. The stock has fallen from 70 to 12, which takes a lot of risk out of the situation.
Three years ago, hedge-fund manager Sy Jacobs told Barron's that serious trouble was brewing in the housing market, predicting that "the bursting of the housing bubble [would] be a dominant theme for investing in financial stocks in the next decade." He was right.
Jacobs, 47, is the founder of New York's JAM Asset Management, which runs two funds, both focused on financial stocks and closed to new investors. The larger entity, JAM Partners, follows a market-neutral, long-short strategy and has close to $300 million in assets. As of May 21, the fund's year-to-date total return, net of fees, was 9.6%, versus a 4.5% loss for the S&P 500. Its annualized return since inception in 1995 (through April 30) was 16.6%, compared with 9.9% for the S&P. The $45 million JAM Special Opportunities Fund invests in illiquid private-equity holdings. Jacobs' familiarity with financial stocks dates to the 1980s, when he worked as an analyst at firms like Salomon Brothers and Alex Brown. To find out where Jacobs sees new problems emerging in the financials -- surprisingly, they are not in the subprime arena -- read on.
Barron’s: You were early in detecting the serious problems in subprime mortgages. That turned out to be a great call.
Jacobs: About three years ago, we were worried about subprime specifically. And that view very much paid off for us as we were short a host of such companies. More than a year ago, in another interview with Barron's, we said subprime was already in a full meltdown mode, but the idea that subprime was somehow isolated was still popular. Our message was that the mortgage-credit tail was going to wag the capital-market and economic dog. That is coming to pass now.
Looking ahead, what do you see for the financials?
We believe the recent rally in financial stocks -- and for the whole market -- is a bit of a head fake that will prove to be a bear-market rally.
What is your premise?
After first ignoring subprime, people now are too focused on it and they are missing the broader storm coming -- that is the head fake. While the bursting of the housing bubble produced all sorts of headline-making losses for some, it is just starting to drag down the rest of the economy. Separate from subprime, you are seeing diminished ability for consumers to spend their home equity. The securitization market, which banks and finance companies use to get funding, has slowed. So we see consumer and business spending slowing; the economy will falter.
In a recent letter to your investment partners, you noted that you were very concerned about the health of construction loans. Could you elaborate on that concern for us?
I spent a week recently in California, visiting some troubled, or soon-to-be-troubled, banks. With home sales down so much, construction lending is becoming a problem. You have a lot of developers and home builders stuck with homes that are not moving. And they are sitting on lots that have loans against them. Subprime is such a small piece of the banking industry, but construction lending is a core product. If the housing market stays weak for much longer -- and it seems to be getting weaker -- construction-loan losses are going to be a big problem.
After the brutal real-estate recession that occurred in the early 1990s, there was a sense that banks had finally learned their lesson and would be much better fortified for the next downturn. I take it you do not think that is true.
I take a pretty cynical view of whether bankers have gotten smarter. We have had a real-estate bull market ever since the early 1990s. I think you are going to see the same thing again. The number of banks that get taken over by the FDIC and disappear may not be as high as it was in the late-1980s and early 1990s because there is strength in the energy patch now. But real-estate lending institutions are the bulk of the community-bank world, and I think you are going to see a lot of banks disappear.
What is your sense of the prevailing views of the financials right now?
People are trying so hard to believe that the Bear Stearns crisis in March was some sort of financial crescendo and represents the bell that gets rung at the bottom, as if that happens. But just because we got saved from what would have happened that Monday if Bear went down does not mean we are saved from all the forces that conspired to get Bear Stearns to the brink in the first place. Bear was not the sacrificial lamb to the market gods. It got knocked down by the same winds that are affecting everybody else. Credit destruction is a process -- not an incident. And avoiding that particular meltdown does not mean that things are getting better -- and yet that is how financial stocks in particular and the market in general have acted ever since.
You are a fundamental stockpicker, but are there any interesting trends you see in the financials?
One of our themes on the long side is that local plain-vanilla, over-capitalized community banks, especially thrifts, are in a position to gain back market share in the lending business. And they have real deposit franchises that they can fund themselves with. They have been losing market share to the Countrywide Financials of the world for a generation. Now, though, they are going to gain a lot of that market share back, because they suddenly have a funding advantage, relative to the larger financial firms that have been securitizing their loans. That market has been discredited. We are long lots of micro-cap ways to play this, but they are too illiquid to mention here.
Fair enough. Let's discuss some of your holdings, starting on the short side.
The first one is Wells Fargo, trading at 12 times 2008 estimates and 2.7 times tangible book. The group trades at less than two times book. The Wells Fargo name has a storied past and gets the Warren Buffett halo effect because he owns a lot of the shares. But if you look back at the last real-estate recession in the early 1990s, the Wells Fargo side, focused on California, had a lot of credit problems in the real-estate area, and the stock underperformed during that period. The Norwest side, which has more exposure to the Midwest, still has a lot of consumer-credit exposure. Of particular concern is the bank's portfolio of home-equity loans. ... [D]elinquencies and losses are already rising pretty sharply. But they also have a big unfunded exposure to the undrawn lines of credit. Also, despite their reputation for being conservative, their loan-loss reserve at the end of March was lower than their annualized charge-off rate for the first quarter. Given the prospects for rising losses that we see, that is not conservative. We think they will disappoint this year and next and, as a result, their premium multiple will go down.
Wells Fargo, however, is known as a well-run bank. One example of that is the company's reputation for being very effective at cross-selling its products.
We are most concerned with their exposure to home-equity loans at the top of a real-estate bubble. Remember that home-equity lines of credit sit on top of first mortgages. So if home prices depreciate, which is what is happening now, and a home goes into foreclosure, the home-equity line often gets wiped out. The first mortgage holder can get most of their money back, but the home-equity line absorbs all of the loss.
Let's move on to another short position.
BB&T, which operates in the Southeast. The stock trades at 11 times 2008 earnings and 2.5 times tangible book. It has bounced about 30% off its lows in January. They have gotten a pass because, to some extent, their core Carolina and Virginia real-estate markets were among the last to roll into home-price depreciation. So their non-performing assets are still low. But we listened to the Toll Brothers conference [call] recently. [Chairman and Chief Executive] Robert Toll graded the markets they operate in and he gave Charlotte an F-minus for current home-building conditions and Raleigh a C-minus. We are also concerned that they have 4% of their portfolio in Alt-A mortgages, which are between prime and subprime, and 20% in construction loans.
As with many of the financials, there was this big relief rally on first-quarter earnings. The thinking was these results were not so bad, but we think that more credit losses are ahead of us.
How about a different short holding?
Hudson City Bancorp, which is based in New Jersey. The shares have gained about 60% from their July 2007 lows and now trade at 21 times 2008 estimates and two times tangible book. They have a wholesale funding and asset-generation strategy, which allows them to keep expenses low.
Could you elaborate on that?
Basically, they borrow funds from the Federal Home Loan Bank of New York and use repurchase agreements. So they, in effect, purchase money, more so than relying on deposits. In addition, they buy most of their assets, usually through brokers. A big chunk of their assets are first mortgages and mortgage-backed securities. So for the most part, they are not a retail originator of loans, and they are benefiting from the steepness of the yield curve.
And, even with all that, they will earn less than a 10% return on equity this year, so I just do not get the valuation. Furthermore, when you have a wholesale business model, that means you do not really have a valuable franchise that another bank would pay much for. So a recent stock price represented approximately a 100% premium for their core deposits, which is how bank acquisitions typically get priced. And I do not think their deposits are worth nearly that much to a buyer. Everything looks great for them now, if you a call 10% ROE great. But they are not immune to credit risk in a recession and a weak housing market. I also think their loan-loss reserve at 0.15% is very low, relative to others'. When the Fed rate-cutting cycle is over, I do not want to own a spread play with credit risk that is trading at two times book.
Let's move to the long side of the ledger. What financial firms do you like?
One is Hatteras Financial, based in Winston-Salem, N.C. They are a mortgage REIT. We bought it in a private placement last year and it recently went public at $24 a share. They own all agency adjustable-rate securities, so there is no credit risk here. The market capitalization is about $630 million.
What is the biggest risk for this firm?
I would say it is yield-curve risk, but, trading at just over one times book value, it is well- factored into the price. We estimate that they will earn $4.50 to $4.75 a share from mid-year 2008 to mid-year 2009, once the IPO proceeds are invested. As a REIT, they will pay out all -- or nearly all -- of their earnings in dividends. So at 25 recently, the stock was sporting an expected yield of around 19%. We think the stock gets to 30 at least. Between the appreciation and the yield, it is a great total return.
Could you explain their yield-curve risk in a little more detail?
Like all mortgage REITs, they use leverage. They borrow at short-term maturities so they have been benefiting -- and continue to benefit -- from falling federal funds rates. It is very similar to what Hudson City is doing. They are benefiting from falling short-term interest rates because they use the wholesale market to buy funds. And yet, somehow, the market is paying two times book for that, whereas you can buy Hatteras for 1.1 times book -- and Hatteras earns a 20% ROE, versus Hudson's 10%.
Last pick, please.
This is a more controversial long holding: MGIC Investment, in which we used to have a short position.
What made you switch to the long side?
The stock is down from north of 70 in early 2007 to around 12, bringing its capitalization down to about $1.5 billion. One reason we like the company is that it was able to raise more capital recently, something its competitors have not been able to do. In March, they did a common offering that raised about $500 million -- so they have been able to raise liquidity and capital. At the same time, they are raising prices on premiums and tightening underwriting on the business now being written. The new business is being written based on lower home appraisals after the housing bubble burst -- and yet they are still showing good growth despite the fact that the whole industry has slowed down.
Our thesis is that once MGIC gets through writing down its old book of business, the new book will be very profitable and valuable. Even applying our bearish mortgage-credit outlook, we do not see more than another $4 or $5 per share of losses in the next two years. So current book value of $24 should bottom in the high teens in 2009 and start rising from there. They will be quite profitable after that, given their better margins and more conservative underwriting of the current book of business. The stock should trade upward of two times book. So we see the stock, currently at around 12, as a double-to-triple over the next few years.
A NEW INFLATIONARY EPOCH
We believe that Doug Noland, editor of PrudentBear.com's Credit Bubble Bulletin, continues to do some of the best research on this decade's money and credit markets. Combining a grounding in Austrian economic theory and a willingness to delve deeply into statistics and money flow numbers, he provides an invaluable complement to all those interested in augmenting their understanding of the ongoing debacle.
This week, Noland argues that while past rounds of credit inflation showed up in assets markets -- internet/high-tech stocks and junk bonds, and then housing and its progeny -- this round is showing up in commodities markets ... in spades. Previous bubbles were met by massive increases in supply in the effected markets, in the form of technology industry participant financial liabilities, fiberoptic cables, houses, mortgage securities, etc., with no small amount of help from Wall Street. This inflationary episode is outside Wall Street's control, and supply increases are not so readily forthcoming.
Noland concludes that “unlike previous inflation manifestations that tended to remain largely contained within asset markets, today's virulent energy and commodities inflation will spawn broad-based secondary price effects. ... The reality that powerful inflationary psychology has taken hold -- and that the world's leading central banks show no inclination to confront this worsening problem -- motivates tonight's title, ‘A New Inflationary Epoch’.”
Crude oil closed today [May 9] above $126. The most vitally important commodity in the world has now posted a stunning year-to-date rise of better than 30% and has now doubled in the past year. It is worth noting that during the 10-year period 1996 through 2005 crude averaged about $29 a barrel. It is now at four times this level -- and running.
I do not believe it is mere coincidence that crude has posted about a 30% y-t-d price surge at the same time as international reserve positions have expanded at about a 30% annualized rate -- to a stunning $6.769 trillion. Over the past 4 1/2 years, official international reserves have ballooned an unprecedented $3.92 trillion, or 138%. During this period, crude prices surged almost 300%. Chinese reserves ballooned more than 4-fold over this period to $1.68 trillion; India's reserve position tripled to $303 billion; and Brazil enjoyed a 4-fold increase to $189 billion. After beginning 2004 at $73 billion, Russian reserves have almost reached the half trillion mark ($493 billion). And in just the past year, OPEC reserves have inflated 42% to $490 billion. To be sure, the world is awash like never before in excess "liquidity" for which to bid up prices of critical tradable resources.
Especially since the Fed's credit system bailout, anticipating heightened global monetary disorder has been a key Credit Bubble Bulletin theme. The ongoing relevant question: How much would (in particular) China, India, Russia and Asia be willing to pay to procure adequate supplies of food and energy for their populations and economies? The obvious answer is "we have no way of knowing", but the market is becoming increasingly cognizant of the reality that today's massive international reserve positions provide virtually unlimited purchasing power. The bidding war has begun in earnest, in what increasingly appears A New Inflationary Epoch.
The CRB Commodities index closed today at an all-time high, sporting a y-t-d gain of 19% and one-year rise of 37%. The Goldman Sachs Commodities index, also ending at a record high, has gained 28% so far this year and 68% over the past 12 months. During the past year, soybeans have gained 85%, corn 72%, and wheat 68%. Prices for iron ore, steel and hard commodities have experienced similar price inflation. Gasoline prices are up almost 40%, natural gas about 50%, and heating oil about 90% over the past year.
A second important theme also emanated from the Fed's and Administration's desperate measures to sustain the U.S. bubble economy: one upshot of this gambit would be stubborn current account deficits and resulting ongoing growth in the increasingly destabilizing global pool of speculative finance. Not only do China, India, Russia, OPEC and others today enjoy ample reserves to bid up the price of global necessities, the leveraged speculator and sovereign wealth fund communities remain awash in financial resources that embolden huge speculative positions in various energy and commodities markets -- essentially "front-running" real economy purchases. It is turning into a battle royal -- and a prime dynamic of A New Inflationary Epoch.
Perhaps others recall the commercials that seemed to run nonstop on CNBC during the 1996/97 Asian crisis: Make easy currency trading profits from the collapse in the Thai baht, Indonesian rupiah, the Malaysian ringgit, and the South Korean won. I remember thinking at the time how repulsed Asian policymakers must be at the thought of retail U.S. speculators shorting their currencies, while their citizens and economies suffered through such devastating financial, economic, and social upheaval. Some leaders did spew vitriol and point blame at the hedge fund speculators. Yet the bottom line was that these policymakers and their broken systems were basically powerless to mount any response against speculation or other forces unleashed upon them, not to mention the IMF and other western policy strongmen.
The Asian and emerging economies "block" are anything but powerless today. To be sure, surging food and energy prices these days spur the most serious social unrest since the 1990s' "Asian contagion." The head of the Asian Development Bank this week warned that "soaring food prices" were hitting a billion poor Asians "very hard." The so-called "silent famine" became louder this week after a catastrophic cyclone ravaged Myanmar. Rice prices (in Chicago) jumped another 7% this week and have more than doubled over the past year. Throughout Asia, nervous policymakers are wasting little time in reacting to surging prices, hording and supply constraints for rice and other basic foodstuffs. As this crisis unfolds, the various policy responses and courses adopted by countries throughout this region will have a decisive influence on the general global economic and inflationary outlook. One might think in terms of polar-opposite effects to the "disinflationary" forces that arose from this same region during much of the '90s.
Responding to public outrage over the perceived role commodities speculation is having on food prices and heightened general inflationary pressures, the government of Indian Prime Minister Singh has suspended futures trading in soybean and cooking oil, sugar, rubber, and other commodities. India has scrapped import tariffs on many commodities, while banning the export of rice, wheat, edible oils and cement. The government is also pressuring steel and other industries to limit price increases. Politicians in India and throughout Asia will come under only more intense pressure to deal with rapidly mounting inflation pressures. Various forms of intrusive government prices controls are gaining in popularity.
China, Philippines, Thailand, Malaysia and Vietnam have all over the past several weeks moved aggressively to secure additional food supplies. China, in particular, appears to have significantly bolstered its global efforts to procure agricultural and energy resources. It is a fair bet that spiking prices for food, energy and commodities in general will have major trade and geopolitical ramifications -- while our policymakers' attention is fixated on problem mortgages.
Wealth redistribution is an inherent facet of credit and asset bubbles. And I would argue that this inequitable wealth-transfer gains momentum progressively throughout the life of an inflationary boom. As such, various degrees of angst, contempt, unrest and "blowback" are inevitable. I have had particular disdain for Alan Greenspan warning us of the risks of trade frictions and "protectionism." These are, after all, the predictable consequences of a bursting U.S. credit bubble. It would now appear that spiking prices, hording, and supply shocks (emerging most acutely in the Asian inflationary "tinderbox") throughout the agricultural, energy, and commodities markets have the potential for initiating a period of problematic trade tensions, dislocations and acute geopolitical uncertainty.
And it is not only government policymakers grappling with today's new reality: the extreme uncertainty with regard to pricing and availability of critical resources. Industries throughout the U.S. and global economies now confront a fundamentally altered environment, where the future prices and supply of scores of key inputs can no longer be taken for granted. For many, the whole idea of "just in time" inventory management has become a luxury no longer affordable. Moreover, recent media accounts have illuminated the problems suffered by farmers and grain elevator operators due to recent dislocations in commodities derivative trading. Financial derivatives markets, having functioned well in the commodities arena for the most part for years now, will now play a destabilizing role in a new era of acute supply/demand imbalances and disruptions.
In particular, one can expect today's unfolding dislocations in energy trading to inflict bloody havoc on scores of businesses, industries and derivative players alike. Many (i.e., the airlines) that have previously been somewhat hedged against future energy price gains were more recently left largely unprotected because of the perceived exorbitant cost of hedging programs. And those derivative players on the wrong side of runaway price gains are today scrambling to hedge exposures and mitigate mounting losses. Importantly, whether it is in derivatives or in contracts for the future delivery of actual resources, those in a position to provide supply are today much less willing to lock themselves into future commitments. Psychology has changed and changed profoundly. The entire market landscape has been radically altered for key commodities and resource markets, and the ramifications for general inflationary trends are significant.
I am compelled to again contrast today's inflationary forces to other recent bouts of acute pricing pressures. When emerging credit bubble forces fueled the NASDAQ and technology bubbles, inflationary effects were largely isolated in technology stocks, high-yielding telecom/tech-related junk bonds and leveraged loans, and a booming tech industry. This bubble incited huge increases in demand for technology products, yet this demand was met by a massive increase in technology production capacity. The incredible growth in semiconductor and technology output was known as a "productivity miracle." It was, however, industry idiosyncratic. The buyers of these relatively inexpensive new products benefited, while fortunes were made (and many then lost) in the internet and technology stock bubble.
The next Fed-instigated round of credit and asset bubble dynamics then invaded mortgage and housing markets. Wall Street simply created trillions of new higher-yielding securities, while the homebuilding industry constructed millions of new homes. Most Americans relished the wealth effects from inflating home and stock prices. The economy enjoyed a credit-induced boom. Corporate cash-flows boomed, while government receipts swelled. Similar to the technology bubble, few felt or thought they were suffering from the ill-effects of inflation.
I am this evening referring to A New Inflationary Epoch because today's unfolding inflationary dynamics are different in kind. For one, prevailing inflationary pressures are global in nature. Wall Street finance is not the source fueling the boom, and it is running outside the Fed's control. American asset inflation and resulting wealth effects are minimal, while price effects for food, energy, and commodities are extreme. In contrast to previous inflationary booms, while some selected groups benefit, the vast majority of people today recognize they are being hurt by rising prices. This pain comes concurrently with atypical housing price declines. Today's price effects pummel already weakened consumer sentiment, as opposed to previous effects that tended (through asset inflation) to bolster confidence. Furthermore, current inflationary forces are destabilizing and even destructive to many businesses, while playing havoc with the fiscal standing of federal, state and municipal governments.
Revolving around booming Wall Street finance, previous inflationary booms naturally fueled surges in securities issuance and speculation. These bubble effects worked as powerful magnets in attracting foreign financial institutions, foreign-sourced speculators, and cheap foreign-sourced borrowings (i.e. yen borrowings financing higher-yielding U.S. securities) that all worked in concert to "recycle" our current account deficits ("bubble dollars") directly back to our securities markets.
In contrast, inflationary forces these days largely bypass U.S. securities to play global energy, commodities, and hard assets. Foreign financial institutions are fleeing the U.S. risk intermediation business, while "bubble dollars" are chiefly recycled back into Treasury and agency securities (where they now have minimal effect on U.S. home and asset prices). Meanwhile, the massive global pool of speculative finance is today focused on energy, commodities and the "emerging" economies.
Unlike tech stocks/junk bonds, and U.S. mortgages/houses, it is today extremely difficult to meaningfully increase the supply of energy, agricultural commodities, and many natural resources. Moreover, the longer this boom is sustained the greater the demand for energy and commodities from the likes of China, India, greater Asia and the Middle East. And the higher prices rise, the greater the tendency for hoarding and problematic supply disruptions -- only aggravating supply/demand imbalances and emboldening aggressive speculation. Wall Street cannot fix this demand imbalance.
Importantly, surging prices for vital necessities such as energy and food by their nature elicit expanded credit creation -- albeit ...
Or, stated differently, through various mechanisms, processes, dynamics, and rationalizations there will be overriding tendencies to "monetize" today's inflationary effects. And unlike previous inflation manifestations that tended to remain largely contained within asset markets, today's virulent energy and commodities inflation will spawn broad-based secondary price effects. As recent trends corroborate, inflation begets only greater inflation.
- our consumers using credit cards at the gas pump;
- our Congress deficit financing economic stimulus packages;
- our state and federal deficits expanding to pay for generally rising costs;
- corporate America borrowing to finance surging energy and other expenses;
- aggressive borrowing by U.S. and global energy/commodities-related industries expanding operations;
- by the alternative energy Bubble;
- by speculation-related leveraging;
- by governments around the globe that will expand deficit spending programs implemented in an effort to placate outraged citizenry;
- and by OPEC, Brazil, Russia, Australia, Norway and other economies directly prospering from the boom.
The reality that powerful inflationary psychology has taken hold -- and that the world's leading central banks show no inclination to confront this worsening problem -- motivates tonight's title, "A New Inflationary Epoch."
A Red Herring
Now that the U.S./worldwide mortgage finance bubble has popped, talking heads are belatedly debating Alan Greenspan's contention that monetary authorities cannot do anything about an asset bubble in progress -- that it can only "mop up" after the bubble has started to deflate. The Greenspan claim was always preposterous, akin to an arsonist claiming he could only help with an inferno after it had passed its peak and started to wane ... by adding more gasoline to make sure it does not die down too fast.
Given how obvious the dot-com and real estate bubbles-in-the-making were to many of us long before they became full-fledged and then collapsed, it is a wonder that anyone pays any attention to the incompetent policy makers and their courtesans in the press and academia. In an ideal world they would have the good grace to follow the example of the captain of the Titanic and accept responsibility for and the full consequences of their errors. At the very least one would hope they would resign and dedicate themselves to community service and efforts to prevent a repeat of their errors. Instead, we are treated to endless non-mea culps, and a dry debate about whether we should look out for icebergs in the future before we hit them.
But even this debate is a red herring, says Doug Noland. It is too late to do anything about past asset bubbles, and the present bubble is of a different sort -- as he discusses in the "New Inflationary Epoch" piece above. A more pressing need is for the global central bankers to reign in today's "full-fledged unfettered 'wildcat' finance unlike anything the world has ever experienced." He incorporates some suggestions along these lines, but until the powers behind the throne see they have more to gain than lose by following this course we are not holding our breath.
There was a flurry of media interest this week [ending May 16] in the issue of central banking and asset bubbles. Federal Reserve governor Frederic S. Mishkin's gave a speech yesterday [May 15], "How Should We Respond to Asset Price Bubbles?" This morning's Wall Street Journal ran front-page with Justin Lahart's article, "Bernanke's Bubble Laboratory". Also today, the Financial Times' Krishna Guha penned an extensive piece "Troubled by Bubbles: central bankers re-examining the hands-off approach," one of several thoughtful FT pieces on the issue this week.
From Ms. Guha's article:
In the aftermath of the dotcom crash in 2002, Alan Greenspan famously argued that central banks had little power to stop bubbles inflating and then bursting. All policymakers could do, said the then Federal Reserve chairman, was to 'focus on policies to mitigate the fallout when it occurs'. His most vocal supporter was Ben Bernanke, then a Fed governor. As an academic, Mr. Bernanke had championed the view that central banks should ignore asset prices except insofar as they affect forecasts for inflation and growth. 'Even putting aside the great difficulty of identifying bubbles in asset prices, monetary policy cannot be directed finely enough to guide asset prices without risking severe collateral damage,' he said in 2002."
Professor Mishkin's speech offered at best only a flicker of hope that the Federal Reserve is moving away from failed Greenspan/Bernanke doctrine:
"Financial history reveals the following typical chain of events: Because of either exuberant expectations about economic prospects or structural changes in financial markets, a credit boom begins, increasing the demand for some assets and thereby raising their prices. The rise in asset values, in turn, encourages further lending against these assets, increasing demand, and hence their prices, even more. This feedback loop can generate a bubble, and the bubble can cause credit standards to ease as lenders become less concerned about the ability of the borrowers to repay loans and instead rely on further appreciation of the asset to shield themselves from losses. At some point, however, the bubble bursts. The collapse in asset prices then leads to a reversal of the feedback loop in which loans go sour, lenders cut back on credit supply, the demand for the assets declines further, and prices drop even more. The resulting loan losses and declines in asset prices erode the balance sheets at financial institutions, further diminishing credit and investment across a broad range of assets."
I was encouraged that the terminology "structural changes in financial markets," "credit booms," and "feedback loops" were included in the initial paragraphs of Mishkin's paper. This, presumably, would have had the analysis at least heading in the right direction. Yet the inclusion of credit matters turned out to be little more than analytical palliative. Today, Fed policymakers have no choice but to concede that underlying credit conditions are an issue. Meanwhile, they appear content to take the tack that not all bubbles are created equal, that some are more impacted by credit than others, that some are associated with more financial system risk than others -- and, at the end of the day, it is impossible for the Fed to recognize and differentiate among them until after they have burst. Scant real progress has been made.
The conclusions from Professor Mishkin's paper differ only subtly from previous doctrine:
"First, not all asset price bubbles are alike. Asset price bubbles that are associated with credit booms present particular challenges, because their bursting can lead to episodes of financial instability that have damaging effects on the economy. Second, monetary policy should not try to prick possible asset price bubbles, even when they are of the variety that can contribute to financial instability. Just as doctors take the Hippocratic oath to do no harm, central banks should recognize that trying to prick asset price bubbles using monetary policy is likely to do more harm than good. Instead, monetary policy should react to asset price bubbles by looking to the effects of asset prices on employment and inflation, then adjusting policy as required to achieve maximum sustainable employment and price stability ... Third, because asset price bubbles can arise from market failures that lead to credit booms, regulation can help prevent feedback loops between asset price bubbles and credit provision. Our regulatory framework should be structured to address failures in information or market incentives that contribute to credit-driven bubbles."
Such an "academic" approach will bear little fruit. Clearly, all the theorizing in the world will have no impact whatsoever on the burst technology and mortgage finance/housing bubbles. There are, however, present-day issues of pressing vital concern. First of all, if a new regulatory approach is central to combating "episodes of financial instability", I strongly suggest Professor Mishkin and the entire Bernanke Fed move immediately toward assuming GSE oversight (which they will avoid like the plague). Fannie, Freddie, and the FHLB have in total increased their "businesses" by over $900 billion during the past year -- and have been getting geared up to move full speed ahead. The GSE's top regulator, commenting on CNBC back in March, stated that Fannie and Freddie "could do over $2.0 trillion in business this year if the market needs that money." That was a blaring warning that "regulation" will remain a major part of the problem.
I will posit this evening that the entire issue of "central bankers vs. asset bubbles" has become little more than A Red Herring. While it is as of yet too early in the unfolding financial and economic crisis for "consensus opinion" to have reached a similar conclusion, in reality contemporary monetary management can already be proclaimed an unmitigated failure. Cloaked in ideology and a flawed conceptual framework, the Greenspan/Bernanke Fed sat idly by as history's greatest credit inflation and myriad resulting bubbles irreparably damaged the underlying structure of the U.S. credit system and real economy (before going global). And while the Fed executes its latest round of post-asset bubble "mop up," precarious credit bubble dynamics are left to run similar roughshod through global financial and economic systems. Better to downplay the asset bubble issue for now, as we contemplate the nature of what will be a much altered post-global credit approach to central banking.
"The ultimate purpose of a central bank should be to promote the public good through policies that foster economic prosperity. Research in monetary economics describes this objective in terms of stabilizing both inflation and economic activity. Indeed, these objectives are exactly what is embodied in the dual mandate that the Congress has given the Federal Reserve."
In no way do I believe "the ultimate purpose of a central bank" is to "foster economic prosperity," and I certainly do not expect any such grandiose mandates to survive in the post-bubble environment. On many levels the notion that central bank policies are instrumental in creating prosperous economic conditions is problematic. For one, it grossly over-promises in regard to the long-term benefits derived from the government's manipulation of interest-rates. Secondly, it virtually guarantees an accommodative policy regime and, inevitably, a strong inflationist bias. Thirdly, such a nebulous objective invites overly discretionary policymaking, along with an activist and experimental approach to monetary management. Fourthly, such an approach ensures that policymaking errors beget greater and compounding errors.
"After a bubble bursts and the outlook for economic activity deteriorates, policy should become more accommodative. ... If monetary policy responds immediately to the decline in asset prices, the negative effects from a bursting asset price bubble to economic activity arising from the decline in wealth and increase in the cost of capital to firms and households are likely to be small. More generally, monetary policy should react to asset price bubbles by looking to the effects of such bubbles on employment and inflation, then adjusting policy as required to achieve maximum sustainable employment and price stability."
This passage, in particular, goes right to the heart of several key failings of current doctrine. The entire framework of ignoring asset bubbles when they are expanding and "mopping up" when they burst is a recipe for disastrous policy mistakes. And how was this not made unmistakably clear when the post-tech bubble "mop up" stoked the fledgling mortgage finance and housing bubbles?
The problem with post-asset bubble "accommodation" is that it specifically accommodates the very credit infrastructure and related monetary processes that financed the preceding boom. It works to validate the present course of financial innovation (think "Wall Street securitizations," "CDOs" and "carry trades"), while emboldening those at the cutting edge of risk-taking (think "leveraged speculating community"). To be sure, the same Wall Street credit infrastructure that financed the tech bubble was empowered to regroup, reemerge, and aggressively expand to grossly over-finance much more expansive credit and speculative booms in mortgage-related securitizations and housing. These days, powerful forces have been unleashed to over-finance the world.
Moreover, a commitment to aggressively cut rates in response to faltering asset bubbles openly courts leveraged bond market speculation -- a market dynamic that especially engenders artificially low market yields and exacerbates liquidity excess during the late-stage of asset bubbles (think bond market "conundrum"). The last thing a central bank should encourage is an entire industry dedicated to placing leveraged bets on the direction of Federal Reserve policy responses. A strong case can be made that U.S. Treasury and agency markets have become one massive bubble.
The overriding flaw in the Greenspan/Bernanke approach has been to openly disregard credit bubble dynamics, in particular the increasingly profound role played by Wall Street-backed finance in fueling credit, market liquidity and speculative excesses. I believe the ultimate objective of a central bank is to foster monetary stability in the broadest sense. In this regard, asset bubbles should be viewed primarily as important indicators of some type of underlying monetary disorder. The key analytical focus must be on the underlying credit and speculative dynamics fueling the asset price distortions -- to better understand and rectify the source of "disorder" -- and the earlier, the better.
The most dangerous policy approach is to further incentivize a system that has already demonstrated a proclivity for credit and speculative excess -- employment, output and "deflation" concerns notwithstanding. And never ever succumb to the temptation of using the leveraged speculators as a mechanism for stimulating the markets, the credit system and the real economy. In this regard, contemporary finance has created an especially seductive trap for policymakers.
Greenspan, Bernanke, Mishkin and others repeatedly stress the inability of policymakers to recognize the existence of a bubble until after it pops. It is my view that the entire notion of asset prices dictating monetary policy is flawed. The focus should instead be on the underlying sources of monetary fuel -- the credit growth and financial flows underpinning asset inflation and spending boom. In the case of the technology bubble, the Fed should have been focused on the massive issuance of telecom junk debt and leveraged loans, the fledgling CDO and "structured credit products" markets, NASDAQ and NYSE margin debt, derivative-related leveraging, and the enormous speculative flows over-financing the industry boom. The unfolding mortgage finance bubble was conspicuous as early as 2002, with the onset of annual double-digit mortgage credit growth and the rapid expansion of Wall Street mortgage-related securitizations and derivatives.
Central bankers can and should avoid being in the difficult position of having to respond directly to inflating asset markets. Instead, there must be carefully fashioned, communicated and administered "rules of the game". To begin with, it is incumbent upon the Fed to clearly articulate to the public (and their elected officials) the overwhelming benefits of stable credit and financial conditions. It must be conveyed that credit and speculative excesses are destabilizing, fostering boom and bust dynamics and structural impairment. The public must come to appreciate that the effects of destabilizing credit inflation come in many forms, including asset price inflation and bubbles, current account deficits, currency debasement, traditional consumer price inflation, and various distortions to underlying financial and economic structures.
The Fed could then take a more active role in supervising and regulating system credit within some predetermined parameters -- a "rules-based" as opposed to discretionary approach to monetary policymaking. For example, if total mortgage credit exceeded some threshold, say 5% or 6% annualized, the Fed would have a mandate to move to restrain at the margin real estate lending (through various means, including increased reserve and capital requirements, higher interest rates and other punitive measures). Ditto for corporate and public sector debt growth. Specific margin lending limits would be enforced, and derivative and securities leveraging strategies would be closely monitored and regulated as necessary. Similarly, credit growth beyond some predetermined threshold -- albeit bank credit, broker/dealer liabilities, finance company borrowings, securitizations, etc. -- would elicit a meaningful rebuke from monetary policy. The punchbowl would be closely guarded. There would be general parameters for major sectors, as well as for total system credit growth.
I expect the idea of the Fed regulating credit to be unappealing to many if not most. I offer it as food for thought. It is, after all, my strong belief that unconstrained credit and speculation are the bane of free-market capitalism. For the Economic Sphere to remain generally unencumbered dictates a somewhat encumbered Financial Sphere. Unfortunately, radical and ill-conceived government intrusion into all aspect of our financial and economic lives will be the likely post-bubble reality.
I was compelled to share some thoughts with respect to the "asset bubble" debate. Actually, the subject matter is now little more than a distraction from more pressing credit and pricing issues. Somewhat strangely, U.S. asset inflation is no longer the overriding concern. Instead, I ponder the ongoing issue of the current extraordinary financial backdrop: a global economy that continues to operate in a unique environment without a functioning monetary regime. There is no mechanism -- gold standard, Bretton Woods, or otherwise -- to in anyway limit the quantity or quality of global financial claims inflation. It has become full-fledged unfettered "wildcat" finance unlike anything the world has ever experienced.
It is tempting to fixate on the asset bubble issue. Yet a more pressing need is for the Federal Reserve and global central bankers to begin working towards the implementation of some type of functioning monetary "regime," with the intention of returning some semblance of order to international finance. And similar to anticipating new U.S. central banking doctrine, one can bet confidently that change will not arrive ahead of "post-bubble impetus". No doubt about it, heightened monetary disorder -- the cost associated with the Fed's U.S. credit system bailout -- is increasingly on display. Destabilizing speculation is returning with a vengeance, and it is anything but limited to commodities markets.
INFLATE AWAY DEBT? THREE LESSONS FROM HISTORY
The Federal Reserve's de facto policy for getting U.S. consumers and governments out from under the burden of debt weighing heavily on them is to depreciate the real, inflation-adjusted, value of those debts. There are a lot of common sense reasons to think that the scheme will not work. For starters, when everyone knows what is going on they will adjust and undermine the policy's effectiveness. Just as once you see that a coin is rigged to come up heads twice as often as tails you will bet accordingly, once people come to see that inflation is cast in stone they will adjust their transaction terms and contracts.
Beyond theory, one can look at history. As Dr. Phil might ask: "Inflating away your debts? How well has that worked for you?" Well, you see, um ... not all that well ...
"We can pay anybody by running a printing press," said Thomas Gale Moore, one of Ronald Reagan's economic advisors, when the United States became a net debtor to its foreign investors in 1986. "Frankly, it is not clear to me how bad [being a net debtor] is." And for the next two decades or so, owning fewer assets overseas than foreigners laid claim to inside the United States did not seem so bad at all.
The long boom delivered by a steady inflow of foreign credit and cash delivered the greatest stock market gains ever enjoyed by U.S. investors. When they topped out, the party switched straight into real estate -- adding more than 2/3 to America's household wealth on the Federal Reserve's metrics.
So what if non-U.S. claims on that surging wealth rose faster still? Now the party is over, inflating away the value of America's debt will work just as beautifully as always before. Right?
"In my view," says John H. Makin -- a visiting scholar at the American Enterprise Institute writing in the Wall Street Journal -- "the least bad option [in fixing the financial crisis] is for the Federal Reserve to print money to help stabilize housing prices and financial markets."
"America is a country that owes money," agrees Philippa Malmgren, a former Bush advisor and now head of a risk consultancy in London. "It is natural when you are a debtor that you lean in the direction of inflation, because it makes paying it back so much easier."
The logic is simple: inflate the number of dollars in issue, and you will shrink the real value of each outstanding dollar you owe. But if escaping your debts really could prove that easy, then why is history is littered with the mischief that inflation causes instead? ...
Restoration England, 1668
Charles II -- still playing his "divine right" as king some 20 years after Parliament cut off his father's head -- steps up the issue of new bonds. Then called "stocks," they let the King raise cash for yet another losing war against the Dutch.
Charles side-steps Parliamentary approval for these new debts, and starts selling stocks against the promise of future tax receipts (the same wheeze adopted by governments worldwide today, of course). Come 1671, however, all the new money raised went straight to paying interest on the outstanding loans. So Charles opted to default, wiping out 11 of London's 14 biggest goldsmiths -- those early banks who had first lent the Crown money -- and destroying his credit with England's loyal subjects.
The upshot? The King strikes a secret deal with France, promising to stay out of its war against the Dutch in return for regular cash pay-offs. But the deal -- uncovered amid a rash of anti-Catholic panics in London -- undermines all support for the Stuart royal family. Fifteen years later, and with the English crown bankrupt once more, his brother James II is overthrown in a popular and (pretty much) bloodless coup. He is replaced by William of Orange ... head of the Dutch Republic!
Revolutionary America, 1775
Lacking a mandate to tax its population while fighting a war, the second Continental Congress authorizes the "limited" issue of paper money. The new notes, known as Continentals, are backed by neither gold nor silver, but by the expectation of future tax receipts.
Effectively acting as tradable bonds -- but exchangeable for goods and services amongst the Patriots, rather than hard currency -- the Continentals will only be redeemed when the Colonies win their independence from Great Britain. But long before that happy day, they race toward zero, becoming progressively worthless as their supply increases.
Giving rise to the phrase "not worth a Continental" as an expression of worthlessness. The phrase depreciated a long more slowly than the currency.
During the first six months, the supply of Continentals goes from $2 million to $6 million. By 1779, the total supply reaches $242 million on one estimate -- more than 20 times the volume of gold and silver money in circulation before the war began.
"A wagonload of currency will hardly purchase a wagonload of provisions," complains George Washington. In March 1780, Congress announces a plan to redeem the Continentals at 1/40 of their face value, effectively stuffing the American people and taxing the new citizenry more aggressively than George III ever did.
Weimar Germany, 1920
Besides losing 13% of its territory and 10% of its population under the Versailles Treaty after World War I, Germany also owes "reparations" to the Allied victors worth almost 37,000 tons of gold -- around 1/3 of the world's entire above-ground supplies at the time.
Expected to settle the final payment seven decades later, the German government opts instead to pay early by printing money. The volume of Reichsnotes in issue rises 35 billion times over between 1918 and 1924 -- and "the young and quick-witted did well," as the German journalist Sebastian Haffner will record, 15 years later.
Equity prices in Berlin rose some 2,772,164 percent by the time a loaf of bread cost a wheel barrow-full of banknotes. The value of those Reichsnotes, however, went the other way -- sinking from eight per dollar to 4.2 billion per dollar.
The resulting chaos, now regularly blamed for the rise of Hitler during the Great Depression of the early 1930s, saw "wages paid twice a day and promptly and completely spent within the hour," notes Glyn Davis in his History of Money. "Large sections of society, including the middle classes, became impoverished; food riots were common; there was a complete flight from money, which had clearly become worthless to hold."
The Global Banking Crisis, 2008
"U.S. money supply growth is running at a 47-year high," notes Bedlam Asset Management, "as the authorities seek to inflate away the debt bubble and prop up house prices. "Clearly printing such huge amounts of money is not great for the exchange rate. A weak dollar has forced the hand of other central banks as they try and keep their currencies competitive with it."
But might the scam work? Not if China, Japan and the big dollar-holders of the Arab oil kingdoms can help it. Will they really let their own currencies rise ... just so the United States stuffs them by paying its debts with devalued dollars?
Inflation, it is claimed, eases the burden of settling your debts. But for government and private debtors alike, that is only true if your income rises faster than your on-going cost of expenditure. Otherwise, you end up struggling to make ends meet today, only to leave yesterday's debts for repayment tomorrow again.
Middle-class families and savers looking to get ahead of the game -- both inside and outside the Federal Reserve's fast-inflating currency zone -- might want to consider buying gold as defense. Because however this latest attempt to inflate away debt pans out in the long run, it is sure to make history.
And history says -- time and again -- that solid gold bullion holds its value whenever man-made currencies are forced to lose value.
The author of Greenspan’s Bubbles on the biggest clown of them all.
Alan Greenspan's public image was that of an economic genius whose intellect was so overpowering he had trouble expressing himself in way that us mortals could comprehend. As long as the bull market raged no one cared. Success was its own explanation.
The reality was (and is) that Greenspan fit the definition of a modern-day celebrity: He was famous for being famous, accomplishments of substance or not. And there have prooved to be remarkably few of those, before, during or after he was Federal Reserve chairman.
Going a little further with this, it is fair to predict that Greenspan will go down as the John Law of his day. Nineteen Century economics theory heavyweight Alfred Marshall decribed Law as a "reckless, and unbalanced, but most fascinating genius." Second-rate economist and political theorist Karl Marx said that Law had "the pleasant character mixture of swindler and prophet."
Those characterizations of Law when applied to Greenspan work for us. But this may be unfair to the ghost of Law. Law's theories had a semblance of logic. After being refined by later thinkers some of them worked their way into modern microeconomic theory which is still taught today, two centuries later. On the other hand, it is unclear Greenspan has ever developed -- or applied -- a coherent theory.
After ingratiating himself into the French court, Law proposed the establishment of a state-chartered bank with the power to issue unbacked paper currency. (Sound familiar?) The bank expanded pell-mell ... until it collapsed after a bank run in 1720, plunging France and Europe into a severe economic crisis, which helped set the stage for the French Revolution 60 years later. The experience was so traumatic that French banks largely avoided using the word "banque" in their names in order to (falsely) dissociate themselves from the Law escapade. The favored substitute term was "credit", which may yet follow "banque" into disrepute.
In an effort to do their part in making sure Greenspan gets what he deserves, Fred Sheehan and William Fleckenstein have written a book, Greenspan's Bubbles: The Age of Ignorance at the Federal Reserve. Here, Sheehan gives a sampling of highlights from the book. Move over, Emmett Kelly.
It is said that artists speak for the ages. In 1951, Pablo Picasso described the end of our age when interviewed by Giovanni Papini: "From the moment that art ceases to be the nourishment of the best brains, the artist can use all the tricks of the intellectual charlatan. The refined people, the rich ones and the professional layabouts, only want what is sensational or scandalous in modern art. And since the days of cubism I have fed these boys what they wanted and pacified the critics with all the idiotic ideas that went through my head. Whilst I amused myself with all these pranks, I became famous and very rich. I am just a public clown, a fairground barker." The quotation is disputed. Whatever he said, Picasso's reputation suffered no harm when this confession was published.
On February 21, 2008, the Financial Times published the confession of Han de Jong, Chief Economist, ABN Amro Bank: "I am obviously biased, but I find it sad to conclude that the role of serious economists in financial institutions is very limited today. We are little more than clowns, whose purpose is to entertain clients ..."
The substitution of image for substance, the promotion of sensational or simply idiotic ideas that destroy reality, are central to our time. Economic thought is a sad example of this deterioration, personified by a charlatan of little substance. This is not to deny the man credit for understanding how times were changing. Alan Greenspan was one of the first to climb the greasy poll of superficiality. He knew this path to the top did not include the study of economics.
Having earned a master's degree in economics from NYU, Greenspan transferred to Columbia University in 1951. He pursued his doctorate studies under Arthur Burns. Burns had co-authored an influential book, Measuring Business Cycles. His academic achievements were substantial as were his political instincts. Burns would head President Eisenhower's Counsel of Economic Advisers (CEA) and be named Federal Reserve chairman under President Nixon. Greenspan would also serve in both positions.
Greenspan did not finish his coursework at Columbia, but demonstrated his own political aptitude under Burns: He took up the pipe -- Burns's trademark. Picasso might explain that Greenspan was Rene Magritte's subject in the surrealist's famous painting of a pipe. Under the pipe, Magritte painted: "Ceci n'est pas une pipe." ("This is not a pipe.") Greenspan understood he was not smoking a pipe. He knew the forgone parchment from Columbia was insubstantial compared to worshiping at Burns's doorstep. (When Burns was Federal Reserve chairman, he lived in the Watergate complex. When Greenspan moved to Washington as CEA director, he lived in the Watergate complex.)
Lessons learned in young adulthood have a tendency to stick. Alan Greenspan might have observed how promotion was leap-frogging substance in post-War America. Lever Brothers, the soap manufacturer, moved its headquarters to New York. Meanwhile, industrial America was heading for the suburbs. Why this journey? Chairman Charles Luckman explained: " New York is the answer to our major problem -- selling ... .All advertising centers in New York, all show business except the movies. The platform from which to sell goods in America is New York." Soap and Elvis needed a publicity agent.
Greenspan may have observed an economist (aside from Burns) who shuffled seamlessly between academia and policymaking, one who generated the media attention necessary to an economist-politician. Harvard University professor Sumner Slichter told Washington that the Federal Reserve must accept inflation. This would achieve extended prosperity. (The Russians were catching up. Growth at any cost was gaining traction.) For such advice, which could only warm a politician's heart, Fortune magazine dubbed him the "father of inflation." (What a relief from that fussy Federal Reserve chairman, William McChesney Martin: "There is no validity whatever in the idea that any inflation, once accepted, can be confined to moderate proportions.")
By the late-1950s, Greenspan was proprietor of Townsend-Greenspan, an economic consulting firm. He headed President Ford's Council of Economic Advisers in the mid-1970s. His economic forecasts were abysmal. (Senator William Proxmire [at Greenspan's confirmation hearings]: "I hope ... when you get to the Federal Reserve Board everything will come up roses. You can't always be wrong.")
This was of secondary importance. He received adulation where no other CEA director had gone before: the front cover of Newsweek, in the same year Jimmy Hoffa, Patty Hurst, and Liv Ullmann were likewise honored. The CEA was flooded with autograph requests. The clientele was not interested in the CEA director. They wanted Greenspan's autograph because he was famous.
In August 1977, Elvis died. The nation mourned. This was not due to his presumed talent: singing. Elvis himself had said: "I don't know anything about music. In my line you don't have to." In 1977, Alan Greenspan received his Ph.D. in economics from N.Y.U. His thesis is a hodge-podge of articles written in the 1950s. At least, that is the scuttlebutt. N.Y.U. will not release his work. It does not really matter. It can be said of Alan Greenspan, with some exaggeration that "He does not know anything about economics. In his line you don't have to."
His line was fame. Greenspan followed the most direct route: he dated the press. First Barbara Walters, then Susan Mills (a producer for the MacNeil-Lehrer Newshour), then he married a television personality, Andrea Mitchell. He gained entrée to the celebrity circuit. At the home of Oscar and Francoise de la Renta, Norman Mailer asked Giovanni Agnelli if he "was indeed Alan Greenspan ‘the famous economist.’"
Townsend-Greenspan served Greenspan's own ambitions. Of the early Reagan years, White House staffer Martin Anderson recalls: "He had one life ... I don't think I was in the White House once where I did not see him sitting in the lobby or working the offices. I was astounded by his omnipresence ... He was always huddling in the corner with someone." In 1983, he was featured in a New York Times article about the lecture circuit ("The Superstars"). Readers learned that "Mr. Greenspan has emerged as the most sought-after economist by lecture audiences worldwide."
Greenspan became Federal Reserve chairman in 1987 and served until January 2006. He continued his fame game. Fewer than 10% of Americans knew the name of the Federal Reserve chairman in 1979. In 2001, 90% knew Greenspan's name, though zero percent knew what he was talking about. This was to his benefit. It was believed he spoke on an elevated but indecipherable level. To the dedicated student of Federal Open Market Committee transcripts, Greenspan's contributions read like a screwball comedy. Few were in on the joke, so he was recast. He was the greatest testament of Magritte's warning to the twentieth century: "This is not a Federal Reserve chairman."
He played a deity, an icon, Zeus, Moses, God -- descriptions from an adoring or befuddled press. Greenspan lived in his own bulletproof bubble. As has happened in different countries at regrettable moments, the skeptic could only dismiss the transcendental gifts of this very common man at the risk of ridicule and loss of job.
As readers of Greenspan's Bubbles know, he left a remarkable record of back-sightedness. His odes to technology drew a delirious public under the big top. On March 6, 2000, he told a star-struck audience: "[T]he essential contribution of information technology is the expansion of knowledge and its obverse, the reduction of uncertainty. Before the quantum jump in information availability, most business decisions were made in a fog of uncertainty." The Federal Reserve chairman received a standing ovation. Less than two years later, after befogged technology investors had lost a few trillion dollars, he told a different audience: "[A]las, technology has not allowed us to see into the future any more clearly than we could previously."
As stock prices rose in the late-1990s, Greenspan led his audiences to believe the Federal Reserve would calm the waters (if not part them). For instance, in February 1997: "[R]egrettably, history is strewn with new eras that, in the end, have proven to be a mirage ... . [C]aution seems especially warranted with regard to the sharp rise in equity prices during the past two years." Two years later, when the stock market bubble had engulfed the nation, Greenspan told a Congressional committee: "[B]ubbles generally are perceptible only after the fact ... Betting against markets is usually precarious at best." With that, the circus animals bid stocks to the moon, knowing the Federal Reserve was party to the greatest snow job on earth.
In 2004, the Federal Reserve chairman juggled and rode his unicycle for a different crowd: "Many homeowners might have saved tens of thousands of dollars had they held adjustable-rate mortgages rather than fixed-rate mortgages over the past decade." Only a fairground barker could make this statement in the same week it was announced that house prices had risen 17% over the past year in San Diego County, 29% in Los Angeles County, and 28% in New York. Just as his "can't see, can't speak policy" fed the chimpanzees in 1999, the circus act spurred the interest-only mortgage market. This was often the only affordable mortgage, meaning, the owner could make the first monthly payment but not necessarily the second. In California, the percentage of interest-only mortgages had risen from 2% in 2002 to 47% at the time Greenspan spoke. By the fall of 2004, 67% of California residential mortgages were interest-only. (The median residential real estate price in California rose from $262,000 in 2001, to $316,000 in 2002, to $450,000 in 2004, and to $542,000 in 2005.)
His dialogue alone might resurrect screwball comedy, if only it was not real. Alan Greenspan is still famous, but the adoration has waned. His clown act worked when he threw candy and fireworks above the crowd. The masses have eaten the candy and are suffering shellfire. He is no longer an icon. Deities do not scramble for approval. Gods do not attract such headlines as: "Don't Blame Me!" (Sunday Times of London).
Alan Greenspan wants respect. We do not respect gods; we worship them. We respect certain people, when they are deserving. Greenspan told us in early April of this year: "I have no regrets on any of the Federal Reserve policies that we initiated back then because I think they were very professionally done." That the votes were properly tallied is not in question. The accomplishments of the ersatz economist are the enigma.
He wrote articles, "some of them for publications such as Business Economics, which would not have met the scholarly standards for most economics departments." (Jeff Madrick, New York Review of Books, July 19, 2001.) He shambled through his Ph.D. thesis, composed of articles described by Madrick. He used Townsend-Greenspan as a platform to court the rich and the professional layabouts. It is too late to establish himself as a comprehensive economist. He made a different choice 50 years ago. In 2004, John Kenneth Galbraith described the Federal Reserve's painless decisions made "in a pleasant, unobtrusive building in the nation's capital" as not of "the real world but to that of hope and imagination. Here our most implausible and most cherished escape from reality" is led by "an informed, confident and respected figure of no slight theatrical talent." When we are prepared to assess the end of this age honestly, here rests a truthful epitaph for Alan Greenspan and the Federal Reserve System.
|Previous||Back to top||Next|