Issue 63- June 17, 2010

Hip & Groovy – The Source of all Financial Evils

The history of finance in the United States is littered with the headlines of new and improved schemes and can’t miss ideas. While some were out and out frauds as in the Credit Mobilier construction arm of the Union Pacific Railroad in the 1870’s or Charles Ponzi in 1918, while many were simply trading strategies gone awry. Portfolio Insurance was shown to be a “crowded trade” and in October 1987 it helped propel the market to the single largest daily loss since the 1930’s. Then there was Long Term Capital Management. The “Genius that Failed” in 1998 became the modern day gold standard of collapse up until the systemic failures of 2008.

For the better part of this decade, we were collectively lectured by the smart set at the largest endowments, foundations, and limited partnerships to leave behind traditional allocations for the brave new world of alternatives. We were told that by allocating a third or more of our portfolios to this collective class of real estate, hedge funds, and private equity, we would decrease volatility and increase return. To make sure we were all shamed into this allocation, we were constantly reminded that this is what smart people do. That was until the fall of 2008.

In our December 2006 Newsletter (http://www.huntingtonsteele.com/newsletter/newsletter121806.html), we wrote that many large institutional investors, in an effort to deal with a financial landscape that was hampering their ability to meet actuarial liabilities, had turned to alternatives. After all – this was what the best and the brightest were doing and with outsized results that they were all too happy to trumpet on the financial news. But as we noted then, not caring about certain risks is not the same thing as not having them. No one wanted to talk about the lack of liquidity in these instruments and the risk modeling could not and therefore did not consider this limitation. Liquidity was abundant and leverage was seemingly limitless. That was until Lehman Brothers failed. The run that ensued through the credit markets is now legendary and the supervisory agencies and congress have spent the better part of two years looking for culprits and designing reform legislation.

There is certainly plenty of blame and examples of personal irresponsibility to go around with regard to the crisis. However it took several decades of accumulating minor excesses to get us to this point. The dismantling of the Glass Steagall Act took place over six decades after which we promptly found ourselves suffering from a case of the same malaise that had beset us in the 1930’s: depository institutions using deposits to create and hold securities for their own account. In addition, congress moved well beyond encouraging home ownership through the mortgage deduction to mandating lax lending standards through the community reinvestment act. The secret sauce that ultimately ignited this explosive combination of financial engineering and legislative mischief was leverage and it was unprecedented levels of leverage that found its best and highest purpose imbedded within the alternative investment universe.

Commercial Real Estate valuations were turbo charged by previously unseen loan to value ratios. Private Equity transactions (formerly known as leveraged buyouts until that became a dirty word) were made possible through the willingness of investors to suspend disbelief in the ability of the general partner to “lever up” and “rationalize” an asset (that they probably paid a premium for) in order to provide a double digit return. Quantitative strategies had for some time relied on substantial levels of leverage in order to magnify the benefits of small discrepancies in pricing. The absence of price volatility was simply a function of illiquidity and the reality that the investments rarely if ever traded at free market prices. Alternatives single best feature – their apparent stability – was a mirage and it turned out to be the Achilles heel of the entire approach.

The Trouble with Zombies

The trick in cleaning up a multi-decade mess is that you must strike a balance between doing what is good for the short-term and doing what is right in the long-term. In other words, we can’t have the cure be worse than the illness. In our current condition, this has led to the rise of the “zombie banks”. These are banks that are functionally insolvent, but because of their sheer numbers (775 as of 5/20/10), wholesale liquidations would swamp the system including all of the healthy banks. The FDIC and FASB have therefore embarked on a multi year process of closing the zombies a handful per week. In the meantime, the accounting rules have been suspended for all banks so that they are not required to recognize a mark to market loss on their portfolio loans. The thinking was that the mark to market process was causing too much unnecessary turbulence within institutions’ holdings. While that may be true, pretending that the losses are not real has created a number of unintended consequences. The policy known pejoratively as “pretend and extend” has unambiguously slowed down the pace of moving impaired assets into the hands of stronger owners. Zombie banks awaiting their turn at the FDIC auction block conduct no business. They can’t make new loans and they can’t make the important decisions as to which losses to recognize and which loans to renegotiate. Their customers, many of whom are small businesses, are also stuck in this purgatory unable to move forward until old debts are resolved. Even healthy institutions might balk at recognizing a loss when there is very little penalty for delaying the inevitable. Again a “rolling loan gathers no loss”. Both the deliberate pace of bank closings, which may well be entirely justified, coupled with the accounting policy, are certainly contributing to the overall difficult credit environment. However we must bear in mind that there were not any good options presented to magically transport us back to a healthy banking and credit backdrop. The choices were sadly between bad and worse.

Shocked Again

The economy is doggedly improving. Despite the burdens of an uncertain Euro environment, uncertain and increasing federal and state tax policy, uncertain new financial regulatory requirements, uncertain new healthcare costs, despite all of this and more, the economy continues to plow ahead – slowly. Too slowly for many, but ahead is the important point.

The impatience with the pace of recovery is not particularly helpful. In the beginning of the year we noted that every headline included the words “unexpectedly”. Jobless claims were “unexpectedly” higher, housing starts were “unexpectedly” lower, wholesale inventories “unexpectedly” dropped. It seems as though we have fallen back into this rhetorical rut. We need to stop the Captain Renault behavior – we need to stop being “Shocked, Shocked”. This is a long-term recovery which requires serious discussions over difficult issues. The bears don’t need another recession to win the day. Given enough intellectual dishonesty, disappointment could sabotage an uneven recovery.

When we consider the current credit environment it is interesting to note that the only entity who has not tightened their credit posture is the Federal Reserve. Banks are lending far less and the securitization market which was the dominant home of consumer credit is still moribund. The steep yield curve remains a potent source of earnings for banks and will allow them to heal their balance sheets far faster than any other remedy. The Federal Reserve, to a great extent, controls the levers of the recovery.

For investors, balance sheet strength has never been more valuable. The Wall Street Journal noted in their June 11th issue:

U.S. companies are holding more cash in the bank than at any point on record, underscoring persistent worries about financial markets and about the sustainability of the economic recovery.

The Federal Reserve reported Thursday that nonfinancial companies had socked away $1.84 trillion in cash and other liquid assets as of the end of March, up 26% from a year earlier and the largest-ever increase in records going back to 1952. Cash made up about 7% of all company assets, including factories and financial investments, the highest level since 1963.

This is a powerful endorsement for owning US companies. The competitive strength that comes from this posture will be a huge driver of equity performance. In 2009 we did witness a terrific recovery in the riskiest assets, but that may have represented more of a trade than an investment. This recovery is going to be led by those companies and financial institutions with the best balance sheets. Period. With overall credit continuing to contract, those with balance sheet strength are enormously advantaged. This will also true in regards to Municipal borrowers.

Municipal bonds have historically enjoyed default rates of less than 0.05%. However, we are currently witnessing balance sheet stress across many jurisdictions and this has led to an appropriate discussion of whether or not historical default rates will be a reliable guide going forward.

In our practice we have always insisted on owning bonds which are considered essential services and which also carry a supplemental insurance policy. We have also emphasized those states which have stronger balance sheets and we have not ventured into those areas of issuance which have owned the majority of historical defaults. Pacific Investment Management in a report dated November, 2008 made the following comments.

Higher default risk exists in special tax, healthcare and industrial development sectors

• Majority of defaults in the next few years should occur with speculative
  grade credits in special tax (i.e. land-secured), healthcare and
  industrial development (“IDB”) sectors.
• Failed developers and increases in delinquent tax payments from
  homeowners are affecting special tax bonds for real estate projects.
• Over-levered healthcare providers in over supplied markets pose risks.
  Some hospitals in New Jersey are examples. The poor economy is
  pressuring utilization rates and increasing bad debt levels.
• Bonds in the IDB sector are typically backed by private corporations
  and often in cyclical and more speculative businesses, such as chemicals, paper & pulp, airlines and alternative energy.

Warren Buffett has recently added fuel to the municipal debate during his testimony in front of congress regarding his equity ownership of the rating agency Moody’s. He very publically made a point of announcing that his holding company had recently reduced holdings in municipal bonds. But he failed to very publically mention that his insurance arm had significantly added to their municipal exposure over the past two years through their Berkshire Hathaway reinsurance arm.

We should understand that having budgetary stress does not immediately translate into the inability to pay debt service payments. Mr. Buffett is perhaps most concerned that an issuer who is under stress might look to see which of their bonds are insured and then choose to allow Mr. Buffett to make the payments for them on the insured paper while they service those bonds without. While this is merely a theoretical outcome, it is certainly one which worries him and could make him slightly less than objective in his commentary.

Those essential service bonds with dedicated revenues such as electric utilities, water and sewer, and school bonds should remain not only solvent but are likely to see ever increasing demand as the market becomes more discriminating in its approach to municipals.

In addition, tax-free income is likely to play an increasingly important role in portfolio performance in the coming years and we navigate a tax code which is placing increasing burdens on capital and investments.

Best Wishes,

Patsy and Jen

• Hip & Groovy
• The Trouble with Zombies