Issue 84 - September 19, 2012


"Plus Ça Change"

The summer months have given way to the widely anticipated fall economic and policy announcements and to sum them up, “The more things change, the more they stay the same.” Economic readings across the board remain subdued which should certainly not come as a surprise or disappointment to anyone at this point given slowdowns in Europe and China. Despite the hoopla around both the September announcements coming out of the ECB and our own Federal Reserve, what if anything has really changed as we like to say “down here on earth”? Policy makers appear to be firmly committed to a path forward of crisis mitigation rather than one of longer term resolutions. This has taken much of the headlines and focus of the financial markets away from the actual results of companies which is unfortunate. Central bankers have become the proverbial elephants in the living room where their actions, or potential actions, are the main drivers of markets.

Fantasia meets the Euro Zone

In the 1940 Disney film Fantasia, there is a famous scene where Mickey Mouse acting as a sorcerer’s apprentice, dons a cap and proceeds to put a broomstick to work fetching the buckets of water he had been assigned to carry. With this painless solution in place, Mickey retires to take a nap. He awakes to find chaos with the room flooded and every action he takes to slow down the crisis makes the situation worse.

In the early part of 2012, the leaders of the ECB and IMF took the position regarding a restructuring of Greek debts, that their sovereign bond holdings were effectively senior to all of those of private bondholders. This led predictably to the flight of private capital out of the bonds of the P.I.G.S. This was no small matter. Without the pool of private capital to absorb ever expanding sovereign debt issuance, who would take their place? Enter the LTRO.

The LTRO or the long term repo operation was a three year facility put in place by the ECB to lend 800 native banks inexpensive funds with the understanding that these banks would add to their positions of sovereign bonds. Some banks did participate and others did not, but for those that did, they magnified and leveraged their credit risk enormously. This was not lost on the rating agencies or on their depositors. With no hurdles or limits imposed on the moving of funds from say a Spanish bank to a German bank, euro deposits have been flying out of the banks in the peripheral countries. Not to worry, our ECB sorcerers had conjured another provision to account for this possibility. Enter Target 2.

Target 2 is the interbank payment system established to allow for cross border flows in real time. When a Spanish depositor sends money to a German bank, the German bank can then deposit these surplus funds with their native central bank. The reason that we have not seen any old fashioned bank runs in the periphery, is that the ECB then sends the Euros back to the Spanish bank accounting for this advance with the credit on account at the Bundesbank. This circulation presents no problem unless of course say Spain changes currencies or defaults. Germany’s share of any ECB losses stands at 27% of the total amount.

To recap, the ECB has in the course of just this year, managed to drive out of the periphery much of the private capital which had been the traditional buyers of their sovereign debt and much of their native deposit base. Mickey would certainly be empathetic. Undeterred, Mario Draghi has yet another program up his sleeve to maintain the union. Enter Outright Monetary Transactions or OMT.

On July 26th, ECB head Mr. Draghi, stoked market hopes by simply saying that the ECB would do “whatever it takes” to preserve the Euro. Details were to follow after his August holiday. Now in September, “whatever it takes” amounts to outright purchases of sovereign bonds primarily from the banks. For those with a modest memory of the Maastricht Treaty, you might recall that the outright purchase of sovereign debt was prohibited. That was until Mr. Draghi was “bold” and pronounced that buying out to three years was actually not prohibited. Taken in conjunction with the direct financing to the banks (also explicitly prohibited) the ECB has become the primary if not sole source of capital in the Euro Zone periphery. The German courts even gave Mr. Draghi a wink and a nod when they approved the ESM – the Euro Stability Mechanism – a “permanent” bailout fund. The court did impose a limit on German support of €190BB but someone forgot to point out to the highest court that their target 2 liabilities are already well in excess of that!

While these actions take some immediate pressure off of the sovereign bond yields and may force the capitulation of some long suffering bears, they do nothing to address the longer term issues of debt restructuring, economic competitiveness, or employment. Plus Ça Change.

Cue the Federal Reserve

On September 13th, The US Federal Reserve announced the latest round of Quantitative Easing. Where in the past the Fed had announced specific timetables and amounts for open market purchases; the September release was entirely open ended. Taken on face value, this might represent a powerful next leg up for risk oriented financial assets. However, the preceding episode of QE saw substantially diminished returns relative to the first as putting more liquidity into a market already drowning in liquidity apparently does have its limits.

The Fed noted two conditions as the basis for their actions:

“The committee is concerned that, without further policy accommodation, economic growth might not be strong enough to generate sustained improvement in labor market conditions. Furthermore, strains in global financial markets continue to pose significant downside risks to the economic outlook.”

So, specifically, they are concerned about US employment and European growth. Fair enough. The problem is that the tools at the Federal Reserve’s disposal are fairly blunt instruments. It is difficult for them to ultimately achieve the precise results they are looking for without potentially inflicting a certain amount of other unintended and unpleasant consequences.

When the Federal Reserve lowers the benchmark rate, they are hoping to incent individuals and corporations to take advantage of lower borrowing costs. However, the hallmark of this economic period relative to the previous 30 years is the desire to reduce rather than accumulate debt.

The Fed has therefore taken a unique approach of continuing to lower rates through traditional and more recently, non traditional methods. Their thinking goes that if we can’t cajole people to borrow with the carrot of low rates, we can incent them to invest in growth oriented assets with the stick of the same low rates. Simply put, even if we can’t kick start credit demand as we have in the past, we can make interest rates unattractive to the point where investors will have no choice but to consider equities. These flows into stocks would increase the wealth of investors who would in turn spend their increased wealth and help the economy grow during an otherwise restrictive period of debt reduction. The rub has always been whether or not such a policy would ultimately be successful and whether the accompanying unintended costs would be worse than the problem itself. Now that bar has been raised and the new measure of success comes against the entrenched issue of unemployment. Mr. Bernanke was quick to say that the Fed would not keep the throttles of easing open until he sees any particular milepost. Rather he would keep them open until he deemed the matter sufficiently improved. While this latest policy certainly adds yet another wildcard into the economic mix, it may prove to be the case that just as QE2 was less impactful than its predecessor; QE3 may ultimately turn out to be “mostly hat no cattle”.

Shifting Transmission

With the Federal Reserve’s announcement that they will now focus on the purchase of mortgage backed securities, we are seeing a shift in their strategy. As we noted, their previous approach was to drive investors into higher risk/higher reward sectors of the market by making the safety of US Treasuries economically unappealing. This has done much for holders of equities and non governmental debt, but it has not had the positive impact on the housing market that low rates had traditionally prompted. The reason for this lies in the fact that housing was ground zero for the financial crisis. The combination of lower valuations, tighter lending conditions, and increased down payment requirements has made the search for a market bottom a long and painful process. The lack of a robust housing recovery has no doubt also impacted overall employment. From builders to agents, to lenders, the real estate market that made for a lot of jobs has not been restored. Previous programs that focused on mortgage modifications have met with limited success and there is the question of moral hazard when one who isn’t paying their loan gets a reduction in terms when those who are current are turned away. Foreclosures have run into legal quagmires due to the sloppy and lax underwriting standards that accompanied the boom. Current loan standards have run to the absurd in some cases where well qualified borrowers run into an endless do-loop of requests for supplemental information. The result of all of this is that the overall housing market remains impaired.

The Fed is clearly hoping that if they increase their demand for securitized pools of mortgages to the tune of $40BB per month then the marketplace will cooperate by producing more loans. Well, maybe…

Again, back down here on earth, are the banks and insurance companies who provide loan capital going to suddenly change their underwriting standards? Are they going to hire a large group of people to process loans when the buyer of these pools is not so much the market place but the Federal Reserve who may choose to dampen their enthusiasm for these bonds at any time? The banks are not sympathetic characters. However, in this case, they are clearly damned if they do and damned if they don’t.

Furthermore, by simply stating their intentions, the Fed has dramatically altered the current valuation landscape of existing mortgage loans. When Bill Gross comes out and says he is selling US Treasuries, he is very likely buying mortgage securities with the proceeds. Mortgages, just as all non governmental debt, trade at a spread over the similar US Treasury. Spreads on mortgages collapsed after the announcement while longer dated US Treasuries were sold off. Bully for Bill Gross, but higher US Treasury yields impact every other credit market, thus creating higher costs for everyone else. The majority of the committee obviously feels that this is a path worth taking despite the obvious limitations and potential consequences. Time will tell if this program has a lasting impact beyond the initial rollout.

Bottom's Up

The extraordinary measures taken by global central bankers have been center stage now for the better part of 4 years. Investors might be forgiven for allowing their focus to rest too much on their actions. But this would be a mistake. Valuations always matter in the end. We have seen periods when technical factors have overwhelmed the rationality of the market and these episodes always end in upset. While it has certainly been the Federal Reserve’s intention to get investors to look towards risk assets; risk assets have in some cases comported themselves very well and exhibit valuations they are well deserved. But it is hard to ignore certain distortions that the central banker’s actions have led to. This can present some real challenges for investment managers if a popular macro trade far exceeds fundamental valuations. Those sectors with high dividend yields such as REITs, Royalty Trusts, and Utilities have been good examples of this phenomenon. While it is always tempting to “reach for yield”, we will continue to focus our efforts on building and maintaining high quality, liquid portfolios, with a strong income component and defensible fundamentals.

The coming months are likely to feature a heightened level of volatility (and rhetoric) given the backdrop of elections and debates around expiring tax and spending policies. Thoughtful, bottom-up fundamental analysis will be critical in what could prove to be further “interesting times”.

Best Wishes,

Jen & Patsy


In this Edition

  • Plus Ça Change
  • Fantasia meets the Euro Zone
  • Cue the Federal Reserve
  • Shifting Transmission
  • Bottom's Up

Huntington Steele

925 4th Avenue
Suite 3700
Seattle, WA 98104



Past Issues

83 - 08.21.12
Summer Time Slows but the Lawyers are busy/ Whatever it Takes/ Heavy Weight Fight

82 - 06.29.12
Half Time 2012/ 19 Euro Summits - A Tiger by the Tail/ The Crystal Ball

81 - 06.11.12
Next Chapter/ Election Lessons/ A Gentleman's C/ Opportunities

80 - 05.10.12
Choices/ Texas Hedge/ Outcomes

79 - 04.09.12
13,000 x 1,400/ Lessons Learned/ It's Not Insider Trading When Congress Does It/ Crystal Ball

78 - 03.21.12
Goldman's Casablanca Moment/ Mr. Macy meet Mr. Gimbel/ The Fiduciary Standard - The Gold Standard

77 - 03.05.12
Punxsutawney Greece/ Foaming the Runway/ "The Euro Crisis is Behind Us/ Healing Hoopla/ What Price Income?

76 - 01.09.12
2012 - The Continuum/ Europe - Working in the Injury Time/ "Risk On - Risk Off"/ The Road Ahead

75 - 12.05.11
The Problem/ What Could Go Wrong/ Compound Interest/ Germany or Bust/ The Cavalry/ Stress Tests/ Next Chapters/ MF Global

74 - 09.29.11
Broken Transmission/ Chickens and Eggs/ Where to?

73 - 08.29.11
The Confluence/ The ECB/ US Economy - Distinction without a Difference/ A Different Kind of Exit/ Gold as a Thermos/ Where to Now?

72 - 06.28.11
Sovereign, Central, Commercial/ Why we call them "Banksters"/ "Extended Period" just got a lot longer/ Forward.

71 - 05.24.11
The Question is... How Many Years?/ "Unexpected" Housing Weakness/ P.I.G.S. Can't Fly/ Stages.

70 - 04.11.11
Inflation for thee, but not for me/ On the Other Hand .

69 - 04.05.11
Implications - A Bevy & A Wedge/ Implications - Quantitative Easing 2.0/ Implications - Rules Rules Rules/ Catching Up with the Can.

68 - 03.03.11
What Ever Happened to Housing?/ Where Do Loans Come From?/
Where Do Loans Go?/ The Last Straw/ The Path Forward/ Equity/ Clearing Mechanism/ Restart Your Securitization Engines.

67 - 01.10.11
Curiosity of the Federal Reserve/ Complacency & Fragility

66 - 11.12.10
Phew/ Taxes and Employment/ Quantitative Easing Returns/ Incentives & Unintended Consequences/ Dear Mr. President

65 - 09.28.10
Progress in the Absence of Milestones/ Changing Nature/ Correlations & Valuations/ Synthetic Securities

64 - 08.18.10
A Tricky Diagnosis/ Traditional Treatment/ Bad Medicine/ New Age Medicine/ Homeowners/ The Banks/ Pension Plans/ Bull Flattening

63 - 06.17.10
Hip & Groovy/ The Trouble with Zombies

62 - 05.24.10
Next Sequel/ 2012

61 - 05.04.10
Intensity/ Principles versus Rules

60 - 04.01.10
Grand Isle to Lincoln
/ Mile Post 312/ Mile Post 353/ Mile Post 399/ P.I.G.S. are a Problem

59 - 02.17.10
Surprise, Surprise, Surprise/ P.I.G.S. Matter/ Leverage vs. Debt/ Going Forward



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Market Highlights



6/29/12 3/30/12 12/30/11 12/31/10 12/31/09 12/31/08 12/31/07
12,880 13,212 12,218 11,578 10,428
S&P 500 US


1,362 1,408 1,258 1,258 1,115
Nasdaq US
2,935 3,092 2,605 2,653 2,269
EAFE Int'l Equity
1,423 1,553 1,413 1,658 1,581
5 Yr Treasury .73 .75 1.07 .85 2.02 2.71
5 Yr AAA Muni .84 .86 1.03 .94 1.75
10 Yr Treasury
1.73 2.28 1.96 3.38 3.92
10 Yr AAA Muni
2.05 2.24 2.08 3.44 3.26
30 Yr Treasury 3.01 2.78 3.33 2.914 4.325
30 Yr AAA Muni 3.39 3.56 3.72 3.82 4.9
EUR Currency 1.31 1.26 1.33 1.29 1.34
JPY Currency 78.63 79.49 82.08 77.36 81.32
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