Issue 47 - December 5, 2008

Unwinding

Since the failure of Lehman Brothers in mid September, market performance has been chaotic. Value has become irrelevant as liquidations have swamped the market place. Global central banks have rolled out a phalanx of guarantees and direct investments all aimed at restoring liquidity and credit. Pundits spend hours every day explaining the deep inner meaning of each 5% move and providing endless comparisons to the 1930s. But the 21st century global economy is a far cry from the insular Smoot Hawley world of that decade and 21st century global markets would be unrecognizable to the JP Morgan’s of that day.

Modern markets require many elements in order to operate efficiently – not the least of which is confidence and perspective. The economy of the coming months will be difficult. Successfully navigating the markets will require discipline and a view towards the future of where value lies and where risk is appropriately rewarded.

The Past

From the post World War period up until the late 1970s, corporations and their investment and commercial banking peers were fairly straight forward institutions. Markets were highly regulated and commissions were fixed. Investment banks were exclusively private partnerships which went about the mundane business of underwriting and trading of securities of corporations and municipalities. Commercial banks provided lines of credit for only the most creditworthy enterprises.

The 1980s brought enormous and welcome innovations to financial markets. Working with Freddie Mac and Fannie Mae, financial institutions were able to package together individual home loans and the modern mortgage market was born (the US continues to be the only nation offering 30 year mortgages). Short term financing vehicles replaced bank debt as the default liquidity management tool for corporations and municipalities. Michael Milken pioneered a market for less than blue chip borrowers and the leveraged buyout business (aka private equity) was born. Commercial banks had been disintermediated and credit could be provided through securities never before seen. Wall Street was in its heyday.

But capitalism is not immune to Darwinian forces. Just as new structures ushered in new opportunities, competition eroded profit margins just at the time many of these private partnerships had joined the ranks of public companies as a way to finance expansion. Regulations grounded in the Depression era appeared archaic in this environment and the barriers between traditional investment and commercial banking activities disappeared. In a less productive society, the ill timed entry into the public markets would have doomed the investment banks but along came the personal computer and a thing called the internet. The country and the world demanded investment opportunities and the technology boom was on.

The dawn of the new century brought the boom to a bust and many investors looked to embrace any asset class that wasn’t equity. Combining ultra low interest rate policy with an explosion of credit, the technology boom was replaced by the real estate/hedge fund/private equity/commodity binge. Investment banks desperate to replace their busted technology income stream were delighted to gin up an endless supply of engineered alternatives which promised consistent, positive returns regardless of environment all in exchange for a little illiquidity and a hefty fee.

But just like any other boom – the alternatives were destined to bust and it began with a whimper in the summer of 2007. The initial reports blamed sub prime borrowers for the world’s financial woes – a group which comprised a whopping three percent of all borrowers. What was not known at that time, and is still the subject of debate, was how much money the worlds smartest and most credit worthy had borrowed and invested behind their veil of unregulated alternative investment funds. The total leverage was breath taking in hindsight and it is the unwinding of this leverage and of those investment models that is wreaking such havoc on global markets.

The Present

The drumbeat of bad news is hard to miss. Layoffs, foreclosures, and the worst environment anyone has ever seen, and on and on it goes. But this is an uneven downturn. Earnings for the S&P 500 for the third quarter were down 21.6% but excluding financials, the earnings were up 18.1% year over year. Wal-Mart is thriving even if Target is not. $4 gas prices which were front page news in July do not even warrant a comment now that they are back at $2 a mere 5 months later. This is not to say that the economic environment will not continue to be challenging, but it is to say that circumstances are changing quickly and those businesses which have invested most prudently will be highly advantaged over their competitors. This has potentially significant investment implications. What might really be different this time around is not the recession per se, but the differentiation in performance between similar companies.

Beyond the horizon of spirited competition sadly is the specter of failure of many businesses. Leverage is an amplifier and has in some cases masked years of mediocre returns. In the absence of that leverage, certain models are not sustainable. The Federal Reserve, through their myriad of programs, is helping to cushion the impact of these failures, but the catharsis must be allowed to run its course. In time, the stronger enterprises will assert themselves and begin to drive the economy forward. Another remarkable footnote to this episode may not be the recession specifics, but how well and for how long, the leverage kept it at bay.

The Future

The gift of fear has returned. As we wrote in our 2006 year end newsletter:

Not caring about certain risks is not the same as not having them. While an institution may have the ability to participate in more illiquid opportunities, it does not mean that they should not be compensated for taking on that additional risk. The same can be said for adding in leverage. Wall Street has traditionally valued risk in terms of price volatility to come up with a risk-adjusted return. The hallmark of these modern day alternative returns is their use of leverage and their overall lack of liquidity. It is exceptionally difficult to model these attributes to come up with any type of standard or historical data. Therefore the risk incurred in these allocations is a matter of debate. Have the institutions been fairly compensated for the risks they have incurred? All that has mattered is the absolute level of returns which has been quite good. Which brings us to a modern day definition of risk – one in which the risk of underperforming is perceived as more problematic than the risks potentially incurred with leverage and illiquidity.

Many sophisticated institutions are now contending with the consequences of over reliance on illiquid investments and they find themselves caught in an impossible bind. They all have ongoing distribution requirements which must be met. But over the past few years the trend has been to rely on liquidity events within the alternative portfolio rather than to have allocated to a dedicated reliable high grade stock and bond income stream. Liquidity events however are now as scarce as a northwest football team victory. With no interest or dividends to be found, these most sophisticated of all institutional investors have been driven to sell into distressed markets putting enormous downward pressure on all asset classes. The most liquid assets have been impacted the hardest as the discounts on such things as limited partnership interests are punitive and as high as 50%. To make matters worse, many of the largest hedge funds have established “gates” – a legal euphemism for not allowing any further withdrawals for these funds until such time that the general partner deems prudent. This only serves to put further pressure on other asset classes. It is safe to say that when these endowments and state funds achieve a state of equilibrium, they will be far more likely to include a far higher percentage of traditional liquid investments in their allocations than has been recently in vogue. This too has important and very positive implications for the highest quality corporate and municipal stock and bond offerings.

Meanwhile, we are finally seeing coordinated global efforts from every major central bank to provide direct sources of liquidity and credit to needy borrowers. In bypassing the banks who continue to struggle with their eroding capital and mortgage portfolios, the Federal Reserve puts the money directly into the system. This removes what had been a persistent limitation on the speed of the recovery and allows the banks and the borrowers to heal simultaneously.

As the system recovers and money once again begins to flow, it is hard to imagine that the impact of low rates will not be powerfully successful. This is the point at which we will move the conversation from Depression comparisons to rampant inflation comparisons. But this process will take a little while. We know that markets are anticipatory and that they will move higher well in advanced of the data looking comforting. As the selling pressure abates and the deleveraging process runs its course, investors will have an opportunity to see in much clearer detail exactly how rich or cheap markets have become.

We welcome a return to more fundamental analysis and believe that high quality portfolios will be rewarded for their discipline and patience.

• Unwinding
• The Past
• The Present
• The Future