Issue 58 - December 29, 2009

2009 – The Year in Review

As 2009 winds down, it does feel as though we have all just exited an extended roller coaster ride that we really never intended to take. This was not just a turbulent year. This was a tumultuous, 22 month episode where credit driven excesses collapsed under their own weight and initially took quality, liquid assets along as collateral damage.

On the positive side, 2009 was a validation of traditional investing styles and asset allocation. Investors with robust, diversified and liquid portfolios were able to withstand all that the markets threw at them and were rewarded with a powerful recovery across asset classes. This performance stands in stark contrast to those pensions and endowments who for years had been crowing over their success in being clever enough to plow ever growing amounts into illiquid alternative assets such as hedge funds, private equity, and commercial real estate. Their over reliance on illiquid investments turned out to be their Achilles’ heel. Many were forced to sell their liquid stocks and bonds at market lows in order to meet basic operating expenses and as a group they were well under allocated to the powerful 2009 recovery.

On the less positive side, this year has also been filled with reminders that we have significant remaining financial challenges in front of us. All told, 140 banks were shuttered this year, yet the most intransigent loan problems remain and credit overall remains impaired. The depth of the commercial real estate refinancing problem and the total supply of foreclosed but not yet listed homes for sale (REO) have yet to be fully reflected into current market values.

Stability rather than health within the financial system was the hallmark of 2009. While it is a most welcome and necessary element, it is not an entirely sufficient component to putting the economy back on a growth track. Stability, however will allow us to continue the difficult process of recognizing major losses and to eventually transferring these impaired assets into the hands of investors with the financial strength to see them through.

2010 - The Year "The Exit"

Since the failure of Bear Stearns in March of 2008, the Federal Reserve in concert with the US Treasury and the FDIC have provided a series of extraordinary lending facilities as they fought to keep financial markets functioning. From direct open market purchases of US Treasuries and Agency Mortgages, to the Money Market Mutual Fund Liquidity Facility, the Commercial Paper Funding Facility, the Primary Dealer Credit Facility, and the Term Securities Lending Facility; these programs have largely achieved their desired purposes and have either expired or in the process of winding down. These Measures are know collectively as “Quantitative Easing” or “QE” and were the tools used to go above and beyond the traditional steps such as the lowering of the Fed Funds benchmark rate which in this situation was rapidly taken all the way to 0%. The thinking went that even the use of free money does no one any good if all the banks and businesses are closed.

As markets have recovered this year – discussions have now turned to the Monday morning quarterbacking of the decisions that were made during the time of crisis and to debating how and when the remaining support can be withdrawn. However, not all problems are created equal. Restoring confidence in money market accounts is a challenging but different task than trying to thoughtfully shutter the remaining impaired 500+ banks without creating undue disruptions. Certain problems just take longer to solve and these are whoppers. We should be mindful of these timing issues when we consider what the next steps might be.

There are those who hold the position that what we have come through is deeper than an average recession and as such, we should expect at a minimum, a strong recovery as pent up and replacement demand assert themselves. There is much to admire in this view and history is certainly on their side.

But there is also a school of thought that we just experienced is not so much a business cycle recession but rather a massive, deflationary monetary shock. In this view, the steps that the Federal Reserve has taken, while colossal, are perhaps not sufficient offsets. While this school of thought has less history on its side, they might have more current reality.

Meredith Whitney, the New York based banking analyst who presciently called the depth of the banking crisis while others could or would not has said recently the following:

“Anyone counting on a meaningful economic recovery will be greatly disappointed. How do I know? I follow credit, and credit is contracting. Access to credit is being denied at an accelerating pace. Large, well-capitalized companies have no problem finding credit. Small businesses, on the other hand, have never had a harder time getting a loan….

Unfortunately for small businesses, credit-line cuts are only about half way through. Home equity loans, also historically a key funding source for start-up small businesses, are not a source of liquidity anymore because more than 32% of U.S. homes are worth less than their mortgages.

Why do small businesses matter so much? In the U.S., small businesses employ 50% of the country's workforce and contribute 38% of GDP. Without access to credit, small businesses can't grow, can't hire, and too often end up going out of business. What's more, small businesses are often the primary source of this country's innovation. Apple, Dell, McDonald's, Starbucks were all started as small businesses.”

The reality surrounding growth for 2010 no doubt lies somewhere in between these views. Given how dreadful the economic performance has been for the previous two years, the bar for improvement is set awfully low and measurable forward progress should not be too hard to achieve. The real test of this economy however will not be surpassing some arbitrary hurdle rate; rather it will be to see if whatever growth we do initially enjoy can be sustained especially as the benevolent government policies are withdrawn and the enormity of the real estate losses are actually recognized.

Deflation or Inflation?

It is simply remarkable that given all that we now know about the state of our economy and financial institutions that we continue to debate about which diametrically opposite problem we should be most concerned about. Has the Federal Reserve done enough to combat the deflationary effects of the shock or have they over flooded the system with way too much inflationary cash?



The chart above shows what is known as the Money Multiplier effect. Despite all of the liquidity that has been fire hosed into our economy, cash is simply not being deployed. As credit has been withdrawn – cash should be used as a buffer and a replacement, but it is not. The forces of deleveraging are at this time far more potent than any inflationary impact of excessive cash in the system.

The reasons for this lie within the landscape of the typical bank. Banks own a portfolio of both commercial properties and residential loans and are experiencing defaults far beyond what was ever imagined. However, at this time, they are being shown relief from the mark to market accounting rules and are not required to write down non performing loans until such time as the bank officially recognizes the loss. This is known pejoratively as “pretending and extending”. But pretending that losses are not real is not the same thing as not actually having them. Bank officials know the losses will someday have to be accounted for and this is a major reason why they continue to squirrel away capital that might otherwise be used to make old fashioned loans. In addition, there are continuing calls for higher levels of regulatory capital. One can hardly blame bankers for wanting to sit on their hands. On the one hand – they know they have losses even if the regulators don’t want to know, and on the other hand, they know that those same regulators want them to raise still more capital to prevent further shocks down the road.

To complicate matters further, many of the largest institutions can go borrow from the Federal Reserve at 0% and buy, for example, a two year US Treasury note and make a risk free return of 85 basis points which can then be added back into the sorely needed capital account. Making a traditional loan is at best the 3rd thing to do on their list and in fact it is a very distant 3rd. This healing process for the banks is going to take years given the breadth and depth of the bad loans. This is not an insurmountable problem, but as investors we should not have expectations that credit will magically begin to expand at a time when there continues to be a tremendous amount of de-leveraging and loss recognition that has yet to take place.

4 Cylinder Economy

Given all that the economy and investors have endured, we should take a moment to consider how much healing as taken place in 2009. While unemployment has continued to rise overall, the pace of the decline has slowed considerably. The major market indices, while still well below their October 2007 highs, are up an eye popping 60% off of their March 2009 lows and credit spreads for corporate and municipal borrowers fortunate enough to have access to the capital markets have tightened back to more traditional levels. What lies in front of us though can not be dismissed by historical charts and pundits’ enthusiasm.

This has been a recession caused by a credit shock. Never before had we as a society borrowed so much on the strength of such little collateral and such thinly based projections. Credit losses have been and will continue to be staggering and the implications for the economy are profound. We can certainly expect a return to growth but it will not be the growth we had become accustomed to. We will have a four cylinder economy where we had been accustomed to a six.

The coming increases in taxes and regulatory requirements in conjunction with credit limitations will impair hiring. Impaired hiring prospects combined with increased consumer savings will change what had become traditional demand patterns. Uncertainty in end demand will temper investment in business expansion even in the cases where credit is available.

Credit is caught squarely in a catch 22 – those who qualify to borrow won’t and those who don’t qualify would dearly love to. This is very much a deflationary cycle and until such time as the banks have some visibility to the end of their loan losses and the possibility of returning to normal operations, the cycle will continue.

Rates and Returns

Where will the market go from here? As we’ve been know to say, “We could sure use a crystal ball right about now!” The turning of the calendar in fact changes very little. 2010 must continue the healing process.

On interest rates, the Federal Reserve has been emphatic meeting after meeting this year:

The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

Low rates and a steep yield curve are the perfect recipe to manufacture robust bank earnings which can then be used to reinforce capital and to offset loan losses. A flattening yield curve as defined by higher short rates which the Federal Reserve most influences, only serves to prolong the healing process. The more the banks can earn and the faster they can earn it, the sooner they can return to more traditional lending. Furthermore there is the matter of unemployment. The Federal Reserve is not in the business of tightening credit conditions during periods of employment stress. They will want to see meaningful improvements in the underlying metrics before they move and they will likely err on the side of extended low rates to ensure they do not repeat the sins of the either the 1930s or more modern day Japan by tightening before the growth in the economy is self sustaining. Deflation is public enemy number one, at least for the time being.

On stocks, the companies who have access to credit and enjoy strong balance sheets will continue to receive outsized advantages over their competitors. Top line growth or lack there of will be the focus, as earnings this year were largely propelled by increased productivity and efficiencies. Given all that has been recovered this year it would be reasonable to expect a period of some consolidation.

All in all – 2009 was a watershed year in financial markets where investors were well rewarded for the courage of their convictions. It has hopefully set the table for what should be continued improvement, albeit not without its own volatility. Conservative allocations with emphasis on risk adjusted returns and liquidity will remain our best advice.

Best Wishes,

Patsy and Jen

• 2009 - The Year in Review
• 2010 - The Year of "The Exit"
• Deflation or Inflation?
• 4 Cylinder Economy
• Rates and Returns