April 2008: Avoiding Armageddon; After Nearly 100 Years, Bear Stearns Disappears
During the March 15-16th weekend, the Secretary of the Treasury, Chairman of the Federal Reserve Bank (FED), assorted Congressional worthies, and yes, untold numbers of lawyers, were crafting a solution to avoid the possible collapse of the world’s credit markets. The venerable investment banking firm of Bear Stearns, which was leveraged more than 50 times its owners’ equity (equivalent to a home mortgage of $2 down for each $100 borrowed) was faced with a massive margin call and needed to raise additional capital. If a rescue could not be devised, Bear Stearns would have to declare bankruptcy. If a bailout could not be agreed to, Monday morning, the borrowing binge for Bear Stearns, at least, was about to hit the wall.
The solution, finalized late Sunday by Messrs. Paulson and Bernanke and the good folks at J.P. Morgan, and announced before the NYSE opening bell on Monday morning, was a takeover by J.P. Morgan Chase of all of Bear Stearns operations and obligations, with the FED guaranteeing a portion of the debt assumed. In other words, once again the U. S. taxpayer became the guarantor and lender of last resort.
One might be tempted to suggest that Bear Stearns’ owners, whose stock had plummeted to $2 from $70 per share in a period of a few days, deserved what they were about to receive (i.e., the loss of all their investment). Why was such a rescue necessary, and why perhaps will others occur in the future? The answer lies in the maze of mandatory, arcane accounting rules and financial reporting conventions governing how commercial and investment banking company capital and reporting requirements operate. In the U.S., banks and many financial services companies by law must account daily to their regulatory oversight authorities, who in turn monitor minimum and maximum capital and leverage ratios to assure financial viability. A margin call, a notice by a lender to a borrower that the value of collateral pledged to cover covenanted secured debt obligations, requires immediate remediation.
If a firm, like Bear Stearns, is compelled to liquidate collateral pledged to cover its borrowings, it must do so almost within the hour of receiving notice by the lender of breach of the collateral agreement. Forced to liquidate into a buyer’s market, inevitably such collateral securities’ fire sales are closed out at depressed prices. If collateral offerings go without bids, in today’s Sarbanes-Oxley accounting world, this translates into a valuation of zero on the seller’s books. Since the accounting rules require all other owners of these affected securities to in turn reflect current market values on their balance sheets, the ripple multiplier impact throughout the system can (would) be devastating. If that fateful Monday morning, March 17th, Bear Stearns would have been placed in liquidation, the mark-to-market financial accounting requirements would have put many other investment banking firms in the U.S., and others throughout the world, in immediate jeopardy. So Sunday night, March 16th, the authorities, were faced with what Sam Zell (one of this country’s preeminent bottom fishers) termed “… not a cash crisis, but a ‘mark’ crisis.” A bailout had to be engineered.
Mr. Greenspan's Mea Culpa
For the genesis of these recent credit market developments, future analysts will probably call to task some of the central banking strategies employed by the recently retired Federal Reserve Chairman, oracular wordsmith Alan Greenspan, famous for keeping the credit markets on edge with nearly undecipherable policy pronouncements. Richard Russell, editor of the former Dow Jones Newsletter, answering his own question was once prompted to ask “Why did it take Alan Greenspan ten years to get around to marrying his girlfriend? Because it took her ten years to figure out what he was talking about.” Concerned he might be losing the initiative with the media, Greenspan has recently been attempting to set the record straight.
In the first of a series of Financial Times articles (March 16, 2008), sounding a bit like Captain Renault (Claude Rains) in the movie Casablanca when closing down Rick’s Café Americain, commenting on the subprime mortgage crisis, Greenspan says, “Those of us who look to the self-interest of lending institutions to protect shareholder equity have to be in a state of shocked disbelief.” A computerized financial modeling junkie, Greenspan generally placed an inordinate amount of faith in complex economic scenario and risk-control models to guide U.S. central bank policy during his 18 years at the FED’s helm. What he now admits is that heavy reliance on these techniques did not (cannot) adjust for “…the innate human responses that result in swings between euphoria and fear that repeat themselves generation after generation with little evidence of a learning curve.” (www.FT.com 3/20/2008) Some money managers might suggest he read a book called Extraordinary Popular Delusions and the Madness of Crowds by Charles Mackay, first published in 1841 and reissued a number of times since. In Greenspan’s own words, we have moved from an investment market emotional state he once famously characterized as “irrational exuberance,” to irrational avarice, and on to irrational fear today; all recognizable and well chronicled behavior patterns continually repeated since Tulip Mania of the early 17th century.
With an eye on the history books, in a second Financial Times article (4/6/08) headlined (presumably by the editor) “The Fed is blameless on the property bubble,” Greenspan asserts that “… it is not credible that regulators would have been able to prevent the subprime debacle… the core of the subprime problem lies with the misjudgments of the investment community…” The blame game begins. For someone of almost Olympian stature, it seems a sad postscript to an otherwise admirable public service career. Take your places, sit back and watch the spin unfold further.
The New Regulatory, Trade and Tax Policy Environment
Someone no doubt has been quoted as saying the root driver in politics is economics. In this election year, who gains, or holds, the political reins will have everything to do with whether investors in the years to come will achieve their personal economic independence objectives. The cost of the Federal and State entitlement programs due to kick in during the next 10-30 years can only be covered in the best of circumstances by increasing tax revenues derived from a healthy growing economy. Globalization, trade expansion, and reasonable corporate and personal tax policies are essential to provide the backdrop, the motivation to put capital at risk, invest for the long-term, and build companies which will create job opportunities and the incentive to work.
With almost no understanding of the possible consequences of their votes, in the early 1930’s Congress enacted legislation to raise tariffs and increase taxes, both at a time of a weakening domestic economy and global crisis in confidence. The result was the Great Depression, from which it took nearly a generation to recover. “Those who fail to study history are doomed to repeat it.” The investment markets today are certainly attempting to discount what is ahead for corporate earnings in the immediate future, but almost just as importantly assessing the longer term political and economic prospects for 2009 and beyond. In the current political setting, it’s difficult to anticipate the possible November election outcome, but its importance for savers and investors cannot be underestimated. If our politicians continue to focus their electioneering rhetoric on what’s politically correct and what’s not, longer term the resources needed to cover our growing backlog of entitlements will never materialize.
Nearing a Bottom, a Reversal or More of the Same?
From some equity market observers there is an emerging sense that the Bear Stearns deliverance was at least a psychological turning point for the U.S. stock market. To a degree, circumventing the Bear Stearns turmoil probably imparted a certain confidence that the FED was capable of handling any such future crisis. But, given the continued severity of the current credit market malaise, the lack of a more obvious capitulation on the part of stock market momentum players like hedge funds, institutional money managers, individual speculators, plus the continued need to remove further leverage from the banking system, it would seem premature to expect the lifting of the pervasive bear market sentiment.
By some estimates, another $200 billion in securitized credit market obligations remains to be written off. Also, many non-U.S. banks, subject to less onerous oversight and operating under less immediate time-sensitive reporting requirements, have yet to be heard from. More unpleasant financial market surprises most likely lie ahead, but the worst may have been experienced.
Millennium Portfolio Results...Where's the Excess Return?
Since 1926, the average compound annual return for the S&P 500 Index, a benchmark throughout the period representing roughly 80% of the U.S. market’s common stock capitalization, has been a bit more than 10%; for smaller U.S. companies the rate has approximated 12% per annum. Earning 10% per year, an investor’s capital doubles every seven years, at 12% it only takes 6 years.
After WWII, U.S. equity investors have experienced these results, almost without interruption, accepting (expecting) such performance almost as if another entitlement. Stated another way, using calendar year periods as a measure, the stock market by December 31st of each year has risen 72% of the time. Rolling seven year periods throughout this 82 years of market history equal or exceed a 10% compounded rate 57% of the time. However, there have been lengthy periods of flat results (e.g., 1973-1981) during which long-term equity investors, many depending on their invested capital to cover living expenses, have been tested and endured drawdowns of their capital which were/are painful.
Since the millennium (remember Y2K!), a period of the last seven years, most U.S. stock investors might well ask whether their common stock portfolios have performed up to benchmark expectations and if the equity portion of their accounts has earned anywhere near the historic rate of return to which we have become accustomed? As the chart below illustrates, the answer as of the moment to this question is likely to be disappointing. Unless one was diversified more broadly into small companies, international and emerging markets, as well as U.S. bonds, most individual investors since the millennium lost purchasing power (i.e., inflation-adjusted capital value) in the equity portion of their holdings. Even the fixed income (bond) segment outperformed U.S. large companies during the period. An allocation to natural resources, secondarily a play on China’s and India’s growing economies, also enhanced investor results during this period of relatively lower U.S. large company stock returns. In summary, a global, sector and asset class diversified portfolio, our approach, has generated above average returns (vs. the U.S. stock market).
As one might infer from the earlier parts of this letter, these below-average equity results are likely to persist as the unwinding of the credit market excesses plays out the remainder of this year. As the underlying economic fundamentals begin to improve and the credit markets return to more normal levels of liquidity, the equity markets will begin to firm up and discount improving corporate earnings prospects. It is at such times as this that investors look to the fixed income portion of their balanced portfolios to cover required withdrawals for emergencies and life style maintenance.
As always, we welcome your questions, comments, and suggestions.
Sincerely,
James L. Joslin
Chairman, CEO