February 3, 2009
What Have We Learned?
Greetings,
By now most have developed their own list of the blunders (whether political, central bank policy, regulatory, institutional, or individual investor) responsible for what will likely be the worst global recession since World War II. As we still seem to be in an extension of the "Great Meltdown of 2008," recognizing some of the factors leading to the current financial market and real economy malaise might be worth re-emphasizing; if only to place markers to guide future collective behavior.
George Soros, a much publicized international hedge fund investor, attempts to explain away the global credit market demise with his self-proclaimed "revolutionary theory of reflexivity."* However, the bursting of the housing bubble last year, of course, was the first domino to fall in a series of events which began building in the late 1990's. Initially, the unfettered issuance under the regulator's radar screen of opaque financial instruments labeled "derivatives" (which supposedly shifted the seller's investment risk to the buyer) laid the groundwork. Alan Blinder, professor of economics at Princeton, indicates in his January 25, 2009 New York Times article that allowing Wall Street investment banks in 2004 to increase their capital leverage from 12x1 up to as high as 33x1 was a second misstep. Although, perhaps not as extreme, of course, this was nothing more than a reflection of what was also taking place on consumer personal balance sheets.
Next came the surge in sub-prime lending which began in the banking system as a politically motivated means to broaden home ownership. Unfortunately, the unintended consequence was that this became a vehicle to build commercial bank fee income which spread to non-bank originators, again outside the purview of regulators. Lending standards lapsed. Mortgage brokers became wealthy overnight. While housing prices rose, increasing owner equity value covered a spate of real estate wealth extraction in the form of mortgage refinancings, in turn fueling a continuing consumer spending binge. As housing prices topped out and began to decline, homeowner equity disappeared, foreclosures erupted, and the political finger-pointing and obfuscation began.
In the spring of last year, JP Morgan absorbed an unsustainably leveraged Wall Street investment bank, Bear Stearns; but later in September, Lehman Brothers was allowed to go under. The latter set off an iterative series of events leading to the string of federal government interventionalist policy and fiscal measures, which, along with the Federal Reserve banking system actions, are being implemented today. The Treasury proposed, and Congress enacted, the Troubled Asset Relief Program (TARP), but its uncertain implementation seems to have undercut its original purpose. Financial markets, abhorring uncertainty and desiring transparency, collapsed in late September, declined to historic lows in mid-November, and now appear to be casting about for a new equilibrium which can be supported by current fundamentals.
Are the Right Decisions Being Made?
Hopes today are pinned on the pending $800 billion "stimulus" bill passed by the House and working its way through the Senate, and a soon-to-be-announced aggregation bank (or "bad bank") proposal. The former has become a vehicle to fund a long wish list of pet political causes which even the "non-partisan" Congressional Budget Office finds contains only a modest potential economic stimulative impact. The latter, due out of the Treasury Department shortly, appears to be a serious attempt to deal directly with the "toxic asset" problem presently plaguing our banking system.
Vaguely resembling the Resolution Trust Corporation (RTC) of the early 1990s set in place to remedy the S&L crisis, the "bad bank" would be a creature of Congress funded by taxpayers. It would acquire toxic paper from U.S. banks at heavily discounted prices, hold most to maturity, and hope in the long run to book a profit. Initially capitalized at $1.0-$1.5 trillion, if this proposal can navigate its way through Congress without disabling log-rolling, pork and earmarks, there is a chance a workable solution may have been reached. If carefully put into effect, there would be a reasonable probability taxpayers could achieve a modest, non-inflationary payback from such a program.
Optimizing Fixed Income Portfolio Structure
As the credit markets have attempted to sort through the global deleveraging process, even though the U.S. has its own well-publicized financial and investment market difficulties, investors world-wide have again turned to the U.S. dollar as the ultimate reserve currency, and to our Treasury securities as the wealth defense of last resort. Treasuries (bills, notes and bonds) are now priced at historically high levels in some instances, depressing yields on these government guaranteed obligations to negative real (i.e., inflation-adjusted) returns. In the short maturity end of the yield curve, investors are actually paying the U.S. Treasury for the privilege of lending our government their money!
In an extreme risk-aversion posture, forsaking income for security, this massive cash inflow into U.S. government securities has realigned many long-established yield-spread relationships in the fixed income securities markets. For example, for the first time in 50 years, tax-exempt bonds offer a greater pre-tax return than Treasury bonds. The spread between yields on high quality corporate bonds and U.S. Treasury Bonds, although narrowing somewhat in the past month, is today 2-3 percentage points (i.e., 200-300 basis points). We remain risk-averse for the most part in the fixed income sector, but for taxable investors the after-tax return offered by high quality tax-exempt and corporate bonds appears to suggest the reallocation of at least a portion of balanced account bond and cash reserves. For tax-exempt endowments and retirement accounts, the additional yield available through high quality intermediate corporate bonds also seems an attractive risk vs. reward trade-off.
The after-tax yield on both intermediate corporates and tax-exempt bonds today competes favorably with historic total returns on equities. Balanced account rebalancing programs during the weeks ahead will include shifts in the fixed income allocation taking advantage of these current yield-spread anomalies. These are opportunistic moves which will not produce major incremental portfolio returns, but when the low-hanging fruit seems reachable, it would seem sensible to take this opportunity to fine-tune client fixed income (i.e., bond fund) positions.
Realigning Equity Allocations
Turmoil in global stock markets also presents new opportunities to be evaluated. Although not requiring immediate action today, during the weeks ahead, the reallocation of cash equivalents and short-term fixed income positions to stock mutual funds in several installments over the next 6-12 months is part of the discipline we think should be considered. Our next e-mail update will be devoted to this issue. In the interim, as background to such a discussion, we recommend you review the article written by Dr. David Kelly, Chief Market Strategist and Andrew Goldberg, Market Strategist at JP Morgan Asset Management (PDF). In particular, attention is drawn to the sidebar on page 4, "Financial Silver Linings." The news today, and probably during the next few months, will continue to be dismal, but the vital signs, albeit faint readings, are beginning to indicate underlying market adjustments are running their course.
Please feel free to share your comments and questions.
Regards,
Jim
* George Soros, The New Paradigm for Financial Markets, Public Affairs, 2008.