The price of everything

When overconfidence and leverage meet other people’s money

“Trust is a tough thing to come by these days.” – RJ MacReady (Kurt Russell) in John Carpenter’s ‘The Thing’.

 

Those of us who grew up in the 1980s have a special affection for ‘The Thing’. The last great gasp of special effects before CGI and a spirited remake of Howard Hawks’ cold war sci-fi classic, the film is set in an isolated Antarctic research station. A dozen Americans are assailed by an extraterrestrial with the ability to change shape at will. Because the alien can easily imitate human beings, pretty soon the atmosphere of tension, mutual distrust and paranoia becomes almost unbearable. As the small band gets whittled down further and further, self-preservation wins out over camaraderie. As helicopter pilot MacReady comments in a diarised recording to tape,

 

“Nobody.. nobody trusts anybody now, and we’re all very tired.. there’s nothing more I can do, just wait..”

 

‘The Thing’ bears further comparison to current markets in that the carnage is unbelievable.

 

Financial markets are reliant on trust to function normally. The days of gentlemanly capitalism and dictum meum pactum are of course long gone, but a vestigial sense of surety in the financial system is still required for its smooth functioning. Unfortunately, having failed to entirely crush all faith in propriety during the dotcom boom, a motley combination of investment banks and leveraged speculators has had another go at mutually assured destruction. This time round they seem to have come closer to succeeding. What is more than a little shocking is how few lessons appear to have been learnt by ‘hedge’ fund managers from the LTCM crisis. Too much reliance on financial modelling; optimistic assessments of market liquidity; crowded trades; grotesque overleverage.. History may not repeat itself, but it sure does rhyme.

 

Reading one book will have made a substantive difference to investors this year. Yale endowment manager David Swensen’s ‘Pioneering Portfolio Management’ has much to recommend it, but two observations are invaluable: bondholders are typically fighting a losing battle; and boutique fund managers have demonstrably fewer conflicts of interest than full service investment banks. Suffice to say, the initial spark to this year’s market tinderbox was structured debt distributed by investment banks. Fingerpointing is never that productive at the best of times, but it is perhaps worth noting the reputational and material damage inflicted upon full service houses after forays into largely non-core investment businesses. Any lessons learned from the subprime debacle will of course be long forgotten by the time the next broad market dislocation grinds into being.

 

What now ? Amid such extraordinary volatility, it only makes sense to be positioned for the longer term, both at an asset allocation and an underlying level. Specific pockets within the equity market (notably diversified miners and resources groups) have at least optical cheapness, but the price swings are still so wild that averaging into them makes more sense than calling a definitive bottom to either market or sector, emergency Fed action notwithstanding. And the future behaviour of the US consumer is uncertain. Equity markets are not just reflecting being caught in the drive-by shooting of a credit market panic but are starting to price in genuine economic weakness. Last week’s deteriorating newsflow from the likes of Wal-Mart and Home Depot points to the real world impact of what would otherwise be a problem limited to the residential property and mortgage market. There are worsening property-related economic impacts to follow – most likely in the UK, but Eastern Europe and Asia will not be immune. Tellingly, Asian stock markets were shocking performers at the end of last week. (Though again, over the long run, Asia’s anticipated outperformance versus US and Europe looks as inevitable as a force of nature.)

 

It’s difficult to see how easier monetary policy substantially brightens the mood. Nevertheless, on a ‘least worst’ basis, government debt, though technically overbought, is proving a safer haven than many of the usual suspects, including gold – which now looks like a good candidate for longer term portfolio diversification and a hedge against a dollar crisis that may yet come in the aftermath of easier money – again – in the US. Many commentators are lambasting commodities and precious metals for failing to hedge conventional investments. This criticism is premature, as the recent correlation between any number of disparate assets has been extraordinary, and the markets have been notably indiscriminate as investors dash for liquidity. The good, the bad and the ugly have all been sold, but the good will obviously recover in time. Given the dependency of much of the private equity and much of the ‘hedge’ fund market upon cheap credit, it feels like we have seen the high water mark in the fortunes of these sectors for quite some time. (If this proves to be the case, it will not necessarily make sense to buy financials when the low is apparently in – the knock-on effects upon underwriting, lending and prime brokerage, and most importantly confidence, will be severe.) The traditional defensives in equity markets include tobacco, utilities, pharmaceuticals, consumer personal care products, food and brewers. Foodstuff inflation will probably dampen the outperformance of the latter two sectors, but the composition of the list should still make sense. Notwithstanding Warren Buffett’s advice to get greedy when others are fearful, the same investor also counselled: Rule No. 1: Don’t Lose Money. Rule No. 2: See Rule No. 1. While markets are evidently part-way through the cycle of fear, it is by no means clear that the final revulsion stage has successfully been passed.

 

(Caution: spoiler warning.) In a desperate attempt to destroy the alien in ‘The Thing’ and prevent it from infecting the rest of the world, the survivors – Childs and MacReady - set fire to their Antarctic base..

 

Childs: “The explosions set the temperatures up all over the camp. But it won’t last long though.”

 

MacReady: “When these fires go out, neither will we.”

 

Childs: “How will we make it ?”

 

MacReady: “Maybe we shouldn’t.”

TRILLIONS TRASHED IN TOXIC TSUNAMI

August 10, Pohnpei Island – The stock markets of the Federated States of Micronesia tumbled for a 16^th straight session earlier today on concerns that sub-prime lending problems in the US would hamper growth in the world’s 287^th largest economy. Finance minister Kiribatiguam RuarruruaarrRGGGHHhrroo voiced fears that Micronesian GDP would be “crushed” by ongoing tensions in the US mortgage and credit markets. The annual GDP of Micronesia is one coconut.

Micronesia’s problems are symptomatic of the climate of fear that is slowly surrounding the global capital markets like a giant strangling scarf made out of fear. United Bank of Micronesia shares slumped on speculation that amid the global financial turmoil Micronesia United Bank would pull out of a long drawn out and bitterly contested acquisition for its Palau-based rival which would have taken both banks’ combined payroll to two.

As investors worldwide huddled underneath blankets and started chanting fervent prayers to make peace with their respective gods, there were some concerns that overzealous financial journalists were compounding the problem and casting discipline, objectivity and nuanced or balanced coverage to the winds. “Investor sentiment has been napalmed by a carpet-bombing campaign of unmitigated nuclear horror. Aaaargggh !!” commented London rough sleeper Liam O’Shaughnessy, who has no apparent connection with the world of finance beyond the two pounds sterling that he spends daily on White Ace cider.

The Morgan Stanley Capital International World Index, citing extreme mark-to-market pricing volatility, abandoned digital calculations for updating its value and reverted instead to a methodology involving the physical transfer of forty-ton giant stone statues on a small Pacific island in an attempt to calm overstressed traders.

Following revelations from Australian, North American, French and German banks about the extent of their sub-prime investments and related exposures, it was left to Cheshunt, Hertfordshire-based retailer Tesco plc to be the latest corporate to reveal its liabilities to distressed structured debt. Tesco announced at a press conference last night that it has no exposure to sub-prime debt – primarily because it is a supermarket and not a poorly run financial conglomerate with no real risk controls and asset management divisions populated by ill-disciplined chancers. Tesco shares were marked down 68% regardless on the basis that money needed to be raised somehow to pay for all this leveraged rubbish.

Analysts and financial journalists continue to spend their time trumping each other’s jeremiads of imminent financial destruction. Analyst Jeff Venal of mortgage lenders, mortgage brokers, CDO underwriters and credit ratings agency TaintedFokker said he believed that the stock market, which is the one asset class his company doesn’t earn revenue from, was “a sort of vengeful, evil, poisonous lake of putrid horror” that would end “in a horrible fiery apocalypse” between now and next Tuesday. Other commentators were more bearish.

The markets’ current travails can be traced back to a sub-set of the US housing market. Investment banks’ views on property prospects are mixed. Housing market commentators queried whether investment banks, having been complicit in the equity market bubble, the premature flotation of absurd internet stocks, conflicted equity research and the construction and distribution of now obviously fatuously rated structured debt vehicles, really had the ethical high ground to speak meaningfully about the one asset class beyond their capacity to manipulate.

A brief history of financial insanity

“KLEPTOMANIAC, n. A rich thief.” – Ambrose Bierce, The Devil’s Dictionary.

How did we end up here ? The polite version would have it that the problems originated in what is euphemistically called sub-prime debt, which represents only about 12% of the US mortgage market. It is becoming increasingly clear that over the last two to three years, too many lenders pretty much abandoned any discipline in underwriting criteria – just as Wall Street investment banks and US exchanges collaborated to abandon any discipline in underwriting criteria in the years and months prior to the dotcom bust. Plus ça change.. Money was loaned out that never should have been. To this extent the current credit crisis shares common characteristics with previous booms and busts, specifically a sense of mania fuelled by greed and helped on its way by financial innovation, sleepy regulators and complicit participants from the financial sector, not least the ratings agencies. A growing number of delinquencies and souring debts is now infecting other parts of the credit markets and a variation of Gresham’s Law, that bad money drives good money out of circulation, is ensuring that the more speculative or sloppy financial players are liquidating good assets to pay for bad ones. Equities would have been caught in the crossfire at some point, but since easy credit has also fuelled much of the private equity party, fears of a credit contraction are taking an inevitable toll on the mid- and small-cap sectors that were always the most susceptible to the LBO story. And in a twist appropriate to this bold new globalised trading environment, the victims are popping up all over the financial world’s beaches: Bear Stearns “hedge” funds; Australian “hedge” funds and Macquarie; Germany’s IKB; France’s AXA Investment Managers..

So much for the polite version. James Kunstler, whose financial weblog carries a monicker inappropriate for repetition within such a family-friendly milieu, puts it a little more colourfully and forcefully:

“..a financial sector rigged for the falsification of reality eventually enters a danger zone where reality implacably reasserts itself, expectations dissolve, and all that remains is the sour odour of fraud..

“ This long episode of market mania, running for seven years, was based on the idea that non-performing loans could be turned into money by removing them from their point of origin and dressing them up in respectable clothes -- like taking all the winos in downtown Los Angeles, putting them in Prada suits, and passing them off as the faculty of the Harvard Business School. It was a transparently ludicrous racket and the wonder is that America proved to be so utterly bereft of regulating authority -- not to mention plain decency and self-restraint -- at every stage.

“ It's really hard to account for the stunning failure of responsibility. What you had was a whole industry that surrendered the standards and norms that brought it into being and enabled it to function in the first place. Mortgage lenders stopped requiring house-buyers to qualify for loans; bankers stopped caring what stood behind the paper they issued; dubious loans were bundled and resold like barrels of rotten anchovies -- in such numbers that no individual stinking minnow  would stand out -- and the barrels were traded up the line, leveraged, hedged, fudged, fobbed,  and fiddled until, abracadabra, they were transformed into so many Tribeca lofts, Hampton villas, Piaget wristwatches, million-dollar birthday parties, and Gulfstream jets.

“It worked for the Goldman Sachs bonus babies, and the private equity scammers, and for the corporate CEOs and their board members, and for the politicians who parlayed their votes into cushy lobbying jobs, and even for the miserable quants in the federal government's termite mounds of statistical reportage. It even worked for about 18 months for millions of feckless US citizens gulled into contracts for houses they could never hope to pay for, under arrantly false and ruinous terms.”

It is a psychological function of markets that participants lose their minds collectively and then slowly recover their sanity one by one. Given that corporate credit spreads had become outrageously tight during the long, lazy bull market in everything, the only way that the greedier and more ill-disciplined members of the speculative community could hope to generate investment returns in excess of their management fees was through leverage – and so the hot money funds calling themselves hedged when they were anything but, perpetuated the rally just long enough to ensure that the pain would be universally distributed through the financial system when the music stopped which, notwithstanding Chuck Prince’s recent hubristic bombast, it did earlier this summer. For fans of historical irony, just as in the LTCM debacle, some of the smarter money (for example Harvard / Sowood) got carried out on stretchers alongside the hicks.

Which takes us up to the present day. Given the current climate of heightened tension and uncertainty, G7 government debt probably enjoys a few more months of a ‘flight to quality’ bid, but could hardly be called cheap. Quality corporate debt is evidently in the process of being repriced so spread widening may not yet be complete. While the universal nature of the asset rally meant that selectivity could be thrown out of the window, the new environment calls for qualities that haven’t hitherto been required: discipline, discernment and prudence. Globalisation notwithstanding, the dispersion between returns from different national equity markets has demanded stock-level discrimination, and that requirement will persist. For investors still willing to trust third party managers, those same qualities of discipline, discernment and prudence deserve to trade at a premium (some hedge fund managers actually are hedged, for example). And we now break with tradition to mention a specific security. For those who believe that US financial stocks still have some pain to undergo, we draw your attention to something we discovered last week: the UltraShort Financials ProShares exchange-traded fund (Bloomberg ticker SKF US <Equity>). This ETF attempts to deliver returns equivalent to 200% of the inverse performance of the Dow Jones US Financials Index. Not that we would ever be drawn into activity like day-trading, but just for reference this ETF returned 6.6% last Friday. Needless to say it is not for widows and orphans, nor for US financial sector bulls.

The bonfire of the inanities

Whenever investors are unable to rationalise market trends, they resort to cliché. The latest hoary old chestnut to be trotted out to justify extraordinarily robust equity valuations (until last week, at any rate) is that all bull markets climb "a wall of worry" - a platform of problems that perversely boosts stock prices to fresh highs.

There is doubtless something to the "wall of worry" conceit. There are certain successful investors (one thinks of the likes of George Soros, John Templeton and Marc Faber) who have spun widespread disenchantment about market returns into gold. It is easier said than done, for example, to buy when there is blood on the streets. But heuristics, those rules of thumb that traders use as shorthand to parse the financial runes, can only take us so far. And there are times when widespread conventional fears about the market's prospects will turn out to be wholly justified. Now feels like one of those times.

We can trace the market's current tremors back to the previous Federal Reserve chairman, Alan Greenspan. It was Mr Greenspan who, in the aftermath of the dotcom bust, practically drowned asset markets with a tidal wave of liquidity and easy money. It was Mr Greenspan who drove the Federal funds rate - the rate charged by US banks for lending to their peers - down to 1 per cent in 2003-2004, a four-decade low. And it was Mr Greenspan who opened the floodgates of liquidity that might have saved the US equity market, for a time, but that also triggered an unsustainable boom in government and corporate debt, residential property, and a carnival of mortgage lending unimpaired by anything approaching prudence. It is now left to his successor, Ben Bernanke, to reap the whirlwind.

The post-millennial stock market rescue was not the only time Mr Greenspan stepped in to "save" Wall Street. He has form as a serial inflationist, willing to slash interest rates to bail out investors who should not need rescuing from themselves: one thinks of the stock market crash of October 1987; the Savings and Loan crisis; the Asian crisis; the collapse of hedge fund Long-Term Capital Management; the feared Y2K crisis. No central banker has done more for the concept of moral hazard - the risk that the perceived support of the monetary authorities will cause financial institutions to play fast and loose with other people's money.

It is abundantly clear that, having gorged on overly easy money for years, Anglo-Saxon financial markets are suffering from indigestion.

As in previous financial debacles, the regulators will be found to have been asleep at the wheel. How else to explain the lax standards implicit in the lending activities of US subprime financiers - or the conflicts of interest at the heart of the ratings agencies tasked with appraising structured debt vehicles that now resemble pyramid schemes? Or the "price-to-model" evaluations of illiquid debt securities that allowed investment banks and hedge funds to price their portfolios pretty much wherever they wanted to?

The problem for financial markets now is that a functioning financial system ultimately comes down to trust. When trust is in short supply, there is no obvious price base for securities and credits that during the good times seemed to offer unimpeachable quality. Nor is this crisis of trust restricted to the corporate sector - national Treasuries have been busily debauching their own currencies with the help of the printing press. As Mr Greenspan himself admitted in 1999: "Gold still represents the ultimate form of payment in the world. Fiat money, in extremis, is accepted by nobody. Gold is always accepted."

So the US now nurses concerns about credit quality and a possible credit crunch, a housing crisis, the sustainability of corporate profit margins and the logical response of consumer spending to deteriorating fundamentals. US lenders, mortgage brokers, investment banks and ratings firms will all, one suspects, enjoy their day in court.

But when the central bank itself was complicit in the funny money boom of the new millennium, one is left to wonder just how sizeable the "correction" and cross-market contagion could ultimately become.

 

This piece was originally published in the Financial Times.