The price of everything

A faint dread..

“I’ve had all the fun I can stand in investment banking”

-      Ken Lewis, (current) chief executive, Bank of America. 

“Things are going to get a lot worse before they get worse.”

-      Lily Tomlin, another high profile comedian.

By any measure it was an appalling figure, worse even than Jade Goody’s. When Merrill Lynch on Wednesday announced a $7.9 billion writedown on mortgage-backed securities, it signalled no quick fixes to the carcinogenic impact on the body financial of a credit orgy run amok. That the writedown was $3.5 billion more than Merrill had foreseen less than three weeks ago points to a systemic failure of risk management and pricing transparency on Wall Street  - a trend that the mooted MLEC superfund seems destined to perpetuate, at least to those who can understand it. Merrill’s losses also point to the essential fallacy of full service investment banking: in their case, whatever revenues the retail brokerage brought in, top-of-the-market acquisitions, proprietary trading and “underwriting” managed to dissipate, and then some. While some argued that by ‘kitchen-sinking’ bad quarterly figures, Wall Street could draw a discrete veil over the subprime fiasco and lay the ground for a meaningful recovery, it seems increasingly obvious that Wall Street itself didn’t have a clue about the figures, and was going to use vehicles like the superfund to continue to fudge the fact that it simply didn’t like and couldn’t accept the market’s prices (as opposed to its own ‘marks’) for its rotten debts. The FT’s Lex put it well: banks “remain worried about unexploded ordinance somewhere in the system”.

It will be cold comfort to Merrill shareholders (and employees) that it is not suffering in a vacuum: Bank of America simultaneously announced 3,000 job cuts, primarily from investment banking. But as far as Wall Street is concerned, they are unlikely to be the last. In the face of a deteriorating property, subprime and interbank lending market, investment banking shares during the summer seemed to be floating on a tide of unreality. Indeed, many stocks have rallied off their August lows. But to see anything remotely akin to a ‘resumption of normality’ in financial market conditions is to be blind to the sight of skies darkening with a burgeoning mass of chickens coming home to roost. The days of easy credit are over. By extension, boomtime for private equity lending, new issue underwriting, credit origination and general credence in financial innovation is over, too. Not only is there no shortage of evidence of US economic slowdown, there is no shortage of commentary highlighting it. When Dow component Caterpillar, evidently a major beneficiary of global spending on infrastructure (total return on the shares: + 366% over the past five years), reported its recent quarterly earnings, there was evidence of foreign sales growth but precious little at home:

“..sales and revenues in North America were down 11%. From an end market standpoint, inside North America, it is a very weak picture for many of the industries that we serve. US housing is down and we expect it to continue its decline. Non-residential construction is weak. Coal mining and quarrying are down in the US. And on-highway truck engines are down significantly from last year and we do not see much sign of a major turnaround for a while.. We are expecting weak growth in the US (in 2008) with GDP at about 1.5% for the full year, which is well below the economy’s potential and historic average growth rates. While we do expect additional rate cuts by the Fed, we don’t expect much benefit to the economy or the industries we serve in 2008.. In the US, we expect housing starts to decline further to about 1.2 million units for the full year 2008, and that’s a drop from our 1.4 million estimate for 2007. That would make 2008 one of the worst years in the last 50. And if you look at housing starts in relation to either population or the size of the country’s housing stock, that picture is even worse.” (Emphasis mine.)

For fund manager and commentator Barry Ritholtz, the conclusion is clear:

“Housing is a drag on the US economy, and the US is a drag on the global economy..”

Jeff Matthews was also quick to point out that growing evidence of a US slowdown was not confined to Caterpillar:

“Caterpillar was not the first company to warn that “What happens in sub-prime is no longer staying in sub-prime”.. Earlier in the week, Illinois ToolWorks – which makes everything from arc welders to simple hose clamps – reported seeing “a noticeable slowing in North America” in September.

“That came on top of a previously reported “slowing” in the general industrial market which ITW discussed three months ago on its second quarter earnings call.

“Another fairly important data point – not that anybody was paying attention until Friday – came Wednesday when Manpower, which happens to be the world’s largest employment agency, likewise commented on the US slowdown:

“We continue to see positive revenue trends in most places, though in some places like the US we are seeing softness.. we didn’t see that typical seasonal pick-up that we would be getting in September and October. Our clients aren’t desperate, but there is a high level of cautiousness.”

For a change of scene, let us come back closer to home, where the Bank of England has just warned that the UK financial system “remains vulnerable” to fresh surprises from the credit market. The Bank may have lost some of its own credibility over the handling of Fraggle Northern Rock, but at least this Bank isn’t simultaneously trying to offload onto gullible investors impaired debt of dubious provenance – unless you count Gilts. The Bank singled out the commercial property sector for being “particularly prone to further shocks and to rises in the cost of finance”. And as Chris Giles for the FT helpfully pointed out, there has never been a banking crisis in the UK without a simultaneous commercial property crisis.

There comes a time when the growing hubbub of discordant news just becomes too loud for comfort. Now is one of those times. To be overly simplistic,

Lousy US property market + wounded US financial sector + scared European financial sector + deteriorating UK property market = a good rationale for reassessing portfolio risk exposure.

Rather than resorting to cheap analogies with 1987 (or 1997) or lazy allusions to the imminent spookiness of Halloween, let us rather voice our concerns with delicacy: the markets have entered and for that matter transcended a ‘fin de siecle’ period. Depending on which reference source you use, ‘fin de siecle’ hints at supposed sophistication (‘AAA’ subprime..) or something formerly used to refer to progressive ideas but which is now generally used to indicate decadence (recent financial innovation more generally). My preference is for the art history definition, “a faint dread that stops short of impending doom”. In any event, what has until recently worked seems unlikely to work for much longer.

Ageing Bull

“My candle burns at both ends

It will not last the night;

But ah, my foes, and oh, my friends –

It gives a lovely light.”

- Edna St. Vincent Millay.

Hold the front page – investment bank issues pertinent research. Robert Buckland and Orrin Sharp-Pierson of what used to be called Citigroup have issued a strategy document entitled ‘The Maturing Bull’, which hints strongly at declining cyclical fortunes for the credit cycle but continued positive returns from equities, albeit in the context of a mature bull phase.

Citi strategist Matt King points to four stages in the credit cycle. Phase 1 follows in the wake of the bear market trough for credit. In Phase 1 investors benefit from credit exposure as corporate spreads tighten from balance sheet repair – the telecom sector was a good example in 2002/3. But it is still too early to buy stocks. In Phase 2 both bonds and stocks thrive, with credit spreads continuing to contract on the back of improving corporate cashflow. Citi call this the ‘immature equity bull market’. By Phase 3 the credit bull market is over – spreads start to rise as investor risk appetite declines and leverage as a whole goes out of fashion. Sound familiar ? By Phase 4 it is time to be short both credit and equity markets – a period associated “with falling profits and worsening balance sheets”. Phase 4 favours the most defensive assets – cash and government bonds. The trillion dollar question: are we there yet ?

The market volatility of the summer has seen debt and equity markets pulling in opposite directions and the relationship now looks untenably stretched. Tim Lee of pi Economics intriguingly suggests that the problems are not about contagion from subprime mortgages – rather,

“Subprime mortgages are simply a manifestation of the divergence between credit and associated asset price growth and true savings. The credit bubble had allowed asset values, particularly including housing, to move far out of line with incomes and accumulated savings and now that bubble is bursting. As asset values fall, those debtors that were most dependent on rising asset values will obviously be in trouble first. That is subprime mortgage borrowers.”

Tim Lee sees the credit / equity cycle rapidly approaching Phase 4:

“The extraordinary resilience or buoyancy of equity markets up to now as the global financial system begins to crumble around us must either reflect mass insanity, or at best total ignorance, on the part of equity investors or alternatively it must discount the possibility of a highly inflationary outcome, which would be a positive for equities to the extent that very high inflation would inflate profits. The strength of oil and gold.. would seem to support the latter interpretation. But if I am right equity markets are making a mistake to assume that an inflationary outcome is the most probable.”

All of which makes ‘appropriate’ asset allocation a more highly nuanced decision than under ‘normal’ market conditions. My own view is that the emergency Fed rate cut has prolonged the environment of credit delusion, unwarranted exuberance and the mispricing of risk, leading to at the very least a shorter term threat of inflation. This, in turn, argues for caution in reallocating portfolios to conventional debt, just as the downturn in the credit cycle argues against a bias toward corporate credit. So ‘AAA’ government paper (and let’s not forget cash) seems the logical haven, and given the inflationary threat, a substantial allocation to inflation-linked protection seems more than usually prudent. As to the equity perspective, in the light of current developments it seems to make more than usual sense to focus on defensive orientation, with growth coming from a combination of developed market company risk (albeit focused largely on supplying the emerging economies and particularly Asia) and BRIC-type growth. Retaining a significant exposure to natural resources, commodities and other ‘real’ assets, notwithstanding the substantial rallies enjoyed by these sectors, still makes eminent sense, particularly in the cause of reducing portfolio exposure to exclusively ‘paper’ assets. Sir Christopher Ondaatje, interviewed in The Telegraph (hat tip to Lloyds TSB’s Paul Rodriguez), and who admittedly has a positively apocalyptic outlook for financial markets, has evidently plumped for Canadian and UK T-Bills.

Investment folk are often accused of seeing little more than pounds, shillings and pence, or their foreign currency (and redenominated) equivalents. But Carrick Mollenkamp and Ian McDonald for the Wall Street Journal provide a genuinely moving example (in this Wednesday’s cover story “Subprime mess has domino effect”) that hints at just how many victims the subprime web has snared. Roger Rodriguez is the former truck driver who took out an adjustable rate mortgage which reset after two years. He has now lost his job and his family has lost its home of the last 22 years. CIT Group, the New Jersey finance company that provided Mr. Rodriguez’s new mortgage, announced plans in July to close its mortgage business and fire about 550 staff, citing a “problematic outlook”. RBS Greenwich Capital is the subsidiary of RBS which bought Mr. Rodriguez’s loans, amongst others, repackaged them, and sold them on to investors. RBS Greenwich recently laid off 44 of its 1,760 employees. James Kelsoe is the portfolio manager at Memphis-based Morgan Keegan & Co. who ended up buying part of Mr. Rodriguez’s mortgage in the form of the Soundview 2005-1 trust and its riskier B-3 tranche. In February 2006, Roger Rodriguez lost his job at Waste Management after an accident. While his income fell, his monthly mortgage payments rose from $545 to over $700. On July 23^rd this year, he filed for bankruptcy protection. His loan default was not an isolated event. By June 2007, defaults had afflicted 3.44% of the loan pool – more than triple the level of a year earlier. About four in 10 loans were at least 30 days in arrears – “all in a period during which the US economy was growing at a healthy pace and unemployment was low”. At the end of August, Mr. Kelsoe’s high income fund had posted a loss of almost 28% for the month. Mr. Kelsoe declined to comment for the Wall Street Journal; according to a Morgan Keegan spokeswoman, because “he was focused on managing his funds”. It’s like an inverted version of the Midas myth – every entity that came into contact with this loan turned to crud.

Some entities have come out of the crisis smelling of roses despite their complicity. (Hat tip to Diapason’s Sean Corrigan.) Hank Paulson, US Treasury secretary, remarked last week that the conduct of some mortgage market participants had been “shameful”. This is evidently a different Hank Paulson from the one who was Goldman Sachs group chairman and CEO between May 1999 and July 2006 and who oversaw the launch of structures like the Goldman Sachs Alternative Mortgage Products (GSAMP) Trust 2006-S3, or any of the other 82 mortgage-backed issues totalling $44.5 billion that Goldman Sachs sold last year. As Fortune’s Allan Sloan points out, 68% of GSAMP’s loans were rated ‘AAA’ by both ratings agencies, and 25% of the issue was rated investment grade. GSAMP began defaulting on its obligations in March (less than a year after it was sold), and by September, 18% of the loans had defaulted.

The point being, a monumental financial debacle involving a deficiency of savings and a secular credit pyramid, naive borrowers and unprincipled mortgage brokers, unprincipled mortgage lenders, unprincipled investment banks and naive investors occurred during an otherwise benign economic environment. ‘Only’ the housing market became problematic, but that was sufficient ultimately to provoke international financial crisis. Now the IMF has added its voice to the chorus expressing concern over prospects for the UK property market. Citigroup’s Buckland and Sharp-Pierson are probably right, in that the tide has turned for credit markets for this cycle, and not in a good way. It would be nice to think that the equity bull run still has legs, as they suggest – but the gathering and deepening storm clouds (not least the ominous rises in the prices of oil and gold) suggest otherwise, at least as far as western markets are concerned. The credit / equity cycle may not, in other words, be at 6 o’clock (Phase 3), but approaching 9pm (Phase 4 – be short credit and equity). Concentrated and more aggressive investors may wish to start ‘derisking’ their portfolios, if they haven’t already started. We may not be about to experience a Crash, but all does not feel well - and discretion is the better part of valour.

There’s a patch of snow on the ground..

“Price is what you pay. Value is what you get.” – Warren Buffett.

It isn’t just this week’s foul weather – there are other signs of incipient winter in the markets. The Financial Times reported on Tuesday, ‘Property party over as Ireland’s prices fall’. Combined with earlier confirmation that the UK commercial property market was now starting to see prices and returns decline (and with evidence from the Royal Institute of Chartered Surveyors that UK house prices fell at the fastest pace in two years in September), that just leaves prospective evidence from property prices in Australia, Belgium, Denmark, France, Italy, Spain and Sweden that would serve as confirmation that the real estate slowdown that began in the United States is in the process of becoming a global event.

Why does property matter ? Columbia University economist Joseph Stiglitz, writing in The Guardian (“Houses of cards”), points out that direct and indirect spending relating to housing accounted for two-thirds to three-quarters of US economic expansion since the end of the technology boom. Ominously for consumer-sensitive stocks, much of the product of consumer equity withdrawals went immediately on consumption rather than to longer term investment. Since US homes are no longer acting as ATMs, it is logical to fear that the real economy will suffer an impact. Stiglitz foresees a higher US savings rate (which would still be tiny by comparison to “normal” standards), weaker aggregate demand, and a softer economy.

A combination of globalisation and securitisation has led to financial contagion. It was a British and not an American bank that suffered the first run triggered by diseased mortgage infection spreading in the market for interbank confidence. Stiglitz raises the interesting charge against western capitalists that while the US Treasury and the IMF warned East Asian sovereigns 10 years ago of the risks of bail-outs and punitive interest rate policy, at the first sign of trouble the US has brazenly ignored its own rhetoric about moral hazard, bought up billions of lousy mortgages and cut rates. The unwieldy triumvirate of the Bank of England, the Treasury and the FSA have opened up their own Pandora’s box of moral hazards.

Stiglitz’s prescription is, if readers will pardon the inadvertent pun, academic. Greater financial sector regulation, better protection against predatory lending and improved transparency might conceivably help smooth out future crises, but they will be powerless to act upon the dead sheep of impaired credit currently working its way through the financial system’s python. Worse, the Federal Reserve’s emergency 50 basis points cut has fuelled another upsurge in equity mania as the more biddable, not to say Pavlovian, members of the investor community have refused to recognize anything except a green light for growth. The knock-on effect in emerging markets still surely heavily dependent on US consumption has been extraordinary: as the Financial Times’ John Authers pointed out, Shanghai B shares, held by foreigners, are now up by 324% over the past 16 months.

UBS’ George Magnus, writing on the credit crisis last week, quoted J.K. Galbraith:

“Over all history, (money) has oppressed nearly all people in one of two ways: either it has been abundant and very unreliable, or reliable and very scarce.”

Magnus concluded that in the midst of this transition, monetary policy “faces stern tests of effectiveness as the credit cycle evolves.” That is a polite way of putting it, given that certain individual credits have effectively disintegrated, together with the credibility of monetary authorities in both the US and the UK. One of the more abundant forms of money recently has been the paper kind, with the words “United States of America” and “Dollar” printed upon it. But not everybody views this form of money as a must-have unit of exchange, much less as a store of value. The Qatar Investment Authority, reputed to have around $50 billion in assets, announced earlier this month that it had cut its dollar holdings from 99% of its portfolio to 40% over the last two years. If other sovereign wealth funds (now increasingly cited as swing participants in the international markets) feel similarly inclined to “diversify” their currency exposures, the implications for US Treasury assets, and for the dollar, are plain. Yale professor Jeffrey Garten was offering advice in last Thursday’s Financial Times about forestalling a dollar rout. But as Yves Smith noted,

“..what is disconcerting in reading Garten’s four recommendations is that they are inadequate for the magnitude of the problem he sets forth. He really has only two remedies (selective central bank intervention to punish speculators and holding off on pressuring China over the value of the yuan); the other two are longer-term measures that won’t counteract a rapid, destabilizing slide.. Garten has been thinking about this problem for quite a while. The paucity of his solutions reveals that governments and regulators are pretty powerless in the face of sustained currency moves.”

Or, as was the case in the recent run on Northern Rock, also pretty powerless until after the fact when faced with a sudden and catastrophic loss of consumer confidence. In short, dollars are not the only currency, just as equities are not the only asset class, for investors looking for long term capital preservation as well as shorter term price appreciation. But it is admittedly difficult to hold to a conservative view when so much (short term) profit is being made by an ill-disciplined and probably unsustainable flood into higher risk assets. Or to use an analogy from the retailing sector, that looks increasingly vulnerable to macro-economic developments,

“The bitterness of poor quality is remembered long after the sweetness of low price has faded from memory.”

Irrational Exuberance II

“You can’t buy what is popular and do well.” – Warren Buffett.

Markets are often accused of being irrational, but the recent behaviour of equities points to a more urgent need for psychoanalysis than normal. After months of an interbank lending crisis, a US property market slowdown, mortgage default contagion, oil trading above $80, the failure or near failure of at least two banks (Northern Rock and the US’ Netbank), and $18 billion in bank losses – so far – the S&P 500 now stands at a record high. We should evidently have systemic financial emergencies more often.

While there are undoubtedly some pockets of genuine cheer in the markets (US exporters will benefit from a weaker dollar; most financial institutions will benefit from lower official rates and any steepening in the yield curve) one requires  heroic doses of wishful thinking to see more good than bad in the stock market as a whole. ‘The Times’ reckons that the world’s largest investment banks have announced more than 33,000 job losses this year. If that figure is even remotely accurate, it is not a terrific barometer of economic health. Unlike previous purges, Wall Street’s 2007 cull has involved major scalps, Merrill Lynch’s Osman Semerci and UBS’ Peter Wuffli and Huw Jenkins among them. Whether it makes sense to dismiss senior executives after a credit debacle that has visited itself upon pretty much everybody, and whether it makes sense voluntarily to pass up the experience of managing through, and enduring, such a crisis is another matter, but then investment banks have never claimed to have a monopoly on fairness, meritocracy or common sense. But the biggest irrationality is surely to interpret a 50 basis point cut from the Federal Reserve as a cause for optimism rather than a sign of just how awful US and for that matter global financial market conditions had become.

Nevertheless, equity markets are, to use the now common expression, partying like it’s 1999 (an appropriately ominous point of time), and the objective observer has to at least respect the price action even if he can’t rationalize it. Stocks appear to be pricing in a rapid recovery in the financial sector and no broader economic implications from a softening housing market. Is that really credible ? JP Morgan points out that Europe’s biggest banks will have £415 million less than expected in profits from asset-backed securities business in the second half of the year. That is just one part of their business. But there are plenty of areas where it is easy to believe that fragile confidence will be some time in returning. As systemic deleveraging rolls on, profit prospects for prime brokerage, equity and particularly debt underwriting, merger and advisory work, private equity lending, all look questionable. Indeed, the financial crisis of 2007 has blown another hole in the argument for ‘full service’ investment banks – having multiple business lines especially in fixed income trading hasn’t necessarily spared banks, it has merely led to more opportunities to lose money. But as mortgage-holders internationally come to terms with more punitive rates even as official interest rates fall – an uncomfortable coincidence that no amount of public relations will soothe – it is difficult to see an outcome for retailers, for example, that is anything other than worrisome. And there are early signs that a property slowdown that wrought such tremendous damage in the US has now crossed the Atlantic. Last week’s Halifax survey pointed to a 0.6% fall in UK house prices, while the Financial Times reported over the weekend that commercial property funds have just seen their first fall in total returns for 15 years. The FT’s Martin Wolf reminds the bulls that the UK could easily go the way of the US, in that our house price bubble has been more extreme than North America’s.

Doug Kass also articulates the bearish perspective well:

“non-traditional (and creative) credit originators are in intensive care and will not fuel growth anywhere near the degree to which they have in the past.. The credit unwind in the upcoming years can be expected to have a profoundly negative impact in the current down cycle of economic activity – possibly for years to come.”

Other factors Kass cites in the eventual unravelling of stock prices: lower business spending based on a weakening domestic economy; the economies of industrialized nations are beginning to weaken; emerging economies will not be entirely insulated from deceleration in the developed world; housing is replacing technology as the Achilles heel of future growth; the salutary inflation environment of the last decade is in the process of being reversed; slowing top-line growth, cost pressures and higher corporate tax rates augur poorly for profit margins; international savers and consumers might no longer be kind enough to underwrite US consumption and growth. A potentially toxic cocktail.

The unwarranted euphoria at play in the stock market is causing all sorts of tired investment mantras to be dragged out for a fresh airing: markets can remain irrational longer than you or I can remain solvent; the trend is your friend, until the end, when it bends.. There is a line in ‘1999’ that doesn’t get the attention in the investment media that it deserves:

“But life is just a party and parties weren’t meant to last”.