September 22, 2008
An Open Letter to the U.S. Congress Regarding the Current Financial Crisis
Summary Of Principles
1) Public funds must function to increase the capital of distressed financial companies, not simply to take bad assets off of the balance sheet at market value (which may improve the "quality" of the balance sheet, but does nothing to improve the capital cushion and therefore little to avoid future runs on the institution).
2) In return for these funds, the government should NOT take equity (which is a subordinate claim and also creates potential conflicts of interest), but instead should take a SENIOR claim that precedes not only the stockholders but also the senior bondholders in the event the company defaults anyway. Congress may need to make some modification to existing bankruptcy law or provide for expedited bondholder approval to do this, but essentially, the government's claim should be subordinate only to customers in the event of default, and senior to both stockholders and bondholders. However, it should also be countable as capital for the purposes of satisfying bank capital requirements.
3) Ideally, the rate of interest on such funds should be relatively high (which will encourage these firms to substitute private financing as soon as possible), but actual payment should be made once the firms are again profitable so that the payment burden does not weaken them during the present recession.
4) The bill should allow for expedited bankruptcy resolution for these institutions, so that in the event of failure, the "good" bank (all assets and customer liabilities, but excluding debt to bondholders) can be cut away and liquidated to an acquirer as a "whole bank" sale. For nearly all of these institutions, the debt to bondholders is far more than sufficient to absorb any losses even in the event of bankruptcy. The current difficulty is that the bankruptcy process itself draws out the process of taking receivership, cutting away the good bank so that it can be sold to an acquirer, and delivering the proceeds as a residual to bondholders. Streamlining that process is one of the best ways to ensure that the failure of one institution does not have "systemic" effects.5) To assist homeowners, the bill should allow for a reduction of mortgage principal during foreclosure, but the mortgage lender should also receive a Property Appreciation Right (PAR) that gives the original lender a claim on future property appreciation up to that original mortgage amount. In other words, the homeowner receives a substantially lower mortgage balance and payment burden now, but the lender stands to be made whole over time through property appreciation rather than immediate burdens on the homeowner to make payments.
To the Congress of the United States
In 2006, the president of the Federal Reserve Bank of St. Louis noted "Everyone knows that a policy of bailouts will increase their number." This week, Congress is being asked to hastily consider a monstrous bailout plan on a scale nearly equivalent to the existing balance sheet of the Federal Reserve.
As an economist and investment manager, I am concerned that the plan advocated by Treasury is essentially a plan to bail out the bondholders of financial institutions that made bad lending decisions, with little help to homeowners that are actually in financial distress. It is difficult to believe that the U.S. government is contemplating taking on the bad assets of these institutions at probable taxpayer loss and effectively immunizing the bondholders (and shareholders) of these companies.
While it is certainly in the public interest to avoid the dislocations that would result from a disorderly failure of highly interconnected financial institutions, there are better ways for public funds to accomplish this, other than by protecting corporate bondholders while homeowners remain in distress.
Consider a simplified balance sheet of a typical investment bank:
Good assets: $95
Assets gone bad: $5
TOTAL ASSETS: $100
Liabilities to customers/counterparties: $80
Debt to bondholders of company: $17
Shareholder equity: $3
TOTAL LIABILITIES AND EQUITY: $100Now, as these bad assets get written off, shareholder equity is also reduced. What has happened in recent months is that this equity has become insufficient, so that the company technically becomes insolvent provided that the bondholders have to be paid off:
Good assets: $95
Assets gone bad (written off): $0
TOTAL ASSETS: $95
Liabilities to customers/counterparties: $80
Debt to bondholders of company: $17
Shareholder equity: (-$2)
TOTAL LIABILITIES AND EQUITY: $95
These institutions are not failing because 95% of the assets have gone bad. They are failing because 5% of the assets have gone bad and they over-stretched their capital. At the heart of the problem is "gross leverage" - the ratio of total assets taken on by the company to its shareholder equity. The sequence of failures we've observed in recent months, starting with Bear Stearns, has followed almost exactly in order of their gross leverage multiples. After Bear Stearns, Fannie Mae, and Freddie Mac went into crisis, Lehman and Merrill Lynch followed. Morgan Stanley, and Hank Paulson's former employer, Goldman Sachs, remain the most leveraged companies on Wall Street, with gross leverage multiples above 20.
Look at the insolvent balance sheet again. The appropriate solution is not for the government to purchase bad assets with public money. The only way such a transaction would add to the institution's capital would be for the government to overpay for those assets. Rather, the government should either a) provide new capital, taking a claim in front of the company's bondholders and stockholders, or b) execute a receivership of the failed institution and immediately conduct a "whole bank" sale - selling the bank's assets and liabilities as a package, but ex the debt to bondholders, which preserves the ongoing business without loss to customers and counterparties, wipes out shareholder equity, and gives bondholders partial (perhaps even nearly complete) recovery with the proceeds.
The key is to recognize that for nearly all of the institutions currently at risk of failure, there exists a cushion of bondholder capital sufficient to absorb all probable losses, without any need for the public to bear the cost.
For example, consider Morgan Stanley's balance sheet as of 8/31/08. Total assets were $988.8 billion, with shareholder equity (including junior subordinated debt) of $42.1 billion, for a gross leverage ratio of 23.5. However, the company also has approximately $200 billion in long-term debt to its bondholders, primarily consisting of senior debt with an average maturity of about 6 years. Why on earth would Congress put the U.S. public behind these bondholders?
The stockholders and bondholders of the company itself should be the first to bear losses, not the public. That is the essence of what a free and fair market, and a responsible government would enforce. The investors in the companies that produced the losses should be accountable for them, and the customers and counterparties should be protected.
The case of Fannie Mae and Freddie Mac was special in that government had already provided an implicit guarantee to their bondholders, so that bailout couldn't have been done otherwise without harming the good faith and credit of the government, but it's absurd to tell Wall Street "send us your poor and your tired assets, and we will tend to them." The gains in financial stocks we have observed in recent days reflects money that those firms expect to be taken out of the public pocket.
A further difficulty with the Treasury plan is that it does little to actually reliquify banks that are at risk. To the contrary, the process of reverse-auctioning bad mortgage debt will provide for "price discovery" about what these assets are actually worth, most likely forcing other institutions to write down assets that are still held on the books at unrealistically high values. As a result, we may observe an increase, rather than a decrease, in the number of financial institutions having insufficient capital.
Replacing the bad assets on the balance sheet with cash, at the market value of those bad assets, may improve the quality of the balance sheet, but does nothing to increase the capital on that balance sheet or the ability of financial institutions to lend. If the objective is to prevent these institutions from bankruptcy or liquidation, or to increase their ongoing lending capacity, then the government requires a method to provide more capital. It is essential that in return for providing more capital, the government should receive a special, possibly novel, security interest that places the government in front of even senior bondholders in the event that the institution fails anyway.
Rather than making small changes around the edges of Treasury's vague and costly proposal, Congress should focus its attention on approaches that will provide capital to viable institutions and expedite the assumption and "whole bank" sale of failing ones.
On the regulatory front, Congress should restrict the speculative use of credit default swap (CDS) transactions. These swaps are essentially insurance policies that pay the holder in the event that an institution's bonds fail. Both credit default swaps and short sales should be allowed for bona-fide hedging purposes when an investor has a related asset that is at risk. However, it is appropriate for regulators to curtail the speculative use of credit default swaps and short sales relating to financial institutions.
With regard to assisting homeowners, purchasing the bad mortgage securities from financial institutions will do nothing to help those homeowners because it does nothing to alter the cash flows expected of them. Congress will be a far better steward of public funds by offering distressed homeowners what amounts to a refinancing, coupled with a partial surrender of future appreciation.
In practice, when a homeowner defaults on an existing mortgage, the bankruptcy court would be allowed to "push down" the principal value. Alternatively, government could purchase the foreclosed property at an amount near existing foreclosure recovery rates (presently about 50% of mortgage face value), and the government would then sell that home back to the owner with a zero-equity mortgage, allowing individuals to keep their homes. In either case, there would be an additional obligation placed on the property owner in the form of what might be called a "Property Appreciation Right" (PAR), which would be provided to the original mortgage lender. Though it would accrue no interest, it would provide a claim to the original lender on any appreciation in the value of the original home (or other property subsequently purchased by the homeowner) up to the difference between the foreclosure proceeds and the original mortgage amount. Note that the PAR would only become relevant at the point that the government was fully repaid.
For example, consider a homeowner with a $300,000 mortgage balance on a home now worth less than the mortgage balance itself. The government would buy the foreclosed property at say, $200,000 and mortgage it to the existing homeowner. The original lender would receive $200,000, plus a Property Appreciation Right (PAR), giving it a claim on $100,000 of any future appreciation of property. If the homeowner was to sell the property later for, say, $250,000, the owner of the PAR would receive $50,000, and there would be a remaining lien on future appreciation of property purchased by the homeowner. At any point the recovery from price appreciation satisfied the $100,000 claim, the PAR would be fully repaid.
Some provision would have to be made for the appreciation of an unsold home, but that detail could be accomplished through some form of equity extraction refinancing. To account for time value, the claim on future appreciation could be increased at a small rate of interest. Though the credit impact of a mortgage default would likely be sufficient to dissuade solvent homeowners from making inappropriate use of the program, the government could impose additional costs or eligibility requirements to avoid such risks.
In summary, the Treasury proposal to address current financial difficulties places corporate bondholders ahead of the public, rewards irresponsible risk-taking, and sets a precedent for future bailouts. Moreover, we know from a long history of economic experience across countries that a major expansion of government liabilities is invariably followed by multi-year periods of extremely high inflation, particularly when it is not matched by a similar expansion of economic production. Such inflation would initially be modest because of the current weakness in the economy, but could pose unusual challenges to the United States in the coming years.
Congress can benefit the American public by maintaining a focus on responsibly assisting homeowners in distress rather than defending the stockholders and bondholders of overleveraged financial companies. It is essential to recognize that the failure of these companies need not result in "financial meltdown" provided that the "good bank" representing the vast majority of assets and liabilities is cut away, protecting customers and counterparties, so that the losses are properly borne out of the capital base of the companies that incurred them.
Again, everyone knows that a policy of bailouts will increase their number. By choosing who bears the losses for irresponsible decisions at these companies, Congress will also choose the scope of the bailouts that follow.
John P. Hussman, Ph.D.
Further Commentary and Background
Freight Trains and Steep Curves: July 11, 2003 - "T.S. Eliot once wrote "Only those who risk going too far can possibly find out how far one can go." It seems that the U.S. financial system is bound and determined to find out. The major force shaping economic dynamics over the coming decade is likely to be an unwinding of the extreme leverage that individuals, businesses, and the U.S. itself (via its record current account deficit) have accumulated..."
Warning, Examine All Risk Exposures: October 15, 2007 - "There are only a handful of historical periods that fall into this syndrome of conditions: December 1972, August 1987, July 1998, July 1999, December 1999, March 2000, and October 2007. All of the prior instances were followed by steep market losses. When the declines were not abrupt, they were protracted. There is not a single counter-example."
Minding the Hinges on Pandora's Box: January 7, 2008 - "I am emphatic that investors should evaluate their risk exposures and tolerances now, in order to allow for substantial further market weakness. Market conditions presently feature a Pandora's Box of rich valuations, vulnerable profit margins, rising default risk, rapidly deteriorating market internals, failing support levels, and accumulating evidence of oncoming recession. Given that the heavy resets only started in October, we are still about two or three quarters away from the really serious credit losses, foreclosures and writedowns. To imagine that financial companies can simply "come clean" and "just put their cards on the table" assumes that lenders actually know which loans are facing default, and how many. But lenders are still months away from even finding that out."
What Congress and Investors Should Understand About the Bear Stearns Deal: March 31, 2008 - "For Bear Stearns to 'fail' means that it may not fully repay its own bondholders, but it has never meant that Bear Stearns' customers and counterparties would be hurt - their accounts and contracts are precisely what J.P. Morgan is eager to purchase and can easily transfer. The misuse of public funds is assisted by blurring the distinction between 'failure' of Bear's customer and counterparty obligations (which nobody wants and is neither likely nor necessary), and the 'failure' of Bear Stearns's stocks and bonds to be successful investments. Why should investment losses be bailed out at public expense?"
Which "Inning" of the Mortgage Crisis Are We In?: April 14, 2008 - "Clearly, as we enter April 2008, we appear to be quite early in the mortgage crisis, with only about a quarter of the cumulative resets having occurred. That places us near the start of the third inning, where we can expect each of the nine "innings" to be about three months in duration. Unfortunately, the next three innings (quarters) are when the heavy hitters on the opposing team will come up to the plate, as the cumulative amount of resets will surge. With that surge, loan losses and foreclosures will also predictably spike higher."
Remarks to Shareholders
A number of shareholders have inquired in regard to the temporary ban on short sales of financials. It is important to note that the Fund does not sell short individual stocks. Rather, when the Fund is hedged, we offset the market risk of the stocks held in the Fund using index option combinations (generally long put option - short call option combinations). By extension, the market makers in these options typically hedge their risk in the futures markets. If we observe any effect at all, the inability to sell short financial stocks until early October might induce a slight discount (versus theoretical value) in spread between index futures prices and the underlying cash indices. Normally, such discounts are arbitraged away by program traders who buy the cheaper futures and sell short a basket of the actual stocks in the index. Even here, the arbs can always complete the financial portion of the basket in the swaps market, and index funds would also have an incentive to buy the futures rather than the stock basket if any material futures discount emerges. Accordingly, I expect that any impact on the futures spread is likely to be quite small, since options and futures still settle based on the cash index at expiration.
The Strategic Growth Fund registered a record high on Wednesday of last week. As financial stocks soared from extremely oversold to extremely overbought conditions on Thursday and Friday, the Fund (which continues to carry a near-zero exposure in financials) declined by an unusual 3.45%, reducing the Fund's net asset value by 1.84% for the week as a whole. Essentially, highly leveraged financial stocks soared, none of which we own, but many of which contributed to strength in the indices we use to hedge, particularly financials having modest but non-negligible weight in the S&P 500 (on Thursday and Friday, Bank of America surged by 36.8%, J.P. Morgan by 31.5%, and Citigroup by 45.8%). Clearly, repeated and sustained gains of that magnitude are not likely, but those unusual gains produced a greater advance in the indices we use to hedge than in the stocks held by the Fund. I anticipate that further fluctuations in financial stocks are likely to account for only minor fluctuations in Fund value.
As of last week, the Market Climate for stocks was characterized by unfavorable valuations, and still-unfavorable market action (despite a "fast, furious, prone to failure" rally late in the week, that had all of the markings of a short-squeeze). On a short-term basis, the market is moderately overbought, but not to the level that typically allows us to form expectations about market direction. The Strategic Growth Fund remains fully hedged. Even if the immediate financial crisis has been contained, which is not at all clear, it remains likely that the broad market has not fully conceded a recession. It is also of some concern that there is only one precedent for the size of the advance observed in the past two days, which was a short-term stopping point in October 1929, following which the market proceeded to establish fresh lows for two more weeks.
As I have noted in recent weeks, the best prospect for accepting significant market risk would be for the market to move materially below the recent trading range. Had Thursday's decline continued for another day or two, I expect that a more durable low might have been established. But having already cleared last week's oversold condition with an enormous short-squeeze in financials, the question remains, exactly what sort of economic recovery are investors anticipating within a few months - and if they are not, exactly why should they expect sustained gains in a market having continued economic pressure on a broad range of industries even outside of financials?
For our part, we remain hedged, but would be willing to establish a moderate speculative exposure to market fluctuations if market internals provide evidence that investors have a more robust tolerance for risk. Presently, we do not have that evidence.
In bonds, the Market Climate last week was characterized by relatively neutral yield levels and slightly unfavorable yield pressures. Short-term Treasury yields spiked down to zero at the height of last week's crisis, and Treasury yields soared following the announcement of the Treasury's bailout proposal. I am quite concerned that if that proposal succeeds, the U.S. economy will be set on a path of double digit inflation along the same lines that we observed after the expansion of government spending in the late 1960's and early 1970's. While inflationary pressures are not an immediate threat, longer-term Treasury yields (and thereby mortgage rates) could surge if this plan gains ground, which would ironically accelerate the trajectory of delinquencies and foreclosures.
The Strategic Total Return Fund continues to carry a relatively short duration of about 2.5 years, mainly in near-term Treasury securities having less price impact from yield fluctuations. The Fund also has about 6% of assets in utility shares, just over 10% in foreign currencies, and having clipped our exposure slightly on price strength early Thursday, about 10% of assets in precious metals shares.
The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse.
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