October 3, 2011
Recession, Restructuring, and the Ring Fence
In recent months, our recession models have forcefully shifted to warning of oncoming recession. Our initial concern in August was based on a fairly compact set of indicators that we track as a Recession Warning Composite (see Recession Warning, and The Proper Policy Response ), followed by a deterioration a few weeks later in much broader statistical and ensemble models we've developed (see An Imminent Downturn ).
On Friday, Lakshman Achuthan of the Economic Cycle Research Institute reviewed the weight of ECRI's research, observing "Now it's a done deal. We are going into a recession." (Required viewing: Lakshman Achuthan on CNBC , as well as additional commentary at the ECRI website... I'll wait).
For us, the ECRI is an important source of analysis to confirm or question our own views, as it is undoubtedly the best private economic research group we know. They are conservative in their major economic calls, but are still invariably far ahead of the consensus. Though ECRI's Weekly Leading Index deteriorated sharply in 2010, ECRI did not go to a recession warning, and the Fed was successful in provoking enough hope, speculation, and pent-up demand to kick a downturn slightly down the road in any case. Soon after reaching what we've called "the cliff" at the end of June (when the major sources of fiscal support and Fed-driven speculation simultaneously ran out), numerous leading economic measures promptly collapsed.
The way you spot a thoughtful economist, in my view, is to listen for an understanding of both data analysis and equilibrium. In our experience, most economists and Wall Street analysts seem to analyze the economy as what I'd call a "flow of anecdotes" - weekly unemployment claims did this, retail sales did that, we got a positive surprise here, and so forth, without putting that information into any real structure and without knowing which data points actually matter or in what combination. In contrast, good economists think about the economy as a system - where multiple sectors interact. We tend to use words like "equilibrium" and "syndrome" when we talk about economic data - emphasizing that the best signals involve a whole conformation of evidence, not one or two indicators, where the data - in combination - captures a particular signature of recession or recovery. Look at how Achuthan described the situation on CNBC on Friday, and you'll see a good example of this sort of thinking:
"This is a done deal. We are going into a recession. We've been very objective about getting to this point, but last week we announced to our clients that we're slipping into a recession. This is the first time I'm saying it publicly. A broad range - this is not based on any one indicator - this is based on dozens of indicators for the United States - there is a contagion among those forward looking indicators that we only see at the onset of a business cycle recession.. These leading indicators, which are objective.. they have a certain pattern that they present in front of a recession, and that is in, that is in right now.
"A recession is a process, and I think a lot of people don't understand that; they're looking for two negative quarters of GDP. But it is a process where sales disappoint, so production falls, employment falls, income falls, and then sales fall. That vicious circle has started. You're looking at the forward drivers of that, which are different indicators - there's not one - everything's imperfect. The Weekly Leading Index .. that is saying unequivocally, this is recession. Long Leading Index, which has a longer lead, is saying recession. Service sector indicators, non-financial services where 5 out of 8 Americans work, plunging. Manufacturing, going into contraction. Exports, collapsing. This is a deadly combination, we are not going to escape this, and it is a new recession."
For investors, if you believe that current analyst estimates of forward operating earnings are correct, and you believe that the inappropriate bubble-era benchmarks for price-to-forward operating earnings are actually valid, and you've ignored all evidence that the Fed Model is spectacularly devoid of validity, and you believe that the only course for valuations is to move toward those misguided benchmarks regardless of what happens to Europe or the U.S. economy, then it's easy to believe that stocks will head higher. For our part, we believe none of those things. At present, we estimate that the S&P 500 is likely to average nominal 10-year total returns of just 5.7%, with the bulk of those returns most probably emerging in the back years, and significant risk of substantial losses in the earlier ones. Moreover, investors face not only an oncoming recession, but probable sovereign default out of Europe, and more likely than not, a compounding of both factors into heightened credit risk here in the U.S. (note that credit spreads are beginning to scream higher, particularly among banks and high-yield debt).
Still, as always, we're data-driven, and there are possible combinations of evidence (not in hand at the moment) that could move us to a modestly or moderately constructive investment stance even in the context of broader economic risks. My impression continues to be that the best hope for a sustained advance (early on, probably only several weeks or a few months in duration) is from substantially lower levels, but we'll take our evidence as it comes. Suffice it to say that we remain defensive here, but are quite willing to shift our investment stance if the evidence supports that.
"Failure" and Restructuring
We are headed toward a new recession because our policy makers never addressed the underlying problem in the first place, which was, and remains, the need for debt restructuring. This is an issue that I suspect will re-emerge to the forefront of public debate in the next year. Hopefully, the response of our policymakers will be at different.
Think of restructuring this way. U.S. stocks just lost $2.5 trillion last quarter. Why should the public bail out the bondholders of financial institutions when the assets of these companies are far beyond what is needed to cover their liabilities to depositors and customers? The problem for banks, of course, is that they are leveraged, so even a drop of a few percent in their assets wipes out much of their own capital and threatens to make them insolvent. That should be a major concern for the lenders who have allowed the managements of those banks to leverage their bets with increasing lack of transparency (thanks to the FASB). But "failing" institutions can be restructured without any loss to depositors or counterparties. When banks become insolvent, my view is that receivership and restructuring is exactly what should happen, and swiftly.
Look at Bank of America's balance sheet, for example. Reported assets are $2.261 trillion. Against that, liabilities to depositors amount to less than half that, at $1.038 trillion. Add in $239 billion for securities that they are obligated to repurchase, $129 billion in trading account and derivative liabilities, and $155 billion for accrued expenses. Now you've covered counterparties, as well as vendors or others who might have invoices outstanding. Even then, and you're still only up to $1.561 trillion of the liabilities. The remaining 31% of Bank of America's liabilities represent obligations to its own bondholders and equity of its own shareholders. This is well beyond what is sufficient to buffer any loss that the company might take on its assets, while still leaving customers and counterparties completely whole. To say that Bank of America can't be allowed to "fail" is really simply to say that Bank of America's bondholders can't be allowed to experience a loss.
What "failure" really means is that bondholders lose money, and the operating part of the institution is taken into receivership, sold for the difference between assets and non-bondholder liabilities, and recapitalized under different ownership. Often the only thing that customers and depositors notice is that there is a new logo on top of their statements.
Now take a look at Citigroup's balance sheet. Reported assets are $1.956 trillion. Against that, liabilities to depositors again amount to less than half of that, at $866 billion. Add in $204 billion in repurchase obligations, $209 billion in trading and brokerage liabilities, and $73 billion in other liabilities, and you're still only up to $1.352 trillion. The remaining 31% of Citigroup's liabilities, again, represent obligations to its own bondholders and equity of its own shareholders. And again, to say that Citigroup can't be allowed to "fail" is really simply to say that Citigroup's bondholders can't be allowed to experience a loss.
You can do the same calculations for nearly every major financial institution in the world. The amount of bondholders and equity coverage varies somewhat, but in virtually every case, bondholder and shareholder capital of these institutions are more than sufficient to absorb any losses without the need for public funds, provided that the objective of government policy is to protect the people and the long-term viability of the economy, rather than defending the existing owners, bondholders, and managements of these institutions. Make no mistake - that choice is what the oncoming crisis is going to be about (See An Imminent Downturn - Whom Will Our Leaders Defend? ).
But who are those bondholders? They include corporate investors, pension funds, endowments, mutual funds and ordinary investors. And all of them willingly take a risk in order to reach for return. As do stock market investors. And if the risk doesn't work out, none of them should look to the government to fire teachers, lay off social workers, underfund the National Institutes of Health, cut Medicaid, and print money (because until the Fed sells its Treasury and GSE holdings, it has indeed printed money), just because they take their risk in a different type of security.
My impression is that the scare-mongering of self-serving financial "experts" on Wall Street is shortly about to become deafening. It would be catastrophe, utter catastrophe, no, Armageddon, to let the global financial system collapse - collapse! - because the world as we know it will indeed collapse, as day follows night, if bondholders, who knowingly and voluntarily take risk and invest at a spread, are actually allowed to lose anything! We cannot, in a thinking society, allow losses to befall risk-takers who make reckless loans and bad investments. We must, must at all costs, divert money away from health, education, and welfare, in order to save these companies from failure, because neither health, nor education, nor welfare are even possible unless we save the financial system from unthinkable meltdown. We have no choice. No choice at all. They are too big to fail, and we cannot hesitate - they must be saved, for the sake of our children, for our children's children, for our freedom, for the flag, and to honor the legacy of our forefathers, so that these Champions of Disfigured Capitalism can continue to do their vital work with impunity, unbound by any of the incentives or consequences that actually allow capitalism to work in practice.
To reiterate the observations of Sheila Bair, the outgoing head of the FDIC, in her discussion of the 2008-2009 crisis (see Sheila Bair's Exit Interview ): "'We were rarely consulted. They would bring me in after they'd made their decision on what needed to be done, and without giving me any information they would say, 'You have to do this or the system will go down.' If I heard that once, I heard it a thousand times. 'Citi is systemic, you have to do this.' No analysis, no meaningful discussion. It was very frustrating.' ... As she thinks back on it, Bair views her disagreements with her fellow regulators as a kind of high-stakes philosophical debate about the role of bondholders. Her perspective is that bondholders should take losses when an institution fails. When the F.D.I.C. shuts down a failing bank, the unsecured bondholders always absorb some of the losses. That is the essence of market discipline: if shareholders and bondholders know they are on the hook, they are far more likely to keep a close watch on management's risk-taking."
I feel it is important to emphasize - as we move toward recession - that we shouldn't blame what is happening here on capitalism or free markets. We really have only a caricature of those here. We have a system that is constantly eager to abandon the proper role of government in the markets - which is effective regulation of risk - and to substitute it with the worst role of government in the markets - which is absorbing losses for those whose losses should not be absorbed, and pursuing policies tilted toward the constant creation of speculative bubbles and the avoidance of required economic adjustments, rather than the productive allocation of capital.
Free markets work - provided that they operate within a framework of government policy that enforces property rights, provides reasonable regulation, coordinates objectives that cannot be achieved privately (e.g. certain infrastructure, insurance coverage for pre-existing conditions - which otherwise creates an adverse selection problem even for companies that would like to offer it), and maintains reasonable consumer protection (because there is a huge "information problem" in requiring each consumer to have all of the requisite facts to avoid abusive practices). To blame our economic problems on the free market is an insult to what has proved for centuries to be the most effective economic system for creating prosperity and raising living standards. We would be wise to stomp out the incessant policy of bailouts and monetary distortions if we hope for that to continue.
One of the perplexing aspects of the discussion on European stabilization is the idea of "leveraging" the European Financial Stability Fund (EFSF) with funds from the European Central Bank (ECB). More than a few analysts have suggested that this sort of structure would help to avoid a Greek default. My impression is that this is wishful thinking.
As background, the EFSF represents a fiscal commitment of European countries to a fund intended to stabilize the European financial system. It is not, however, money that these governments have eagerly decided to simply flush down the toilet - the intent is to use it for stabilization, but also to get most of it back, as the overall commitment represents about 6% of the GDP of the European union. Notably, the total amount of Greek debt alone represents nearly 80% of the size of the EFSF, which would leave only 20% of the commitment available to other states if the EFSF was to buy it up, as some have suggested.
But for the sake of argument, let's assume that European nations are willing to blow the whole amount on bailouts, and even to lose it all. Now comes the idea of turbo-charging the EFSF by "leveraging" it with funds from the ECB in order to allow it to purchase European debt in amounts 7-to-10 times the size of the true fiscal commitment. The key problem is this - in the event that there were losses on the purchased debt, any losses exceeding the true fiscal commitment of the EFSF would amount to money printing. The ECB will have none of it. Hence the resistance from ECB officials about this idea (not to mention that the original promise that the ECB would never be used to buy the debt of distressed countries has already been broken).
Given that Greece would have a primary deficit even if its debt service was cut to zero, and there is no hope of closing that deficit with further austerity (which continues to plunge Greece into deeper depression), it's already clear that the recovery rate on Greek debt is likely to be less than 50%. So including Greece in the "ring fence" essentially wipes out at least 40% of the EFSF capital as a starting point.
The resulting math is straightforward, but skip this paragraph if it makes your eyes glaze over. In order to avoid a situation where the ECB actually prints money to cover sovereign losses, the maximum leverage of the EFSF would be 60%/(1-R), where R is the worst-case expected recovery rate for non-Greek countries. More plausibly, since buying up Greek debt would eat up about 80% of the notional size of the EFSF, any lending against the remaining capital would probably be against the remaining 20% of the fiscal commitment, allowing leverage of no more than 20%/(1-R).
The bottom line is this. It is misguided to believe that Europe can save Greece from default and also contain contagion from Europe's other distressed countries. If Greece is included in the ring-fence, then even if we assume a worst-case recovery rate of 90% on distressed non-Greek European debt, the maximum leverage of the EFSF would still only be 2-to-1. The idea of 7-to-1 or 10-to-1 leverage is a pipe dream that assumes the ECB will be complicit in destroying the euro through currency creation.
The only real option for Europe is to allow peripheral defaults; to allow distressed and insolvent countries to exit the euro; and then for those countries to redenominate their own national currencies and peg them to the euro at a gradually depreciated level (which would be best for their citizens and could plausibly improve their competitiveness enough to close their primary deficits). At the same time, the proper way to avoid European contagion is to restrict the "ring fence" to Europe's more solvent and fiscally stable member countries.
As of last week, the Market Climate in stocks remained negative, though with a further slight improvement since last week. In general, our investment exposure will be fairly proportional to the expected return/risk profile that we estimate for stocks. We aren't binary ("buy/sell", "bullish/bearish") but instead target our investment exposures to reflect the strength of the expected return and the extent of the risk and uncertainty we observe. So a shift to a slightly positive expected return/risk profile would move us to a slightly unhedged investment stance, whereas a shift to an unhedged or "leveraged" position (an unhedged stance plus a few percent of assets in call options) would require a more sizeable expected return/risk profile.
Accordingly, a shift to a more constructive stance - as we've briefly done on a few occasions even this year - should not be interpreted as a forecast about the extended market outlook, or a "call" on general market direction. For now, we remain defensive as we're still looking at negative return/risk estimates, but suffice it to say that they've improved from the terribly negative levels we saw earlier this year (see Extreme Conditions and Typical Outcomes ). I suspect that we're quite a way from a large or durably unhedged investment stance, but the possibility of a modest to moderate exposure is constantly open, depending on the data we observe. Again, I think the best chance to establish a constructive position for any extended period (at least several weeks) is likely to emerge at significantly lower levels. Strategic Growth and Strategic International Equity remain tightly hedged.
Strategic Total Return has about 17% of assets in precious metals shares, where the Market Climate remains quite favorable, but where we would await a further boost to the expected return/risk profile before adding to existing positions, which have pulled back in recent weeks, and account for most of the day-to-day fluctuations in fund value. The Fund also has about 3% of assets in utility shares, and about 2% in foreign currencies. The overall duration of the Fund's Treasury holdings remains about 1.5 years.
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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