Archive for March, 2009

We are learning more about the US Feds efforts to improve securitized mortgage markets. Specifically, the legacy loans program and the legacy securities program are designed to entice private investment involvement in turning around the credit crises. There is a good review of the Toxic-asset proposal in today’s Wall Street Journal.

The incentives have to be generous enough so as to attract private investors but not so generous that a risk free return is funded by tax dollars to the benefit of private interests. So what is a reasonable return for assuming this risk? How will these prices be established?  The public purse will be best served by a wide and broad market with many participants. Some will get better deals than others but on average many participants will serve to get the prices right and move the market to an equilibrium position, balancing risk assumed and return yielded. If we end up with a closed shop -where access is limited to a few players, then the likelihood of a subsidy from taxpayers to a small number of market dominant players is enhanced.  PIMCO spokesman Bill Gross has already voiced his firm’s intention to support the program.

Joint ventures between government and private investors are complex and rightly the subject of increased scrutiny by all interested parties. If you are a tax payer then you are a stakeholder. There is a big cost to focusing on limiting return through regulation.  There have been a series of announcements from AIG that executives will return some bonuses. These relatively small victories act as a dis-incentive to those that are considering participation. There is a view that so called excessive future gains may be clawed back by government after the fact. Increased perceived risk (regulation) will require an offsetting increased future return.

In my view, well executed programs will result from a large number of independent private interests bidding for these assets. More participants results in better asset pricing. Better asset pricing will reduce the likelihood of subsidies to private interests from taxpayers.  It is in all of our interest that the program become accessible to all parties willing and able to assume the risk. We need many participants and we should encourage bidders. We have had enough focus on punishing executives and managers of financial firms. It will not help to discourage their participation. We need to get past the need to find and punish the  parties responsible for this mess and instead focus on the task at hand. Increased effort to identify and pursue manager bonuses is an unnecessary additional cost to the bailout.

Well as the above math indicates, the markets have improved so now they are  fully half of what they once were.

There are so many opinions/recipes/predictions for fixing the financial system:

Do Mark to Market assets on company balance sheets to improve visibility and certainty about earnings; or

Don’t mark to market assets as these add to volatility in earnings and in the end are estimates only

Buy equities, the recession is ending in 2009; or

Do nothing, the recession is deeper than expected and mid 2010 is the earliest relief point

Since the public purse is bailing out AIG (Citigroup, Bank America…) the new owners should protect us by reneging on employee bonuses. The principle is one of fairness to those who are preventing these companies from disappearing entirely; or

Pay the bonuses, keeping the companies whole will pay off in the future as a more valuable asset is sold. These bonuses represent insignificant dollar values

New expanded monetary policy is helpful in the short term and disastrous later; or

The US economy is expected to drive world recovery, the reasonable  cost of this effort is more US dollars in circulation

I expect many of you find all of these conflicting views compelling even as they are source of argument. I  usually find both sides of the noise plausible and somewhat meaningless as a result. The loudest opinion is unlikely to be the most helpful, or best considered. In times as these, we need to have some reasonable basis for  making investment decisions.

There seems to be a quest to define the moment of inertia, when the economy begins to grow instead of shrink.  If we could guess the day what would we do exactly? Search for a new job… buy an investment property? Maybe we could pick that exact moment to buy stocks in our retirement accounts.

Unfortunately,  we would probably be late to the party for stock markets.   If we look at the most severe recessions in the past 40 years for Japan, UK, US and Germany at the official end of each recession the local stock market had rebounded from a low of 31% in US markets in March of 1975 to a high of 137% in the UK in December of 1975. Of course the end of recessions are defined by looking back 6 months. Not helpful if you are trying to time a stock entry point or major purchase.

Good judgement starts with clearly understanding your unique situation. Investment activities should be added to after accounting for and funding cash requirements and perhaps reducing debt. In this way you will not be forced to turn what should be a positive into a negative investment experience.

The term ‘credit crisis’ seems to imply that we can expect a resumption to normal market conditions, and economic growth, as a direct result of increased lending by banks…maybe, but things haven’t worked out that way before.

Much of the recession fighting efforts by central bankers and global political administrations is focused on a forced expansion of credit. In 2007-2008, a ceasing of credit markets was crippling to economic activity. De-leveraging of global markets resulted in a sharp reduction in economic output and a pervasive global recession. The reaction by central bankers was to create conditions where bank-to-bank lending was possible again. To a great extent, and at incredible expense,  this has been accomplished. Indeed in the past few weeks we have seen credit market spreads expand. A positive indicator, since banks are probably using their own capital to lend to clients rather than simply passing on the fire hose of cash flow from the Fed.

While resumption of a normalized credit market is a precondition to ending this recession, the evidence suggests that credit expands only after the economy has rebounded. The effect is to further fuel an already expanding economy. In every recession since 1960 real bank credit didn’t peak until several quarters after the end of each recession. While this time may be different, it is likely that the same economic principles apply today as they have the past 50 years. Banks typically tighten credit as a result of loan losses. This is a reasonable response to limit losses and participate less to the downside of an economic cycle. These normal incentives operate to limit the expansion of credit prior to some clear evidence of economic expansion. When the economy begins to expand lenders expand their efforts to capture the growing market shares. It is unlikely that policy makers will be able to engineer conditions where lenders will lead a meaningful expansion in the economy. At some point incentives should switch in favour of the consumer and creating conditions for expanded demand to replace liquidity concerns as the primary focus of economic leaders.

Here is  a related short essay by Kevin Kliessen, Economist with the  Federal Reserve Bank of St. Louis  http://research.stlouisfed.org/publications/mt/20090301/cover.pdf

Today’s  Opening Value

We posted new lows last week and the S&P 500 is priced at less than half of the value in November 2007.  The recent investment experience has been brutal. Last week was one of the worst in terms of stock market performance that we have seen in the past couple of years and just about everyone is looking for the misery to continue.

Last Thursday Bank of Montreal economist Douglas Porter, suggested the worst was over and we should begin to consider the prospects of a better economy by the end of 2009. His opinion wasn’t appreciated by those that offered comment. Practically no one agreed with his point of view. The average opinion was outright critical and many dismissed his thoughts as someone who is shilling for a bank, his opinion therefore bought and paid for. I don’t know Douglas Porter other than by his reputation as a good economist.  I do have some respect for his decision to release information to the hostile crowd. He was, I think,  aware of the probable feedback. So what is going on here? Is everyone so sure that they know the future will be a continuation of the recent past? Is Porter simply rolling the dice with other people’s money (risk) to generate profit for his bank? It seems to me that investors understand there is higher risk in the investment markets. Their recent experience is bad and they look for this to continue. The idea that economists or financial analysts can predict the bottom for investment markets is a source of irritation bordering on anger.

For the sake of clarity here are some basic financial principles in which we can rely:

• Higher return comes with higher risk. The risk premium or compensation for risk is higher when things are not going well.
• Investment decisions should be made on a forward-looking basis not by looking at the recent past as prologue.
• It is improbable to predict or time the turn in the investment markets.
• Short term returns from a trough, or market low,  is very high.
• Selling after a significant drop in prices means you will probably give up significant short term return when the market recovers.
• Some short term traders will correctly predict the turn in the market but only by chance.