Wednesday, November 30, 2011

Hurrah! The Fed To The Rescue - Again

Stocks rallied sharply today on the back of a coordinated intervention by the world's central banks, led by the U.S. Federal Reserve.

Market rumors suggest that at least one major bank in Europe was on the verge of failing due to not being able to secure funding.

This would not be surprising: across the globe, financial institutions including American money market funds and Asian pooled investment vehicles have been rapidly reducing their European financial exposure.

It is also apparently consensus opinion among the world's financial leaders that letting Lehman Brothers go under in September 2008 was a mistake.

Today's move puts government money behind this view.

The larger question, of course, is whether this intervention is simply buying time, or whether there is a larger, more comprehensive solution to the euro crisis in the wings.

At the same time, all of these hundreds of billions being tossed around the world is beginning to make me just a little uneasy about how dominant a role that central banks have become in the global economy.

Today's move, for example, effectively inserts our central bank into the midst of the euro zone crisis. Is that really part of the Federal Reserve charter?

Oh, and I understand the argument that says that money is truly a global commodity, and that the Fed is acting to protect US interests.

Still, the real reason the Fed and company needed to act was the refusal of the German government to take any action. And it is not clear that today's actions are doing anything more than delaying a Day of Reckoning for the euro zone.

The United States went off the gold standard* in 1971. President Nixon was desperately trying to figure out a way to frustrate the currency markets, which he believed was unfairly attacking the dollar. Nixon was initially successful, as the dollar rallied, but inevitably economic fundamentals won the day, and the dollar has steadily declined over the next few decades.

Fast forward 40 years. Today we think nothing of literally trillions of dollars being created by central banks around the world that stave off credit market dislocations. Ben Bernanke might be one of the smartest people to ever head a central bank, but the numbers have become staggering.

I don't know how this all resolves itself. Worries that massive injections of liquidity being added to the system will lead to inflation have to date been unfounded. The money has to come back out of the system but until the twin reasons behind our financial system woes are addressed - the American housing market, and the rapidly weakening state of European sovereign debt - it seems more likely that we will see more central bank interventions in the months ahead.

*As I have written numerous times on this blog, I am most decided not a huge fan of investing in gold. On the other hand, having a gold standard definitely created a brake on government actions.

Tuesday, November 29, 2011

Why Won't the Germans Come to the Rescue?

“The problem in politics is this: You don’t get any credit for disaster averted. Going to the voters and saying, ‘Boy, things really suck. But you know what? If it wasn’t for me, they would suck worse.’ That is not a platform on which anybody has ever gotten elected in the history of the world.”

-Rep. Barney Frank, quoted in this morning's New York Times, to the CBS “60 Minutes” correspondent Leslie Stahl

Pity the poor Germans.

After years of prosperity and fiscal probity, the Germans are now being blamed for bringing the eurozone - and possibly the world's economy - to the brink of disaster.

Poland's foreign minister Radoslaw Sikorski gave a speech in Berlin yesterday which was reprinted in this morning's Financial Times. Here's an excerpt:

I demand of Germany that, for its own sake and for ours, it help the eurozone survive and prosper. Nobody else can do it. I will probably be the first Polish foreign minister in history to say this, but here it is: I fear German power less that I am beginning to fear its inactivity. You have become Europe's indispensable nation. You may not fail to lead: not dominate, but to lead in reform.

Then there's columnist Joe Nocera writing in this morning's New York Times:

Today, it is Germany that is making policy moves that seem insane. Locked into their modern-day orthodoxies, German politicians look at Greece with something akin to contempt. Aid to Greece — aid that is given grudgingly, when it is given at all — must be accompanied by severe austerity measures, the Germans believe, because the Greeks need to learn how to live within their means, the way Germans do.

But harkening back to Rep. Frank's quote, would the world really be so grateful if the Germans came up with a few spare trillion euro to bail out its neighbors?

And what would the verdict of German voters be on Chancellor Merkel's government if she orchestrates a bailout?

Then there's the small matter of German constitutional law.

Last September, the German Constitutional Court ruled that while it would reluctantly accede to allowing German participation in the European Financial Stability Facility, any permanent financial commitment to the eurozone by the German government could potentially be in violation of German law.

For example, there have been several proposals that the European Central Bank issue eurobonds which would carry the joint credit backing of all of the euro community, most importantly Germany.

However, it's not clear that the German government could even make such a commitment even if it wanted to, according to the on-line magazine Der Spiegel:

But euro bonds would be an entirely different case. Wolfgang Münchau, the Financial Times columnist... points out that they would be everything that the German Constitutional Court finds questionable about bailout programs thus far. They would have the potential to make Germany liable for debts incurred by other countries in the euro zone, the program would be huge (otherwise there would be no point in introducing them in the first place) and German guarantees could be triggered by the actions of foreign governments. "The court's verdict leaves me no alternative but to conclude that (euro bonds) are indeed unconstitutional,",1518,799803-4,00.html

U.S. stocks soared yesterday on rumors that the euro crisis was nearing a resolution. However, this optimism seems premature, at least based on the news from Europe today.

Time will tell.

Monday, November 28, 2011

Anyone Have a Spare $3 Trillion?

The markets are up sharply this morning on rumors of a possible solution to the euro zone crisis.

I hope the rumors are right, but unfortunately I am a little skeptical. The euro problems are enormous, and political solutions among 17 different member states are not going to be easy.

For example, last Wednesday CNBC interviewed Oliver Sarkozy, the half-brother of French President Nicolas Sarokozy (tip of the hat to blog Zero Hedge).

While I doubt that his more famous relative is giving him any inside information, Oliver Sarkozy happens to be a director of the Carlyle Group, and seems to be pretty well connected. He also is pretty good at math.

As you can see for yourself in the interview below, Mr. Sarkozy figures it would "only" take $3 trillion to stabilize the European banking system. Here's how he figures it:

"The math I'm working with is very simple. In the US banking sector, we had $3 trillion of wholesale funding that needed to be stabilized, got stabilized by the implementation of TARP which saw the US treasury buy $212 billion worth of preferred in the banking sector to stabilize that $3 trillion, give our banks the time to work through their problem assets.

In Europe, that $3 trillion is $30 trillion. so if you multiply the $212 by 10, you get the $2.12 trillion. In my view, the issues on the European banks are bigger than the issues on the books of the US Banks. So if you want to stabilize that $30 trillion and in my view it's not that you want to, it's that you have to, you do not have a choice, you're going to have to be at least at 2.1 trillion and I suspect it may need to be more."

Wednesday, November 23, 2011

Credit Crisis Worsens in Europe

“The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought.” - Rudiger Dornbusch

The situation in Europe continues to worsen.

New leaders have been installed in Italy and Greece, to no avail. Spain held an election last weekend that should have provided some comfort to the capital markets, but instead Spain is now paying a higher rate of interest on its short term debt than Greece.

The role of the European Central Bank (ECB) remains critical. Reluctantly, the ECB has been pulled into the crisis even as there is little agreement on how far it can go without violating its original charter.

In the meantime, the ECB has provided essentially the only bid for Italian and Spanish bonds in the secondary market. In addition, European banks have turned to ECB for critical funding as credit conditions in Europe continue to tighten.

And now Germany - the bastion of the euro zone - is having its own credit quality questions.

Today's German bond auction was one of the worst in recent memory. Trying to sell €6 billion 10 year bunds, investors only bid for €3.6 billion, meaning that the Bundesbank is now the not-so-proud owner of €2.4 billion bunds that it will attempt to sell in the coming weeks.

The U.S. government has been the beneficiary of the euro zone crisis. The U.S. Treasury sold $35 billion in 5 year Treasury notes yesterday at a yield of 0.937%, which is the lowest yield on record. Indirect bidders - mostly foreign central banks - bought 44% of the deal, while investors only bought 9% of the new issue. Safety of principal, not yield, is driving Treasury bond prices these days.

OK, I know this is the day before Thanksgiving, and I should be giving thanks to the Europeans for helping us keep our government's interest costs lower.

But time is working against European leaders, and we can only hope that a workable solution to all of this is figured out in short order.

Tuesday, November 22, 2011

Why Did Gilead Pay So Much for Pharmasset?

The health care sector was rocked yesterday by Gilead Sciences's $11 billion buyout of Pharmasset.

Located in Princeton, N.J., Pharmasset is a company that is developing a treatment for hepatitis C, a disease that affects an estimated three to four million Americans. As many as 170 million people worldwide are also estimated to have hepatitis C, which is often caused by use of contaminated needles.

The infection can cause serious liver damage, and treatment so far have involved a combination of pills and injections. Pharmasset is working on treatments will be all-oral (i.e. no needles) with considerably less negative side effects.

But still: the total worldwide market for hepatitis C treatments is estimated to be around $3 billion per year. Gilead is paying $11 billion for a company that has 52 employees, lost $92 million last year, and that is working on a drug that will not be available until 2014, if it proves to be successful.

Only time will tell whether Gilead's move is visionary or ill-considered. What it does highlight, however, is the fact that returns from research and development efforts in the drug industry have been steadily declining, despite the massive amounts of funds being thrown at new drug development.

Before yesterday, Gilead's management was widely regarded as one of the smartest in the biotech field. It is unlikely that they would suddenly become reckless and pay too much for Pharmasset unless they felt that the returns from buying the company would not outweigh what they could achieve on their own R&D efforts.

According to the consulting firm Deloitte, as discussed in an article in yesterday's Financial Times:

The average internal rate of return on R&D for the top dozen pharmaceutical companies fell from 11.8% in 2010 to 8.4% this year, while the cost of developing a new drug rose from $830 million to $1.1 billion.

The problem is not only the cost of developing new compounds. Bringing a new drug to market involves massive amounts of testing that can last for years, and often can wind up in failure. Even drugs that eventually are brought to market can be pulled; just last week the FDA pulled Genetech's Avastin, a widely-used treatment for breast cancer, from the market after patient data indicated that it carried considerably more negative side effects than trials had indicated.

The health care sector faces a number of significant headwinds in the coming years. Costs continued to rise, yet there is widespread support for trying to contain costs of medicine, including drug prices.

In other words,the days of high earnings growth for the health care sector seem to be largely in the past.

Monday, November 21, 2011

More Municipal Cuts

Last Friday, Detroit Mayor Dave Bing announced plans to lay off 9% of Detroit's public work force.

The Mayor's cuts will directly affect 1,000 municipal workers, but will also have a significant impact on thousands of poor and elderly citizens who demand on government services.

Detroit's moves will doubtlessly be repeated by dozens of municipalities across the U.S. by cash-strapped cities and towns in the months ahead. Already there have been several towns in California that have not only laid off administrative officials but also police and firemen as well.

Once home to some of the strongest and most vibrant economies in the United States, Detroit in recent years has turned into one of the hardest hit of the major U.S. cities. Fully one-quarter of the homes in the greater Detroit area, for example, now stand vacant. The level of unemployment in the greater Detroit metropolitan area is 13%. Cuts in municipal services will hit hard.

Worries about municipal credits have waned over the course of this year. Concerns about the fate of the euro, and euro zone bonds, have rightly dominated investment discussions recently.

But that doesn't mean that municipal finances have improved. Like Marley's ghost, most municipals are bound by the chains of poor decisions and bad contracts forged in earlier years.

It seems likely that discussions about the poor state of municipalities will begin again.

An article in last Saturday's New York Times notes that Mayor Bing's cuts may not do enough to help:

For months, Mr. Bing and other leaders have bemoaned the city’s financial state as dire, but a new urgency has clearly set in. The mayor has called on union leaders to agree by next week to concessions to their existing contracts, even as City Council members have suggested that Mr. Bing’s cuts may not go far enough and that even sharper layoffs may be needed.

There is a looming threat hanging over all such talks: the possibility that the state may ultimately find Detroit’s woes so troubling that it requires the appointment of an outside manager to take control of the city, Michigan’s largest. State officials say that so far, no such plan is under way.

Friday, November 18, 2011

Is The US De-Coupling from Europe's Woes?

Is the US dancing while Europe is burning?

The news from Europe remains troubling, to say the least. Yields on Italian and Spanish bonds remain elevated, despite the best efforts of the European Central Bank (ECB).

The 17 members of the European union continue to squabble, and the rhetorical levels continue to move higher in each passing day.

Liquidity is drying up as banks desperately try to reduce their sovereign credit exposures.

Ambrose Evans-Pritchard of the London Telegraph writes this morning that Asian buyers are also trying to reduce their European bond holdings:

Asian investors and central banks have begun to sell German bonds and pull out of the eurozone altogether for the first time since the debt crisis began, deeming EU leaders incapable of agreeing on any coherent policy...

Traders say Asians are taking profits on Bunds and pulling out, with signs that even China's central bank is shaving holdings. Mid-east wealth funds have remained firm.

Meanwhile, Spanish Prime Minister Zapatero is insisting that ECB step up its intervention in the capital markets to try to keep interest rates low:

José Luis Rodríguez Zapatero, Spain’s prime minister, on Thursday became the latest leader to demand that the bank find a solution to the euro crisis, saying that “this is what we transferred power for” and that it had to be a bank “that defends the common policy and its countries.”

Mr. Zapatero made his unusually blunt statements on a day when markets sagged further and contagion continued its seemingly inexorable spread from the small economies on Europe’s periphery to Italy, Spain and even France at the core. Spain was forced Thursday to pay nearly 7 percent on an issue of 10-year debt, the highest since 1997, while investors demanded the largest premium for buying French as opposed to German debt in the decade-long history of the euro.

At the same time, however, both the U.S. economy and our markets remain remarkably unaffected by the euro crisis.

Many businesses report that activity remains reasonably strong, and in some cases improving. Warren Buffett remarked the other day that only 5 of the 70 businesses owned by Berkshire Hathaway are showing any signs of weakness, and all of these are related to housing.

Recent US economic data also show signs of strengthening, as Neil Irwin reports in this morning's Washington Post:

... following a year of one economic disappointment after another, a variety of economic indicators are pointing in a more positive direction... reports showed strong results on two key measures of economic activity in October: A 0.5 percent gain in retail sales and a 0.7 percent gain in industrial production. Also welcome news: Inflation is becoming more subdued, with consumer prices falling 0.1 percent in October. That leaves the Federal Reserve more flexibility to take action if the economy worsens.

Putting all the recent evidence together, forecasting firm Macroeconomic Advisers projects that the economy will have grown at a 3.2 percent annual rate in the final three months of 2011, compared with a 1.4 percent average pace of growth through the first nine months of the year.

Our markets also appear slightly confused. Although Treasury bond yields remain at historically low levels - indicating there is still a strong desire for safety among a large class of investors - stocks continue to trade with a good tone, and have largely held on to October's gains.

We will see.

Thursday, November 17, 2011

The Euro Comes to the US

Markets took a tumble yesterday after Fitch's Ratings released a report saying that Europe's debt crisis may be a significant threat to American banks.

I can't believe this was really fresh news to anyone.

To me, what it really illustrates is the fact that U.S. investors have been assuming for months that euro crisis will all somehow just work itself out. While that might still be the case, global bond markets are telling you a completely different story.

Yields in "safe haven" countries like Germany (1.86% on 10 year bunds) and Sweden (1.66%) continue to move lower. Even the U.S. - which was only downgraded last summer - still can find investors willing to lend it 10 year money at 2.01%.

Meanwhile, the countries that really need the cash are getting killed. Even after massive intervention by the European Central Bank (ECB), Italy still needs to pay almost 7% to borrow money. Spanish 10 year notes now yield 6.60%, up from 5% a month ago.

And now France (mon dieu!) is coming under attack. French bonds are trading at levels nearly 200 basis points higher than Germany. If France is in trouble, then the euro really is in dire straights.

With all of this as a backdrop, it is little wonder that European banks are desperately trying to secure funding. Here's how the blog Business Insider describes the situation:

Specifically, traditional sources of bank funding in Europe, such as institutional investors and other banks, are getting cautious as fears grow about the need for sovereign debt restructurings. As liquidity dries up, the only reliable source of funding is often the ECB.

But the ECB only accepts certain types of assets as collateral for loans, and some banks are running out of those assets.

So they're turning to investment banks and other "counter-parties" that have them. And they're entering into "swap" agreements in which they exchange their assets for the counter-parties' assets and then stock-pile the latter assets for use as collateral.

And that's a fine plan... until the music stops and one big "counter-party" fails.

So is it really a surprise that the US banks are also at risk?

Wednesday, November 16, 2011

Bond Traders vs. the European Central Bank

In January, 1993, President-elect Bill Clinton was discussing fiscal policy with several economic advisors.

The topic was deficit reduction, and his aides were telling the newly elected President that the success or failure of his administration depended on a credible deficit reduction plan. If he failed, the bond market would punish the economy with higher interest rates.

According to Washington Post author Bob Woodward - as detailed in Woodward's book The Agenda - Clinton's face turned red with anger as he said:

"You mean to tell me that the success of the program and my reelection hinges on the Federal Reserve and a bunch of f**king bond traders?"

I was reminded of this anecdote when as I have been reading about the ongoing euro bond debacle.

The success or failure of the euro zone ultimately will not rest on any particular politician or grand strategy. Instead, it will rely on whether the countries most at risk - Greece, Spain, Italy, et. al. - will be able to finance themselves at reasonable levels of interest rates.

So far, the "f**king" bond traders do not seem to be impressed.

Reuters is reporting this morning that the European Central Bank has been intervening heavily in the bond trading of Italy and Spain. Even with the ECB intervention, yields have been soaring for euro bonds from these countries.

Italian euro bonds now yield almost 7%. The contagion is now apparently spreading to other countries, even France. The yield spread between French euro bonds and German bonds is at levels not seen since the early 1970's.

Tuesday, November 15, 2011

Investing Like Warren

Warren Buffett announced yesterday that he amassed 5.5% of IBM stock over the past few months.

While this is interesting news - Buffett has always said that he doesn't understand technology well enough to invest money in the sector, but apparently IBM is transparent enough - what really caught my eye was the way he went about analyzing the company.

Buffett was interviewed on CNBC yesterday for about 3 hours. The complete transcript of his thoughts can be found on the CNBC website, but several comments stood out to me:
  1. He has been reading IBM's annual report for 50 years. I don't think he was just reading the President's letter - I'm sure he has been studying it from cover-to-cover for half a century. But it was only this year that he began buying stock;
  2. He never met IBM senior management. In fact, at one point in the interview he mispronounces current CEO Sam Palisano's last name. While this is consistent with Buffett's investment style - focusing on the business, not the management - this too is far different than most investment managers;
  3. He was buying IBM stock at near all-time highs, but seemed genuinely unconcerned about the price. Buffett notes in the interview that he bought railroad stocks at their highs also, and has made a bundle;
  4. Buffett re-read former CEO Lou Gerstner's book about IBM Who Says You Said Elephants Can't Dance before buying stock. I wrote about this book a few months ago here on Random Glenings, and now you have Warren Buffett's recommendation as well (!);
  5. He liked the idea that IBM has dramatically reduced the number of options outstanding from 240 million to 30 million today. This, in Buffett's opinion, is a sign of respect for the shareholder.

I could go on, but I think you get the point. The investment genius of Buffett has been earned by more than 50 years of study, and what often seems effortless is actually the result of countless hours of study and preparation.

Finally, I liked this quote from Buffett about where investors should be putting their money today:

{Buying IBM and other large cap stocks}t also means that some great big strong American companies look very cheap compared to investment alternatives. I mean, in the end, you know, you're sitting with money in your pocket. Do you leave it in your pocket, you get zero on, do you put it in a money market fund, you still get zero on it, do you buy 10-year Treasuries and get 2 percent, or do you buy American businesses that are earning very good money, that have high returns on equity, have high returns on incremental capital, are buying in their stock at a rapid rate so that your ownership in the business increases significantly? I love all those things. Now, you measure one vs. the other. But in the end, you have—you know, you do something. Doing nothing is doing something.

Monday, November 14, 2011

More on Europe

If you think replacing the leaders of Italy and Greece over the weekend gives an "all clear" to the European community, German Chancellor Merkel would suggest otherwise.

Here's an excerpt from a Reuters news piece desribing Merkel's speech this morning in Leipzig:

"Europe is in one of its toughest, perhaps the toughest hour since World War Two," Merkel told her conservative party in Leipzig, saying she feared Europe would fail if the euro failed and vowing to do anything to stop this from happening.

But in a one-hour address to the Christian Democrats (CDU), Merkel offered no new ideas for resolving the crisis that has forced bailouts of Greece, Ireland and Portugal, and has raised fears about the survival of the 17-state currency zone.

"If the euro fails then Europe fails, and we want to prevent and we will prevent this, this is what we are working for, because it is such a huge historical project," Merkel said in the east German city of Leipzig.

Then there's the human costs of the euro crisis. Across Europe, ordinary citizens are seeing their standard of living shrink dramatically as governments struggle to comply with the demands of European leaders lead by the French and German governments.

Here, for example, is an excerpt from last Friday's Financial Times. In a small article titled "Sign this and accept a 25% salary cut", the FT described how highly educated members of the upper middle class in Greece are being forced to take huge pay cuts or else lose their jobs:

...White collar workers such as Constantinos Makris, a stockbroker in Athens, are also feeling the sting. Managers "gave me a call one morning and said 'Would you come downstairs?'...Then they said 'Sign this paper and accept a 25 per cent reduction in your salary'. After threatening to quit, Mr. Makris eventually settled for a smaller cut.

The problem is not just belt-tightening; it's a sense that the good times might gone for a generation, thanks to debt obligations incurred by governments who understood that the path to power was to never tell voters "no".

In post-World War II Europe, austerity ruled for years. Rolling Stone guitarist Keith Richard, for example, describes in his autobiography Life that he never tasted sugar for the first nine years of his life after being born in 1946 due to post-war shortages. Everyone understood why basic necessities were rationed, which seemed to make it more bearable.

Today, according to this morning's New York Times, citizens are facing the hard times with more bitterness than a couple of generations before:

In the lands of southern Europe, used to getting by with wile and guile, the prospect of hardship seems all the more bitter, illuminating, as it does, what outsiders cast as an all-too-predictable national failure to live up to the membership rules of the euro club that were devised and watched over by hard-nosed Germany in particular.

Modern austerity could never be described as an ethic; for southern European nations squirming under pressure from the Continent’s wealthier northern lands, it is an affront to come to grips with the legacies of economic ill-discipline. And in the north, it is a high price to pay to rescue the profligate south.

Austerity is a time bomb ticking ever louder.

Thursday, November 10, 2011

Are We Facing A Repeat of 2008?

The crisis in Europe is raising uncomfortable memories among investors.

Several commentators harken back to the latter days of 2007, when it seemed that the subprime mortgage crisis would be limited to just a small segment of the credit markets.

Then, as now, the stock markets kept rallying, eventually reaching new highs in October 2007. At the same time, the credit markets were already showing signs of strains, which eventually manifested itself through the demise of Bear Stearns in early 2008 followed by Lehman Brothers in September 2008.

I don't need to mention that the stock market eventually wound up falling -34% for the calendar year 2008, with most of the decline occurring in the last three months of the year.

I have two thoughts today, one positive and the other negative.

I wish I could be more definitive but I think the situation in Europe is just too fluid - and potentially too catastrophic - to be confident of how this all plays out.

But here's my positive thought: unlike 2008, when the credit markets totally froze, credit today is widely and readily available. Total corporate bond issuance this week, for example, will be well over $30 billion, and most issues have been gobbled up by yield-hungry investors.

Moreover, corporate America is awash in cash. Corporate treasurers have generally positioned their companies' finances to be able to withstand another shutdown of credit availability, at least for a while.

Now for my negative thought: In 2008 and 2009, there was a massive government response in response to the credit crisis. The Fed slashed interest rates, offered guarantees on money market funds, aggressively bought debt in the secondary market - you name, the Fed did it.

The other branch of the federal government did their part also. The Obama administration forced through a fiscal stimulus package of nearly $800 billion. Two years later, it is not clear how much impact this spending actually made on the real economy, but if nothing else it was a huge psychological boost.

I very much doubt this could happen today in the U.S. today, let alone Europe.

Technically the Fed could enact something like QE3 (where it would buy mortgages in the secondary market) but the political reaction would probably be extremely negative. And the talk in Washington is all about cutting spending, not fiscal stimulus.

The most recent proposals from the Europeans basically boil down to cutting spending and tightening credit, which makes no sense to me. When the European Central Bank cut rates earlier this week, they made it clear that they considered it a temporary move. In short, there is almost an Calvinist attitude towards dealing with the debt crisis, which probably means any solutions will not work.

Finally consider this: In 2008, three US government officials - Bernanke, Paulson and Geithner - could sit in a room and come up with solutions. Today, in order to get any resolution in Europe, you essentially have to get 17 different countries to agree,which to date has proven to be nearly impossible.

Several commentators - including one of my favorite columnists Ambrose Evans-Pritchard of the London Telegraph - have suggested that if the US and China joined forces they could end this crisis in the European credit markets*. However, I think this is simply not going to happen.

I am very concerned, to say the least.


Wednesday, November 9, 2011

Are Bank Stocks A Value Trap?

I got together yesterday afternoon with a pretty savvy client.

The meeting was great - as always, we had a spirited exchange of ideas.My client likes not only to hear some of my recent investment thoughts, but challenge my thinking as well.

We got to talking about the financial sector, and banks in particular. I reiterated my generally bearish views on the financial stocks despite the fact that on a pure valuation they look very attractive.

My client - who used to manage money for a couple of decades - pointed out the some of the historic valuation metrics for banks could be flawed.

He noted that banks used to be like utility stocks are today: boring, slow growth stocks whose main attractions were dividends and stability.

Money center banks today have little resemblance to the large banks of a generation ago. Any restrictions on their activities have largely disappeared. Banking is also much more concentrated in just a few large entities which, as the events of 2008 illustrated, are largely "too big to fail".

I think my client is right: simply saying "oh, look how cheap the price/book ratios are for the money centers" is not necessarily going to be a good guide to profitable investment opportunities.

Even if the crisis in Europe is contained to the European banks - which quite frankly I very much doubt - banks still face the prospect of very slow loan growth in a world focused on de-leveraging.

Moreover, with yields in the bond market so meager, net interest margins are being pressured like never before.

I remain cautious on the group.

Tuesday, November 8, 2011

Corporate Treasurers Continue to Stockpile Cash

Around the world, corporations are awash in cash.

There is an estimated $1.9 trillion stashed in US corporate coffers, yet the dividend payout ratio for the S&P 500 is a meager 26%.

Numerous companies are sitting on cash stockpiles that are far in excess of any possible corporate use; Apple, for example, will have nearly $80 billion in cash by the middle of next year, yet does not pay a dividend.

So why are corporations continuing to raise cash at record rates?

Nearly $20 billion in new corporate debt issues came to market yesterday, and underwriters are looking to sell an additional $10 billion or more in this holiday-shortened week. Only one company - Amgen - has announced that it will be doing a stock buyback with the proceeds of its $6 billion offering. The rest apparently are just going to hold onto the cash.

According to CNBC:

If the corporate issuance this week surpasses $30 billion, it would be for the fourth time this year. The last was in May, when the week of May 20, issuance reached $35.97 billion. There have been 11 weeks of $30 billion plus issuance since April, 2008.

Corporate treasurers are justifiably nervous about the state of the credit markets. They remember all too well the credit crunch of 2008, when borrowing window slammed shut for all but the highest rated borrowers. Better to stash cash in Treasury bills - even at 0% interest rates - than to not be able to fund normal business operations.

And it's not likely that we will see a resurgence in M&A activity, even though it might make sense. Citing a survey from Fidelity International, here's an excerpt from another article on CNBC yesterday:

Companies' cautious outlook has also led firms to avoid growth through acquisitions, the survey said, adding however that conditions were right for a resurgence of M&A activity given strong balance sheets, low interest rates and attractive valuations.

Fidelity analysts said roughly 84 percent of companies they covered had either dismissed M&A entirely to drive growth or were only considering it on a small scale.

"That's because they are generally paralyzed with fear about what's going on in the world, and they don't really want to do anything with the cash," {one Fidelity analyst}said.

"They are worried that they may have to survive a six-month period where global liquidity freezes again."

With interest rates so low, huge positions in cash are not especially helpful to shareholders, but it appears that caution is outweighing investment considerations for the time being.

Monday, November 7, 2011

My Education at Parents Weekend

My wife and I traveled to Wesleyan University this past weekend to visit our son Michael, who is a junior at Wes, for Parents Weekend.

We had a great time - the weather was very pleasant for this time of year, with temperatures reaching the mid-50's by mid-afternoon while were in Middletown.

The campus, too, was in surprisingly good shape considering the fact that much of the town was without power for most of last week in the aftermath of the snow storm.

We attended a number of different lectures given by Wesleyan professors, which gave us a glimpse of what a terrific education Michael is getting. We had time to walk around campus, and also attended a football game.

In short, we got the full higher education education experience in just a couple of days.

One of the things that struck me, however, was the dearth of any passionate protest movements on campus. True, there was the usual signs protesting pollution, or conditions in rural India, but most seemed fairly perfunctory. Perhaps this is a good thing, but maybe it also reflects a student body more interested in jobs and the economy than global concerns.

I don't think this is confined to Wesleyan. According to an article in this past weekend's Financial Times titled "Harvard rebels snub Bush aide's economic class", one of the hot protest topics on campus at Harvard revolves around what is being taught in introductory Economics:

On Wednesday, about 70 students walked out of Economics 10, the introductory class Professor {former Bush economic advisor Greg} Mankiw teaches, to protest at what they called a bias towards a destructive brand of free-market economics.

"We found a course that espouses a specific - and limited - view of economics that we believe perpetuates problematic and inefficient systems of economic inequality in our society today, {said the students}. There is no justification for presenting Adam Smith's economic theories as more fundamental or basic than, for example, Keynesian theory."

Given my experience as an undergraduate at the University of Michigan - where the hot topics were areas like Vietnam or legalization of marijuana - the "hot buttons" on campus have changed considerably in a generation!

Thursday, November 3, 2011

What if Greece Just Says No?

I've been trying to figure out what happens if Greece simply defaults.

It's easy to dismiss the cries of protest emanating from the Greek populace about the terms imposed by the European leaders as part of a bailout package.

After all, the thinking goes, the Greeks lived well beyond their means for many years. Borrowing levels soared, and a corrupt and in-bred government did little if anything to improve basic government functions like tax collections.

And yet, the terms of last week's deal are incredibly draconian. Greece is expected to accept austerity measures for the next 10 years. Unemployment will soar, probably in excess of 20%, for years to come. Public services will be cut and the standard of living of most Greeks will deteriorate further.

All this so the big European banks can be repaid for loans that never should have been made to begin with.

I'm not defending Greece - they could have stopped this train wreck long ago - but I am also questioning whether the medicine is more than most populations would reasonably be expected to take.

A number of commentators have begun to say maybe Greece should just default. Yes, the near term consequences could be dire, but longer term the country could wind up ahead.

Iceland, for example, told its bank creditors to take a hike back in 2008 when it was in the middle of its own credit crisis. As Bloomberg news wrote earlier this year:

Unlike other nations, including the U.S. and Ireland, which injected billions of dollars of capital into their financial institutions to keep them afloat, Iceland placed its largest lenders in receivership. It chose not to protect creditors of the country's banks, whose assets had ballooned to $209 billion, 11 times gross domestic product.

And where is Iceland today? Quoting Bloomberg:

In the beginning, banks and other financial institutions in Europe were telling us 'Never again will we lend to you' {one Iceland official} said. "Then it was 10 years, then 5. Now they say they might soon ready to lend again"

The political winds are considerably different than 2008, when the world was told that we were facing financial Armageddon if the banks were not bailed out.

At this point I think the risks are much greater for French and German banks - and I think that Greek Prime Minister Papandreou had figured this out long ago.

Wednesday, November 2, 2011

The More Things Change, The More They Stay the Same

French diplomat Charles Maurice de Talleyrand once famously said that the Bourbon family dynasty that "had learned nothing and forgotten nothing."

This quote came to mind when reading about the fall of MF Global.

The investment "bets" that MF Global had made were not on the surface particularly aggressive. From what I read, the firm had amassed huge positions in short sovereign debt of countries like Italy which are trading at a modest discount to par in the secondary market.

The idea was simple: at the end of the day, it seems very likely that all of most, if not all, of the debt would be repaid in a year or so.

The problem is the fact that MF Global borrowed heavily to buy as much of the sovereign debt as it could. When its creditors turned skittish, and pulled their credit lines, MF Global tried to get out of its positions, but there is obviously not a particularly strong bid for euro bonds these days.

Exit MF Global.

This strategy seems very similar to the ones followed by Long Term Credit Management (LTCM) back in the late 1990's. There again, a group of very smart investors decided to leverage up their investments in sovereign bonds issued by countries like Russia. When Russia defaulted, LTCM collapsed.

Ironically, one of the firms that helped liquidate LTCM was Goldman Sachs, headed by none other than Jon Corzine. Corzine, of course, is the head of MF Global, and pushed MF Global to make the same type of leveraged bets on sovereign debt that LTCM had done.

And now MF Global has reached the same fate as LTCM.

Roger Lowenstein wrote an excellent book about the hubris that ultimately lead to the demise of LTCM called "When Genius Failed: The Rise and Fall of Long Term Capital Management". He wrote a column for Bloomberg yesterday which discussed the similarities of LTCM and MF Global:

MF Global was leveraged 30 to 1, shades of LTCM. And of MF Global’s roughly $40 billion in assets, more than $6 billion were in volatile European sovereign debts. Corzine was the author of the firm’s strategy of risking its own capital. He wanted a firm like {LTCM}, and he got one. Corzine also approved the strategy of loading up on European debt. According to the Wall Street Journal, he told a company executive that “Europe wouldn’t let these countries go down.” Just as, 13 years ago, traders believed that Russia wouldn’t default.

Corzine’s bet may still prove correct; “these countries” -- Italy and Spain, for instance -- may emerge from the current crisis solvent. But if they do, MF Global will not be around to reap the gains. Because the firm was so highly leveraged, and because it was dependent on short-term financing, its liquidity dried up and it failed. This seems to be the lesson that Wall Street never learns.

As Talleyrand might have said: Plus ca change, plus c'est la meme chose (the more things change, the more they stay the same).

Tuesday, November 1, 2011

November Starts on a Rocky Note

I'm worried about how quickly the apparent Greek debt accord reached just last week in Europe is unraveling.

The decision by Greek Prime Minister Papandreou to put the European Community's plan to a vote in the Greek Parliament illustrates very clearly which country is in control. And, no, it's not Germany - it's Greece.

John Maynard Keynes once famously observed that "If you owe your bank a hundred pounds, you have a problem. But if you owe a million, it has."

Greece knows that if it defaults on its debt obligations, and it is forced out of the eurozone, the consequences will be huge for all of the remaining members.

The major euro players are trying to force draconian austerity measures on Greece in return for more financial help. But my suspicion is that Papandreou knew this wouldn't fly in Athens, but went along anyway last week. Some observers noted his almost surreal calm in the midst of the conference; maybe he is a better poker player than the other leaders thought.

German Chancellor Merkel - who expanded so much political capital on last week's agreement - must be hugely frustrated at this point.

My real concern is what happens next. I doubt they will convene another European summit if the Greek parliament does not agree to the terms imposed last week. And the ECB is not the Fed - it can't just print money to intervene in the capital markets.

I am getting the uneasy feeling that we saw this meeting before, in 2008. Could the collapse of MF Global be this year's Lehman Brothers?