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.

*http://blogs.telegraph.co.uk/finance/ambroseevans-pritchard/100013198/america-and-china-must-crush-germany-into-submission/

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.

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.

http://www.cnbc.com/id/45194318

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."

http://www.cnbc.com/id/45200565

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.

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."

http://www.ft.com/intl/cms/s/0/5aae33bc-069b-11e1-8a16-00144feabdc0.html#axzz1d24r3L8e

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!

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.

http://www.bloomberg.com/news/2011-02-01/iceland-proves-ireland-did-wrong-things-saving-banks-instead-of-taxpayers/

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.

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.

http://www.bloomberg.com/news/2011-11-02/corzine-forgot-lessons-of-long-term-capital-roger-lowenstein.html

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

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?