Debt Continues to Haunt Global Economies

Even though there's snow on the ground, and many homes in New England are without power, it's Halloween.

It seems appropriate, then, to on the "debt ghosts" coming back to haunt us in the economy.

If the specter of this past weekend's storm wasn't enough to haunt you (we just got power back this morning), consider this discussion of the global debt burden that arose at a recent conference sponsored by the Economist magazine (I have added areas of emphasis):

Typically, however, the other striking speech came from Kyle Bass, the investor, which illustrated the other side of the problem. He pointed out that total global credit rose from $80 trillion in 2000 to $210 trillion today. In many nations, debt is three to four times GDP. These figures have normally been seen only in the course of major wars (i.e 1914-1918 and 1939-1945) when the result was a complete wipeout for creditors of the losing states.

http://www.economist.com/blogs/buttonwood/2011/10/unemployment-and-deleveraging?fsrc=nlw%7Cnewe%7C10-28-2011%7Cnew_on_the_economist

Mr. Bass's figures include the so-called shadow banking system, which are entities that exist outside the normal banking channels (e.g., money market funds) that also provide credit.

These debt figures are obviously staggering. Now, to be sure, some would argue that they could be overstated, since much of what is considered "debt" are actually credit derivatives that probably will not be exercised.

But still: $130 trillion in a decade?

The Financial Times also picked up on some of the figures that Mr. Bass discussed, noting (again, I have added emphasis):

A study by the Financial Stability Board of the 11 largest economies with significant shadow banking found the sector, which previously peaked at $50,000 bn in 2007, dropped to $47,000 bn in 2008, but is now back up to $51,000 bn. It now constitutes more than a quarter of the financial system and is about half the size of traditional banks....

Regulators fear {non-bank credit} remains a big threat to long-term stability, particularly as more activities move out of the bank sector to escape tighter regulation there.

http://www.ft.com/intl/cms/s/0/39c6a414-00b9-11e1-930b-00144feabdc0.html#axzz1cNzz8NPv

In short, while we continue to talk about paying off past debts and getting our global economy on a sound footing, the numbers would suggest that in fact we're heading in the opposite direction.

One final thought: Imagine if the shadow banking system was subject to the same capital rules as the banks? It might make the system more stable in the long run, but the shorter term consequences would be very negative.

European Banks

The markets had a huge rally yesterday with the news of the apparent resolution to the Greek debt problems.

European bank share prices soared, led by a rise of more than +20% in French bank stocks.

As I will explain, I can understand why banks are rallying - they're getting bailed out (again).

What I can't figure out is why the solution is anything but very bad news for European economies.

Here's the part that I'm focused on: the plan calls for banks in Europe to raise capital between now and the end of June next year. The figures being thrown around are around 110 billion euros, or about $150 billion.

The idea is laudable: banks need to raise more capital in the event of other sovereign credit problems, especially in countries like Ireland, Spain, Portugal or even (gulp) Italy.

Problem is, most bank stocks in Europe are trading below book value, just like in the U.S.

Issuing equity capital below book value is a sure-fired way to kill your stock value, and it seems logical that most bank managements will be reluctant to do so.

Which then leads to the real heart of the matter. For this, let me show you a very simplified bank balance sheet:

Assets

Loans and Investments 100

Total Assets 100

Liabilities & Capital

Deposits, Borrowings* 94

Bank Capital 6

Total Liabilities and Capital : 100

What you can see here is a fairly typical balance sheet which has 6 euros supporting 100 euros of loans and investments. This ratio - 6 euros for 100 euros of assets - is 6%, which is roughly where most of the European banks currently stand. This 6% figure is called the capitalization ratio.

The agreement reached yesterday called for bank capitalization ratios to be raised to 9%. The question is: how can this be done when bank stocks are trading below book value?

Simple algebra will tell you that if you're not going to sell stock, you have to reduce your assets.

If you have 6 euros in capital, and you want the capitalization ratio to go to 9%, you have to shrink the amount of assets to 67 euros, or about one-third less than their current levels.

If this is the case, this will be hugely depressing for Europe. Reducing loan portfolios by 33% between now and next June doubtlessly will entail economic pain. Shrinking the debt markets so quickly means less credit available for all kinds of meaningful economic purposes.

Now, some of the people I have spoken to say I am being too pessimistic.

First, it was announced yesterday that the authorities will be watching the banks very carefully to make sure they don't just shrink their balance sheets in the manner I am suggesting. Honestly, I don't know how effective moral suasion can be in this case, but maybe it will work.

Second, the banks themselves are claiming that they can simply retain more earnings and build capital through business operations. Well, maybe, but these are big numbers, and loan growth in Europe is really slow.

Oh, and the banks might cut their dividend payouts (as French PM Sarkozy suggested yesterday) to retain more earnings. But how does this make bank shares attractive to investors to provide needed capital?

Maybe the banks don't need to shrink their balance sheets: maybe they can just sell off huge chunks of their loan portfolios to other investors, which means that the credit will still remain in the system.

Problem with this happy scenario is that it implies that banks will be able to sell their loan portfolios at attractive prices. We tried this in the U.S. in 2008, and essentially failed - the bids were at huge discounts to book.

If you are a buyer of bank loans, and you knew the banks had to sell, are you really going to make an aggressive bid?

I could go on, but you can see my problem. If the politicians force their solution on the banks, and the "happy" solutions don't pan out, it has the danger of tipping a fragile economic situation into something more serious.

More more ominous note: Almost immediately after the Greek deal was announced yesterday, the Irish Prime Minister was quoted as saying, hey, we would like that deal also - why should we be forced to pay back all of our debt at face value if the Greeks only have to pay 50%?

Look for the rest of Southern Europe to follow Ireland.

Lots to ponder this weekend.

BTW: The funding of the loans is largely done through deposits and borrowing. In the case of the European banks, they make extensive use of the money markets. This makes the Europeans more vulnerable to changes in credit perceptions, since lines can be quickly pulled if any lender becomes nervous.

Richard Rosenbloom

One of my favorite clients died earlier this week.

Although Boston Private Bank prides itself on confidentiality, I think I can make an exception in this case, because Dick Rosenbloom was more than a client to me.

I first met Dick in the spring of 2000. He was still teaching at the Harvard Business School, where he was the David Saranoff Professor of Technology. In the summer, Dick and his wife Ruth would head out to the Bay Area, where he was consulting at Hewlett Packard. He was also on the board of Arrow Electronics.

Although I was managing an equity portfolio for Dick, I often felt like I was learning more from him than vice versa. His insights on the world in general, and technology in particular, were incredibly interesting and helpful.

Dick made a terrific market call in August 2000. He had just finished reading Robert Shiller's book Irrational Exuberance, which described the incredible overvaluation of the stock market at that time. Although I was on vacation, Dick called me and told me to sell nearly all of the stocks in his portfolio.

The S&P 500 then started the swoon from which it has yet to recover; the market is off nearly -20% from the time Dick told me to sell.

Dick took the proceeds from his stock sales and moved them into bonds, where he also did very well. Here again his instincts were uncanny: In the midst of the credit crunch in the fall of 2008, for example, he pushed us to invest in bonds issued by banks and brokers, correctly surmising that the government would never let our largest financial institutions fail.

But there was more to Dick than investing - much more. He was totally devoted to his family. He loved talking about his three children, and their activities were always a source of interest. When his wife Ruth became ill, he became a full-time caregiver, and never complained about the burden. Her death left a void in Dick's life, but he continued to live life as best as he could even after the loss of his best friend.

I always enjoyed meeting with Dick to catch up on the markets as well as family. To be sure, Dick could be very challenging, as all good teachers can be to students.

For example, Dick disliked the idea that institutional investors had diversified portfolios, and pushed me to put only my very best ideas into his accounts, regardless of whether it increased volatility. Thanks to his prodding, I must confess that my equity performance numbers in Dick's portfolios were among the best in my client book.

Dick moved to New York City in his last years, and loved the energy and vitality of the City. While I had not seen him as much as I would have liked after he moved, we talked occasionally on the phone, and our conversations were always pleasurable.

Dick will be missed not only by me, but several other members of the Boston Private Bank community who knew him well.

More on Bank Stocks

We had a long and heated discussion here at the bank this morning about investing in the financial sector.

The S&P 500 has slightly more than 13% weighting in the financials. Underweight the sector in client portfolios, and financials rocket ahead like they did at the end of 2010, your relative performance suffers.

On the surface, the group looks incredibly cheap. The money center banks in particular are trading at a price/book ratio not seen in 30 years, so it would seem that they are ripe for investment opportunity.

But not to me.

Yes, I recognize that the problems of the financial sector are widely known, and that any "good news" from Europe could cause the group to soar.

Moreover, if the glimmers of economic resurgence continues, financials historically have done very well when economies are healing.

My main problem with the group relates in part to the post from yesterday about Ray Dalio. Dalio's company Bridgewater Associates focuses on what they don't know as much as what they believe, which is an approach I favor as well.

So, what is it that we don't know about the financial sectors health?

Plenty, I would argue.

For example (quoting from Monday's Financial Times Lex Column):

Try this on your credit card company: your creditworthiness has weakened, so you write down the value of what you owe to reflect the greater risk that you will not pay it all back and credit the difference to your personal account. That is exactly what accounting allows; the top five big US banks - Citigroup, Bank of America, JP Morgan, Morgan Stanley and Goldman Sachs - have just reported gains equivalent to more than four-fifths of their quarterly $16bn net profit as a result of falls in the value of their own debt and credit standing. Now European banks are set to report with the same system.

http://www.ft.com/home/us

Bank of America reported reasonably good earnings last week - until you stop to consider that it needed 15 separate "one-time" boosts to get to a reasonable earnings number.

This, by the way, was on the heals of the 16 different "one-time" boosts that BofA employed in the second quarter.

So, in fact, we really have no idea what banks are even making.

Then there is the simple problem of low interest rates. Banks typically make a good chunk of their earnings from the spread between short term and long term interest rates. However, with loan demand tepid, and rates on Treasurys at 1% or less on all but the longer maturities, there is no spread available.

This becomes particularly important to banks at the present time, when they are being inundated with deposits. As Monday's New York Times pointed out:

Normally, banks earn healthy profits by taking in deposits and then investing them or lending them out at substantially higher interest rates than what they pay savers. But that traditional banking model has broken down...

Today, banks are paying savers almost nothing for their deposits. As it turns out, the banks are not minting money on those piles of cash. Lending levels have not bounced back from only a few years ago and the loans going out are not keeping pace with the deposits rushing in.

http://www.nytimes.com/2011/10/25/business/banks-flooded-with-cash-they-cant-profitably-use.html?_r=1&scp=1&sq=banks%20cash&st=cse

And what do we know about the quality of bank balance sheets? Nothing. Banks have been reluctant to write down non performing loans since they do not want to recognize losses.

In short, we don't know what banks are actually earning, nor do we know anything about credit exposure. With the economy mired in de-leveraging mode, prospects for loan growth do not seem promising.

So what is the catalyst for bank stocks? I'm hard pressed to find one, but I will continue to look.

One final point: one of my fellow managers kept insisting that "everyone" is bearish on the financial sector, and banks in particular. He concludes that the contrarian play, then, is jumping back in the sector.

However, financials still represent the second largest sector weighting in the S&P index, despite massively underperforming the rest of the market this year.

The stock market that by definition has to have a buyer for every seller, there apparently are still lots of folks that believe that the banks are about to turn.

Ray Dalio of Bridgewater

I had the chance to watch Ray Dalio of Bridgewater Associates being interviewed on the PBS talk show Charlie Rose last week.

Ray Dalio is one of the most successful money managers of our generation. Starting in 1975, his firm now manages approximately $125 billion for a wide variety of clients, including some of the largest public pension plans. Last year, Bridgewater was the top performing hedge fund in the United States, proving that size isn't necessary a deterrent to performance.

Unfortunately I was not able to figure out how to imbed the video from Mr. Dalio's appearance. However, if you have 37 minutes at some point, and want to hear from one of the Best, I would encourage you to visit http://www.charlierose.com/ and watch the entire interview.

Bridgewater is a "macro" investor, which means that they place their investment bets based on their work on global economic and market trends.

One of the most interesting parts of the interview, in my opinion, is how much Mr. Dalio says that his firm focuses on what they don't know. Unlike many investors - who make a specific forecast, then invest accordingly - Bridgewater considers a wide range of scenarios, and tries to figure out investments that will do well in a variety of different outcomes.

In this tendency Bridgewater is not alone. It seems to me most of the best investors - including Warren Buffett - spend more time on downside risks than they do opportunities. Despite their enormous success, Dalio and Buffett are humble enough to recognize that events often take place that virtually no can anticipate, and they make their investments accordingly.

Dalio has an editorial in this morning's Financial Times in which he repeats some of the themes that he discusses on the Charlie Rose program.

Dalio believes there are three important trends to consider right now:

1. We are in the midst of a massive de-leveraging process. Dalio notes that he is not only concerned about the huge government debts around the globe, but also the massive amount of debt that individuals also have amassed. In his opinion, the process of reducing this debt will be a drag on economic growth for years;
2. Governments are largely out of ammunition. Dalio believes there is are few alternatives left for our elected officials to improve the current economic climate;
3. We are at each other's throats. The tone of any policy debate has become incredibly nasty and strident, and no one seems to want to try to come up with any workable solutions. This, in Dalio's opinion, is probably the biggest danger to our economies and markets.

Here's the final paragraph of Dalio op-ed piece:

If we calm down and work together to properly manage this difficult situation....we can get through this deleveraging without great pain. If we can't, we may experience an economic, social and political collapse.

http://www.ft.com/intl/cms/s/0/ed4439d4-fbeb-11e0-9283-00144feab49a.html#axzz1bnIVgYrW

Managers, Pigeons, and The Perils of Overconfidence

Let's start the week with a pop quiz.

I am going to sit you down in front of a screen where I will flash two lights: red and green. I will tell you the sequence is completely random, but 80% of the time the light will flash green.

And, oh, by the way: one of my assistants will be doing the exact same experiment in the next room, only she will be having a pigeon doing the guessing.

Who do you think will get more right? You or the pigeon?

Now we'll start our experiment. I will start flashing the light, and I want you tell what color is coming up next.

Here's what you should do: I have already told you that 80% of the time the light will flash green, and that the sequence will be totally random. So, the correct guess will always be "green", so you will be right 80% of the time.

But that's not what most humans do. They tend to look for patterns where none exist. Here's how Jason Zweig described our human tendencies in his book Your Money & Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich:

Human, however, tend to flunk this kind of experiment. Instead of just picking green all of the time and locking in an 80 percent chance of being right, people will typically pick green four out of five times, quickly getting caught up in the game of trying to call when the next red flash will come up. On average, this misguided confidence leads people to pick the next flash accurately on only 68 percent of their tries. Stranger still, humans will persist in this behavior even when the researchers tell them explicitly...that the flashing of the lights is random.

Meanwhile, the other room, your pigeon competition is guessing correctly 80% of the time, since the bird automatically picks green every time. Mr. Zweig explains:

...birds seem to stick within their limits of their abilities to identify patterns, giving them what amounts to a kind of natural humility in the face of random events. People, however, are a different story.

In short, the pigeon probably wins.

---------------------

I was reminded of this story yesterday, when I read a piece by Dan Kahneman in yesterday's New York Times about the perils of overconfidence.

Dr. Kahneman was awarded a Nobel Prize in 2002 for his groundbreaking research into behavior finance. He has also written extensively about how one should view any predictions about future events, especially economic or related to the stock market, with a grain of salt.

In my field, you often read predictions about the future course of the stock market, or the direction of interest rates. These pronouncements are usually made with great confidence, yet are often just as likely to be wrong as they are right.

Just as in the behavior experiment, we humans like to look for patterns where none exist. We might know, for example, that investing in stocks will tend to outperform other asset classes, yet we persist in trading in and out of the market based on our belief that we will be able to "time" the market.

Here's Dr. Kahneman's advice:

We often interact with professionals who and confident predictions even when they know little or nothing. Overconfidence arises because people are often blind to their own blindness. ls who exercise their judgment with evident confidence, sometimes priding themselves on the power of their intuition. In a world rife with illusions of validity and skill, can we trust them? .... We can believe an expert who admits uncertainty but cannot take expressions of high confidence at face value. As I first learned on the obstacle field, people come up with coherent stories and confident predictions even when they know little or nothing. Overconfidence arises because people are often blind to their own blindness.


http://www.nytimes.com/2011/10/23/magazine/dont-blink-the-hazards-of-confidence.html?pagewanted=4&_r=1&ref=general&src=me

TIPS Are a Crowded Trade

Ned Davis - founder of Ned Davis Research, a market research firm that I highly respect - has three simple rules for investors:

1. Don't fight the tape (i.e., when the market is trending in one direction, don't try to fight it);
2. Don't fight the Fed (i.e., when Fed policy is easy, buy stocks, or vice versa);
3. Be wary of crowds at the extremes (i.e., when sentiment is overwhelmingly skewed in one direction, be careful).
   

I have often thought of Ned's rules, but I was particularly reminded of rule #3 this morning, when I read this sentence from an email sent by Brad Hintz, Bernstein's financial analyst (TIPS are "Treasury inflation protected securities"):

Yesterday, the U.S. Treasury sold $7 billion of 30-year TIPS at a record low yield of 0.999%. Demand was very strong as the bid-to-cover ratio was 3.06, well above the average of 2.40. Indirect bidders, a class of investors that includes foreign central banks, purchased 43.2% of the securities, above the average of 40.0% for the past four auctions

Think about that: there apparently is a large enough group of investors so convinced that inflation will be roaring back that they are willing to lock in returns of less than 1% for the next 30 years (!).

I know I wrote yesterday that investors should avoid predictions, but here's one that I can safely make: The world will look alot differently in 2041 than it does today.

So does that mean that bonds are overvalued?

Well, maybe, but I think with the Fed keeping short rates at 0% for at least the next couple of years, and deflation, not inflation, a bigger risk, bonds can still play a role in investor portfolios.

But for investing, it still seems to me that dividend-paying, large cap stocks are the way to go. So too does legendary investor Leon Cooperman, who is not a big fan of bonds.

Instead, Mr. Cooperman likes stocks:

“I wouldn’t be caught dead owning a U.S. government bond,” he said today during a presentation at the Value Investing Congress in New York. “Not because I have a problem with the credit. I have a problem with paying 35 percent on the 2 percent to Uncle Sam, and then have a 2 to 3 percent rate of inflation,” he said. “It’s confiscation of my capital. I think I’m too smart to play that game.” ...

Stocks are cheap relative to history, relative to inflation, relative to interest rates,” he said. “The recent facts suggest the economy is accelerating moderately.”

http://www.bloomberg.com/news/2011-10-18/cooperman-says-u-s-will-avoid-recession-stocks-appealing-1-.html