Sunday, November 15, 2009

Post Mortem 2007-8 and Pre Mortem 201X

In last week’s blog, I promised to devote this week’s musings to the causes of the recent declines in the economy and markets. You will find my focus is more of a systemic approach than singling out specific instruments, organizations, regulations or people.

The history of the rise and fall of markets and related economies goes back to the beginnings of recorded time. This history can be described graphically as undulating waves following a cyclical pattern. As these waves began long before the creation of hedge funds and credit default swaps, there must be something more basic in human nature. I believe the drive that causes these cycles is the four letter word that a well known labor union leader enunciated more than a century ago when asked what his laborers wanted; the reply was “More.” It is each person’s desire for more of what is in short supply that drives the demand side of the economic equation. The supply side is provided by those who produce or possess “more” than what they can consume. In periods of population growth and net immigration, there is normally more demand being generated than supply coming onto the market. Spurred on by the dynamite of rising expectations driven by all forms of media, the demands for higher priced goods and services drove demand. There is hardly a human alive today who does not want more of something, including ‘peace of mind,” which itself can be costly. (Think of various forms of physical, medical and financial protection.) In this sense, we are all the sinners of driving for “More.”

There is a two letter word that we do not want to hear from our government or employer. That word is “No.” Thus, governments rarely say no to a demand for more services. The normal solution is reliance on inflation, as governments can repay their enlarged debts with currency that is worth less due to inflation. Employers also want to avoid saying no to increased wage demands if they can avoid it. Employers count on both increased productivity and higher selling prices to meet wage demands.

The growing demands for more goods and services could not be satisfied in their entirety through growth of the market. Most developed economies, including the US, have been growing more slowly than the escalation in demands. The solution to this problem was to borrow money in ever- increasing amounts. In effect, borrowing new money to repay old debts. In the corporate world, debt grew faster than equity, so any shortfall in the ability to issue new debt for old debt would have a dramatic impact on a proportionately smaller equity base. (Leverage has this annoying characteristic of working both ways to magnify gains and shortfalls.)

As an equity analyst and portfolio manager I did not pay much attention to fixed income securities. Neither did most individual investors. I should have been more conscious that segments of the fixed income markets were showing signs of distress by requiring higher yields to clear transactions. These particular securities were housing-related, and mostly the hot new Wall Street product called structured finance securities (which were large packaged and sliced residential mortgages). Their rising prices at the same time that more of the financial community’s capital base was being devoted to this trade, should have been the proverbial chirping of the “canary in the mine.” Like most others, I missed these early warning signs. Along with the regulators, I further failed to understand the implications of counterparty risks on a global basis. I missed the fact that overseas participants had taken on much more leverage. One could borrow more money, at better terms, in London than in New York. The poorly identified mortgage products were sold around the world to satisfy local needs for income to meet “more” demands.

Space and time do not permit for a more inclusive analysis of what went wrong and how we missed spotting the problems. What I want to focus on now is the possible “Pre-Mortem” for a future decline, which history tells us will surely come at some point. (Let us hope years in the future!)

Many people fear two possible causes for the next major decline that I do not. The first is a dramatically worse real estate market. Could residential market prices drop further, causing more defaults? Yes, but in terms of magnitude unlikely to be major. (Remember, I missed spotting the first decline when I knew local prices were unsustainable.) Many have identified commercial real estate as the next big problem. I think these problems have been largely identified. Vacant properties are a problem but I believe the order of magnitude is much smaller than the residential real estate hit we sustained, and the market is prepared for defaults.

The second popular worry at the moment is the relative decline of the US dollar. In the last couple of weeks, I have commented on the decline compared to other currencies, not commodities.

My true concerns however, are for two other problems that I perceive on the horizon. Either one could cause major instability in our markets.

The first concern is the increasing level of speculative foreign exchange trading. Corporations, financial institutions (including hedge funds), and increasingly individuals, have discovered these markets whose daily volume is larger than the traded securities markets on many days and nights. (Currencies are traded around the clock, around the world.) The advertised leverage potential for the retail participant is 500 to 1. (Many of the frauds in the financial markets have been caused by attempting to regain undisclosed losses by the rapid trading of highly leveraged products.) Foreign exchange that goes through banks has some regulatory oversight, but not heavy. Those trades executed outside the bank channel have little or no oversight. Either a suspected (or actual) fraud, or a surprise devaluation/revaluation by a government could cause a significant amount of margin calls. Many organizations and individuals could not immediately meet the repayment obligations on their loans from such margin calls, possibly leading to some bankruptcies. Nevertheless, a foreign exchange collapse is analogous to other kinds of margin calls, with enough case law in place that we should quickly seal off the problem.

My second concern is pure conjecture. Assume, whether, we like it or not, some healthcare legislation is passed. Initially the first victims of this price- control legislation will be the profit margins of doctors, hospitals, pharmaceutical companies, medical equipment providers, as well service companies. Most important of all, individuals will find their costs will rise; particularly the elderly and the formerly wealthy. Many different approaches will be attempted to restore their past financial relationships. Almost guaranteed, more debt will be found on hospital balance sheets,* doctors’ practices, as well as many other organizations. I suspect some individuals either by happenstance or by conscious decision will find it necessary to borrow money against some future financial stream. As many of these groups are inexperienced in shopping for, and managing external debt, they will fall behind in their repayments. My fear is that we will see medically-induced bankruptcies with enormous emotional pains, and very little easily convertible collateral. As a society, we are not prepared for this contingency. Pity the judges who will have to deal with these issues.

*I sit on the Financial Oversight Committee and chair the Investment Committee for an important not-for-profit hospital group that currently holds a very good credit rating.

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