Sunday, July 24, 2011

Default Discussions Could be Good for Sound Investing

A few years ago there was a not too successful Broadway play with the title “I Love You, You’re Perfect, Now Change.” That is the way I am beginning to feel about the endless discussion about a possible default by the US government if it cannot borrow new money as of August 2nd.

First, let me say the obvious, that I do not know what political solution will accommodate the opposing forces of spending too much money and the unwillingness to pay for it. Having seen the professional negotiators for my clients (the National Football League and the former NFL Players Association) apparently come to agreement after a four month lock-out, I have great faith that some interim agreement is probable. Like with the football agreement, for those of us who care, God will be in the details. While both disagreements were foreseeable for at least the last two years, the players in Congress and the White House have not been in serious negotiations until perhaps a month ago, thus they lag the professional negotiators for the football collective bargaining agreement.

Second, the financial community has been of two minds, either there will or will not be a default. Separating all the chatter from market prices has a way of sharpening the focus. One of the more modern innovations to the bond market is the development of credit default swaps (CDS), in which the buyer wants to be assured that he/she will receive full payment of principal and interest when due, and the seller will insure that delivery. CDSs were initially used for high yield bonds (junk bonds), more recently a market has appeared for those who want insurance on sovereign debt of various countries. One of the ways the market gauges the chance of a downgrade is to rank the cost of CDSs on $10 million face value bonds. According to Saturday’s Wall Street Journal, “Currently, one-year protection against a U.S. default is roughly double that of other triple-A rated nations such as the U.K. and Germany….” The article also states that the cost is higher than for Indonesia with a credit rating of BB+. According to Markit, the cost for the 1-year CDSs and the annual five year cost is an identical 53,000 Euros or approximately $76,000. Further, the WSJ article states, “The annual cost of protection over five years, which more investors focus on, was also €53,000, but has risen by a smaller magnitude since January 2011 and remains well below its peak of €100,000 in early March 2009, at the height of the recent financial crisis.” These are small markets and do not represent the market judgments of hundreds of billions of dollars held by various institutions around the world. If that is not enough of a warning, I have been informed that the six leading insurance companies with an AAA rating may be facing an immediate down-grade because so much of their required reserves are held in US government paper.

Third, while up to this weekend the markets have not significantly reacted to the possibility of a failure to raise the debt limit, some have been thinking quietly about how to operate under such conditions. For example, I believe that there has been a group within the Federal Reserve developing plans as to what checks will be honored and when. I know that a number of government contractors including Caltech, which I have the privilege to serve as a trustee, have drawn up plans to deal with an uncertain stream of payments. If by the opening of markets on Monday there are others accelerating their contingency plans, interest rates will rise and fixed income prices will fall.

Fourth, the much maligned, but essential credit rating agencies’ warnings of a downgrade will be examined more closely. (Our financial services hedge fund has a position in Moody’s.) Unlike most other downgrades which are based on the odds that there is some insufficiency to meet debt obligations, these potential downgrades are based on the evidence of an unwillingness to meet our obligations.

The Good

How can any of these traumas be good? First, the situation forces recognition of the inevitable clash between our society’s apparent demands for goods and services from the central government and our willingness to pay for them concurrently. Similar clashes are observable in numerous European countries that have had socialist leanings for a long time. This battle of wills was a long time coming and it was naïve to ignore the issues as the markets have largely done. Whatever the outcomes of these struggles, we are entering a true-up phase which recognizes that deficits do count and cannot go on forever. Second, few of us fully recognize the multiple roles the government plays in our lives. For example, one can not travel by air, rail, boat, or by road and not be subject to governmental rules and regulations as well as the spending of taxpayers’ money that subsidizes our movements. In similar fashion, in the fields of energy and health care, we have become heavily influenced by government actions and direct as well as indirect payments. Clearly among the most dependent arenas of government influence are the financial markets (bonds, stocks, commodities, real estate and intellectual properties). Most often prices in these markets are directly or indirectly priced off of similar maturity Treasuries. The private sector’s retirement contributions are keyed off of the level of interest rates for many pension plans and the investment policies stated or unstated for defined contribution and other retirement plans. Note that in periods of turmoil, various investment policy statements and prospectuses permit a 100% commitment to Treasuries.

Why do I say that listing these dependencies on potentially downgraded government paper is good? The first step in helping a person with some form of behavior disorder is to recognize the problem and the levels of chemical or other dependencies on the source of the problem. Without this recognition, there will be little chance of a cure. I do not know what will be the various solutions used. But the genius of the American culture (also found elsewhere) is that we will find appropriate, if not elegant, solutions.


If that is what I label as good, can you stand what I label “better”? Coming out of these economic traumas we normally look to change our risk exposure to past problems. The standard prescription would be diversifying beyond the all-powerful US dollar. That is going to be difficult to do. Almost all global assets have their prices impacted by US activities. Ideally we should look at public and private investments in countries that have relatively small populations but with sufficient internal capital to develop large resources for the benefit of the present and future generations of a striving population, e.g., Canada, Australia, Singapore and Mongolia. These were some of the main characteristics that have made the US an attractive place for both domestic and foreign investment in the past. We are on a search for the next investment horizon. We are not alone; many of the international portfolio managers that I speak with are on the same search either directly or through the companies that they put into their portfolios. Whether they recognize it or not, most institutional portfolios of endowments and mutual funds are also deep into the difficult process of finding different, and hopefully better places for investment.

The ultimate irony of both the debt/expense problems and the search for new investments is that it is possible, perhaps unlikely, that the American public will take its bitter medicine so that the children and grandchildren of the US will once again live in a society that is an attractive investment home. That truly would be best.

Do you have any long-term solutions or portfolio construction suggestions?


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