Sunday, October 23, 2011

To Avoid Moral Hazard: Buy Asian Equities, Hold Cash for Redeployment and Sell High Quality Bonds

This week’s blog is based on thinking about the signs shown for “Occupy Wall Street,” seeing the video rendition of “Too Big to Fail,” remembering the insight of a blind leader, looking at extreme numbers and watching the NY Jets beat a better team. Part of the intellectual handicap we all have is that our views of history are shaped by commentators who lack full understanding of what they thought they saw or heard.

D/F + TBTF + OWS = Bigger failures - - bigger opportunities

By now the media savvy recognize "OWS" stands for Occupy Wall Street which has gone global as sites of anger, frustration, and the willingness to break laws. "TBTF" abbreviates the title of the book entitled Too Big to Fail, which was made into a movie which was rebroadcast last night. "D/F" is my symbol for the Dodd Frank law that is being imposed on the US financial and economic community, which has implications to financial communities around the world. This witches’ brew of maladies will, in my opinion, lead to bigger failures and greater disruptions to global progress and at the same time open up new opportunities for the wise to make money.

The complaints

Two of the complaints coming from the inhabitants of the various “rescue encampments” are first, the banks got bailed out of their problems and we “ordinary people” did not; and second, we have selected various financial institutions to receive future bail outs whenever they get into trouble. I do not expect the strident to allow me to share my personal historical perspective from both fifty years of professional investment experience and having listened to other professionals who went through the changes in the financial community for over one hundred years.

Ever since the “Money Panic of 1907,” (if not before), financial people have been concerned about the potential damage that a concerted “run on the banks” could do to individuals, themselves and the community as a whole. In its simplest form, banks collect deposits and loan most of their deposits back out to the community in the form of demand loans or term loans. Banks require interest income from these loans to pay for deposits, other expenses and to build reserves to cover for periodic credit losses. No bank keeps enough cash on hand to meet redemptions of all its deposits. Thus, if there was a “run on the bank,” the bank would attempt to call all its demand loans and as much of its term loans as possible. The news of a run on one bank is likely to cause a run on other banks. This fear is what led to the founding of various government financial agencies like the Federal Deposit Insurance Corporation (FDIC) in the 1930s. Those of us who have spent our lives in the mutual fund world have harbored the same fear about “money funds.” As a matter of fact, Jack Bogel, the first president of the Vanguard Funds, has told of his fear of one day turning on a Philadelphia television news program and seeing a helicopter reporting on a long line of people formed around Vanguard’s Malvern offices who want back the billions in their money market funds. Both the current US administration and its immediate predecessor felt that they had to “do something” to prevent harm to ordinary citizens. In the government’s eyes, it was bailing out individuals and small businesses. One could argue that the government and financial community leaders should have let various banks fail, and individuals lose the value of some of their deposits. Such inaction could well have led to a lack of confidence in the financial community that supports the government’s funding requirements. Bank failures and government defaults have been going on since their creation without total loss of economic progress.

The way the potential run on the banks was headed off was to force Federal government or Federal Reserve Bank loans on the banks, which led to the belief that certain financial institutions were so important that the society could not afford to let them fail financially. In other words, they were too big to be allowed to fail. There is a term for this which is “moral hazard,” which means that the government will permit these groups to make significant financial mistakes and they will still be bailed out. This concept goes directly against the wisdom of a very successful regional brokerage firm. On the occasion of the annual meeting of its partners, I was paid to give a speech on how I saw the brokerage business evolving. This was in the early days of Power Point graphics which I used in my slides to support my conclusions. To my horror, no one told me the chairman of the firm (who was sitting next to me) was totally blind. Trying to recover in my conversation with him, I recognized he did not have to see the charts, he intuitively knew what I was talking about. We then discussed what his firm should do in the face of the increasing market share that larger brokerage firms and banks were taking out of his market. I inquired why his very successful firm had a small capital base, (where the substantial profits were paid out at the end of each year). He replied that he did not want to accumulate firm capital, for he feared that his partners would invest it poorly. Too much capital would lead to putting undue pressure on the firm.
Today, I wonder whether firms that get into financial trouble should be bailed out. The FDIC has a model that a failed bank’s deposits and sound loans get auctioned off to a competent nearby bank, and the losses to be absorbed by the bond and shareholders of the failed bank. In the UK, the banking authorities are trying to “ring fence” or separate the retail deposits and loans from the business loans and investment activities of the bank. (In some ways they are trying to put back in place the Glass–Steagall Act in the United States.) This weekend in Europe, the powerful countries are trying to determine how to help their national banks with faulty sovereign debt and underwater loans, either through a materially stronger bailout fund backed by a central bank, or a facility that would insure some of the value of the loans. To me, the insurance scheme has less moral hazard.

All governments need to be careful about changing established ways of conducting business. In the US, we have merged investment banking with commercial banking rather than keeping them separate and in some cases, competitive. Almost all of the losses suffered by the large investment banks were in their investments, particularly illiquid real estate. Similarly the Savings & Loan scandal of the 1980s was caused by pulling down the interest rate advantage the S&Ls had in attracting deposits for making local home mortgage loans. Once there were level interest rates, many S&Ls went into commercial lending that they were ill-equipped to do, and commercial banks built up their home mortgage business without the requisite local and personal knowledge of hometown people and properties. Further, when the SEC introduced price competition in brokerage commissions (as distinct from service and research competition), it changed the game which led to the need for capital to facilitate trades. The SEC compounded the problem when it encouraged multiple sites for trading, executions, and reporting. To some degree, the fragmentation of the market has led to increased volatility.

Many investors believe that the increase in volatility is a sign of increased economic risk. I think you have to look at volatility as any time series, and dissect it to derive meaning. In Saturday’s WSJ, which is what they are labeling the Saturday edition of The Wall Street Journal, there were two items that address volatility. “The S&P 500 would be up 16% for 2011 if the three biggest declines were excluded and it would be down 13% if the three biggest daily gains were excluded.” The message that I get from this data is that we have been in trading range markets with periodic extremes. For the technical or chart analysts, this pattern is either of a distribution where stocks move from strong (in theory, “bright”) sellers to weak (presumably dumb) buyers, or it is an accumulation by bright investors picking up bargains from tired or discouraged speculators. Only time will tell which is correct when a significant move breaks out of this trading range. My long term bet is for a breakout on the upside. In a contest, the bright or better team doesn’t always win. We just returned from seeing the New York Jets, with their home in New Jersey, play football against the San Diego Chargers. While I was cheering for the Jets for “hometown” and other reasons, I had to admit that most of the time the Chargers played a better game, except for two pass interceptions which led to a Jets victory. Thus, it is often better to be lucky than smart; and I hope that while I understand the negatives facing us, I hope to be lucky on the upside.

To put my neck out further, I was a member of an investment panel addressing a group of Caltech alumni and scholars. Our final question was what would we buy, hold, and sell. We ran out of time before I could answer, but as some of that audience are also members of this blog community, I thought I should very briefly give my answer which we can discuss in future posts. I would buy Asian equities, hold cash for redeployment, and sell high quality bonds.

What would you do?

Did you miss Mike Lipper’s blog last week? Click here to read.

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