We all know that this has been the most turbulent year for financial markets in living memory. 2009 presently offers us only the promise of further uncertainty. So how did we arrive at this inner ring of financial hell? Despite a torrid January, the markets calmed down from February onward, even trading within a 1000 point range between 11 and 12000 from March until September. Then it fell apart. On July 8th, I wrote the following in my blog, http://theconstantbroker.blogspot.com/
“Nearly all of my portfolio clients have nominated to sit out the next few weeks and wait for the fog from this bear market to lift. We see no reason to participate in a market that appears to have no leadership or direction (other than down).
August is coming and with it is the most dangerous trading environment of the year. It can be highly volatile at the best of times, but this year the market ambiance is potentially highly toxic. Mortgage based financials such as Fanny Mae and Freddy Mac are under particular pressure after Lehman Brothers said new accounting requirements might force them to raise more capital.
Since their highly generous downgrades, financial and mortgage guarantors Ambac and MBI claim to have enough funds to cover their commitments. However, should they face further downgrades that would become doubtful.”
On September 14th, the gates of hell flew open. Barclays had agreed in principle to buy Lehman but couldn’t quite pull the trigger. Bank of America came in but needed federal cash to do the deal. The truth was that they were never particularly interested. Within hours of making his final unanswered call to BoA Chairman, Ken Lewis, Lehman Chairman Richard Fuld Jr announced that after 158 years,Lehman Brothers was dead.However, this was suicide not murder. Killed by its own greed and self deception, Lehman was the architect of its own demise with its myopic obsession with profit at any cost. Failing to understand the mechanism and ramifications of its over commitment to mortgage default swaps, Lehman dug a deeper and deeper hole with a shovel made of false profits.
It wasn’t as if they hadn’t been warned. On 7th November 2007, Bloomberg reported “ Nov. 7 (Bloomberg) -- U.S. banks and brokers face as much as $100 billion of writedowns because of Level 3 accounting rules, in addition to the losses caused by the subprime credit slump, according to Royal Bank of Scotland”. The article concluded with “Lehman has the equivalent of 159 percent of its equity in Level 3 assets, and Bear Stearns has 154 percent.” What I find utterly confounding is that the Financial Accounting Standards Board (FASB) issued Statement 157 ("Statement 157") to the banks in September 2006 to provide guidance about how entities should determine fair value estimations for financial reporting purposes. These were divided into three parts; Levels 1,2 and 3. Wall Street had two years to defuse the ticking time bomb and chose to ignore it. Arrogance indeed.
One of the more bizarre stories concerns a Japanese bank in London who supposedly (at enormous expense) headhunted a team of mortgage-bond traders earlier this year. The guys brought their clients with them, forcing their former employer to issue a writ against the Japanese bank. As soon as the sub-prime market collapsed, the writ was withdrawn leaving the Japanese with an enormous financial headache. It is beyond me, how negligent some of the worlds’ most august institutions have been.
The banks however, were not the source of the collapse of the global banking system. Much guilt has to be shared by the UK and US governments. Both were committed to the “Ownership Society”, which in Britain was called the “Stakeholder Economy”.
...if you own something, you have a vital stake in the future of our country. The more ownership there is in America, the more vitality there is in America, and the more people have a vital stake in the future of this country. - President George W. Bush, June 17, 2004
The governments encouraged banks to loosen up their lending criteria. Britain first began this back in the 1980’s. More recently, Gordon Brown has spoken of creating a "home-owning, asset-owning, wealth-owning democracy." Millions were happy to buy into the vision that began with Thatcher. Tenants of local authority-owned properties gladly took up the Conservative government's offer to sell them their homes at knockdown prices. More than 70 percent of Britons now own their homes, compared with 40 percent of Germans and 50 percent of French. The competition to buy property pushed up prices to record levels, forcing competing banks to loosen criteria further in order to maintain momentum. It seems that greed compels us to participate in bubbles, lest we get left behind.
In the United States, where land is more freely available, the viscosity of the bubble was not as thin, but the bubble itself was far bigger. The classic story was of the California strawberry farmer who was given a $720,000 mortgage based upon an annual income of $14,000pa. Similar stories are to be found everywhere and that my old dear is the problem.
In 1998, fuelled by the $1.4tr liquidity injection from the Greenspan LTCM bailout and congress looking the other way, the Wall Street banks were armed to the teeth with the financial wherewithal required to begin a new financial revolution. And so here we are, in the midst of an unprecedented financial crisis.
This crisis however, whilst partly the fault of the banks, is largely due to the negligence of politicians. Blaming the banks is like condemning junkies for their addictions and drug related crimes. We should be more concerned with those politicians who encouraged them to imbibe and did nothing when they overdosed.
Banks are greedy by nature and are staffed by success oriented, highly competitive people. The politicians though, are populist to the core and tend not to give a damn about consequences beyond their next elected term. If the prerogative of the politicians is to legislate, then they failed. It is a myth that Wall Street and the City hate regulation. The financial industry lives by regulation and prides itself on its ability to financially engineer new, innovative products.
The effect of the crisis was that it would decimate interbank lending. Institutions no longer trusted each other to be able to fulfil their counterparty obligations. So not only were banks no longer lending to each other, they had ceased lending per se. The effect has been catastrophic. Banks are not lending to small businesses or are restructuring their existing loans on terms far more stringent than could previously have been imagined. Small businesses are now, having to either retrench staff or close down altogether.
This will exacerbate the crisis. As jobs are lost, mortgage loans will default and a surfeit of available property will push down property values still further.
In the US, this could lead to the next stage in the chain of events. Due to massive drops in tax revenues and a corresponding huge demand for services, state governments in the US are facing record budget deficits. California already has a crippling forecasted shortfall of $42bn over the next 18 months and Ohio is $7bn short.
Unlike the federal government, states have to legally comply with balanced budget laws. Even more critical, the market for state bonds has all but collapsed. Investors trust nothing other than federal treasury bills and those states that can borrow; do so at punitive rates.
President Obama is widely expected to announce a fiscal stimulus immediately after inauguration. Even if he does get his proposed $800bn, will it be enough? If the states are no longer able to even pay their staff, what will happen to the planned rebuilding of America’s infrastructure? He also has to deal with the Big 3 auto companies for a second phase of subsidies in March.
What if Obama runs into opposition from the Republican and Blue Dog Democrats and has to accept a much smaller figure? It is possible that that may happen. The Republicans who previously didn’t believe that there was a deficit too big have now become deficit hawks. It is absolutely in their interest to shorten the Obama honeymoon as much as possible.
So what is the investment outlook for 2009? Much like 2008, we will invest based upon what we actually know.We know that the equity indexes will probably continue to be weak during the first quarter of ’09. Property prices are expected to drop further until at least the beginning of the summer buying period and unemployment has much further to rise. At a time when the markets are negative, it makes sense to take advantage of that. We will continue to recommend a small percentage of client money to be invested in ‘short’ ETF’s. Short ETF’s, profit from drops in the equity indexes. Recently, there has been a bear market rally making the purchase of short ETF’s very good value indeed.
We know that gold purchases are at record levels and that gold is a finite commodity. We know that the Federal Reserve and Congress have been injecting liquidity into the system like drunken sailors. We also know that massive increases in the money supply will always lead to currency weakness and inflation. These are the twin catalysts that drive the precious metals markets. Additionally, America needs a much weakened dollar to help manufacture its way out of recession. So fear not that gold will revisit $1000 per troy ounce. Its destiny is to go much further north.
Our 2008 strategies generally worked very well. Those of you who bought the gold ETF after my 10th November recommendation on my blog have garnered a 15% return as have those who bought Yen in October.
I look forward to 2009. There are some tremendous opportunities
No comments:
Post a Comment