Brave New (Financial) World
Satyajit Das

From the Financial to the Real ...

As the "financial" crisis moved into the "real" economy at the end of 2008, the incomprehensible discourse about arcane minutiae of securitized debt and derivatives (toxic three letter acronyms such as ABS, CDO, MBS, SIV; CDS etc,) that no sane person really understood, could be abandoned for the more familiar language of "recessions" and "depressions." Familiarity, no matter how terrible, is comforting.

Commentators and pundits, generally with books to promote, jostled for position to proclaim that this was the "worst crisis" since, well at least, the "last worst crisis." A new three letter acronym - GFC (Global Financial Crisis) - gained currency. The real causes of the crisis, its continued evolution and, most crucially, the solution remained elusive. As John Kenneth Galbraith observed: "Between human beings there is a type of intercourse which proceeds not from knowledge, or even lack of knowledge, but from failure to know what isn't known. This is true of much of the discourse on the market."

2008 - Look Back with Horror!

In the financial carnage of 2008, the value of financial assets fell to such depths that shell-shocked investors needed specialized diving equipment just to find what anything was worth.

Shares (both developed and emerging market), residential and commercial property, credit investments and commodities all fell sharply in value. Defensive assets (traditional widows and orphans stocks and high quality corporate bonds) fell. Alternative assets (private equity and hedge funds) that were meant to perform differently to other asset classes and diversify investment portfolios also fell. Only "boring" investors who presciently owned government bonds or "lucky" shorts who had short-sold everything else registered positive returns.

Volatility reached astonishing levels. Correlation between asset classes hovered close to one as all prices moved in unison, mimicking gold-medal winning synchronized divers. An investment in a Zambian copper mine behaved almost identically to a bond issued by a high quality corporation in Scandinavia.
What the "geeks bearing Greeks" and their quantitative investment models, risk analysis and trading strategies made of all this is unknown.

The Great Deleveraging ...

Fundamentals of value were largely irrelevant as the "great deleveraging" (surely the financial word of 2008) dominated. In recent years, cheap and abundant money (mainly borrowed) drove up the value of other assets. As the debt in the financial system was contracted, money became scarce and expensive, triggering a sharp fall in asset prices. Anybody who had borrowed to purchase financial assets had to stump up margins or were forced to sell to reduce debt.

A shortage of buyers and lack of available liquidity meant that generally selling risky assets was nigh impossible. The marginal seller, usually distressed, and the cash-rich buyer, increasingly scarce, set market prices. Central banks and governments, depending on the plan du jour to save the world, were "buyers of last resort."

The process is far from complete. Many hedge funds put off liquidating positions taking refuge behind "gates" - the new buzzword for suspending redemptions to prevent hapless investors taking out their vanishing investment capital.

The hope was that markets would miraculously improve in the New Year (I think it was 2009 that they were referring to but am not sure!).

On Life Support ...

The health of the financial system and the extent of the slowdown in the real economy remain keys to economic stability and recovery.
Banks continue to be on shaky life support. Further losses, more bank failures, a bleak earnings outlook and difficulties in raising equity and funding mean that state led "no bank left behind" support programs continue to be necessary for survival. The creeping nationalization of many banking systems is probable.
 
The cost of money rose and availability reduced. As Mark Twain observed: "A banker is a fellow who lends you his umbrella when the sun is shining, but wants it back the minute it begins to rain."  "Loan" and "debt" are now four letter words.

Substantial losses in investment portfolios of insurance companies, pension funds, asset managers and endowments will emerge. A combination of investor redemptions and unavailability of leverage will result in gradual liquidation of a significant portion of the hedge fund industry.

The sharp decrease in debt levels is driving reduction in growth pushing most major economies into recessions or near recessions.

The financial headlines scream "deleveraging" at every turn. Companies are cutting production, reducing staff and costs, suspending investment plans, raising equity and trying to sell assets to reduce debt. Consumer spending is falling sharply as individuals increase savings and reduce debt. Falling investment earnings and lower interest rates also adversely affect the income of savers reducing consumption. Increasing unemployment (as companies retrench) and lower investment (as global demand collapses) mean the chance for a quick recovery is receding.

U.S. employment statistics are bleak with the rate of job losses now running at around 500,000 per month. The state of Ohio reported receiving 80,000 calls per day for unemployment claims (versus a normal 7,500 per day). Ohio indicated that it needed to hire temporary staff to handle the volumes of unemployment claims - surely an unproductive employment scheme. The problem of rising unemployment is now a global phenomenon.

Emerging markets have not "decoupled." China and India have slowed dramatically. Russia, Brazil and the Gulf are also facing a slowdown as commodity prices fall sharply in the face of slower global growth. Global trade is also slowing.

There is renewed concern about emerging markets, especially in Central and Eastern Europe ("CEE"), Latin America and Asia. The fundamentals of the CEE economies are not dissimilar to the position of the Asian economies in the period immediately before the 1997/1998 crisis. European banks have large exposures to emerging markets in CEE, Latin America and Asia. "It's deja-vu all over again" as Yogi Berra might have said.

The deleveraging may claim further casualties. Companies that have taken on debt to finance acquisitions will face challenges in refinancing debt. Many private equity transactions, undertaken on aggressive terms, may be unable to service its debt commitments and will need to be restructured or will default. More than 71% of debt outstanding in 2008 was rated non-investment grade. This compares with less than 30% as at 1980 and less than 50% as at 1990.

We are all Keynesians Now!

The markets are placing considerable reliance on the ability of governments to arrest the decline and restore the global economy's health.
 
Central banks have flooded money markets with liquidity. The money unsurprisingly is not flowing through into the economy.
 
Banks are stockpiling the cash or using it to purchase government bonds. The money is needed by banks to finance around $5 trillion to $10 trillion of assets that are returning to bank balance sheets from the off-balance "shadow banking" system. Banks also need to refinance substantial amounts of maturing debt and finance corporations who are drawing down credit facilities. Banks are reluctant to lend as the real economy slows with rising unemployment and lower corporate earnings. They also lack the risk capital to make loans.

Central banks, in some countries, have moved to recapitalize the banks and have guaranteed bank borrowings. This provides the banks with expensive capital and funding. It is difficult to see that these steps will be sufficient to arrest a sharp decline in the balance sheets and credit creation capacities of banks.

Governments are resorting to lower interest rates and massive spending initiatives to stimulate growth. It seems we are all Keynesians now!

But the experience of Japan is salutary. Zero interest rates and repeated doses of fiscal medicine have not restored the health of the Japanese economy that remains mired in a form of suspended animation. The rest of world is struggling to avoid "turning Japanese."

In 2008, aware of the massive deleveraging of the financial system, credit markets bought government bonds anticipating slower growth and lower interest rates. Equity markets, at least initially, viewed lower rates as supporting growth and to corporate earnings. By late 2008, equity markets saw low rates as symptomatic of low growth prospects and declining corporate earnings. Equity market did not react positively to the announcement from the U.S. Federal Reserve that it will adopt a zero interest rate policy. Equities remained weak even as interest rates continued to decline.

Corporate bailouts are all the rage. The financial sector has prompted others to get into the queue - carmakers are apparently now banks! Larry Flynt (founder of Hustler magazine) and Joe Francis (creator of "Girls Gone Wild" videos) are - tongue in cheek - seeking $5 billion to bailout the adult entertainment industry where revenues are falling.  Flynt reportedly stated that "Americans can do without cars and such, but they cannot do without sex."

Government spending has converted a private sector problem into a public sector financing problem. High levels of public debt in and poor fiscal positions of some countries mean that the spending may be difficult to finance. The continued heavy reliance on savers in Asia, Europe and the Middle East is increasingly problematic given emerging problems in these countries that may limit the funds available. At a minimum, the increased issuance of public debt risks crowding out other borrowers.
 
The problem is most acute for the United States. In late 2008, Akio Mikuni, president of Japanese credit ratings agency Mikuni & Co., suggested that Japan should write-off its holdings of Treasurys because he believed that the U.S. government would struggle to finance increasing debt levels let alone repay the borrowings. He suggested that debt forgiveness was the only way out of the problem.

These pressures have manifested themselves in the currency markets. The last weeks of 2008 saw astonishing volatility in the euro/U.S. dollar rate, which moved between U.S. $1.3356 to U.S. $1.4719 (10.2%) in less than one week.
 
The risk of deflation (falling prices) is creating another massive asset price bubble in government bonds. Investors concerned about recession and deflation have purchased long maturity bonds, driving long-term interest rates to unprecedented levels. A rate less than 3% per annum for 30-year U.S.  government debt appears inadequate compensation for the risk entailed.

From 'Shock and Awe' to 'Trench Warfare' ...

The aggressive reduction in debt globally will result in a sharp reduction in sustainable growth rates. Four to five dollars of debt is required to create $1 of growth.

Approximately half the recorded growth in the United States in  recent years was driven by debt, primarily from mortgage equity withdrawals. As the level of debt in the global economy decreases, attainable growth levels also decline.

In effect, the world used debt to accelerate its consumption. Spending that would have taken place normally over a period of many years was squeezed into a relatively short period because of the availability of cheap financing. Business over-invested, misreading the demand and assuming that the exaggerated growth would continue indefinitely creating significant over-capacity in many sectors.
 
2008 was the year of "shock and awe." 2009 may well prove to be a year of grim and brutal trench warfare as the world adjusts to a new economic order and reduced expectations.

A lower growth future has political and social implications. China and India are deeply concerned about failing to provide jobs for the millions coming into the workforce each year.

New Investment Mantras  ...

Investment logic has undeniably changed. Any business model based on the availability of cheap and abundant debt, such as private equity or hedge funds, is now questionable. Anybody with major amounts of debt to refinance in the immediate future or any other financial cash calls (such as margin calls on credit downgrades) will be carefully scrutinized.

In recent years, the value of real and financial assets were driven by a combination of higher earnings from the "great moderation" (strong economic growth and low interest rates) and an expansion of price earning multiples.
 
During this period, earnings also became "financialized." Companies relied on financial engineering to boost earnings. Industrial companies boosted profits by financing purchases of their products, acquiring, merging and de-merging, borrowing to share buybacks, or trading in financial instruments. Financial sector profits rose to around 30% to 40% of total corporate profitability.

Prices reflected high termination or resale values from private equity, hedge funds and share buybacks; that is, a "greater fool" with even greater leverage and more "financial engineering" would come along and buy whatever the investor had bought at an even higher price. All this now is a distant and fond memory that is unlikely to return until collective memory fades and scar tissue heals.

Investors are now focused on cash flows (income or dividends) from the investment. Capital gains have joined the list of endangered species. Prices must equate to the cash flows discounted back at capitalization rates factoring in much higher costs of capital. Valuation fundamentals that Benjamin Graham would have recognized are once again fashionable.

Some of this is already in the price. Nobody knows whether assumed earnings sufficiently factor in the low growth environment ahead or whether the higher costs of capital have been incorporated.

Investment patterns favor debt over equity. Current credit margins are pricing in very high levels of default on high quality debt. Abundance of cheap debt drove down debt margins boosting equity returns. As credit margins increase there is a transfer of value from equity to debt. Potential equity raisings and asset sales as companies deleverage also increase the risk of dilution of equity returns.

The form of investment may also change. Investors want to get as close to the cash flows as possible and avoid complex investment structures. Leveraged investment vehicles are out of fashion. Absolute rather than relative returns will be sought.

Management of the "liability" side of funds, specifically redemption risk, is increasingly important. Investors will be wary of the risk of value erosion in pooled investment structures (such as mutual funds and unit trusts). In 2008, unrelated redemption pressures drove down values of pooled investment and absorbed scarce liquidity. Closed end funds and self liquidating structures may become the new "New thing."

Fund manager's fees will be under pressure. A fee of 1% plus management expenses of 1% for a fund where the returns are negative will not pass muster. The hedge fund standard 2% and 20% of performance will only be acceptable for exceptional managers with a long history of high and stable returns (like Mr. Bernard Madoff) or where the performance fee is paid on realized returns.
 
We are, of course, in a "new paradigm." Investors will need to adjust their expectations. The new investment mantras may well be:

1. Flat is the new up.
2. Debt is the new equity.
3. Interest and dividends are the only return.
4. If you're looking for the bottom of the market there's a special offer - buy one, you get the next one free.

Keynes famously observed that investment is "anticipating the anticipations of others." Bill Gross, founder of Pimco, one of the world's largest investment managers, recently suggested that the best investment strategy may well be to buy whatever it is that the governments of the world will buy up next.

Range Rover to Game Over ...

The best investment story of 2008 relates to a banker who had a modest shareholding in his employer - a storied investment bank. Upon being transferred to London, he sold the stock to finance a Range Rover. As business in London turned down, the banker was transferred to Dubai.
 
When selling his Range Rover, he suffered a loss of around 50% of the price he paid barely six month ago. The interesting thing was that the proceeds from the sale of the car (despite the 50% loss) would have allowed the banker to purchase five times the number of shares he sold to finance the car. 2008 is perhaps the only year on record in which a distressed price for a Range Rover outperformed equities.

In Iceland, where there is an oversupply of Range Rovers as the economic good times ended, the cars are now known as "Game Overs." For investors, 2008 was also a case of game over.

As in Genesis, the "years of plenty" have ended. The improvident wasted the bounty of the years of prosperity and now find themselves in want in the "years of dearth."
 
Satyajit Das is a risk consultant and author of a number of key reference works on derivatives and "Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives" (2006, FT-Prentice Hall).

Views are as of January 23, 2009 and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security.

Federated Equity Management Company of Pennsylvania.

www.prudentbear.com