Quarterly Newsletter - Autumn 2008
The Markets
“Panic
Stations”, “Financial Meltdown”, “Market Mayhem”, “Day of Reckoning” and “£2,000,000,000,000”
(the latter a guess what it has cost governments to save the financial system
from collapse) were just some of the front page headlines in newspapers during
the last two weeks.
The
financial crisis recently took so many twists and turns that one could have
written a newsletter like this on a daily basis. No doubt you will have been very aware of
what has been happening – you would have had to live on Mars to avoid the news!
Ever since Bear
Stearns became “America’s Northern Rock” in March of this year and were
“acquired” by JP Morgan Chase for $2 a share (down from $158 a year earlier!),
we have seen household names topple like ninepins. Who would have thought it possible that we
would see the demise of old established firms like Merrill Lynch and Lehman
Brothers!
As these banks went
down, we heard many protestations from Chairmen, CEOs and Financial Directors
about the health of their businesses. “Our
firm is well capitalized” and “Business as usual” sounded like a UK Prime
Minister saying that one of his ministers enjoyed “his full support”... In other words, the businesses in question
often were about to fail and needed bailing out.
Let us now make a
quantum leap and bring us right up to date, i.e. after the UK government
reached the momentous decision to effectively partially nationalise some of our
biggest banks. The writer of this
Newsletter has on more than one occasion seen fit to heavily criticise Gordon
Brown, either in his recent capacity as Prime Minister or, more poignantly, his
previous role as Chancellor of the Exchequer since Labour came to power. After the initial two years of what we now
could call his “prudence” period, he fully opened the public spending tap and
simultaneously championed the availability of cheap money to consumers. Whether you call it political agenda or
misguided economic strategy, it did provide the UK citizen with a “feel good”
factor and ensured an unprecedented third term for the Labour government,
albeit against a weak opposition. During
his watch, not only did Gordon Brown allow personal debts to spiral out of
control (from student credit cards to 130% mortgages, whilst the national
savings ratio sank into negative territory), but he exacerbated the problem by
state borrowing on a huge scale which resulted in his falling foul of his
self-imposed and much vaunted “golden rules” of keeping the nation’s
indebtedness below 40% and the budget deficit below 3% of GDP. Well, he has failed on both counts, even if
you ignore the Northern Rock affair, the latest bank bailout costs or the many
“off-balance sheet” Private Finance Initiative schemes.
For the sake of
fairness, therefore, we would like to go on record that we fully support and
applaud the decision Gordon Brown reached regarding the UK bank bailout by
taking a physical stake in the financial institutions. Apparently, the blueprint for the rescue was
drawn up by the CEO and Finance Director of Standard Chartered, but the Government acted very decisively and quickly to implement
the plan. If we understand the terms
correctly, this action could well result in an eventual windfall for the much
beleaguered UK taxpayer. By contrast, we
were not entirely happy about the original US bailout plan for Wall Street
firms which, in effect, meant nationalising debt whilst keeping assets and
profits in private ownership. This has
since been rectified, and it would appear that the American administration, and
now also the European Union, followed the UK’s example. Of course, the US bailout scheme even now is
highly unpopular with Joe Main Street. He
is highly suspicious that Treasury Secretary Hank Paulson, the former CEO of
Goldman Sachs and the co-architect of the bailout in conjunction with Federal
Reserve boss Ben Bernanke, was trying to help his mates at Wall Street. Furthermore, the rescue package smacks of a
socialist agenda which is anathema to the average American.
Be that as it may, it
was imperative that the crisis was dealt with in a meaningful manner. A continued credit crunch would have wreaked
havoc among ordinary people and ordinary businesses. When banks are so mistrustful of other banks
that they stop lending to each other, what chance is there to renew terms of a
private mortgage or renegotiate much needed finance in the business community? Quite simply, a failure and collapse of global
banking and the financial system would have meant the end of life as we know it. We believe state intervention in the UK,
Europe and America will avoid an outright collapse, but it will take time to
properly rebuild confidence. The problem
was so deep rooted that it took an unbelievable amount of money to stave off
the worst. We are now told that it is
costing governments an incredible two trillion pounds to save the global
financial system. That is a truly
staggering figure!
What does not help is
the fact that this sort of figure is beyond most normal people’s comprehension. One trillion means the figure one, followed
by twelve noughts, i.e. 1,000,000,000,000, or a thousand billion, or a million
million! A million million rolls easily
off the tongue, but if you consider what such a figure represents in the
context of daily life, the amount takes on a different meaning. Let us assume that you own a trillion pounds
and wish to buy yourself and the 30 regulars in your local pub a daily pint of
bitter (average price £2.20 according to the British Beer and Pub Association –
although the landlady of my local clearly isn’t aware of that statistic!). You and the 30 regulars would have to live
and keep drinking for over 40 million years before the money ran out!
Okay, so you don’t
frequent pubs and don’t like beer, but you are really extravagant to the nth
degree! If, therefore, you bought yourself
a brand new private jet (£25million), a smart yacht (£15million), an estate
(£15million) and a run-around in the form of a Bugatti Veyron (£840,000) each and every day of the year, you
could do so for over 49 years. You get
the picture!
Sadly, we will not be
able to afford such luxuries, because our government’s actions come at a price. There is little doubt that, one way or
another, we collectively will suffer a period of financial austerity. Whether you are lucky enough to escape any
personal hardship very much depends on your individual circumstances, but the
nation as a whole will suffer financially. The immediate cash call will have to be raised in the form of yet more
borrowing and it would have been interesting to see in what guise Messrs. Brown
and Darling were going to raise taxes to offset this additional public
expenditure burden. We say it wouldhave been interesting, because they are in no position to do so
immediately. With unemployment rising at
its fastest rate for 17 years to just under 1.8 million and the country going
into recession – indeed, many commentators say we are there already – the last
thing the economy needs is a hike in taxation. That will be left until afterthe next general election, and the way things look at the moment politically,
it will be a very unpleasant legacy that Labour will be handing over to the
incoming Tory government.
Banking practices
will change as well. We already know
that several heads of major banks have been asked to vacate their offices, and
there will be other job cuts as well. Unemployment
already has hit the City, and more jobs will have to go. The era of excessive lending, looking for
short term profits at the expense of longer term stability and the obscene
bonuses we have been reading about surely have now come to an end. A more sober approach to banking practices
perversely may well lead to better margins and thus decent earnings for the
banks, but at least it will not end in tears as it has done recently.
Having said that, please
do not for one moment assume that the massive injections into the financial
system means we are out of the wood. Many
questions remain, and we at Lacomp have serious concerns about the so-called
CDSs (credit default swaps). You will
recall that a year ago, when the American sub-prime debacle was making
headlines, we were worrying about another acronym, namely CDOs (collaterised
debt obligations). Specifically, we were
wondering which financial institutions owned how much of the CDOs, and we
pointed out that it would be well into 2008 before we would learn who had been
swimming without clothes. We all have
seen the fallout of what was then euphemistically called “low-grade debt”. More recently, “low-grade debt” became “toxic
debt”, but we consider even that adjective to be on the benign side. A toxin usually can be remedied by an
antidote, but the debts in question were not merely poisonous, they proved
fatal for many financial institutions.
Well, now we have
similar concerns, but this time it relates to credit default swaps. At a rough guess, few people had heard of
CDOs before the sub-prime crisis, and even fewer knew about CDSs. Put very simply, a CDS is an insurance
contract against a borrower being unable to service or repay a loan. Banks, hedge funds and other institutions,
including pension funds, have been using CDSs to not only offset the risk of
defaults of loans, typically corporate debt, local government bonds and
mortgage securities, but also to achieve above average returns in their fixed
interest portfolios.
This all sounds
pretty reasonable so far. However, there
are a number of issues that make these CDSs a far more worrying proposition. First of all, the credit swap market is
completely unregulated. As a result,
there is no supervision, no standard contract, no capital adequacy requirement
and no standard valuation formula. Secondly,
CDSs can be sold from investor to investor, and the investors do not need to
have any relationship to the loan or debt which forms the underlying asset. As such, a CDS may be traded on from investor
to investor a dozen or more times, and because of the lack of transparency, the
holder (the insured) may not fully know whether the issuer (the insurer) has
the necessary financial resources to make good any damage. In other words, it is akin to a casino or
betting shop. Thirdly, the size of the
CDS market has increased massively in recent times, not dissimilar to the
volume expansion we have seen in CDOs. According
to figures issued by the Bank for International Settlements, the Swiss
institution often called “the central bankers’ bank”, the notional amount of
outstanding CDSs stood at over $42 trillion in June 2007, up from $14 trillion
in December 2005. That means the size of
the market tripled in only 18 months! And a month ago, the US Securities and
Exchange Commission Chairman stated that the global CDS market was nearing $60
trillion!
What we are saying is
that this crisis is not over yet, and we are looking at a rocky road ahead. In terms of asset management, we are in
somewhat uncharted waters since we have never seen a financial crisis of this magnitude. Investor sentiment took a hammering and first displayed a lack of
confidence, but this has now been replaced by fear. However, it is important to remember that many fundamentals are basically sound, and this crisis is more
institutional than general.
The writer of this
Newsletter has been in fund management for some 40 years and has seen the dark
days of the first oil crisis in 1973 to 1975, when UK equities fell by 73%. You can add the Crash of 1987 when the FTSE
100 fell by some 34% in less than a month, followed by the burst of the
so-called Dot.com bubble which saw the market decline by 51% from 2000 to 2003. You may further add the Latin American
defaults during the early 1980s, the Asian currencies crises in the late
eighties, the long and slow decline of the Japanese stock market and the
Russian financial crisis in 1998. It is
in the very nature that equity investments from time to time undergo periods of
volatility to varying degrees, and it is therefore of paramount importance to
take a longer term view and not let fear override sound judgement.
Portfolio valuations
currently are at a very low level, and day-to-day market volatility in the last
week or so has been huge. A CNBC TV
pundit commented: “It is like falling down a well. You know you are going to hit bottom sooner
or later, but getting out will not be easy.”
Some people have been
drawing parallels between the Crash of 1929 and the ensuing Great Depression
and the present situation, and that is simply wrong. As we pointed out in our Market Newsflash at
the end of September, the Great Depression was caused by a lack of action by
the US government and a misguided monetary policy of the Federal Reserve of the
day. It seems that lessons have been
learnt from that debacle, and the concerted actions now taken by governments
worldwide ensure that we will not see a repetition. In fact, we believe that the recession will
be relatively shallow and short-lived, although that view might not be shared
by many. We shall see.
To lighten the
atmosphere of this rather serious Newsletter somewhat, a wit pointed out that
you knew you were in a recession when your neighbour lost his job. A depression meant you lost yours.
To sum up, whilst we
are aware that we are facing a complex recovery phase, we do not share the doom
and gloom views so frequently expressed in the media. We will gradually reposition portfolios when
we deem it appropriate to do so, and it is worth remembering that these
difficult times also present us with great opportunities.
17thOctober 2008
