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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