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Quarterly Newsletter - Winter 2007/08

Truly, 2007 has been an extraordinary year for financial markets.  Sterling has hit $2, which it last did in 1992.  The oil price virtually doubled during the year, and we believe that oil is going to remain expensive for some time to come.  On top of that, we are now reading about foreign owned home suppliers of gas and electricity perceiving the UK as a “treasure island”!  Food prices are shooting up, due to bad climatic conditions resulting in poor harvests, a newly found taste for Western foods from developing countries like China and an ever increasing demand for bio-fuels.  UK house prices stagnated and recently have been reported as falling at their fastest rate in two years.  Retailers in the UK had a miserable Christmas, and their share prices have come tumbling down.  Banks are suffering big losses, and investment bankers in particular will have to do without their fancy bonuses.  Indeed, many have, or will, lose their jobs.

When we first wrote about the US sub-prime mortgage problems, back in April 2007, little did we realise that these problems would lead to the biggest credit crunch we have seen for a long, long time.  One of the biggest sub-prime lenders in America went bust in April, and the knock-on effects of what originally had seemed a purely American malaise spilled over to Continental Europe and, closer to home, culminated in the first run on a bank in over 140 years.

In September, we witnessed barely believable scenes: long queues of Northern Rock customers who had funds on deposit in that bank were desperately trying to retrieve their money.  At that time, Northern Rock was the UK’s fifth largest provider of mortgages.  It was a truly shocking sight.  After all, 2007 had started in a rather benign fashion, with stock markets at six-year highs and the outlook presenting a relatively calm picture.  A lot of mergers and acquisitions activity was in the offing, and private equity firms made the headlines in the press, heavily leveraging their buying sprees on the back of the availability of cheap finance – lots of it!

We have written in detail about the sub-prime crisis in previous Newsletters, but to briefly recap: Against a background of rising interest rates, US lenders made initially cheap mortgages available to people who could barely afford them at the outset, let alone at the costs involved once these mortgages were moved on to more realistic levels of repayment.  Had those mortgages simply remained on the books of the lending institutions involved, they themselves would have had to live with the repercussions of their risky lending policies.  However, these mortgage debts were “parcelled up” into packages called CDOs, an acronym which stands for Collaterised Debt Obligation, and sold on to other institutions the world over.

CDOs have been around for nearly twenty years, but there has been a massive growth in these financial instruments over the last six years or so.  Although only a “guesstimate”, it is reckoned that the global market in CDOs is in the region of $2,000 billion!  They are being used by fund managers of pension and insurance funds, as well as banks and other investors.  Essentially, CDOs offer a defined cash flow against (supposedly!) known risks represented by the underlying mix of collateral, which can range from AAA rated down to unrated securities including, of course, mortgage debt – the latter traditionally being predominantly commercial mortgage debt.  However, as we now know, recent years have seen a dramatic increase in sub-prime private mortgages featuring as part of the collateral in CDOs.

CDOs have never been easy to understand, being largely based on mathematical metrics as well as assumptions regarding risk and reward, and they are also very difficult to price.  The difficulty of valuing the various debt tranches that make up a CDO is  becoming  an even bigger problem with asset prices, particularly in the housing sector, falling.  We at Lacomp are the first to admit that we never fully understood CDOs.  Unfortunately, it would appear that neither did the many financial institutions that bought them.

The fallout from this debacle continues to the present day, and as we stated in a previous Newsletter, it will be at least March or April before the full damage will be known.  Many well known banks were forced to make cash calls in the billions, culminating only this week in America’s biggest bank, Citigroup, writing down over $22 billion(!), largely due to the continuing credit crisis and a worsening downturn in the American housing market. They also needed a cash injection of $14.5 billion in order to shore up their balance sheet.  Of course, Citigroup are not alone in facing some harsh realities.  The same has been happening at UBS ($13.4 billion write-off to date), Credit Suisse and, also this week, Merrill Lynch, to name but three of the financial giants. Amazingly, the cash calls are largely being met by Middle Eastern and Far Eastern Sovereign Funds.  Even the Chinese are providing much needed finance. It is a rather bizarre situation to see Western capitalism being bailed out by Communist money, and a wit called these Sovereign Funds “the lenders of last resort”, a role that traditionally was the domain of Central Banks such as the Bank of England.

Against this very worrying background, global stock markets actually performed quite reasonably during 2007.  With the exception of Japan, which suffered a correction of 11% in the Nikkei, most markets finished the year in positive territory.  The Dow Jones was up 6%, the FTSE 100 nearly 4% and the Eurostoxx 50 added almost 7%. The Shanghai Composite index was the star performer by nearly doubling last year.

Renewed inflationary pressures during the first half of 2007 brought about a number of interest rate hikes – three increases of 25 basis points in the UK from January to July – only to see a smart reversal when the Fed and the Bank of England decided that the slow down in global economic growth and the tightening credit situation were possibly bigger concerns than inflationary worries.  Only the European Central Bank has maintained its interest rate since June, but recent comments suggest that it also may be softening its position.

There has been a lot of speculation as to whether America might lead the world into a recessionary period.  Although Goldman Sachs was the first, at the end of November, to predict a US recession, the consensus then still felt that a recession was unlikely.  However, the mood in that respect has altered somewhat, and the fallout in market valuations in the first two weeks would suggest that the markets are in the process of discounting the possibility of recession.

In yesterday’s testimony to the American House of Congress, Federal Reserve boss Ben Bernanke hinted that further interest rate cuts may be in the offing, and he also talked about economic emergency measures in the form of tax cuts.  Referring to GDP growth, he agreed that the downside risk was more pronounced, and that the financial situation remained fragile.  With regard to the sub-prime mortgage crisis, he reckoned that the overall loss could be as high as $100 billion.  However, he went on to say that whilst one could expect a below trend GDP growth through 2008 and into early 2009, he did not forecast a recession!

We at Lacomp feel that a recession is entirely possible, but we would expect it to be relatively shallow and short-lived.  As always, consumer spending is the main worry here, particularly if property and stock values keep falling.

Our clients’ portfolios reflect this thinking inasmuch as we have gradually adopted a more defensive stance, unloading hitherto successful smaller and mid-cap positions in favour of cash.  In this context, it is interesting to note that our Lacomp World Fund managed to stay in positive territory even throughout the first two turbulent weeks of 2008.  In 2007, this fund has increased by 12.1%, against the MSCI World benchmark of 2.8%.  The fund currently holds 10% in cash and 15% in gold, a defensive policy that should stand us in good stead in the months ahead.

Gold currently  is  making  headlines,  having  recently  broken  through its  previous  all-time  high and recording a new high of $910 an ounce last Monday.  Readers blessed with a good memory will remember the crazy days of December 1979 and January 1980 when the gold price raced ever higher, caused mostly by a combination of high inflation (US interest rates, for instance, stood at 20%!), the revolution in Iran and Soviet intervention in Afghanistan.  When the gold price went above $800 per ounce, people started rummaging through their jewellery boxes, looking for unloved pieces that could be converted into hard cash!  However, if one takes into account the effects of inflation, this precious metal remains well below its then highest price of $850.  Adjusted for inflation, the price of an ounce of gold in 1980 would be worth over $2,000 today.

One person who will not be pleased to see the price per ounce at above $900 is one Gordon Brown.  He decided, in 1999, reportedly against the advice of the Bank of England and certainly to the dismay of the city, to sell 300 tonnes of Britain’s gold reserves.  He sold the gold at $275 per ounce, a price that was very close to a 20-year low!

The billions effectively lost by this ignominious sale would come in very handy now, seeing that Northern Rock increasingly seems destined for nationalisation at a cost of around £2,000 per tax payer.

Much more will be written about the Northern Rock case.  The UK’s Tripartite Structure (the Bank of England, the Treasury and the FSA) and its Standing Committee were launched in 1997 by the incoming Labour Government and charged with maintaining financial stability, which includes, among other things, the regulation of banks.  The first inquests into what exactly had happened made for interesting reading as MPs of the Treasury Select Committee tried to establish which of the three parties were to blame for the fiasco.  “Moral hazard” or not, the Bank of England did not come out of this affair very well. Neither did the FSA, who must have been aware of the unusual (call it risky) ratio between monies the bank held on deposit and its lending book.  The Treasury’s role seemed less well defined, and one can only guess about any involvement of their political masters.  Recriminations have been flying in all directions between the participants, and whoever was to blame, the whole Northern Rock affair was badly botched.

An EGM this week called by the two hedge funds (RAB Capital and SRM Global) that acquired 18% of the company’s stock after the initial collapse of the share price – and rather burnt their fingers in doing so – tried to obtain shareholder approval to block a fire sale of assets.  They failed to get the necessary 75% agreement of their fellow shareholders, but they at least managed to stop the board from issuing £5 million of shares without prior shareholder approval.

The board are still considering bids from Richard Branson’s Virgin Group and Olivant, a private investment company run by former Abbey National boss Luqman Arnold.  The main stumbling block with these bids concerns the question of how to repay the £24 billion that the Bank of England currently is out of pocket. Who, in the present tight credit climate, would lend these bidders this sort of money? If such a bid were successful, it could end up being the most highly geared deal ever!  Goldman Sachs, who have been asked by the government to advise the Treasury, are working on a number of financing options, and there is talk about some of the money lent to Northern Rock being issued as bonds that would then be sold to investors.  That would raise the question as to who would actually buy these bonds.  If a quasi government backed guarantee were attached to make them attractive, the whole thing would still be the government’s responsibility.  However one looks at it, nationalisation looms ever larger.

18th January 2008