Saturday, September 29, 2012

A German Sovereign Wealth Fund Redux

I used to read the Economist when I was in graduate school, but I gave it up because it is currently as stimulating as reading Time magazine.  Someone sent me a link to an online article from the Economist, and this quote caught my eye:

"Lastly, if the euro is to survive, creditor countries need to give more aid to deficit countries. They could do this directly, or the ECB could provide liquidity to banks or buy up government bonds before they fall too far."

Thinking about the direct comment, that would be the course taken by using the instrument of a German sovereign wealth fund, which we have posted about before.  Such a fund would be looking for returns, and potential investees would have to present their cases just as private entities would have to do.  Ideas with good economics would earn the capital investment. The interests of the German state in continuing the euro experiment would advanced through their own oversight and control.  There would be no intellectual policy fog or dead weight cost leakage from the ECB, IMF, or other bureaucracies.

The equity markets are looking a bit queasy as the European policy machine continues to founder. 

Friday, September 28, 2012

Europe Needs A New Idea of Itself

European politicians are desperate for good news.  So, today the consulting firm Oliver Wyman recast numbers from bank auditors and pronounced that Spain's banks need only  €54 billion euros to recapitalize themselves, and not €62 billion euros as previously thought. Oliver Wyman came to a happy conclusion.  Politicians hailed the news as a "great step forward."  Excuse me?

Meanwhile, a report from the European Commission shows that the magnitude of divergence in economic indicators among EU members has widened to historical highs. Using the unemployment rate, for example, the report notes that Spain's reported number of 25.1% is 20.6 percent above that of Austria at 4.5%, the widest divergence ever for this indicator. 

Our indoor soccer group welcomed back one of our players who just completed about eighteen months studying and working in Barcelona for a busy design firm.  We laughed about the American press giving even the slightest credence to the possibility of a Catalan secession.  On the more serious side, he noted that when he began his academic term in Spain, there were signs, though quiet, of well dressed young people walking through well-to-do parts of Barcelona looking for food in dumpsters, even as Catalonia was celebrating the success of FC Barcelona in La Liga and in Europe.
Now, as we know, the world has seen the photos. Problems have escalated into a much higher youth unemployment rate and to angry rioting in the streets.

There is talk among some economists of adjustment mechanisms to reduce the disparity between core and periphery performance among the EU members.  It revolves around, for example, higher inflation rates in Germany and France than in the peripheral countries, like Spain and Portugal.  The goal would be to force changes in real wages, which might recalibrate competitive advantage.  What would the mechanism be for this differential transmission?  In any case, it wouldn't be enough.

For all the freer movement of goods and capital within the EU, the labor markets are not free.  A combination of regulations, quotas and different work rules, as well as taxes serve to remove labor markets from the adjustment mechanism.

Without a freeer EU labor market, a move to budgetary integration is nonsensical.  Finally, the latter is highly unlikely to happen given the loss of sovereignty that will be politically unacceptable.  As time continues to pass, Greece, Spain, and next probably Italy will force Europe to come up with a vision of itself that may not include an omnipotent Brussels and a single currency for 500 million Europeans. 

Wednesday, September 26, 2012

New Study on Private Equity: Buyout Funds Add Value

Steve Kaplan is Professor of Entrepreneurship and Finance at the Chicago Booth School of Business. He and his two co-authors have published a paper which tries to systematically measure the comparative performance of private equity and venture capital funds against a public investment equivalent.  Private equity returns are anything but transparent.  Time series are subject to all kinds of bias in performance measurement, survivorship bias, absence of cash flow data, and no performance standards equivalent to AIMR standards which govern most mutual funds. 

This aura of mystery helps no one but the sponsors of these funds.  The authors have done yeoman's work in putting together this study, which is not definitive but certainly an improvement over what is uncritically reported in the financial press.

Broadly speaking, here are some highlights of the findings.  It has long been contended that buyout funds add value when they take over troubled firms.  The authors data analysis confirms these prior studies.
"Using cash flow data from 598 buyout funds and 775 venture capital funds from 1984 to 2008, the authors calculate the average public market equivalent ratio for each vintage year. They find that buyout funds did better than public markets in most vintage years since 1984. The average US buyout fund outperformed the S&P 500 by at least 20 percent over the life of the fund, or by at least 3 percent per year."
Venture capital funds, on the other hand, have decidedly mixed results.  Again, this confirms the broad conclusions of several other prior studies.  The authors find,
"The average venture capital fund, on the other hand, did better than the S&P 500 in the 1990s but not in the following decade. Kaplan thinks this is not surprising. The tremendous success of venture capital funds in the 1990s attracted a huge amount of capital in the early 2000s that subsequently contributed to lower returns."
I believe that there are other factors at work in the inter-decade performance of venture capital funds.  Larger capital flows are one issue; declining quality of the sponsors and their paucity of top talent are also important, but difficult to measure.  Hot sectors--one might call it luck--play an important role.  Healthcare and medical devices had its heyday before FDA issues, reimbursement issues, pricing pressures, and greater emphasis on clinical value conspired to put an end to outsized returns.  Technology investments also had cycles of innovation, followed by a host of 'me too' companies which were not worthy of their multiples.

Broadly speaking the outperformance of buyout funds remains consistent over the most rigorous transformations of consistent industry data sets.  Those of venture capital funds show consistent value-added through the 1990's, but not thereafter. 

So,  from the point of view of the asset class, private equity firms that buy troubled or undermanaged assets seem to turn them around, providing demonstrable value-added to return profiles over the life of the funds. 


Taking It to the Streets: European Style

La Nouvelle Grande Illusion de l'Europe remains in full swing.  (apologies to Jean Renoir)  Columnists are arguing about whether or not the European Stability Mechanism's "decision" to allow direct recapitalization of national banks from ESM funds is retroactive.  Mario Draghi must be talking to himself as he discusses budgetary union among EU members.  Chancellor Merkel has finally been advised to always agree, since it is never clear what she agreed to and on what terms.  She always reserves the right to be overturned by her courts, regulators, or coalition members.  None of this falderol may matter because of what is unfolding in the economy, and worse, in the streets.

Meanwhile, the economic news from the emergency room is not good:
  • Ireland, which seemingly took early action on bank resolutions and fiscal austerity, has just seen its 2012 and 2013 GDP growth forecasts downgraded.  Domestic final demand and net exports are weaker than expected.  Significant emigration is taking away business owners, entrepreneurs and technical workers. The property market is in shambles.  Debt/GDP will finish 2012 above 100% and will trend higher in 2013, according to the IMF.
  • Spanish and Italian bond yields are rising today, despite the "unlimited firepower" of the ECB bond buying program.
  • Spain still doesn't know how much money it will take to recapitalize its banks until the new austerity budget is submitted. 
What's more important than this political and economic foolishness?  Here's a picture:
                                                New York Times

No, this is not a picture of Bane in Gotham City from "The Dark Knight Rises."  It is a real life street picture from Greece, where the riot police are risking injury from rocks and Molotov cocktails.  The Greek government has to start asking itself: what do we, as elected officials, really have to gain by the current Euro status quo, continued dithering, and by the ultimate medicine we'll have to take? 

In Spain, protests have moved beyond displaced workers to scenes of genuine urban hunger and deprivation.  Here's another New York Times photo,
                                                       Sam Aranda for New York Times
Even the patrician Spanish Prime Minister will have to realize that "dumpster diving" among his young constituents may require coming down from his throne to actually do something besides turning up his nose at a bailout.  Even if he were to get the terms of a bailout, he too may have to reconsider what it means for Spanish sovereign governance. 

The most important leading indicators for the euro crisis unfolding may be in financial rates, but better indicators may be from the streets, as captured by the photographers' eyes. 

Friday, September 21, 2012

Private Equity and Conservative Canadians

Now that our favorite Uncle Ben has promised the investment world the Fed will  mainline MSB purchases into the system until the unemployment rate reaches 7%, we are deeply conflicted.  In a surprising display of one-upsmanship,  Minneapolis Fed President Kocherlakota suggests using a threshold unemployment rate of 5.5% before the quantitative easings are unwound.  So, the hard-working, responsible saver faces a long horizon of low investment returns. 

Folks looking to build up balances for college tuitions or retirement are facing a trifecta of low returns, rising taxes and, eventually, rising inflation.  Meanwhile, we see political commercials for the supposed evils allegedly inflicted on coddled union workers by Bain Capital and other private equity firms.  Here we go again, Two-Face!

What's an institutional investor to do?  Really, public pension funds have no choice but to increase their allocation to alternative assets.  Otherwise, they should meaningfully decrease their expected rate of return on plan assets, thereby putting pressure on state and local taxpayers to make up the contributions to the gold-plated, public pension funds.  This would make taxpayer-voters pretty mad, unless the headlines are buried beside the obituaries in the paper.

Our conservative and circumspect Canadian neighbors to the north are planning to step up their allocations to alternative assets, according to a Royal Bank of Canada survey reported in the Globe and Mail.  According to the survey,

"Of those funds looking at boosting alternative asset holdings, 45 per cent said they planned to increase their real estate holdings, 34 per cent are looking at infrastructure, 14 per cent are planning private equity investments and 7 per cent are planning more hedge fund investments.

Mr. MacDonald said large public sector pension plans have had better performance in recent years due to their investments in alternative assets, and smaller plans increasingly want to emulate that success"
There is no doubt that public pension funds face challenges in matching the alternative asset class performance of funds such as the university endowment funds of Harvard, Yale and Columbia.  Smaller funds don't have the capabilities in-house to structure the right deals, and brokers often lead them astray.  Larger funds, like CalPERS are able to structure better deals, but even they have conflict of interest issues and other inefficiencies which come with a public organization. 

Bringing the capability entirely in-house, where the group actually finds, values and structures private equity investments for a public pension fund is something that is being tried by one large Canadian fund.  Even if it works for a time, the issue of compensation and culture will weigh on retaining that group for any length of time.

So, like our brown-suited Two-Face, we have to rail against the distorted, artificial low return environment in which Uncle Ben has trapped the economy.  Poor retail schmoes will face a limited set of expensive, unproven options for alternative investments. We can also posture for the press about the bogey-men of Wall Street, particularly in an election year.

At the end of the day, however, an investor has to find a way to reach for higher return, which means more risk.  Our chalk-striped half is outraged by the 2/20 fee structures and by the tax treatment of carried interest , but the alternative investment class should offer higher expected returns than the liquid asset classes of stocks and bonds looking forward in this surreal rate environment.  It makes a person's blood boil!

Wednesday, September 19, 2012

Our Foreign Policy Future in Central Asia

The following statement is as close as I can come to a succinct formulation of our foreign policy vision.  The interested reader can find the full exposition in a White House document on national security strategy from 2010.

"The starting point for that collective action will be our engagement with other countries. The cornerstone of this engagement is the relationship between the United States and our close friends and allies in Europe, Asia, the Americas, and the Middle East—ties which are rooted in shared interests and shared values, and which serve our mutual security and the broader security and prosperity of the world. We are working to build deeper and more effective partnerships with other key centers of influence—including China, India, and Russia, as well as increasingly influential nations such as Brazil, South Africa, and Indonesia—so that we can cooperate on issues of bilateral and global concern, with the recognition that power, in an interconnected world, is no longer a zero sum game."
A problem with this paragraph is that one could substitute the name of any other country for that of the United States, and the statement reflects a bland sameness.  As we lurch from one international crisis to another, reacting to unanticipated events, I began thinking about Central Asia beyond 2012.  This will likely be a theater where none of the policy desiderata in the above paragraph may be achievable.

Turkey, a country of some 68 million people, has not been a focus of media attention in Central Asia, compared to Afghanistan, Iran, and Pakistan, for example.  Yet, within its geopolitical ambit sits the Balkans, the Caucusus, and the Middle East. Turkey falls under the Western security apparatus, although at a distance. It has had second class citizen ties to the EU since joining the Council of Europe in 1949.  My thinking about this issue was inspired by the research of Svante Cornell, Director of the Central Asia - Caucusus Institute, and the Silk Road Program at Johns Hopkins University, my graduate alma mater.

Turkey's economy has been experiencing GDP growth in the 7 percent range, and it has tapped a long standing wellspring of entrepreneurship and Western-style capitalism.  Prime Minister Erdoğan, the leader of the Justice and Development Party ("AKP"), has a goal for Turkey to be among the top ten leading economic powers by 2023. 

As Cornell points out, since 1990, Turkey's GDP has grown four-fold, its exports five-fold, and foreign direct investment in Turkey has grown to twenty-five times the 1990 level.  France and Germany have long opposed Turkey's joining the EU as a full member, and Germany's unending rhetroic about Turkish guest workers, together with the opposition to membership has had a psychic impact on Turkey's foreign policy tilt, according to Cornell.

Whereas Turkish foreign policy from Ataturk's time was built on a pragmatic reticence, Prime Minister
Erdoğan's policy focus has been vocal and sometimes strident.  It has also clearly shifted eastward, away from Europe. He has also made public overtures to Iran, Syria and the Sudan.

For all our talk of isolating Iran, the Turkish PM has become a vocal supporter of Tehran's nuclear ambitions.  A long, cordial relationship with Israel deteriorated to the point of the 2009 shouting match with Shimon Peres at the Davos economic summit.

Given, Israel's choreographed saber-rattling at Iran, we should be very concerned about how the Turkish tilt towards rogue states may play out in the next few years.

Turkey sees itself as an "honest broker" among the Central Asian states and the West.  Referring to the Obama administration's paragraph above, we probably don't have the same "shared interests and values."  Turkey envisions an important role for itself at the Afghan peace talks scheduled for 2014, after the putative U.S. exit. 

The Erdoğan government in Turkey has begun a direct energy trade with the Regional Authority of Kurdistan, and there have been lots of announcements of expanded trade in oil and gas through pipelines to Turkey.  None of this sits very well with the Shia-dominated government of Iraqi President Maliki.  Turkey is also concerned about Iraq being overly influenced by Tehran, despite Turkey lending its verbal support to Iran's nuclear program.  So, will Turkey and Iran be rivals for center stage or allies?  It is not clear at all.

It is clear that Turkey will have a visible and important role to play in Central Asia post-2014 Afghan peace talks.  Russia and Pakistan will have their own interests.  Unfortunately, our "partnerships" with the latter two nations are threadbare.  Our 2014 exit and its aftermath will not be a quiet period for U.S. diplomacy.

Friday, September 14, 2012

David Einhorn's Book: What Else I Learned

David Einhorn's financial involvement with Conseco, Inc. is very instructive for anyone involved in investment research or portfolio management. The patterns of individual and corporate behavior exhibited by Conseco and its CEO have been, and will continue to be repeated by many other actors in specialty financial services. 

The bulk of the book, however, is a copiously detailed recounting of Greenlight's involvement with a Business Development Company called Allied Capital.  I have to believe that some of Mr. Einhorn's motive for writing at such great length was cathartic, given "what a long strange trip" shorting these shares must have been.  It's understandable, but I took away a couple of points which I think are very important for the future of our markets and regulation.

Greenlight Capital did a prodigious amount of due diligence on Allied, its accounting, and even on its portfolio companies.  It even hired the global investigations firm Kroll International to help them, along with a colorful retired business executive and shareholder who was a research pit bull on Allied.

Greenlight chose to share its research findings with buy and sell side analysts, portfolio managers, the SEC, the Small Business Administration, Congressional staffers and the top guns in the financial press. 

It was absolutely no surprise to me about the conflicted behavior and personal lassitude of Wall Street analysts.  That is a given, and it has always been thus. The financial press writers Mr. Einhorn spoke to really never took the bit between their teeth even though they were spoon fed data and clues, like bread crumbs.  I wonder why they demonstrated such passivity towards this story?

No, the biggest disappointment came from the Federal regulators, particularly the SEC and the Small Business Administration, which had jurisdiction because of direct funding and their oversight of BDC's and their portfolio companies.  Both the SEC and the SBA come across as arrogant, distant, lazy and incompetent.  Federal financial regulators recent performance history has been less than stellar, just when the need for superior acumen was greatest.

In the case of IndyMac Bank, which we have written about, Congress and auditors found the Federal Office of Thrift Supervision so negligent and incompetent that OTS was dissolved and folded into the Office of the Comptroller of the Currency. 

Dodd-Frank has multiplied the number of Federal regulatory actors, at great expense to taxpayers and businesses.  Given the culture of these Federal agencies, the quality and motives of senior political employees, and the lack of incentives to perform, our financial regulation structure will be prohibitively expensive and unproductive for managing or reducing systemic risks.  This was not a happy lesson to take away from the author's book.

Thursday, September 13, 2012

David Einhorn Meets a GE Turnaround Expert

I just finished David Einhorn's book, and though it wasn't an easy read, I learned a lot, which is why I seek out his presentations and speeches.  Several years ago, his presentation at a Graham and Doddsville seminar on St. Joe was funny, illuminating and right on the mark. 

With all the talk about financial companies, I had to laugh as I read the author's tale of doing a "capital structure arbitrage" on Conseco, Inc.  Conseco's bonds were priced to yield 20% in 2000, suggesting extreme distress.  Meanwhile, he points out that the company's shares were priced as if things were hunky dory.  Greenlight's strategy was to go long the bonds and to go short the equity. 

Gary Wendt, a 24 year veteran of General Electric, had earned a reputation as a turnaround artist, working on some ten business unit restructurings within the Jack Welch-led behemoth.  Wendt is a graduate of the Harvard Business School. According to one press bio, after taking command of GE's Capital Services business in 1985, he grew it into a business with $255 billion in assets worldwide and 67,000 employees.  As Bill Gross eventually wrote in one of his letters, GE Capital and its balance sheet were the engine behind the stock performance of General Electric.  He was brought in to turn Conseco around.

In 2000, the board at Conseco paid Wendt $45 million in cash and 3.2 million options upfront to turnaround a troubled specialty finance business.  This should have been a walk in the park for Gary Wendt and a boon to the poor shareholders.  True to his GE heritage, Wendt, according to the author, promised an "immediate turnaround" by bringing in Six Sigma black belts with their dark arts, to improve the operations.  The market bought into the promises, and the 20% yielding debt was soon priced to yield 11%, even without any specifics about how the business was going to be rejuvenated. So, Greenlight Capital had already made money on its long bond position.  The reader, however, can feel Mr. Einhorn's antennae going up. 

Thirty investors and analysts were invited to Conseco's midtown New York offices, and they were asked to wait in a warm conference room until the entire invited group had assembled.  When all the Wall Street participants were seated, a minion brought in Mr. Wendt's "throne," a specially crafted chair that was put at the center of the conference table. (I have actually witnessed this phenomenon working with another former GE executive who brought his GE furniture with him to a new assignment.  It must be the karma of success residing in the handcrafted wood and leather.)

After a lengthy pitch by the CEO, a question and answer period began.  Einhorn recounts that whenever a question concerned numbers or financial details, Wendt's response was "Someone will get back to you." 

Now, David Einhorn didn't have to run any complicated Excel spreadsheet models to make his decision: "I had seen enough."  Greenlight Capital sold out its bond position for a profit, and it then added to its short equity position.

Gary Wendt went to work cutting costs and restructuring debt, straight out of the corporate finance playbook.  According to the Indianapolis Star,
" In his first year at the helm, Wendt outsourced call center work to India, shut down the company's unprofitable medical insurance line and dispensed with the art collections, airplanes and other conspicuous trappings of the Hilbert era. Stock prices rose in response, to nearly $20 in the summer of 2001." (The stock had been as low as $5)
Einhorn recounts that the company issued irregular "turnaround memos" which were largely self-congratulatory, at intervals that seemed chosen to "goose the stock."  Each release raised more questions about the numbers and how the business model worked.   The company provided no answers.  "The stock kept going up, until it didn't." 

The Indianapolis Star's account of the denouement is a bit fuller than the author's:
"... investor confidence did not hold, particularly after a third-quarter 2001 write-off of $471 million that shocked many investors. The company was also burdened by more than $500 million in loans to its own directors, including Wendt, who had used the money to invest in Conseco stock.

After more than two years, during which the stock continued to fall to a low of $.07, and amid talk of impending bankruptcy, Wendt resigned as chief executive officer."
Like Sam Zemurray, the Banana Man, said, "Go and see for yourself."  Having come into that investor meeting with all the research homework done, and the senses quickened by having skin in the game, there was nothing better for a savvy investor like David Einhorn to do than to sit across a table from Gary Wendt, look him in the eye and take a reading of what kind of person was managing his investment.  It's a great story.  Beginning around the same time period, the specialty finance sector produced fizzled growth rockets like Green Tree Financial, Metris, IndyMac, Washington Mutual, and Countrywide Financial.  There is nothing new on Wall Street.

BAE Should Put the Brakes on EADS Merger

It seems hard to believe that the management of BAE, based on their recent presentations and strategic focus, would contemplate a merger with the parent of Airbus, EADS.  BAE is gaining traction in areas of great interest worldwide, namely defense services,  round the clock, electronic surveillance and intelligence, as well as commercial security.  They recognize that the defense hardware budget cycles are moving against them, but the market for services that support continuous monitoring and electronic warfare should be robust across all regions. 

The market for commercial aviation has seen an order spike around the delivery of the next generation of jumboliners.  This is now history.  Manufacturing and delivering these behemoths won't be easy.  The market will likely change to smaller, more fuel-efficient aircraft after the jumboliners are in service for a few years. Who needs this kind of long cycle, politically order-driven business? Boeing is a fine company, competing with the EU subsidized EADS. Boeing is not troubled by this proposed merger. That's not a good sign.

Merging these two companies and their distinctive selling cycles will be an absolute nightmare.  Customers will be very nervous about their future support. As Raytheon has crowed, it will mean contract gains for their sales teams during the integration cycle. 

At the end of the day, BAE shareholders will own only forty percent of the combined company.  Some better valuation work needs to be done by the BAE bankers.  It seems like I've just begun to see BAE appearing on institutional ownership lists.  10 analysts have BAE as Buy or Strong Buy, with 12 Holds, pre merger. Post-merger, newer shareholders may move on to greener pastures. Too bad.

Tuesday, September 11, 2012

A German Sovereign Wealth Fund

Finally, an original and very interesting idea to save the euro, from Daniel Gros, director of the Centre for European Policy Studies in Brussels, and Thomas Mayer, Senior Fellow at the Financial Studies Centre, Goethe University in Frankfurt.

In addition to the benefits of such a fund, the proposal also recognizes the problem of the phony interbank payment systems represented by Target2 and provides an exit. 

As the authors recognize, the objections to this market and investment oriented proposal will be political, directed at Germany and suggesting that it is, once again, taking a ham-fisted approach to the deserving but profligate EU periphery. 

The authors address this by saying,
"...under the current circumstances one has to choose the lesser evil: a strong euro combined with ever-increasing tensions which threaten global financial stability, or a weaker euro without the internal tensions.  We believe that the global economy will be better off under the second scenario."
I would add one thing.  A 'stronger' euro under the ECB proposals is an artificial and illusory construct that would eventually be hollowed out by economics and by the markets. 

Monday, September 10, 2012

Draghi Has No Solutions For Euro

After watching the market reach new highs, and after reading all manner of learned European commentary on European banking regulation, I still believe that the Draghi's chest thumping about saving the euro and the banking system is empty posturing. Our reasoning has been laid out before, but let's see what's new this week.

I'm really surprised by the dearth of any sensible economic commentary from the European think tanks, e.g. the Institute for New Economic Thinking to name one. Some of their pundits put their faith in the ECB and its unlimited ability to buy bonds, manage interest rates, control EU-wide inflation rates, and manage the bank regulation and resolution process for 6,000 banks in the union.  This latter objective would be carried out in conjunction with partners, like the IMF.

The IMF as an institution can barely carry out its current charters: it a large bureaucracy and not an effective multinational bank auditor and regulator. 

The INET says that the balance sheet of the ECB won't be an impediment to unlimited bond buying, because its equity doesn't matter.  But, the equity holders are the member states which provide the capital.  They are the "owners."  The relative contributions of the equity holders should be what determines the composition of the governing board, in a normal institutional arrangement.  Why on earth would Germany agree to this kind of madcap arrangement without the concomitant protections? 

The austerity programs continue to founder, and we learn this morning that the proposed  menu of Greek austerity measures has been rejected by "international inspectors."  These inspector Clouseaus are demanding that the Greek government come up with alternative measures.  How long can a Greek government continue to play this game out and lose face? 

Meanwhile, the Spanish government is in denial, like the Black Knight in  Monty Python and the Holy Grail.  It was thought to be the "new sick man of Europe" in 2009, and now its banking sector is on the brink because of the failure of its own monetary and regulatory mechanisms.  It is now where the Black Knight was at the end of the Python sketch.  The Spanish Prime Minister hasn't decided if he wants "to ask for help" yet.  The ECB can't handle this critically ill patient. 

Italy lurks in the background as the patient to enter the emergency ward.  It unfortunately is nominally the third biggest economy in the EU. 

Even France has begun talk about "austerity measures," although this will probably prove to have been for show by the politically inept Hollande government. 

For national labor productivity ratios to re-equilibrate among EU states, Germany would have to run a higher inflation rate.  Which government is going to go along with a scheme like this, with the German economy already going into a deep slowdown?  Despite Chancellor Merkel's more dovish cooing about the euro, nothing much has changed for her coalition.  The policy options on the table now are blank checks, with no accountability, and bad outcomes for the stronger players in the EU. 

Uncle Ben Bernanke will have to deliver good news for the markets this week if the bull leg is going to continue upward. 

It all gets back to political unwillingness to cede national sovereignty and to the balkanization of economic interests. Without the mechanism of country exchange rates to adjust labor productivity and without meaningful labor market and regulatory reforms, even a more powerful ECB cannot paper over the flaws in the current system, no matter how big its balance sheet becomes. 

Friday, September 7, 2012

Grazie Signore Draghi!

Bill McBride of Calculated Risk has the following chart on his blog.  Get out those rose colored glasses from your last Grateful Dead concert, here it is:

Our equity markets are 112.5% above the financial crisis lows.  Investor sentiment, a contrary indicator, is extremely negative, as further evidenced by the continuing outflow from stock mutual funds into bond funds.  Keeping the macro focus paradigm, our markets should be healthy into midweek, when thoughts turn to the next EuroConfab on Thursday. 

What about the "fundamental" side, if that means anything anymore?

This quote is from Reuters,
"In fact, the recent price-to-earnings high was 13.5 in February 2011, just above current levels. If you are of the view that little has changed since then, there is no reason for the ratio to go much higher. That combined with a slowing earnings picture inevitably means lower prices.

"Our view is that the next double digit move in the market is down not up," said Morgan Stanley in a research note.

The analysts, led by equity strategist Adam Parker, believe the S&P 500 will finish the year at 1,214, 15 percent below where it is now."
Slowing earnings and no multiple expansion...hmmm. 

Tuesday, September 4, 2012

Jeff Gordon of Columbia Law on Money Market Funds

Professor Jeff Gordon of Columbia Law School posted on a blog this morning about an issue we covered in yesterday's post, namely the failure to reform money market mutual funds (MMF). 

Here's an excerpt from his post:

"The core problem, which the SEC staff has identified, is that money funds hold risky assets but have no independent capacity to bear loss — no capital nor any other loss-absorbing layer. In times of systemic instability, money fund users will run, because being first in line to redeem may increase the chance of receiving 100 percent. A required “holdback” of a small percentage of deposited funds for a fixed period would reverse the run dynamics because it would mean that an investor’s best chance to avoid loss is from not running. That plus a small capital layer would add considerable stability to the money market fund industry.

Money market funds assemble diversified packages of short term credit claims, particularly short term claims issued by banks and other financial institutions. In their present fixed NAV form money funds can play a useful transactional role as a bank substitute, especially for large institutions with large cash balances that exceed the limits of deposit insurance guarantees. But stability of the financial system is a public good that cannot be sustained in the presence of pervasive free-riding. The present money fund structure is like a nuclear power plant atop an earthquake fault. The question of a disaster is not whether but when."
My take on this is different.  The SEC's effort, and perhaps rightly so, was to focus on improving MMF transparency beyond the current level of additional disclosures, and to increase their capacity to bear loss.  Additionally, a holdback in investor redemptions would have added an element of shareholder risk sharing, which partly addresses the 'free rider' problem.  Good ideas.

However, the bigger potential, systemic risk locus is in the repo market itself and in its mechanics.  In particular, I refer to the risks posed to the two clearing banks in the event of a large broker-dealer's inability to get short-term funding and the dealer's subsequent failure.

MMF are one class of cash investors. which are but one element of the repo market.  The broker-dealers perform a valuable service, but they too get a 'free ride' in the shadow banking system's repo market.  A freezing up of their short-term financing poses significant systemic risk, as opposed to shareholder risks at the MMF.

All of this "reaching for yield" is exacerbated in the continuing low-interest rate environment, which is not attributed as social cost of the unconventional monetary policy of the Fed. 

Monday, September 3, 2012

Labor Day Idylls and Europhoria

Think back to the dreaded global financial meltdown of 2008.  Monetary policy spigots wide open.  U.S. and then global real estate prices escalating. The 'originate and distibute' model in full swing at specialty finance companies.  Underwriting standards out the window.  Real estate price increases self-fulfilling.  Investors move to riskier and riskier trades to amp up their returns. 

Charles Prince makes the penetrating observation,
"When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing."
According to Deloitte's Shadow Banking Index research, assets in the shadow system peaked in the first quarter of 2008 at $21 trillion, compared to $15 trillion in the regulated banking sector.  The Reserve Primary Fund breaks the buck in 2008, beginning a run on more than $300 billion in assets in prime money market funds.  You know the rest of the story.

Here we are in the summer of 2012.  Monetary policy no longer operates through spigots but through a fire hose.  The Fed Chairman says he has a study showing easy money has produced 2 million more jobs than would otherwise have been possible, and nobody laughs or asks him to explain who created these jobs and why.  It is utter nonsense, but markets turn upward. 

Looking at a beautiful day on the Midwestern prairie, Walt Whitman's lines seem to summarize the views of our manic/depressive markets,
"O CAPTAIN! my Captain! our fearful trip is done;
The ship has weather’d every rack, the prize we sought is won;
The port is near, the bells I hear, the people all exulting.."
 Let's think about our more sophisticated neighbors in the European Union.  Global stock and bond markets have been buoyed by a Eurobanking bureaucrat stamping his feet and saying something like, "Dadgummit, I guarantee that the euro will survive.  You can bet the Sardinian villa on it."  The people exulted.  One thing he didn't say: what will that currency look like, and which nations will be in the currency union?  I don't think that Greece will be on the list.

Spain has had Valencia, Catalonia and Andalusia ask for central government help.  The Spanish government cannot cope with their requests, plain and simple.  Now, the Spanish PM talks about a EU-wide banking resolution system that will take care of Spanish banks and some 6,000 EU-wide institutions in total. Note to file: the EU does not have and is unlikely to create a workable mechanism for achieving these ends before the Spanish situation worsens with 20 billion in euro debt coming due in October. 

Yet, "currency markets are calm," and "European stocks finish higher."  The prospect for a Thursday EU meeting will keep the music box cranking and the weasel will stay contained until then. 

Recent earnings announcements from technology bellwethers like HP, Cisco and Dell have all been characterized by anemic top line revenue growth, and cuts in 2013 revenue estimates.  Asian manufacturing is slowing down dramatically, and some of its tech leaders like Acer are on life support. Cost cutting, staff reductions and restructuring are already factored into valuations. This isn't a great scenario for multiple expansion or for earnings growth looking forward.

The recent failure of SEC Chair Mary Schapiro to bring about reform of money market funds is important when looking back to the 2008 crisis.  The SEC has been "engaging for two and a half years on structural reform of money market funds."  Commissioner Luis Aguilar's two page, volte-face on reform seemed hollow and out of character.  Even with the 2010 reforms to the repo market, this market, particularly the roles of the two clearing banks, JP Morgan Chase and Bank of New York Mellon, still poses significant risks to the global system in 2012.  We haven't dealt with these issues either.

Again, U.S. equity market are near their highs, and U.S. fixed income managers now talk about looking at selected European credits as very attractive.  Aside from assurances of central bank backstopping, how can these notes issued by deadbeats be a compelling, risk-adjusted value?   World financial markets see the world as the poet Whitman did in his verse.

Going back to the 2006-2008 analogy, the music today is being played by central bankers.  Bernanke, Draghi and others have promised unlimited, interminable liquidity support to asset markets. 

Chicago Booth Professor John Cochrane puts it best in describing how the Fed has gone off the rails with respect to its fundamental mission as a central bank,

"Since the 2008 financial crisis, however, the Federal Reserve has intervened in a wide variety of markets, including commercial paper, mortgages and long-term Treasury debt. At the height of the crisis, the Fed lent directly to teetering nonbank institutions, such as insurance giant AIG, and participated in several shotgun marriages, most notably between Bank of America and Merrill Lynch.

These "nontraditional" interventions are not going away anytime soon. Many Fed officials, including Fed Chairman Ben Bernanke, see "credit constraints" and "segmented markets" throughout the economy, which the Fed's standard tools don't address. Moreover, interest rates near zero have rendered those tools nearly powerless, so the Fed will naturally search for bigger guns. In his speech Friday in Jackson Hole, Wyo., Mr. Bernanke made it clear that "we should not rule out the further use of such [nontraditional] policies if economic conditions warrant."
When the markets no longer listen to the central bankers' music, the current, long running game of musical chairs will also be over.