The Parallel Stages of the Credit Bubble 2001 versus 2009

Stage 1: An event drives investors into a particular asset class. At this stage the investment thesis for investing in such asset class is likely still sound. When interest rates were cut aggressively in 2001 in the aftermath of the Dotcom bubble bursting investors fled equities and went into fixed income compounding the problem of finding attractive high yielding assets. In the aftermath of the 2008 credit crisis investors fled risky assets such as equities and reallocating into risk free assets like US treasuries.

Stage 2: Valuations in the security asset (that’s the asset investor flee into as they exit the distressed asset), in 2001 corporate bonds, and in 2008 US treasuries, rise, causing yields to compress.

Stage 3: In 2001 as valuations of corporate bonds rose and their yields compressed, alternatives had to be found. Investors moved out the term structure as well as down the credit quality curve leading to a yield drought. In 2008 investors diversified out of US treasuries to corporate credit in a similar pattern moving out the term structure and flattening he yield curve as well as moving down the credit quality ranking from investment grade to junk.

Stage 4: Investors sacrifice quality and prudence for immediate gratification. In the 2001 story, investors later piled into SIVs and CDOs because of the higher yields and at times, a favorable credit rating, for whatever that was worth. In 2008, structured credit was at the heart of the crisis and as a result investors have remained cautious about the asset class. However, investors have managed to pile into everything from emerging market hard currency and local currency debt, junk bonds (or high yield as they are now more respectfully referred to), option writing on any underlying instrument with even a shred of volatility, and dividend paying equites.

Stage 5: When investors seek a specific type of product, regardless of the rationality of that objective, the financial industry always obliges. In the aftermath of 2001 investors sought yield as well as some form of validation in the form of a credit rating. The financial industry packaged assets of varying quality and then issued tranches liabilities of differing claims, often obtaining a credit rating, and a high one at that, in order to satisfy both yield and credit rating criteria. The result were SIVs and CDOs. The perversion of these constructs did not happen immediately but set in when demand for liabilities outstripped the availability of assets and led to serious adverse selection issues in credit markets, most notably the mortgage market. The rest is history. It is also poetic that a construct designed for the dynamics of an earlier crisis should precipitate the second one. We haven’t yet seen a construct addressing the insatiable thirst for yield this time but we have seen some questionable solutions. Mutual funds which pay dividends come hell or high water are one example. These funds may be equity funds or bond funds or balanced funds but their defining feature is a promise to pay a frequent (often monthly, sometimes quarterly) dividend. Some of these funds will even pay out of capital when income is insufficient, a practice which simply doesn’t smell right. Having squashed bond yields, some funds have specifically targeted high dividend paying equities, creating a surreal bull market in these types of stocks. One can only hope that fund managers do not go so far as to invest in companies who pay dividends out of capital or new debt. That would be too comical. Other strategies involve employing increasing leverage to portfolios of bonds, a stratagem which finds parallels if not analogues in CDOs and SIVs. Still other desperate measure for yield junkies involve option writing on any convenient underlying instrument within easy reach.

The parallels between the reaction to the Dotcom bust and the reaction to the 2008 financial crisis are remarkable. History doesn’t repeat itself but it does seem to exhibit a consistent autocorrelation.

I’ve not taken my own advice lately and have been too bearish on risk assets. Entirely my fault for ascribing more weight to fundamentals than I normally do. Slow growth doesn’t mean no growth and while I did expect a US manufacturing and export led recovery in mid 2011 and a slowdown in early 2012 I did not expect US housing to be as resilient as it has been. That’s misreading the shorter term cycle and dynamics and the power of the Fed and QE3 whose focus has brought down mortgage rates and financing costs. The timing of QE3 to coincide in an upturn in housing was also unexpectedly adroit of the Fed.

China as well, where I was extremely bearish in the past two years has seen some incipient signs of bottoming. My view here is still tempered by the substantial risk China runs in its shadow banking industry which is as yet unresolved. The SIV like nature of a large swathe of the Chinese financial system makes it just as fragile as an SIV (basically an off balance sheet, unregulated bank.) Otherwise China’s economy is indeed becoming a more consumption led one, if nothing else because infrastructure led grown has hit its funding limitations as well as point of diminishing marginal returns, and exporting is of limited purchase when your trading partners are all slightly broke.  Consumption now accounts for just over half of China’s GDP, surely a positive sign.

The ECB’s  unlimited bond purchase pledge, the various bailout packages tabled between the Club Med and the Western Club Fiscal Rectitude have reduced the risk of Euro disintegration, at least for now. No one expects the Democrats and Republicans to engage in mutual annihilation and thus expect some sort of rational resolution to the so-called Fiscal Cliff. In fact the markets seem to unwinding from some of the pessimism accumulated in the earlier part of the year.

China’s leadership transition appears to have taken place smoothly although we will only understand the dynamics of the new government better as they begin to govern over the next year or so. Nothing alarming  or controversial has emerged. That the local A share market has shrugged off this development and continued to fall is an artifact of the investors more than the fundamentals of the underlying companies.

Has the world recovered? From what exactly has it recovered? What can we expect for next year? Is the world still Broken?

If equity markets were a barometer for whether the world was broken or not, the answer might be a resounding ‘no’. But equity markets are a barometer for popular opinion and the psychology, and debt markets or indeed any market for securities bearing income must be a barometer for abnormal psychology, so acute has become the thirst for yield from any source from bonds to equities to sale of options.

If to governments have done one thing well it has been to manage so poorly that expectations became sufficiently low that any sort of reprieve or improvement, however infinitesimal, would be greeted with a cheer. While government balance sheets are still stretched and cash flows still unsustainable, sufficient rhetoric if not progress has been made to placate the markets. A perverse reaction to any sort of bad news keeps the treasury market sufficiently supported that the Fed no longer has to buy US treasuries since private investors are buying them anyway. The same can be said of Bunds and Gilts.

The pursuit of yield particularly in the sub investment grade sector is interesting since by underwriting most refinancings, investors are helping to delay defaults.

Equities are being supported particularly in that class of companies who continue to pay a good clip of dividends. Equity income funds sprang to life to capture this new theme. D



So no more broken world?

Interest rates will be forever low since any significant rise in interest rates might impoverish whole layers of society, whole groups of countries, a substantial swathe of companies and buy to let real estate investors (institutions included.) There is no way any central bank could tolerate higher interest rates from a systemic risk perspective. Even Emerging Market central banks rea
lize that their housing markets might do a Spain or an Ireland.

Inflation is already high but its not been sufficiently acute to merit real concern. Poorer nations suffer more from inflation but no country in he world really has the power to address it. In a sufficiently open economy it  matters less who operates QE, the liquidity flows along the path of least resistance.

High levels of public debt. The pledge to print unlimited amounts of money is an equivalent pledge to monetize and refinance unlimited amounts of maturing debt thus ensuring the liquidity (though not the solvency) of public balance sheets. This can theoretically carry on as long as inflation does not accelerate.

Equities are cheap relative to cash, government bonds, corporate bonds and even high yield. One might be surprised why equities haven’t done even better this year. Yet so much of equity valuations hinge on interest rates to support both multiples as well as yield gaps. One consequence of the concerted efforts of government to compress yields is cheap equity valuations. But it also creates correlation and even more; dependence between asset classes.

Investors it would appear would be well advised to be well invested in risk assets. But what about the unresolved problems? The concerns which many market observers have are focused on the excessive debt levels that remain in the financial system, the solvency of sovereigns, unconventional monetary and fiscal policy which some might argue was borderline fraudulent or disingenuous at best, the risk of runaway inflation. The current strategy of governments and regulators has been to delay resolution in the hope that time, economic growth and inflation will gradually bring relief. The risks to the current status quo therefore are a pick up in inflation or a crisis of sovereign debt which in either case leads to a bond selloff and a rise in interest rates, the one unifying force supporting asset markets and economies, which would cause a selloff in most risk assets from equities to real estate, commodities, high yield and just about anything reliant on cheap funding or low discount rates.

Of course this point might never come but I should point out that crises hit not because people don’t see them coming but because people are unprepared when they happen. I’ve seen first hand the years preceding the Asian crisis of 1997 when professional investors fretted about the funding imbalances of Asian corporates and governments. Most of these professional investors stayed invested until the crisis hit, hen sought to exit, some with success, some not. Likewise he Dotcom bust was not unforeseen by professional investors. Some decided to exit early, some late. The crisis of 2008 was telegraphed to the fixed income markets as early as 2006, and yet again intelligent investors were split evenly between those who got out early and those who got out late. If you are the sort who likes to get out late you need to trade highly liquid instruments, not use excessive leverage and be able to manage your own emotions. Those who exit early usually gripe about their own poor timing but should resist the temptation to capitulate and re-enter the fray.

There is a bubble in fixed income as clear as day. Here is how all these stories begin. One: someone gets he ball rolling. The crisis of 2008 prompted a flight to safety and the risk free asset at the time was so sovereign bonds, in particular US treasuries. Two: a non-economic buyer emerges whose purchasing power is overwhelming. This would be the US Federal Reserve expanding its balance sheet as part of QE or quantitative easing. Three: regulation encourages and reinforces the trend. Increased banking regulation, capital requirements and the risk weighting treatment of assets under the Basel 3 framework encourage private commercial banks to buy sovereign bonds. (They consume little to no capital under Basel 3 unless they happen to be Greek, Spanish or Italian.) All this sovereign bond buying leads to a shift of the entire yield curve to lower rates at all maturities. What does this do to all fixed income securities? It reprices them upwards. Corporate bonds rally across investment grade to high yield, so do asset backed securities, perps, real estate REITS and physical, anything that pays a fixed coupon. Floating rate securities do not benefit from this dynamic. Four: investors see a rising trend developing in these fixed income securities and dive in driving prices even higher and yields even lower. Five: yield addiction drives investors to be less judicious in obtaining yield and product providers to be more inventive in providing yield. One alarming sign is that the return on assets in fixed income has shrunk so much that to maintain a decent return on equity investors need to apply increasing levels of leverage.

Bubbles can take a long time to burst. There is a bubble in fixed income. The question is, do you have the flexibility and nimbleness to sidestep the bursting of this bubble or not? If you do, then by all means, lever up your bond portfolio. If not, look for alternatives that are not too linked to interest rates. They are not so easy to find.

You never really own a Patek Philippe, you merely look after it for the next generation. It has been one of the most successful advertising slogans ever. It appeals to our vanity, yet tempers it, it appeals to our immortality, yet reminds us of our mortality, it panders to our hopes for our progeny, yet gets us to buy today, and by suggesting an element of investment for the future it makes us less price sensitive and willing to move up the complication and price point curve.

The thing is that luxuries like Patek Philippe have become more accessible over the generations. While prices have surged in the last ten years compared with previous decades, the broadening of the range among luxury makers, from watches to apparel and accessories, means that manufacturers now cater to a much wider spectrum of society.

Which brings us to the investment thesis. Where in the past luxuries like Patek were the preserve of the few, the number of clients has grown. Moreover, where once a person might have a single watch the modern customer tends to have several watches. They also have many more shoes, suits, bags, scarves and whatever else the luxury companies are able to sell them. Today the value of the 1960s complicate watches may encourage one to invest in such a collectible; we are a species prone to naive extrapolation. But how many such examples of these watches are there? And how many limited editions and apparently collectible watches have been launched in the last decade. Beyond quality, luxury, ostentatiousness, perhaps these objects derive most of their value from scarcity. Now there’s a new concept.

Owners of Patek Philippes and other such luxury items had better hope the next generation values these watches as much as they do, since they will inherit a whole bunch of them.

Apologies to Patek Philippe; I actually like their watches, but they are merely a convenient example of the broader principle: We never really own anything, we merely lease it like everything else on this crazy planet, even life.

Capital gains tax should be reduced over the life of an investment. This creates an incentive for long term investment and discourages short term trading. Every year that an investment is kept, there should be a 10% discount on the capital gains tax payable on that investment so that an investment that is held for 10 years attracts no capital gains tax. A similar principal would apply to losses eligible for offset against income or profits. Such loss offsets would decay similarly.

This encourages long term investing. It discourages short term trading except where the investment is a loss. It doesn’t drive management to greater or less transparency. Successful companies have no incentive to be less transparent, or more. Unsuccessful companies who are not transparent will be quickly sold off as quickly as unsuccessful and transparent companies.

Anyone who has ever worked in a bureaucracy will have figured out what’s wrong with our world. Apocalyptic risks can present themselves in no uncertain terms to the market and still evoke the calmest, most dazed and serene of reactions. Solutions to calamitous problems can stare a herd in the face, and the herd will stare blankly back without even the slightest pupil dilation.

Bureaucracies and herds turn good people into fodder. They turn action into circular motion, friction and heat. Inertia is one of the greatest forces on earth. Given a path that doesn’t work, the bureaucrat will always demand trying harder, in the same direction.

A friend of mine once did work for a tire manufacturer making wheels which were heptadecagons. They didn’t work as they weren’t circular and resulted in a lot of ‘volatility’ for their clients.

Try a circle, he said, it works better. No, he was told, our molds are heptadecagons, so please just make more and sell more heptadecagonal tires.

The passengers will be vibrated to death, he said. The auto manufacturers will not buy our tires. They would have a liability. Which they might even pass back to us.

How about a discount? Or perhaps we can give our salesmen incentives to sell.

OK, but then they’d be selling something nobody wants.

We used to sell tons of those tires, came the retort.

Well, yes, but back then, streets were cobbled. Nobody noticed our wheels were heptadecagonal. Today, things have changed. Streets are paved with tarmac, they’re smooth and clients will notice the bumpy ride of our tires. The car makers will not buy tires which jolt their suspensions to bits and vibrate their passengers into the 4^th dimension.

Really? How are you going to sell smooth tires until you’ve successfully sold our heptadecagonal tires? Let’s get the basics right first, before we try these funky ideas.

Yes, but nobody wants our heptadecagonal tires. They want smooth tires.

What are you talking about? We have some round tires in stock but no one has bought any. If you can’t sell round tires, you’d better sell heptadecagonal tires.

The reason we can’t sell our round tires is that our sales people only have expertise with heptadecagonal tires. We need to train them. And besides, our sales people have recently been asked to sell shock absorbers as well. They don’t have time to do both. And their commissions are much higher for shock absorbers. Many of them refuse to sell any tires, round, heptadecagonal or square for that matter.

Look, you’d better just get on with it. You’re way behind in sales of tires. And shock absorbers.

Shock absorbers? I have enough on my plate that I have to make the bloody tires I’m selling and nobody will give me the round moulds. Why on earth do we even have heptadecagonal tires in the first place?, he said.

They are much easier to make. You
know how hard it is to make a perfectly round tire? And you can’t even sell our heptadecagonal tires…

Because nobody wants them. We need round tires. And how about separating manufacturing from sales?

Just sell the damn heptadecagonal tires. If you sell enough of them then you can invest some time and money into the round tires but you’ve got to do the low hanging fruit first. Maybe then we’ll get you someone in manufacturing. They said.

Under his breath he muttered, the low hanging fruit are necrotic, you idiots.

Thanks.

Thanks.

And before long there is a lawsuit against tire manufacturers who are genetically incapable of making a round tire, thus resulting in a class action suit by plaintiffs who have been rattled to death on their 17 sided wheels resonating their car chassis until they are spat out of their sunroofs like a low level James Bond villain being ejected for being tedious.