Posts tagged ‘subprime’

The European Dog Ate My Homework

I never thought my daily routine would be dominated by checking European markets before our domestic open, but these days it is appearing like the European tail is wagging the global dog. Tracking Spanish bond yields from the Tesoro Publico and the Italia Borsa index is currently having a larger bearing on my portfolio than U.S. fundamentals. When explaining short term performance to others, I feel a little like an elementary school student making an excuse that my dog ate my homework.

Although the multi-year European saga has gone on for years, this too shall pass. What’s more, despite the bailouts of Portugal, Ireland, and Greece in recent years, the resilient U.S. economy has recorded 11 consecutive quarters of GDP (Gross Domestic Product) growth and added more than 4 million jobs, albeit at a less than desirable pace.

Could it get worse? Certainly. Will it get worse before it gets better? Probably. Is worsening European fundamentals and a potential Greek eurozone exit already factored into current stock prices? Possibly. The truth of the matter is that nobody knows the answers to these questions with certainty. At this point, the probability of an unknown or unexpected event in a different geography is more likely to be the cause of our economic downfall than a worsening European crisis. As sage investor and strategist Don Hays aptly points out, “When everyone is concerned about a problem, that problem is solved.” That may be overstating the truth a bit, but I do believe the issues absent from current headlines are the matters we should be most concerned about.

The European financial crisis may drag on for a while longer, but nothing lasts forever. Years from now, worries about the PIIGS countries (Portugal, Ireland, Italy, Greece, Spain) will switch to others, like the BRICs (Brazil, Russia, India, China) or other worry geography du jour. The issues of greatest damage in 2008-2009, like Bear Stearns, Lehman Brothers, AIG, CDS (credit default swaps), and subprime mortgages, didn’t dominate the headlines for years like the European crisis stories of today. As compared to Europe’s problems, these prior pains felt like Band Aids being quickly ripped off.

Correlation Conundrum

Eventually European worries will be put on the backburner, but until some other boogeyman dominates the daily headlines, our financial markets will continue to correlate tightly with European security prices. How does one fight these tight correlations? For starters, the correlations will not stay tight forever. If an investor can survive through the valley of strong security association, then the benefits will eventually accrue.

Although the benefits from diversification may disappear in the short-run, they should not be fully forgotten. Bonds, cash, and precious metals (i.e., gold) proved to be great portfolio diversifiers in 2008 and early 2009. Commodities, inflation protection, floating rate bonds, real estate, and alternative investments, are a few asset classes that will help diversify portfolios. Risk is defined in many circles as volatility (i.e., standard deviation) and combining disparate asset classes can lower volatility. But risk, defined as the potential of experiencing permanent losses, can also be controlled by focusing on valuation. By in large, large cap dividend paying stocks have struggled for more than a decade, despite equity dividend yields for the S&P 500 exceeding 10-year Treasury yields (the first time in more than 50 years). Investing in large companies with strong balance sheets and attractive growth prospects is another strategy of lowering portfolio risk.

Politics & Winston Churchill

Some factors however are out of shareholders hands, such as politics. As we know from last year’s debt ceiling melee and credit downgrade debacle, getting things done in Washington is very challenging. If you think achieving consensus in one country is difficult, imagine what it’s like in herding 17 countries? That’s the facts of life we are dealing with in the eurozone right now.

Although I am optimistic something will eventually get done, I consider myself a frustrated optimist. I am frustrated because of the gridlock, but optimistic because these problems are not rocket science.  Rather these challenges are concepts my first grade child could understand:

• Expenses are running higher than revenues. You must cut expenses, increase revenues, or a combination thereof.

• Adding debt can support growth, but can lead to inflation. Cutting debt can hinder growth, but leads to a more sustainable fiscal state of wellbeing.

Relieving all the excess global leverage is a long, tortuous process. We saw firsthand here in the U.S. what happened to the U.S. real estate market and associated financial institutions when irresponsible debt consumption took place. Fortunately, corporations and consumers adjusted their all-you-can-eat debt buffet habits by going on a diet. As a matter of fact, corporations today are holding records amounts of cash and debt service loads for consumers has been reduced to levels not seen in decades (see chart below). Unlike governments, luckily CEOs and individuals do not need Congressional approval to adapt to a world of reality – they can simply adjust spending habits.

Source: Calafia Beach Pundit (Scott Grannis)

Governments, on the other hand, generally do need legislative approval to adjust spending habits. Regrettably, cutting the benefits of your constituents is not a real popular political strategy for accumulating votes or brownie points. If you don’t believe me, see what voters are doing to their leaders in Europe. Nicolas Sarkozy is the latest European leader to be booted from office due to austerity backlash and economic frustration. No less than nine European leaders have been cast aside since the financial crisis began.

The fate for U.S. politicians is less clear as we enter into a heated presidential election over the next six months. We do however know how the mid-term Congressional elections fared for the incumbents…not all sunshine and roses. Until elections are completed, we are resigned to the continued mind-numbing political gridlock, with no tangible resolutions to the trillion dollar deficits and gargantuan debt load. Obviously, most citizens would prefer a forward looking strategic plan from politicians (rather than a reactive one), but there are no signs that this will happen anytime soon…in either party.

Realistically though, tough decisions made by politicians only occur during crises, and if this slow-motion train wreck continues along this same path, then at least we have something to look forward to – forced resolution. We are seeing this firsthand in Greece. The “bond vigilantes” (see Plumbers & Cops) and responsible parents (i.e., Germany) have given Greece two options:

1.) Fix your financial problems and receive assistance; or

2.) Leave the EU (return to the Drachma currency) and figure your problems out yourself.

Panic has a way of forcing action, and we are approaching that “when push comes to shove” moment very quickly. I believe the Europeans are currently taking a note from our strategic playbook, which basically is the spaghetti approach – throw lots of things up on the wall and see what sticks. Or as Winston Churchill stated, “You can always count on Americans to do the right thing – after they’ve tried everything else.”

There is no question, the European sovereign debt issue is a complete mess, and there are no clear paths to a quick solution. Until voters force politicians into making tough unpopular decisions, or leaders come together with forward looking answers, the default position will be to keep kicking the fiscal can issues down the road. In the absence of political leadership, eventually the crisis will naturally force tough decisions to be made. Until then, I will go on explaining to others how the European dog ate my homework.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds (including commodities, inflation protection, floating rate bonds, real estate, dividend, and alternative investment ETFs), but at the time of publishing SCM had no direct position in AIG, JNJ, Bear Stearns, Lehman Brothers, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

May 27, 2012 at 7:47 pm 1 comment

The Big Short: The Silent Ticking Bomb

A bomb was ticking for many years before the collapse of Bear Stearns in March of 2008, but unfortunately for most financial market participants, there were very few investors aware of the looming catastrophe. In The Big Short: Inside the Doomsday Machine, author Michael Lewis manages to craft a detailed account of the financial crisis by weaving in the exceptional personal stories of a handful of courageous capitalists. These financial sleuths manage not only to discover the explosive and toxic assets buried on the balance sheets of Wall Street giants, but also to realize massive profits for their successful detective skills.

Lewis was not dabbling in virgin territory when he decided to release yet another book on the financial crisis of 2008-2009. Nonetheless, even after slogging through Andrew Ross Sorkin’s Too Big to Fail and Gregory Zuckerman’s The Greatest Trade Ever (see my reviews on Too Big to Fail  and The Greatest Trade Ever),  I still felt obligated to add Michael Lewis’s The Big Short to my bookshelf (OK…my e-reader device). After all, he was the creator of Liar’s Poker, The New New Thing, Moneyball, and The Blind Side, among other books in his distinguished collection.

Genesis of the Bomb Creations

Like bomb sniffing dogs, the main characters that Lewis describes in The Big Short (Michael Burry/Scion Capital; Steve Eisman/Oppenheimer and Co. & FrontPoint Partners; Gregg Lippman/Deutsche Bank (DB); and Jamie Mai & Charlie Ledley/Cornwall Capital) demonstrate an uncanny ability to smell the inevitable destruction, and more importantly have the conviction to put their professional careers and financial wellbeing at risk by making a gutsy contrarian call on the demise of the subprime mortgage market.

How much dough did the characters in the book make? Jamie Mai and Charlie Ledley (Cornwall Capital) exemplify the payoff for those brave, and shrewd enough to short the housing market (luck never hurts either). Lewis highlights the Cornwall crew here:

“Cornwall Capital, started four and a half years earlier with $110,000, had just netted from a million-dollar bet, more than $80 million.”

Lewis goes on to describe the volatile period as “if bombs of differing sizes had been placed in virtually every major Western financial institution.” The size of U.S. subprime bombs (losses) exploding was estimated at around $1 trillion by the IMF (International Monetary Fund).  When it comes to some of the large publicly traded financial institutions, these money bombs manifested themselves in the form of about $50 billion in mortgage-related losses at Merrill Lynch (BAC), $60 billion at Citigroup (C), $9 billion at Morgan Stanley (MS), along with many others.

The subprime market, in and of itself, is actually not that large in the whole scheme of things. Definitions vary, but some described the market at around 7-8 million subprime mortgages outstanding during the peak of the market, which is a small fraction of the overall U.S. mortgage industry. The relatively small subprime market became a gargantuan problem when millions of lucrative subprime side-bets were created through investment banks and unregulated financial behemoths like AIG. The spirits of greed added fuel to the fire as the construction of credit default swap market and synthetic mortgage-backed CDOs (Collateralized Debt Obligations) were unleashed.

Triggering the Bomb

Multiple constituents, including the rating agencies (S&P [MHP], Moodys [MCO], Fitch) and banks, used faulty assumptions regarding the housing market. Since the subprime market was a somewhat new invention the mathematical models did not know how to properly incorporate declining (and/or moderating) national home prices, since national price declines were not consistent with historical housing data. These models were premised on the notion of Florida subprime price movements not being correlated (moving in opposite directions) with California subprime price movements. This thought process allowed S&P to provide roughly 80% of CDO issues with the top AAA-rating, despite a large percentage of these issues eventually going belly-up.

Lewis punctuated the faulty correlation reasoning underlying these subprime assumptions that dictated the banks’ reckless actions:

“The correlation among triple-B-rated subprime bonds was not 30 percent; it was 100 percent. When one collapsed, they all collapsed, because they were all driven by the same broader economic forces. In the end, it made little sense for a CDO to fall from 100 to 95 to 77 to 70 and down to 7. The subprime bonds beneath them were either all bad or all good. The CDOs were worth either zero or 100.”

Steve Eisman adds his perspective about subprime modeling:

“Just throw the model in the garbage can. The models are all backward looking.”

Ignorance, greed, and other assumptions, such as the credibility of VAR (Value-at-Risk) metrics, accelerated the slope of the financial crisis decline.

Eisman had some choice words about many banking executives’ lack of knowledge, including his gem about Ken Lewis (former CEO of Bank of America):

“I had an epiphany. I said to myself, ‘Oh my God he’s dumb!’ A lightbulb went off. The guy running one of the biggest banks in the world is dumb!”

Or Eisman’s short fuse regarding the rating agency’s refusal to demand critical information from the investment banks due to fear of market share loss:

“Who’s in charge here? You’re the grown up. You’re the cop! Tell them to f**king give it to you!!!…S&P was worried if they demanded the data from Wall Street, Wall Street would just go to Moody’s for their ratings.”

A blatant conflict of interest exists between the issuer and rating agency, which needs to be rectified if credibility will ever return to the rating system. At a minimum, all fixed income investors should wake up and smell the coffee by doing more of their own homework, and relying less on the rubber stamp rating of others. The credit default swap market played a role in the subprime bubble bursting too. Without regulation, it becomes difficult to explain how AIG’s tiny FP (Financial Products) division could generate $300 million in profits annually, or at one point, 15% of AIG’s overall corporate profits.

My Take

The Big Short may simply be recycled financial crisis fodder regurgitated by countless observers, but regardless, there are plenty of redeeming moments in the book. Getting into the book took longer than I expected, given the pedigree and track record of Lewis. Nonetheless, after grinding slowly through about 2/3 of the book, I couldn’t put the thing down in the latter phases.

Lewis chose to take a micro view of the subprime mortgage market, with the personal stories, rather than a macro view. In the first 95% of the book, there is hardly a mention of Bear Stearns (JPM) Lehman Brothers, Citigroup, Goldman Sachs (GS), Fannie Mae (FNM), Freddie Mac (FRE), etc. Nevertheless, at the very end of the book, in the epilogue, Lewis attempts to put a hurried bow around the causes of and solutions to the financial crisis.

There is plenty of room to spread the blame, but Lewis singles out John Gutfreund’s (former Salomon Brothers) decision to take Solly public as a key pivotal point in the moral decline of the banking industry. For more than two decades since the publishing of Liar’s Poker, Lewis’s view on the overall industry remains skeptical:

“The incentives on Wall Street were all wrong; they’re still all wrong.”

His doubts may still remain about the health in the banking industry, and regardless of his forecasting prowess, Michael Lewis will continue sniffing out bombs and writing compelling books on a diverse set of subjects.

Wade W. Slome, CFA, CFP®  

Plan. Invest. Prosper. 

www.Sidoxia.com

*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds and AIG subsidiary debt, but at the time of publishing SCM had no direct positions in BAC, JPM, FRE, FNM, DB, MS, GS, C, MCO, MHP, Fitch, any security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

July 19, 2010 at 1:19 am 3 comments


Receive Investing Caffeine blog posts by email.

Join 1,798 other followers

Meet Wade Slome, CFA, CFP®

More on Sidoxia Services

Recognition

Top Financial Advisor Blogs And Bloggers – Rankings From Nerd’s Eye View | Kitces.com

Wade on Twitter…

Error: Twitter did not respond. Please wait a few minutes and refresh this page.

Share this blog

Bookmark and Share

Subscribe to Blog RSS

Monthly Archives