Count Your Blessings
Let’s talk about risk, which is much in the news these days. What is risk? For many of us, risk is standard deviation, beta, tracking error. For most people, risk is the chance of losing money. There is a debate these days about how much risk we should be allowed to take and what risks we should not be allowed to take. That is at the heart of the financial re-regulation bill before Congress (the opposite of progress). Who can take what risks has been a bedeviling question for regulators since we first started modern finance 50 years ago.
Much of the debate today would be silenced if we only had higher interest rates. Think of it this way: when the risk-free rate is zero, it doesn’t take much of a bribe (in the form of higher potential returns) to get otherwise reasonable people to take risks. Today, we have a zero risk-free rate (T-bills). The bribe to take a very small amount of duration risk is only a hundred basis points (2-3 year Treasuries). The bribe to take both duration risk and some credit risk isn’t all that big either, a couple hundred more (corporate bonds). For risk-averse investors, the choice is accept much lower returns and keep averring risk, or accept some risk to keep your returns higher. These folks are opting to go out the risk spectrum a couple of steps and increase their returns markedly.
Among institutional investors, those with return targets to hit like pension funds, the desire to take the risks is high because they can not meet their goals without taking risks. Also, it is other people’s money, not their own they are putting at risk. These other people will fire them if they don’t meet their goals, so the money might be gone one way or the other. They have huge incentives to perform in the short-run and they are reaching for risk and getting paid for it.
This risk trade-off keeps working all the way out the risk continuum until you get to derivatives like options and futures. There, people will use leverage to increase the risk they can take and since the leverage costs so little, they are perfectly willing to use lots of it. So, you see it all boils down to having interest rates far too low for the environment.
We are recreating the same environment that the Fed created in the early 2000s. Rates are unnecessarily low, creating perverse incentives to use leverage and take risks. For crying out loud, raise the stinking rates! You’d have to be a moron to believe that 2% Fed Funds would suddenly drive the economy into a rerun of the recently ended recession. The difference between zero and 2% will not stop anyone from buying a new car or hiring another worker. Just pull a Nixon, declare victory and retreat, take credit for saving the free world from disaster, call the crisis over and pat yourself on the back while doing the right thing.
What we have is a classic case of government interfering in the economy. On the one hand, the Congress (we’ve already done that) is trying to re-regulate the financial sector to get them to reduce risk-taking and increase safety and soundness. Simultaneously, the Fed is encouraging risky behavior. The right hand is working at odds with the left hand. The simple answer to this dilemma is to get both your hands out of the economy as much as possible.
Crisis of the Week
The Goldman witch-hunt goes on apace this week. So, let’s back up and look at this deal so we kind of know what went on and what might happen next.
Way back in 2007, a couple of institutional investors (IKB Deutsche IndustrieBank and ABN Amro Holding) bought a collateralized debt obligation (ABACUS 2007-AC1) from Goldman Sachs. The deal was put together largely at their behest because they wanted to make a big bet on very high yielding, sub-prime mortgage loans, but in a controlled way. Goldman obliged. Goldman also wanted to create a vehicle for one of their hedge fund clients to short mortgage-backed securities. This product looked very much like the answer to both customers’ needs. So, they went ahead.
Fast forward almost three years and things have changed, or they haven’t. The residential mortgage-backed securities market has been through the wringer. The SEC has taken a lot of heat for being lax in this area and allowing many mom and pop investors to get clobbered by investments that were widely viewed as being pretty safe. There hasn’t been the same level of sympathy for institutions, which are broadly viewed as knowing better.
ABACUS looked like a lot of other mortgage-backed CDOs. So, Goldman was surprised by the SEC lawsuit. Usually in civil enforcement actions, the SEC will notify a firm of the action and attempt to settle the whole thing out of court. We’re sure the calls go something like this:
SEC lawyer – “Hello, Jack, this is Bob from the SEC, we met at that continuing education deal last month over at the Hyatt. Wanted to let you know we’re about to sue the pants off you.”
Jack from Goldman – “Hi Bob, how’s the wife and kids? You’re not going to get a dime out of us on these trumped-up charges, but thanks for the head’s up.”
Bob – “Oh we’ll prevail. We’ve got you dead to rights. A large check to the Treasury is in your future. The only question is how much public approbation you want first?”
Jack – “Been good to talk with you. Say, how about we catch a drink later this week?”
But, this suit was announced with no warning and no attempt to settle beforehand. So, we are of the opinion that this has very little to do with ABACUS. It is all about the politics of financial re-regulation and what the administration wants to do. The case study in all this would be the Sarbanes-Oxley Bill from 2002. This law was meant to curb some of the corporate shenanigans which were displayed by Enron or WorldCom or Adelphia Communications. By shutting the barn door after the horses had largely escaped, Congress was able to claim some sort of victory while standing on the charred ruins of the barn. The same may be the plan this time.
We suppose this will drag on a long time. Both the SEC and Goldman have something to prove and the resources to pursue it to the end of the earth if need be. Plus, until the financial re-regulation bill either passes or not, having this sort of public exhibition going on at the same time will prove helpful for the regulators. Goldman, being the biggest, baddest broker on Wall Street, ought to expect to be the most wanted suspect in just about every regulatory action. It doesn’t help to pick on some hedge fund or a small broker. No, Goldman is the trophy everyone wants on their wall.
Oh, Greece finally decided to officially ask for aid from the International Monetary Fund and the European Central Bank. This probably doesn’t mean the crisis there is over, just that they might have bought themselves some time to get their house in order. Riots and work stoppages of civil (or rather uncivil) servants continue with blood in the streets. Remember Nathan Rothschild’s famous exhortation – “buy when there is blood in the streets.” If you can do that in Greece, you’re more of a contrarian than we are.
Leading indicators remained positive and extended their streak to 12 months of gains in a row. It wasn’t all positive. Three of the 10 indicators were negative in the month, but 7 were positive. The overall gain of 1.4% was above expectations.
Producer Prices rose by 0.7% last month, something of a surprise given the typical guess was for a gain of only 0.3%. Excluding food and energy (everyone can get along without that for a month) the gain was only 0.1%, right in line with estimates. Producer prices have risen 6% in the past year, nothing to worry about because the core rate it up only 0.9%. Energy prices are up 23%, food is also up big, but it seems that everything is going up faster than the index. We had this problem the last time inflation got away from us, too.
Existing home sales rose by 6.8% with gains pretty much all across the nation. The benefit of the first-time home-buyer incentive and the smaller repeat-buyer incentive might have made a difference as both of those expire at the end of this month. Probably just as important was the rise in mortgage rates, as many prospective buyers will jump when they think the cost of the deal will start inexorably rising. The better tone to many of the economic statistics probably helped many people finally decide to jump into a home. Existing homes still cost more than twice the average family income based on national averages. Those markets where that measure is lower (homes selling for less than twice the average family income) are expected to do better, while markets where the average home is still priced well above twice the average family income will probably still have trouble making headway.
New home sales shot higher in what is likely a delayed response to the broader home-buyer incentives (see above). Weather also probably helped as the worst winter in a while has finally ended. The pace, 411,000 new homes sold in March (seasonally adjusted at an annual rate), was up 27% from February (which was an all-time low in this series dating to 1963, when the population of the US was roughly 100,000,000 not 300,000,000) and up 24% from March, 2009. If you consider the sales pace in 2005 was more like 2 million new homes, we still have a long way to go in this area. What we probably have here is a temporary blip that might easily be reversed when the government incentives run out next month. But, we also have a pace that would slowly reduce the inventory of unsold new homes were it to continue.
Durable goods orders slipped as aircraft orders fell after the big numbers last month. Non-transportation orders gained solidly.
After much hand-wringing and finger-pointing (and try wringing your hands while pointing fingers) the markets have taken all the crises, issues and speed bumps in stride so far. US stocks gained last week and generally were able to reach new recovery highs with absolutely no fanfare at all. This is a solid achievement and one that will likely be repeated. The technical picture of US stock markets is fairly healthy, despite what all the media yammers about. Stocks are in a bull market, everything will be looked at askance but it won’t matter to stock prices in the end. That is until it starts to matter.
We saw a much bigger impact of investor bullishness than on prices from the Goldman fracas discussed above. We’ve tacked on about 1800 Dow points since the lows in early February and sentiment is still in a funk. You’d think we’d just lost 1800 points from the way folks talk.
The same can not be said about foreign stock markets. There, the Greek tragedy continues to bring far more market consternation than it probably deserves. Greece, despite all the ‘cradle of western civilization’ metaphors, is a fairly small player on the world scene. The extrapolation of the Greek fiscal nightmare into a broader European Union problem is the real issue here. What is the Euro-zone without Spain, Italy, Portugal, Ireland and Greece? Well, it looks about the same, only smaller. That may be the future of the Euro-zone, but until then, we’ll just freak-out about it.
The developing world has also been drug down by this issue. Emerging world debt is being reexamined under the harsh light of the Greek tragedy. Most third world debt looks pretty good by comparison. The major emerging markets are all in net surplus balance of payments situations, with falling indebtedness and improving credit. But, they are getting drawn down in the same maelstrom. China’s Shanghai market fell last week and pulled Hong Kong down with it. We had a rather timid rebound from the drops in Latin America last week and those weren’t enough to make the emerging markets positive for the week.
World bond markets had to contend with a rising dollar, but otherwise did fairly well. The major exception to this rule was the UK, where a tightening up of the polls there has hurt the outlook for any kind of fiscal shift from the path they are already on. Every time the Tories slip in the polls, the bond and stock markets react badly. There is a message in there for the everyday Brit voter.
US bonds were mixed on the week. Treasuries were lower and that dragged down many of the high grade segments. High yield bonds were higher, following the stock market to gains.
Real estate securities were generally higher last week in the US. The momentum there is getting absurd. Any good news on commercial real estate is blown all out of proportion while negative news, all the rage until a couple of months ago, gets widely ignored. Oh well, the momentum crowd will have to go on without us.
Commodity prices were mixed but with energy and precious metals prices higher the averages were higher.
Have a great week
Karl Schroeder RFC, CSA
Investment Advisor Representative
Schroeder Financial Services, Inc.