By Bennet Sedacca | 15 October 2008
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How Did We Get into This Mess?
The question I get asked the most lately is "How on Earth did we get into this mess in the first place?" The answer, to me, plain and simple, is GREED. I have stated numerous times that markets world-wide, throughout centuries are dominated by individuals that cannot seem to shake the two simplest of emotions— fear and greed. Markets tend to overshoot in both directions as investors experience fear and greed and it is also why I live by the mantra of "Buy from the fearful and sell to the greedy."
In my own lifetime, I can trace the evolution of this greed back to a fateful day on May 1, 1975, otherwise known as May Day. Until that day, stock brokers charged a fixed commission on all transactions: There was no negotiation. In order to promote competition, the SEC ended the fixed schedule commissions which had been in place since the signing of the Buttonwood Agreement in 1792, the origins of the New York Stock Exchange. It is believed that over the next few weeks, commission rates dropped in half.
This was a wonderful event for investors, but a black day for Wall Street as one of their chief sources of revenue had now started down the road of deflation.
When I began my career as a retail stock broker in 1981, commission rates were still rather high and with interest rates in the mid to high teens: even bond commissions were very high. In fact, the very first bond trade of my career was a sale of $25,000 Sayreville, New Jersey School District municipal bonds, and I was paid a $750 commission (3%). As my career transitioned to institutional sales and trading, markets became more transparent and commission rates plummeted even further.
I recall my last transaction on the "sell side" in 1997 of $25 million of US Treasury Notes for a commission of $250. Talk about deflation. You can imagine that there is not much incentive to live in a world where you trade $25 million of securities, assume the inherent risks of a trade failing or a mistake being made, and only be paid $250 for that risk. This was no longer a wonderful way to spend my day.
Brokerage firms saw this trend developing and began transitioning the traditional stock broker into "financial advisors". Financial advisors would typically advise their clients to diversify their portfolios into various styles using a group of pre-screened investment managers in "wrap accounts." So rather than charge commissions on individual securities, 'managed portfolios' were concocted to 'diversify' their client’s holdings and still be able to charge fees as high as 3% per year.
As an aside, a couple of the wrap program trading desks were my clients while I was an institutional salesman and to be frank, I was never that impressed with what I saw being done for clients, which led me to becoming a Registered Investment Advisor in 1997. To me, the wrap programs looked an awful lot like a bunch of "mutual funds in drag"— except with a higher cost structure.
In addition, there were closed end funds which are just publicly traded mutual funds that raise a fixed amount of capital through an IPO and whose shares then trade as a stock on a listed exchange. But closed end funds carry commissions and fees that equate to as much as 7% percent of the initial Net Asset Value, which means that the investor paying the IPO price was left with about 93% of their money at work on Day 1.
On top of the 7% in fees, the funds were often leveraged by 50% in order to enhance the yield via sales of Auction Rate Preferred Stock (ARS), the very same vehicle that stranded so many investors earlier this year and that we commented on back in February and that so many brokerage firms have settled lawsuits on lately for vast amounts of money.
In June of last year, I highlighted the structure of closed end funds and the dangers that lurked. Now that these dangers have exposed themselves and the prices have gone through a massive correction, we are now finding many opportunities as my firm begins to buy a few select closed end funds that trade at as much as 40 percent discounts to NAV. We may be early, but buying distressed assets at huge yields at huge discounts to NAV is my cup of tea.
So I suppose one might say that I am slowly becoming more bullish in very specific areas and this is a matter of price, and because we have the cash when others sell more out of fear rather than due to a rational investment decision.
In summary, we can trace the lineage of this greed back much further than sub-prime even just in our lifetime, and even though it wasn’t the originator of that deadly sin known as greed, the brokerage industry helped mightily to get us to the point we now find ourselves in. The traditional revenue streams dried up and yields dropped far enough to entice [ordinarily prudent] investors, both individuals and institutions, to stretch for yield— to ignore prudence, and succumb to ever greater amounts of greed.
Where We Are Now
Once traditional Investment products fell by the wayside, investment banks found more and more esoteric vehicles to create and distribute. As the housing market entered its parabolic state, lending standards fell dramatically. In May 2005, banks were warned about their lending practices from the OCC (Office of the Comptroller of the Currency), Federal Reserve, FDIC, Office of Thrift Supervision and the National Credit Union Administration (Home Equity Lending Guidance to Banks). Despite this, many banks continued to lend in a reckless manner that ended with the bursting of the housing bubble.
If it were not bad enough that the loans were being made in the first place, Wall Street was then encouraged by the SEC in early 2006 to lever their balance sheets up to 30 - 40x shareholder equity, up from a more traditional 3 - 4x shareholder equity. And in this push to higher leverage, the world of esoteric CDO’s (Collateralized Debt Obligations) was born. With interest rates and credit spreads at historically low levels, it should come as no surprise that the underlying investments that were carved up into these CDO’s turned out to be horrible investments, even though they were huge sources of income for brokerage firms.
These practices would come back to bite brokers in their hind quarters. I'm not overly surprised to see that there are now exactly 0 investment banks left in this country that are not either part of a bank, converted into a bank, or have gone bankrupt. Greed is a horrible thing and it caught up to all of the investment banks. All one need do is take a look at a chart of the AMEX Securities Broker/Dealer Index to get a sense of just how bad it has been for this industry.
The typical CDO structure of an Asset-backed Securities deal is shown below. In its simplest form, a CDO takes the cash flows from the assets (let’s use sub-prime mortgages as the "assets" in this example) and distributes them in turn to the creditors of the structure on a preferred basis. The senior creditors receive all of the initial cash flow on a priority basis and therefore received the lowest yield. Lower priority creditors received the last amounts of an uncertain cash flow and were in turn given higher 'expected' returns. As the assets on the left side become progressively "impaired" (seriously delinquent, foreclosed or in receivership), the higher grade 'tranches' become impaired or downgraded and then lose value, in turn.
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What you must remember is that when one takes the lowest quality assets, sub-prime mortgages, and then levers them up and carves them up for the sole benefit of the broker/dealer, greed can play a vicious role. Risk does not magically disappear, but instead is magnified and hidden in plain sight behind the elaborate structures. Unfortunately, when these structures stop working, there can be severe consequences for the owners of these securities; banks, brokers, hedge funds, mutual funds, credit unions, insurance companies etc. [[Apparently, those bond rating firms 'forgot'…: normxxx]]
The availability of these 'structures' to soak up low quality mortgages, enticed mortgage originators to make ever more lousy loans, and it should come as no surprise that issuance of these 'sub-prime' loans peaked in 2006 as a percentage of all mortgage originations. See a chart of Subprime Mortgage Originations as a % of Total Originations.
What followed all of the leverage and all of poor lending has been a spike in delinquency rates at both the subprime and prime level, as depicted in the chart below. This is now spreading to the commercial real estate space and to virtually all other areas of credit. See a chart of Mortgage Delinquency Rates.
The Credit Crisis is picking up steam— at a level that frightens even the most cautious investors (yours truly included). It seems that each weekend, we see more government intervention/intrusion/nationalization (as I write this, the UK has just been forced to inject liquidity into the Royal Bank of Scotland and HBOS, 2 of Britain’s largest banks). Whether it is Fannie Mae (FNM) and Freddie Mac (FRE) being nationalized at American taxpayers' expense, a $700 billion "bailout" of US banks, or Treasury Secretary Paulson suggesting he merely wants 'to inject' liquidity directly into US banks since banks will not do business with each other or lend, the 'solution' appears to be the same. Mr. Paulson apparently thinks that using the money of "We the People", without limit, will surely solve the problem. [[Several adages come to mind here: one is, "When you discover yourself at the bottom of a very deep pit, STOP DIGGING!" Also, "One definition of insanity is to repeat the same thing over and over but expect different results!: normxxx]]
Investors have needs. Dreyfus has solutions.
To be sure, this reeks of socialism and is 'delaying' the "business cycle" as I used to understand it. In my humble opinion, the longer the cycle is delayed, the longer it will take for confidence to be regained in the system, not the opposite, as government officials mistakenly seem to believe. After all, haven’t they noticed that every time they intervene/intrude, the credit markets and equity markets sell off right in their face? I certainly have noticed this, which leads me to the conclusion that intervention/intrusion is the absolute worst direction in which to go.
I say let markets be markets, let those that have made mistakes, suffer, and let those that have sinned, pay for their sins. But not with my money. I have spent my adult life, being prudent, saving money, investing wisely (most of the time) and being prudent with other people’s money. It should be my choice if I want to own impaired CDO’s, Fannie/Freddie/AIG and a bunch of impaired bank stocks, not the choice of the Fed, the Treasury, or the Congress.
Perhaps injecting equity into banks around the world will encourage them to lend, perhaps not. More likely, it may be the cushion necessary to allow banks to write down/write off assets and return to lending. The question that lurks in my mind is lend to whom? Consumers have over-consumed for so long that I wonder if freer credit will actually allow the economy to grow.
Why Have Stock Prices Fallen So Quickly?
The pace and severity of the decline in global stock prices has taken many by surprise. I have to admit that although I have maintained a target for the S & P 500 of 500 - 650 for quite a while now, I too have been a bit surprised by the speed at which the avalanche of stock prices has taken place. Then again, I have stated for months that we were living in a world of a Tale of Two Markets, where the credit markets were dying a slow death and the stock market proceeded merrily along in apparent ignorance. So it is my opinion that the stock market has simply caught up to the credit market, a market with little liquidity and loads of assets for sale due to mutual and hedge fund redemptions in addition to margin calls.
The chart below of the S&P 500 says it all— the uptrend from the 1982 was broken and support line after support line has been broken. It is said that, "in bear markets, support exists to be broken." The next line in the sand is in the 750 - 775 area, the area that was the bottom of the previous bear market low in late 2002— early 2003. But if that support line is broken, it brings into view the uptrend line from the 1974 low in the 500 - 550 area. I have no idea if this will occur or if markets will bounce from historically oversold conditions, but will stand by and watch. Please note that we do not currently maintain a position in the S&P, neither long nor short. See a Long Term Chart of S & P 500 in logarithmic terms.
Summary— What would it Take For Me to Turn Bullish on Equities?
- Credit markets need to normalize and spreads tighten.
- Allow markets to function without government intervention/intrusion.
- Equity valuations need to become oversold, not just stock prices.
- A return to ‘Social Darwinism’— allow the weak to fail.
- A rise in the personal savings rate, even at the expense of recession.
- Leverage reduced at the corporate and consumer level.
- Presidential cycle to reach a low (October 2010).
- LIBOR to normalize.
- Most importantly, we need time to heal the market, not just price.
When I consider the bullet points above, I think of the lyrics at the outset of this piece from my teenager days. I believe that the markets have not been permitted to react on their own in a traditional manner since at least 1997 and the later Greenspan days. Instead, we suffer from chronic dependence on a Fed/ECB/Treasury that [understandably] seems far more interested in asset price increases than they do in 'price stability' and normal business cycles.
Government officials have the fight of their life on their hands and it appears that each time they intervene it delays the ultimate economic outcome, and possibly even reduces the bottom in equity prices further than I can imagine. [[Currently, they are trying to staunch the hemorrhaging of tens to hundreds of trillions of dollars in "credit money" with sums that are still vastly below $10 trillion.: normxxx]]
The avalanche in equity prices has begun and when I think of the amount of assets that have been lost in so short a period of time, I shudder. Pension plans around the globe are now woefully underfunded. In addition, mutual funds and hedge fund redemptions will continue into year-end. See also, Global systemic crisis – End of 2008: Pension funds go off the rails
Earnings estimates will fall dramatically, unless credit spreads and LIBOR normalize quickly. We are possibly about to enter a period of substantially higher tax rates on high wage earners. Margin clerks are busy asking traders to sell, and mutual funds and 401(k) plans have liquidity and credit problems. Credit issues are now spreading to commercial and construction loans— not to mention rising credit card delinquencies. Unemployment is certain to increase further and many more jobs will be lost to emerging markets.
The point here is not to depress anyone or to sound like a spoil-sport. Instead, we must face the issues at hand and deal with them in a fashion that is not a constant "Band-Aid." The only way stocks could be deemed "cheap" here is if we believe the Wall Street S&P 500 estimates of 2008 estimates of $75 per share. We actually think 2009 earnings will come in around the $55-60 range, at best, which would suggest an index price target (if a "normal secular bear market bottom" P/E ratio of 8 to 10 times earnings) that coincides with the price on my S&P 500 chart of 500 — 600.
Bounces along the way are inevitable, but for a true bottom to be put in place, some more work needs to be done to the downside. This may be a trader's paradise, but investors beware.
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Normxxx
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