By John Bougearel | 22 February 2010
Author of Riding the Storm Out: What Do Investors Do Now?
Risk is ubiquitous. Markets misbehave. Financial crises are hardy perennials. Wall Street crashed. The private sector blew up. Again! Yet in 2009 U.S. policymakers managed to extinguish the raging fires on Wall Street[[— at least one more time!: normxxx]] By all appearances it would seem that our policymakers have orchestrated a successful rescue of both our stock market and by proxy our economy.
And our policymakers do concur with that view. US Treasury Secretary Timothy Geithner told NPR's Michele Norris in a December 22, 2009 interview that "the policies that the president put in place are helping lay the foundation for growth and job creation" Americans "can be more confident about their financial future, financial security" and promising that "We're not going to have a second wave of financial crisis. That is something that is not acceptable and we will prevent that". Blah, Blah, Blah.
But are the "Nunca Mas" [[Spanish for "Never Again": normxxx]] policies that the administration put in place, really sufficient? Have policymakers really tamed the misbehaving financial markets that hold the private sector of our economy hostage? Have they really brought to heel the marauding Wild West of the OTC Debt and Derivatives markets that drove our economy to the brink of a Great Depression?
In short, can the US Treasury Secretary really claim that 'all is well', and will 'continue to be be well' from now on? Most importantly, can Americans really be confident about their financial futures and secure in their jobs? Or is there yet to be a malevolent and violent second act to the crash of 2007 - 2009 that followed the private sector boom of 2005 - 2007— that culmination to the 'easy' money so liberally dispensed by Alan Greenspan? [[Is the 2009 'boom' the beginning of a 'new' day, or merely the anti-climax to the end of the 'old' order? : normxxx]]
On general principles, history suggests risk has not been eliminated by the policies put in place in 2009. History indicates risk can't be fully decomposed, nor can markets can't be fully tamed. And crises, well, crises, they just happen. Confronted with these realities, portfolio managers devised models long ago to help investors 'decompose' market risks. It's called diversification.
Standard and Poor's analyst Sam Stovall asked a pertinent question in 2009, "Did diversification fail during this bear market?" To answer his own question, Sam created a theoretical model charting the total returns of a weighted portfolio that was 60% SP500 equities and 40% long term US Govt Bonds. In 2008, it shows this diversification model lost -13%. (chart not shown)
Given that a total equity portfolio comprised of the SP500 lost 39% in 2008 (before dividends), it is clear that this particular diversification model may have absorbed some of the shock for investors because the losses in the SP500 had been partially offset by 19% year-end gains (before interest) in the 30 year Gov't bonds. At first blush, Stovall's diversification model appeared to have been a fairly effective if rather blunt tool in 2008.
But is diversification sufficient? Sam's diversification model dating back to 1929 shows a highly erratic model whipsawing in and out of negative territory. What is more, as we shall see, Stovall's diversification model behaved much like a boomerang in 2008-2009.
On balance, if diversification could fully tame market risk, the oscillations shown in this model should have been much smoother. The premise of diversification, then, appears valid, but insufficient to protect investors from excess market volatility. Upon closer examination of Stovall's model, too, it was only by a bizarre sequence of non-recurring events in the final two months of 2008 that even made it at all possible for the long term bonds to offset the steep losses in the stock market.
To wit, most of the 30 year treasury's 19% gains in 2008 occurred after Ben Bernanke's December 1 2008 'quantitative easing' statement and his December 16 2008 race to embrace a zero interest rate policy. Barring these extraordinary policy actions in December 2008, there would have been little to no offset by holding long term government bonds. Moreover, the fixed income holdings of actual balanced portfolios for most investors were not 30 year long term bonds. Hence it is likely that the majority of 'balanced' portfolios did not benefit at all from the special actions of Ben Bernanke in December 2008.
If diversification is not a stand alone tool, what then can investors do to smooth out market risk and volatility inside their balanced portfolios? I submit that investors take a slightly more active risk management approach than simple diversification. Returning to Stovall's theoretical model, we note the bear market of 2008-2009 exposed a boomerang effect in total returns. What goes up largely in one year tends to go down significantly in the next.
Subsequent to years that produce high returns in long term bonds, it would have made sense for investors to reduce their exposure to long term bonds, and conversely. For the 30 year bond in 2008 (up 19% y-o-y before interest), it would have made sense for investors to reduce their exposure in 2009 (when the 30 year lost more than 16% y-o-y of its value). Likewise, during years that produce high stock market returns such as 2009 did (up 23.4% y-o-y), investors should anticipate that subsequent years are apt to reflect substantially lower or negative stock market returns (for example, which could potentially occur in 2010-2012) as valuations and other market considerations might become unsustainable.
Taking an active risk management approach towards diversification for investors entails rebalancing asset allocation mixes to reflect shifts in market risks. Investors can rebalance equity and fixed income weightings upward or downward on an annual basis to achieve the desired mix. For example, in the three years subsequent to 2009's positive equity returns, the proper allocation mix of a diversified portfolio might be 40% equity and 60% fixed income, or less depending on your risk tolerance.
Rebalancing one's asset allocation mix is an underutilized tool. Investors tend to neglect rebalancing their portfolios much because they are generally advised to just overweight equities when they are young and overweight fixed income when they are old. (I suffered from this flawed approach to investing in the 1987 crash.) But overweighting equities does nothing to help a younger investor avoid downside market risks.
To illustrate this simple but very important point, consider the theoretical young investor that made his or her initial equity investment in the SP500 on January 1 2000. Ten years later on January 1 2010 that initial investment would be down 25%. So much for that head start in life!
When the stock market misbehaves erratically, it behooves investors to heed these market signals and rebalance downward to reduce their equity exposures for a spell until the headwinds pass. Once the storm passes, then it is time to consider rebalancing these equity positions upward, or not. While 2009 did generate generous stock market returns for investors, it won't be too long now before the market risks and headwinds we faced in 2007-2008 return.
[[I predict that they already have; the market is once again "fully priced" and, barring some kind of economic miracle, is at best likely to meander sideways for the next several years— and that doesn't take into consideration the very real possibility of a 'relapse' about here; the second dip of a 'double dip' recession.: normxxx]]
The balance of this report will address the potential malevolent and violent backlash American's will face in 2011-2014 from the private sector boom of 2003-2007 that went so dramatically bust in 2007 -2009. Specifically, this report will look at how the follow-on 'restructuring phase' of the debt cycle initiated in the 2004-2007 commercial real estate 'leveraged buyout' (LBO) boom phase will impact the economy and the lives of nearly all Americans in 2011-2014, notwithstanding the Treasury Secretary Geithner's false reassurances. Moreover, readers should pay special heed to the prevalence of "lax underwriting" standards for commercial real estate (CRE) loans and the "covenant-lite" structures of the LBO loans during those boom years. The lack of safe and sound underwriting standards for both CRE and LBO loans during the boom phase of the cycle present substantial downside risks for the debt restructuring scenarios presented below.
Before presenting the details of the imminent restructuring phase, it is worth pausing for a moment to consider the "investment advice" President Obama gave Americans on March 3 2009: "What you're now seeing is— profit and earning ratios are starting to get to the point where buying stocks is a potentially good deal if you've got a long term perspective on it". Unfortunately, President Obama looked right past the heap of trouble the financial markets and U.S. will face in 2011-2014. This will likely prove to be a big mistake, comparable to the mistake Greenspan made in 2004 when he advised folks to secure their homes using ARMs.
Restructuring The Debt Of The 2004-2007 Boom
What most folks are probably unaware of is that the credit that went towards creating that commercial real estate and leveraged buyout boom during 2004-2007 needs to be refinanced between 2011-2014, because these types of loans typically have 5 to 7 year maturations. The risk, simply put, is that the collateral for the bulk of those loans is simply not worth today what it was three to five years ago. Nor will these loans be worth what they were during the boom years when it comes time to refinance the terms of those loans.
The bust at the end of the boom years has created a funding gap between assets and liabilities for both commercial real estate and for LBO loans. In industry parlance, the assets are simply not worth as much as the liability that they assumed during the credit creation boom. That asset/liability mismatch gap will have to close. Call it the Great Convergence Trade, if you like. Whatever you choose to call it, the convergence is going to create quite a bit of unpleasant turbulence over the next three years, and not for just the borrowers of these loans, but for all Americans.
In contrast with the Treasury Secretary's assurances that another financial crisis is unacceptable and would never happen again, the February 2010 Congressional Oversight Panel (COP) forecast $200 to $300 billion in losses coming from the commercial real estate loans, the bulk of which will hit the economy in 2011-2014, peaking in Q2 2012. (chart not shown) Commercial property values, they noted, had fallen more than 40% since the beginning of 2007. They added:
From the COP:
Note from the foregoing COP report that the "current" lack of investor appetite for CMBS is largely a reflection of and attributable to the lax underwriting standards that were applied to the original loans when written in 2004-2007. It is not a bold predictive statement to infer that investor appetite for CMBS is probably going to be next to non-existent through 2014 (see Figure 6 in above report). An absence of investor appetite for CMBS presents upside risks to the COP's forecast of $200-$300 billion in losses stemming from commercial real estate loans. And in turn, this would mean even more job losses in the private sector and lost revenues to State and local governments.
At the same time Americans find themselves shell-shocked from the commercial real estate markets, suffering banks are also going to be assaulted by a huge surge of refinancing required by the LBO and M&A loans maturing in the 2011-2014. Unfortunately, like commercial property values that have fallen 40% since the beginning of 2007, the equity valuations of many of these LBO's and M&A's have similarly fallen. Banks won't be in a position to refi the original loan amounts. So, it would not be surprising to see a series of LBO and M&A defaults triggering corporate bankruptcies resulting in the loss of even more American jobs.
According to McDermott Will & Emery's Gary Rosenbaum and Jean Leblanc, "debt issuances for leveraged buyout (LBO) transactions surged from $71 billion in 2003 to $669 billion in 2007. The majority of these LBO's were covenant-lite deals, meaning that the loan documents contained few or no financial covenants." In short, we should expect to find material omissions, similar to the material omissions Greece made with respect to its sovereign debt obligations (with a little help from their friends at Goldman Sachs— must be nice to have such helpful friends in investment banking) in many of the transactions that occurred during the LBO boom. Material omissions in one's financial statements, prospectuses, sales literature, etc. erode ones financial credibility WRT potential lenders, whether you are a sovereign or a corporate entity.
Sure, material omissions may be readily 'overlooked' during a private sector boom. But just try getting away with the discovery of material omissions when it comes time to restructure the loans 5 to 7 years after the private sector boom has gone bust and remains busted. Corporate borrowers may find themselves shunned by the investment community altogether and locked out of any chance of refinancing. While that may be just deserts for private equity and corporate executives, defaults and bankruptcies in the LBO space will create significant collateral damage to their employees who suddenly find themselves out of a private sector job. In turn, this means even more people on the dole requiring extraordinary government (eg, unemployment insurance and medical) services and lost revenues for all levels of governments.
Rosenbaum and Leblanc note that the friendly environment LBO borrowers found themselves in during the boom years has vanished. Those borrowers "will be facing a decidedly different environment as their 2005-2006 vintage credit facilities mature during the next few years. They will find fewer refinancing options" since the number of potential providers of new loans have declined. In fact, many of the loan providers such as Lehman Brothers have "disappeared" in the wake of the last financial crisis. Moreover, many of the remaining LBO 'investors'— such as Citi, Bank of America, Wells Fargo, etc.— are still experiencing financial difficulties of their own.
So many of the investors that are still around and had "previously provided a significant amount of liquidity are no longer actively participating in the lending market". The future outlook for borrowers in the LBO space is about the same as that for commercial real estate borrowers— a decided lack of investor appetite, which can in part be attributed to a few principal reasons.
First, the mismatch between assets and liabilities. That is, the borrowers' assets simply do not any longer cover the amount that they borrowed during the boom years and will want to 'roll-over'. Second, the lax underwriting standards used in many of those 'covenant-lite' deals. In many cases, the underwriting of these loans by the commercial and investment banks is simply not credible. The commercial and investment banks could simply refuse to 'eat their own cooking', ie, refuse to provide new financing terms altogether.
In fact, many of these financial vultures will more than likely be placing 'short' bets against the weaker commercial real estate and LBO borrowers before their loans mature. (GS has already demonstrated a willingness to do so— in many cases betting against the very people— supposedly 'clients' owed some degree of honesty and fair dealing— to whom they 'sold' these loans in the form of CMBS.) Thus, the reckless lending activities of 2004-2007 could have substantial negative feedback consequences for the credit markets in 2011-2014.
To the extent that financial intermediaries are willing to work with LBO borrowers, "lenders are showing extreme caution in refinancing many of these loans, leading to more defaults and bankruptcy filings". Many LBO borrowers "find themselves without any realistic refinancing prospects". Standard and Poor's estimate that corporate loan defaults will skyrocket from 4.5% in 2008 to 14% or higher in 2010. What is worse, the schedule of non-financial corporate borrowers LBO debt maturities will "increase each year until they peak in 2012" concurrent with the schedule of commercial real estate loan maturations peaking in Q2 2012.
Rosenbaum and Leblanc conclude that
The already high unemployment rate is creating a huge burden on most state and local governments throughout the country. And it seems that this will only worsen over the next few years. This view is consistent with the forecasts from the Center on Budget and Policy Priorities' Jan 28 2010 report, which notes that the recession is causing more than 41 States to report budget shortfalls. Budget shortfalls in fourteen States are estimated to exceed 17% of their General Fund Budgets in 2010:
Of course, the policy recommendations by the Center for Budget and Policy Priorities for the US government to provide additional fiscal stimulus to state and local governments and what State Governors expect to receive from the federal government may conflict with President Obama's January 2010 announcement "to freeze" government spending for three years beginning in FY 2011 (October 2010). The Center for Budget and Policy Priorities noted in their January 28 2010 press release:
At least eight governors' State budget proposals assume that Congress will extend the increased federal funding for Medicaid enacted in last year's Recovery Act, the report explains. If Congress doesn't extend it, those States likely will make substantially deeper and broader cuts than their governors are now proposing. Without further federal aid, the actions States will have to take to close their budget gaps could cost the economy 900,000 jobs.
The Center for Budget and Policy Priorities noted, in their February 18 2010 reports, not surprisingly, that demand for State services actually rise during recessions. They argue that cutting more of these services now will only exacerbate the problem. Yet cutting more services is exactly what State governors are planning to do with their 2011 budgets. [[And, indeed, is the only option realistically open to them.: normxxx]]
Bloomberg's investigative journalists Christine Richard and Darrell Preston report that state and local governments struggling to survive the recession are now "seeking concessions from creditors of public projects, including bond insurers". The concessions local governments are seeking pose a new threat to the bond insurers or "monolines" that are currently 'backing' $1.16 trillion of public debt. The monolines were almost bankrupted in 2007-2009 by $11.6 billion of claims on collapsed securities backed by mortgages. [[A mere 1% of their potential liability for public debt.: normxxx]]
It is little wonder that bank lending has been curtailed and will continue to contract for several more years. It is also little wonder the Basel committee and the FASB granted the banks until 2013 to get their balance sheets in order and meet stricter reserve requirements. That is precisely because the peak of the loan restructuring cycle for CRE and LBO borrowers will be in 2012. I have always feared that the financial 'shock and awe' of the last crisis may just be a prelude to the further financial shocks that are coming due by 2012.
Unfortunately, US Secretary Treasury Geithner cannot promise that America will not shortly face another financial crisis without its having a false ring to it. Not given the way that the banks structured all of these loans from the previous boom that will need to be refinanced during 2011-2014. The CRE and LBO loan maturations peaking in 2012 amount to 'financial weapons of mass destruction' with delayed fuses.
The next seizure in the credit markets will coincide with the peaking of these loan maturations. For the Treasury Secretary to claim there won't be a second wave to this financial crisis, or that 'they' can prevent it— that Americans can be confident about their financial futures and job security— is just so much Blah, Blah, Blah. At the very least, market forces will sorely test Mr. Geithner's hypothesis that all is well and will remain well from now on.
In its totality, the restructuring cycle that lies ahead is largely about funding the debt-to-equity gap between the overvalued commercial real estate and LBOs. Present day cash flows and valuations can not support the enormity of the CRE and LBO debt issuance that occurred during the 2004-2007 credit cycle. Haircuts, defaults, bankruptcies, will have to be taken [[all of which are hugely deflationary: normxxx]]. But the present mismatch between liabilities and assets, the gap, will have to be closed.
The risks and burdens posed by this restructuring phase in the CRE and LBO spaces will be significantly heightened by 'discovery' of fraudulent and quasi-fraudulent material omissions; namely, the widespread prevalence of the lax underwriting standards and 'covenant-lite' loan documentation. As the full force of the 2011-2012 restructuring cycle gets underway, the equity and credit markets will once again founder. Investors may rest assured that credit spreads will widen during this time window. When this happens, balanced portfolios will experience a boomerang effect.
As the equity and corporate debt markets are repriced downward, long term treasuries will provide investors valuable diversification. Until the restructuring cycle in the CRE and LBO space reaches and passes its peak, thereby closing most of the unfunded gap between assets and liabilities, investors that are overexposed to the equity markets will be hurt. Once the Great Convergence between assets and liabilities results in a sounder match-up in the private sector, equities and private debt will outperform and investors overexposed to long-term treasuries will then be hurt.
Hence the principle of the boomerang effect which will recur in balanced portfolios that are structured similarly to the Standard and Poor's 60:40 diversification model above. With all this doom and gloom, however, isn't there any silver lining for investors? Well yes, actually there is! Once the restructuring cycle clears away most of those private sector's unfunded and partially funded liabilities, the private sector of America should be on a much safer and sounder foundation. Then the US Treasury Secretary can say that a foundation for growth and job creation is in place and stand better than a 50-50 chance of being right.
Such news will bode well for both the economy and the stock market. But, in the meantime, prudent investors must hunker down. The next great opportunity for the stock market, and even commercial real estate investors won't arrive until after the peak of the next financial crisis which looks like it is going to hit apocryphally in 2012— and only for those investors prepared with cash. Crises precede opportunity. Opportunity only exists if the crises are successfully resolved— and that opportunity can't happen until we have passed through the peak of the loan restructuring cycle in 2012.
The private sector should be lean and mean and ready to grow substantially by 2013. The only thing left for Americans to worry about once the private sector has been stabilized will then be the funding of the public sectors liabilities; namely the US government's financial and social obligations to medicare and social security. The public sector to be sure, will be forced to undergo a restructuring cycle as well. But this will occur at a later date and so is a story for another day.
However, looking past 2014, if the U.S is to remain an operationally viable going concern, "how it goes about it will be crucial to its success" says Richard Duncan.
In the meantime, there is one other extremely significant and patriotic thing that would behoove all Americans (us, the little people, the forgotten people) to do between now and the next financial aftershock. And I urge everyone to do it. In the meantime… we can move our money and we can move our credit cards out of the 'bad' banks and into the 'good' banks, [[into banks that are safe and sound and community oriented— rather than motivated solely by greed and the 'fast' buck.: normxxx]] We can start transacting with the good bankers at good banks. This is a feel good opportunity for us all.
As Arianna Huffington and Rob Johnson put it:
Leaving our money sitting on the ledgers of the big banks is a waste of our capital resources. In their present weakened financial condition, and until the restructuring phase passes, most such banks can only hoard— not lend. Deposits on the balance sheets of the big banks have the net effect of building bridges to nowhere as far as the eye can see. There is only one hitch, how do we find the George Bailey's in our communities to do our banking business with? Well that matter has been solved for us thanks to the volunteer services of Institutional Risk Analytics (IRA, they're the 'good bank' analysts).
Simply go to http://moveyourmoney.info/. Click on the button that says Find A Bank Or Credit Union. Put in your zip code. Get a list of sound community banks near you. The IRA only list banks that get a grade of "B" or better according to its (A+ - F) rating system. That's all folks, be ready to hunker down by 2011, and see you in 2013! Sign up for webinars, free monthly newsletters, etc.
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