FSO editorials

It's Déjà vu All Over Again

by Richard A. Eckert, CFA| August 7, 2009

Some very predictable patterns are beginning to emerge in the capital markets. The same trends of “boom and bust” have appeared in both the debt and equity markets in each of the last two years. 2009, for instance, looks eerily similar to 2008. Let’s synopsize that last year:

Last Year's Pattern

The market cratered in the early part of the year, reaching a new low in mid March when the Fed, for all intents and purposes, seized Bear Stearns and sold it to JPM. The equity markets hailed that as a turning point, an “inflection” and rallied furiously through the end of May. In June, new concerns about financial institutions and their asset quality—as well as the broader economy, which appeared to be grinding to a halt—caused the rally to sputter and, gradually, to reverse course. The retreat continued on into July, when IndyMac was seized and whispers about the deteriorating health—indeed, questions about the solvency—of Fannie and Freddie began to be heard. However, better-than-expected results, particularly at the large banks reporting in July, and passage of legislation authorizing the U.S. Treasury to explicitly guarantee the obligations of FNM and FRE, rekindled investors’ enthusiasm. Indeed, their ardor.

The only disappointment that earnings season was Merrill Lynch, which reported a huge MTM loss on its CDOs, a large part of which were sold to Lone Star of Texas at something like 22 cents on the dollar. Furthermore, Merrill financed 75% of the deal non-recourse (meaning that, if Lone Star defaulted, Merrill would once again own those CDOs). Merrill was the only big broker/dealer reporting on a calendar year basis at the time. The other 4 reported on a November or February fiscal year until GS and MS became bank holding companies in September 2008. Activity subsided and the markets traded sidewise for much of the last three weeks of August as they typically do.

Then, seemingly out of nowhere, in early September, Paulson seized FNM and FRE after learning that, absent direct government responsibility for those two institutions’ obligations, new debt would require coupons in the mid teens. A week later, a deal between a Korean sovereign wealth fund and Lehman which would have infused desperately new capital into the latter fell apart. A week after that, Lehman filed for bankruptcy, igniting a powder keg underneath the core reactor of the global financial system. Covenants on cross-lending and cross collateralization agreements were breached. Events of default on trillions of dollars (notional principle) of CDS were declared. The core reactor nearly melted down. Just figuring out who owed whom what added fuel to the fires and an air of chaos to this crisis of historic proportions. But the then Treasury secretary, Henry Paulson started talking of a $700 billion bailout—to this day, I can’t figure out where he got that number (probably something Lloyd Blankfein whispered in his ear as they rode down the elevator to the garage in Goldman’s midtown NYC HQ, from which Paulson was working at the time). Which calmed the markets temporarily. But, in the wake of the Wamu and Wachovia seizures—ironically, both of which reported better-than-expected operating results (lower-than-expected losses, I should say) in July—and the failure of Congress to approve of a bailout on the first go-around, the markets went into a free fall into October. Disappointing earnings, uncertainty following the election, and ominous economic indicators reinforced the trend in equity valuations in the first three weeks of November.

The last major movement in the equity markets, the impetus for which continues to elude me, was a rally spanning the last 5 – 6 weeks of the year. The only thing to which I can attribute the rally were the smaller-than-anticipated declines in retail sales during the critical Christmas shopping season for retailers. The better-than-projected results, however, were the product of sharp discounts. Margins in the retail sector collapsed. Operating results for the quarters that included December were among the worst on record for individual retailers, many of which filed for bankruptcy late in 2008 or this year.

In 2007, it was the ABS and credit derivatives markets that followed this very same pattern.

Another Repeat in 2009?

Now, we are seeing yet another repeat of the same pattern. Meltdown in the first two-and-a-half months of the year. Furious rally. Pause. And finally, a re-ignition of the excitement on terrible revenue and earnings reports because they weren’t as bad as expected. Even though many corporations beat the consensus estimate—basically strictly enforced guidance—when that bar had been deliberately set ridiculously low.

Reaction to third quarter numbers will bear watching. Revenue is still in free fall. Consumer spending fell 1.2% in Q2 despite record stimuli from both the U.S. government and Federal Reserve Bank (transfer payments up 33% on an annual basis and tax payments down by the same percentage on the same basis). And there is a limit to which many companies can cut costs without permanently reducing capacity and the size of their franchises. But expectations are now much higher. Really, what can publicly traded companies do for an encore? I am also confident there will be some kind of budget impasse at the federal level in September, which will distract the White House and Congress from economic policy and additional fiscal initiatives. I fully expect that the federal government will start the new fiscal year in October with a continuing resolution (a continuation at FY09 levels) rather than an official budget.

But even if third quarter earnings reports do not expose ongoing weakness in consumer spending and the resultant permanent loss in corporate earnings power—earnings may grow, but at a tepid pace from a lower level—fourth quarter earnings and 2010 guidance most assuredly will. Even those companies capable of reporting respectable increases in earnings will be very cautious, very conservative in the outlooks they give investors. I can’t guarantee anything, but I am willing to bet some of my own money that 2010 guidance will come as a big, big disappointment to those dwelling on Planet Goldilocks. Other disappointments, if not outright disasters—from this observer’s crystal ball—will be retail sales during the critical Christmas shopping season and the GDP’s slip into negative territory as the calculational benefits of exhausted inventories, declines in net imports and zero or below-zero numbers in the real GDP deflator in Q3 give way to the reality of declining incomes, sales and output in Q4.

Watch Banks in 3rd and 4th Quarters

Finally, I am positive that some time during either the 3rd or 4th quarter that a large number of banks—large and small—will no longer be able to hide their liquidity issues behind the debates over “mark-to-market or “mark-to-model” and the adequacy of loan loss provisions and the carrying value of OREO. The fact of the matter is that many, especially the larger institutions —and especially if one takes their off-balance sheet liabilities into account—are still highly leveraged. It just doesn’t take a very large percentage of their earning assets (loans and securities) to stop cash flowing before serious problems arise in meeting routine obligations as they come due. Overnight repos and FHLB advances, maturing time deposits, regular DDA and money market account withdrawals, payroll, vendor invoices, taxes, FDIC assessments, etc. I know I have dragged its name through the mud ad nauseam in this forum—but still not often enough for my liking—but the late great “Goin” Downey comes to mind. When the OTS seized it, 12 ½% of its loans were delinquent or in foreclosure; two-thirds of these were 90+ days delinquent or in foreclosure. Another 9% were restructured (modified), only one-third of which showed up as problem loans. So, over one-fifth of Downey’s loans by unpaid principal balance (UPB) were either not making any payments or making them at a lower-than-originally contracted rate. Meanwhile, some of its obligations were coming due every day. FHLB advances, for example. Although the FHLB-SF will roll over overnight advances, even from troubled institutions like Downey, it will only do so if they can prove they can extinguish it in its entirety first. So, to obtain another overnight advance, Downey had to repay the original, even if just momentarily, just to demonstrate it had the liquidity, the wherewithal to do so. I’m certain that it was something like this that tripped Downey up and forced the OTS to seize it. Unlike the “Crack Daddy” (a.k.a. IndyMac Bunko), there was no Chuck Schumer-inspired run on the bank. The liquidity issue here was that there was too much cash going out and way too little cash coming in.

There are dozens, if not hundreds, of regional and community banks facing this kind of issue. And a few superregionals as well. Given the concentration of their portfolios in commercial real estate and construction (both SFR and commercial) and the likely withdrawal of $100s of billions of uninsured deposits in the coming months—totaling $4.3 trillion among FDIC-insured institutions, mostly business payroll and other accounts as well as individual accounts exceeding the $250,000 limit on deposit insurance—I am positive we will finally see primary regulators forced to act. It is my understanding that the FDIC is now fully staffed and fully equipped. And the inadequacy of its reserves—now down to less than $20 billion—is irrelevant. Protecting depositors is now the explicit responsibility of the U.S. government. The only reason the FDIC has not started taking over these problem institutions more aggressively is that it can only act when appointed receiver by the primary supervisor—the OCC, the OTS, or state banking departments. As long as liquidity wasn’t an issue these primary supervisors were loath to act—mostly, I believe, out of a fear of losing face, credibility. Remember, the heads of these organizations aspire to higher office or appointment. Or a lucrative job in the industries they supervise. Very few want to appear incompetent to the general public. So, they have given essentially failed institutions a lot of rope, urging them to find buyers or capital infusions. Hasn’t happened. Buyers are not willing to buy at prices sellers think their institutions are worth. And new capital has come with too many strings. Loss of control. New management. Additional directors. So primary regulators have let these banks and thrifts sit out there in limbo. Perfect definition of “zombie” banks. If, as I foresee, liquidity becomes not just a problem, but a crisis at these institutions, their primary regulators will be compelled to step in and appoint the FDIC receiver. They cannot jeopardize the safety of the deposits—or else depositors will flee the system en masse, despite any assurances they receive that their money is insured.

History to Repeat?

I guess what I am taking all of this space to say is that I expect the 2007 and 2008 patterns to repeat themselves. Not only for the reasons outlined above. But because certain self-destructive behaviors are hard-coded into human DNA. Designed by nature or the deity—whatever one believes in—to periodically cull the human herd, these behaviors are the reasons history repeats itself and people keep making the same mistakes. Among the most destructive of these behaviors are those driven by fear, greed and ego. Unfortunately, they seem to be the primary motivations behind most human decision-making. Rationalism and rational expectations are a myth perpetuated by Western political, religious, social and educational institutions. I mean really, would rational thought support a DJIA of nearly 9300 and an S&P 500 of over 1,000 in an era of shrinking employment, wages, and availability of credit—and, therefore, spending power—declining corporate earnings and, thus, business investment, multi-trillion dollar deficits (which will balloon into the tens of trillions once baby boomers become eligible for Social Security and Medicare benefits), homes being bought as speculative instruments or income-earning assets and not shelter, rapidly rising food and energy prices, and even more rapidly rising savings rates given the devastation wrought on most nest eggs (which took the form of home equity and 401k stock portfolios), and onerous debt service requirements forcing both households and financial services institutions to deleverage (which has the mutually reinforcing effects of making less money available to lend and devoting a larger share of incomes to reducing the outstanding balances of debt)?

And if rational expectations prevailed, wouldn’t the market value of all securities reflect all that is known and knowable about those securities? If markets were efficient, wouldn’t those securities be perfectly priced at all times? How, then, does one explain the arbitrage that keeps 100s of thousands, if not millions of traders, bankers, salesmen, portfolio managers, analysts, brokers, etc. employed at above average wages the world over? In a rational world, they’d all be order-taking clerks and there certainly would be fewer of them. I am always bemused by those who, at the same time, both embrace the “efficient markets hypothesis” and make obscene amounts of money exploiting the inefficiencies in the markets.

Some have argued—and apparently their arguments have fallen on deaf ears—that the resurgence in the capital markets is a government-led recovery. Supporting their theses have been data suggesting that the increases we’ve seen in total equity and debt market capitalization approximately equal the liquidity provided by fiscal and monetary stimuli. I’ve attached one such thesis. I guess that this is the mandate of equity investors in the post defined benefit era: to sop up excess liquidity. Prior to that era, institutional investors invested with a purpose, usually to meet projected benefit obligations, cover projected claims liabilities, or fund endowments or philanthropies. Now they are completely (mis)guided by naked fear, greed and ego. They invest against their better judgment because they can’t be seen on the sidelines while the market is running up 40%. They fear they will lose their investors and their jobs. They know stocks are overvalued, but by riding their momentum and merely earning a market rate of return, they can generate meaningful management and performance fees, thereby boosting their own pay without breaking a sweat. And look like geniuses in the process.

Getting back to the thought about U.S. government and Fed stimuli providing all of the increases in equity and debt market values (high yield bonds are up an astonishing 37%, nearly 3x the increase in investment-grade corporates, notwithstanding the expectation of many participants in that market that “junk” bonds will experience much higher losses than those observed over the last decade). The trouble is, no good can come from these stimuli-induced returns. The markets become addicted to them (and most equity investors are junkies). Withdraw them and the Dow is right back to 6500—or lower. Keep providing them their fix and one runs up huge deficits, resulting in higher long-term rates and borrowing costs (and the Treasury will be issuing new debt a lot faster than Ben can buy it), crushing any nascent recovery and the market value of debt and equity securities. This is the worst kind of “cold turkey”.

Also playing a role in the repeating pattern of decline-rally-decline are the perverse incentives embedded in most professional money managers’ compensation packages. Many institutional money managers’ performance is measured against that of the major indexes. Therefore, they have to be invested in the indexes. Even if they know that index values are not supported by economic fundamentals or financial performance and market momentum is ultimately unsustainable. And even if they want to generate a little alpha and earn themselves a little extra bonus, they will not stray too far from the indexes. The reward structure is asymmetrical. Portfolio managers lose a whole lot more by failing to keep pace with the market than they gain by surpassing its performance by several percentage points. Finally, if they are on the same bus with every other money manager when it drives off a cliff, they will most likely keep their jobs. They can rationalize their failure to see the end of the road by claiming that nobody else saw it and their performance was no worse than any other asset manager. Many hedge fund managers also become relative return managers in a rising market, because if they cannot at least equal the performance of the major indexes, they will lose clients, AUM and market share to traditional money managers. Unless they can be very nimble, very agile, they, too, will be on the same bus.

So, while I expect this year’s story to unfold in the same manner and same sequence as last year’s story—and the 2007 ABS and CDS story—I do not necessarily expect it to play out over the same timeframe. I believe the market will trade sideways for most of the rest of this year, with the Dow perhaps breaching 9500 and the S&P 500 surmounting 1050. I think we will hear the same refrains during the Q3 earnings season that we heard last month: “earnings weren’t as bad as expected”, “XXX company beat consensus on the bottom line”, “revenue and earnings declined y-o-y, but at a decelerating pace”, “corporate earnings are approaching a bottom, if they aren’t already there”, and “green shoots are abounding everywhere in corporate earnings reports”. Also, the change in real GDP will probably be positive in Q3, even if it is just the result of restocking (and not necessarily end demand), sharp declines in imports and negative inflation (deflator in the real GDP equation is something akin to core CPI in that it conveniently omits food and energy). Thus, I am not anticipating any significant correction until the end of the fourth quarter or just beyond, when the combination of sobering earnings guidance (as well as, possibly, a few major earnings disappointments) and the report of renewed contraction in the economy I foresee turns those green shoots into weeds. Intensifying the downward pressure on stocks will be the deflation of expectations, which—if everything unfolds as I predict—should be pretty lofty by yearend.

Contact Information

Richard A. Eckert, CFA (415) 674-4996 | San Francisco, CA | Email