Harry Newton's In Search of The Perfect Investment
Technology Investor. Auction Rate Securities. Auction Rate Preferreds.
8:30 AM EST Monday, May 19, 2008: I
am dipping my toes back into my favorite Vanguard funds. I had sold out of all
of these in November, thinking the market would crater and I'd be proven brilliant.
In fact, I'd have been more brilliant if I had come back in on April
1, not the third week of May.
just goes to prove, once again, that you can't time the market. Now,
I knew this when I pulled out. But I figured the markets would totally crater
-- like big time. But they didn't -- though, knowing my luck, they may still.
you read the financial press, you'll get enough doom and gloom to thoroughly
depress you. There is serious inflation in oil and food, which will affect
consumer spending -- two-thirds of the economy. That's not the part that worries
me (and my friends). They worry about the credit crunch, which has curtailed
their borrowing for all their various "projects" (especially real
estate). There's an excellent survey on banking in the latest
A depressing excerpt:
If the crisis
were simply about the creditworthiness of underlying assets, that question
would be simpler to answer. The problem has been as much about confidence
as about money. Modern financial systems contain a mass of amplifiers that
multiply the impact of both losses and gains, creating huge uncertainty.
Poor's, one of the big credit-rating agencies, has estimated that financial
institutions' total write-downs on subprime-asset-backed securities will reach
$285 billion, more than $150 billion of which has already been disclosed.
Yet less than half that total comes from projected losses on the underlying
mortgages. The rest is down to those amplifiers.
One is the use
of derivatives to create exposures to assets without actually having to own
them. For example, those infamous collateralised debt obligations (CDOs) contained
synthetic exposures to subprime-asset-backed securities worth a whopping $75
billion. The value of loans being written does not set a ceiling on the amount
of losses they can generate. The boss of one big investment bank says he would
like to see much more certainty around the clearing and settlement of credit-default
swaps, a market with an insanely large notional value of $62 trillion: The
number of outstanding claims greatly exceeds the number of bonds. It's very
murky at the moment.
A second amplifier
is the application of fair-value accounting, which requires many institutions
to mark the value of assets to current market prices. That price can overshoot
both on the way up and on the way down, particularly when buyers are thin
on the ground and sellers are distressed. When downward price movements can
themselves trigger the need to unwind investments, further depressing prices,
they soon become self-reinforcing.
A third amplifier
is counterparty risk, the effect of one institution getting into trouble on
those it deals with. The decision by the Fed to offer emergency liquidity
to Bear Stearns and to facilitate its acquisition by JPMorgan Chase had less
to do with the size of Bear's balance-sheet than with its central role in
markets for credit-default and interest-rate swaps.
Trying to model
the impact of counterparty risk is horribly challenging, says Stuart Gulliver,
head of HSBC's wholesale-banking arm. First-order effects are easier to think
through: a ratings downgrade of a monoline bond insurer cuts the
value of the insurance policy it has written. But what about the second-order
effect, the cost of replacing that same policy with another insurer in a spooked
amplifier of all, though, is excessive leverage. According to Koos Timmermans,
the chief risk officer at ING, a big Dutch institution, three types of leverage
helped propel the boom and have now accentuated the bust. First, many banks
and other financial institutions loaded up on debt in order to increase their
returns on equity when asset prices were rising (see chart 1). The leverage
ratio at Bear Stearns rose from 26.0 in 2005 (meaning that total assets were
26 times the value of shareholders' equity) to 32.8 in 2007.
institutions were exposed to product leverage via complex instruments, such
as CDOs, which needed only a slight deterioration in the value of underlying
assets for losses to escalate rapidly. And third, they overindulged in liquidity
leverage, using structured investment vehicles (SIVs) or relying too much
on wholesale markets to exploit the difference between borrowing cheap short-term
money and investing in higher-yielding long-term assets. The combined effect
was that falls in asset values cut deep into equity and triggered margin calls
from lenders. The drying-up of liquidity had an immediate impact because debt
was being rolled over so frequently.
That is not
to suggest that the credit crunch is solely the responsibility of the banks,
or that all of them are to blame. Banks come in all shapes and sizes, large
and small, conservative and risk-hungry. Alfredo Sáenz, the chief executive
of Santander, a Spanish retail giant, recalls attending a round-table of European
bank bosses during the good times at which all the executives were asked about
their strategic vision. Most of them talked about securitisation and derivatives,
but when it was Mr. Sáenz's turn, he touted old-fashioned efficiency.
He did not get any questions. There were 'clever' banks and 'stupid'
banks, he says. We were considered one of the stupid ones.
Beyond the banks,
a host of other institutions must take some of the blame for the credit crunch.
The credit-rating agencies had rose-tinted expectations about default rates
for subprime mortgages. The monolines took the ill-fated decision to start
insuring structured credit. Unregulated entities issued many of the dodgiest
mortgages in America.
And no explanation
of the boom can ignore the wall of money, much of it from Asia and oil-producing
countries, that was looking for high returns in a world of low interest rates.
It is indisputable that the global glut of liquidity played a role in
the 'reach for yield' phenomenon and that this reach for yield led to strong
demand for and supply of complex structured products, says Gerald Corrigan,
a partner at Goldman Sachs and an éminence grise of the financial world.
Many blame the
central banks: tougher monetary policy would have encouraged investors to
steer towards more liquid products. Others blame the investors themselves,
many of whom relied on AAA ratings without questioning why they were delivering
such high yields.
Still, the banks
have been the principal actors in this drama, as victims as well as villains.
The S&P 500 financials index has lost more than 20% of its value since
August, and many individual institutions have fared far worse. Analysts have
been forced to keep ratcheting down their forecasts. The downside will
be longer than anyone expects, says David Hendler of CreditSights, a
research firm. There is so much leverage to be unwound.
research by Morgan Stanley and Oliver Wyman, investment banks will be more
severely affected by this crisis than by any other period of turmoil for at
least 20 years. By the end of March the crunch had already wiped out nearly
six quarters of the industry's profits, thanks to write-downs and lower revenues.
Huw van Steenis of Morgan Stanley reckons that the final toll could be almost
two-and-a-half years of lost profits (see chart 2).
have gone through similarly turbulent times: airlines in the wake of the terrorist
attacks on September 11th 2001, technology firms when the dotcom bubble burst.
Even within the financial sector the banks are not the only ones currently
suffering: hedge funds, insurers, asset managers and private-equity firms
have been hit too. But banks are special.
The first reason
for that is the inherent fragility of their business model. Bear Stearns,
an institution with a long record of surviving crises, was brought to its
knees in a matter of days as clients and counterparties withdrew funding.
Even the strongest bank cannot survive a severe loss of confidence, because
the money it owes can usually be called in more quickly than the money it
is owed. HBOS, a big British bank with a healthy funding profile, watched
its shares plummet on a single day in March as short-sellers fanned rumours
that it was in trouble. It survived, but the confidence trick on which banking
dependspersuading depositors and creditors that they can get their money
back when they wantwas suddenly laid bare.
The second reason
why banks are special is that they do lots of business with each other. In
most industries the demise of a competitor is welcomed by rival firms. In
banking the collapse of one institution sends a ripple of fear through all
the others. The sight of customers queuing last September to withdraw their
money from Northern Rock, a British bank, sparked fears that other runs would
The third and
most important reason is the role that banks play as the wheel-greasers of
the economy, allocating and underwriting flows of credit to allow capital
to be used as productively as possible. That process has now gone into reverse.
Banks have seen their capital bases shrink as write-downs have eaten into
equity and off-balance-sheet assets have been reabsorbed. Now they need to
restore their capital ratios to health to satisfy regulators and to reassure
customers and investors.
For some, that
has meant tapping new sources of capital, often sovereign-wealth funds. For
most, it has meant reducing the size of their balance-sheets by selling off
assets or by cutting back their lending. Quantifying the impact of this tightening
is hard, but one calculation presented by a quartet of economists at America's
Monetary Policy Forum in February suggested that if American financial institutions
were to end up losing $200 billion, credit to households and companies would
contract by a whopping $910 billion. That equates to a drop in real GDP growth
of 1.3 percentage points in the following year. If the banks suffer, we all
type of "indexing"? Talking
about index funds (e.g. Vanguard), there's true indexing, and there's manipulated
indexing. The true stuff mirrors the index. The manipulated index includes the
same stocks but weights them differently. It includes factors like dividends.
The manipulated guys say their "index" funds do better. The verdict
is not yet in, because these things are young. I find the argument fascinating.
Emotions run stronger than politics. For the latest on the argument, check out
Joe Nocera's piece in Saturday's New
Please don't chase yields. Chase safety.
Everybody (including me) got stuck in auction rate securities because they or
their brokers were greedy. It is not good to be a yield hog today. A reader
I am looking
to 'park' a sizable chunk of money into something safe with a decent return.
Currently money market fund is paying 2.5% (taxable) Vs 5.00% (tax free) with
haven't looked at the funds he wants to buy. I smell there's a sizable capital
risk. He may lose more on his capital than he will gain on the higher yield.
yields is what got the world into the sub prime / banking mess. And the Economist
makes that very clear. Read it.
LOT'S WIFE:The Sunday School teacher was describing how
Lot 's wife looked back and turned into a pillar of salt, when little Jason
interrupted, "My Mommy looked back once, while she was driving," he
announced triumphantly, "and she turned into a telephone pole!"
A Sunday school teacher was telling her class the story of the Good Samaritan.
She asked the
class, "If you saw a person lying on the Roadside, all wounded and bleeding,
what would you do?"
A thoughtful little
girl broke the hushed silence, "I think I'd throw up."
DID NOAH FISH?
A Sunday school teacher asked, "Johnny, do you think Noah did a lot of
fishing when he was on the Ark?"
replied Johnny. "How could he, with just two worms."
A Sunday school teacher said to her children, "We have been learning How
powerful kings and queens were in Bible times. But, there is a higher Power.
Can anybody tell me what it is?"
One child blurted
This column is about my personal search for the perfect
investment. I don't give investment advice. For that you have to be registered
with regulatory authorities, which I am not. I am a reporter and an investor.
I make my daily column -- Monday through Friday -- freely available for three
reasons: Writing is good for sorting things out in my brain. Second, the column
is research for a book I'm writing called "In Search of the Perfect
Investment." Third, I encourage my readers to send me their ideas,
concerns and experiences. That way we can all learn together. My email address
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