A Moral Hazard

HY6PTSF9NYM2

Almost one year to the day after President Obama was sworn into office as an agent of change, voters in Massachusetts sent a clear signal to Washington that the current status quo was not working.  The surprise vote out of Massachusetts late last month has completely changed the investment and political climate.  The American middle class understands that most of the elected officials in Washington are not working for them, but rather working for their lobbyist groups and major corporate donors.  The first shot was fired last week in what will turn out to be one of the most important policy making years since FDR in the 1930’s.  The people have spoken and they have made it clear that the current status quo of bailing out the big guys while the everyday man struggles to keep his job and pay the bills is not working and must be changed.  President Obama, who has turned into one of the best poll watchers since President Clinton, heard the message loud and clear and immediately called a press conference to explain how his administration is going to get tough on the banks.  Front and center at the press conference was former Federal Reserve Chairman Paul Volcker who is famously known for breaking the back of inflation in the early 1980’s.  Mr. Volcker reemerged on the campaign trail last year as part of Obama’s economics team, but was missing in action this year while Federal Reserve Chairman Bernanke and Treasury Secretary Geithner were busy giving sweetheart deals to the banks.  While the rhetoric in Obama’s speech last week was promising that he would enact tougher rules on the banking sector going forward, we can only hope that the President follows through.  All this comes at a time where the financial markets are enjoying hearty gains with the S&P 500 up over 60% from its March lows.  However for all the gains we have seen in the markets over the past 6 months the economy, while stabilized, is still losing jobs and showing little to no real economic growth after you take away the massive amounts of stimulus and incentives.  Make no mistake about it, the economic recovery we have seen the past year was bought by the Federal Reserve with taxpayer money.  Banks are still not lending, and rightfully so as the economy is weak and creditworthy borrowers are harder to find, while the consumer is still working on deleveraging his personal balance sheet by paying off or defaulting on debts.  If the economy and jobs do not start picking up soon we will see continued budget shortfalls on the federal, state, and local levels as municipalities struggle with significantly lower tax receipts from previous years.  We have begun to see major fights between city and union leaders regarding job and pension benefit cuts and we expect this debate to get heated throughout the year.  The most likely result of further budget shortfalls will be even higher unemployment.  Unfortunately, with time running out, and the market seemingly only going higher, everyone from banks, to pension funds to the individual investor are rushing back into the markets with borrowed money, forgetting the lessons of the past year and again putting the economy at risk of another major collapse.

The most notable and ironic investor to return to the markets after the financial crisis of last year is none other than the bailed out banks.  Wall Street is again marketing derivatives last seen before the credit markets froze in 2007.  Bank of America and Morgan Stanley for example are encouraging clients to buy swaps that pay higher yields for speculating on the extent of losses in corporate defaults.  These are the same instruments that according the President’s own economic advisors took the system to the brink of disaster last year.  As Wall Street recommends more complex trades, investors are also augmenting bets with borrowed money.  Some banks are offering as much as 10-1 leverage on securities backed by prime jumbo home loans for example.  While 10-1 leverage is substantially less than the 30-1 that was used during the lead up to the financial crisis, what we now know is that if the securities purchased on borrowed money begin to lose value, the holder stands to lose most or all of the investment quickly.  And with problems persisting in the residential real estate market, many of these securities seem particularly vulnerable at this time.  But if you are a bailed out bank, investment risks don’t pertain to you because you believe that the Federal Government will once again be there to pick up the pieces.  These are exactly the kinds of financial risks that we hope Obama will address as soon as possible as we cannot afford to have another meltdown like we saw last year.  

Not to be outdone, the individual investor is also back in the markets.  The New York Stock Exchange’s most recent disclosure of margin debt indicates a surge in trading in margin accounts where total debt shot up to $231 billion as of December, up $58 billion from February or 30%, and also an increase of 4.5% from November.  In other words, speculation is now rampant, and to make things worse, those speculators are once again leveraging themselves.  And we all know what happens when levered speculative bets turn out not quite as expected.  For those who may be confused, Dow Jones provides a useful primer of how a margin call feedback loop tends to play out and make things ugly, fast:

A potential pitfall for those trading "on margin" is a sharp decline in stock prices, which can expose investors to margin calls, requiring them to post additional collateral lest their brokers sell their securities to cover the debt. A wave of margin calls can worsen selling pressure on stocks and was seen as partly to blame for the market's woes in the fall and winter of 2008-09.

It’s nice to see that the United States casino is up and running again after almost taking our entire financial system and way of life into the abyss last year.  But not to worry, like the bailed out banker, the individual investor knows that if anything goes wrong Mr. Bernanke will be there to simply print our way back to prosperity. 

And if everyone else is gunning for higher returns, pension fund managers have to keep up so some have decided to leverage their portfolios.  The strategy calls for leveraging or borrowing against a pension funds’ safest assets, like government or other high grade bonds.  The State of Wisconsin for example, which manages $78 billion became among the first to adopt the strategy. The fund will borrow an amount equivalent to 4% of assets this year and as much as 20% of its assets over the next three years.  The timing of this decision to leverage a bond portfolio couldn’t have come at a worse time as many economists are forecasting a pickup in inflation and an increase in interest rates as the economy recovers.  This scenario of higher inflation and interest rates, which we agree with, would cause bond prices to fall, which would only be magnified if leverage was employed. Of course, nothing is certain with the markets and if we do end up in a deflationary environment a bond portfolio would do quite well.  However, the idea that pension funds would add to their risk exposure less than a year after one of the worst financial crashes since the Great Depression should ring an alarm that there is still more pain to come as the excesses have yet to be worked out of the system.

As we have stated here many times before, the idea of fixing a problem of too much debt with even more debt is ludicrous and doomed to fail.  We still do not know the extent of the toxic securities being held at banks (and the Fed itself for that matter), but as more companies, states and entire countries (Greece, Dubai, Spain) default on debts we will soon find out.  Bernanke may have bought the financial sector and himself another couple of years by flooding the system with massive amounts of dollars.   We only hope that investors and individuals alike do not grow complacent and begin to take on excessive risks again as the last crisis fades from memory.  The truth that no one in government is willing to admit is that if economies at home and abroad do not start growing again soon, we are very likely to be right back in the same kind of financial panic we saw last year. 

Comments

[Laurie K. - NYC]

Thought provoking, and eloquently stated! Plus glad you're getting out into the world of social media. Best, LK