Thursday, October 2, 2008

3rd Qtr 2008 Review and Nonno's Mistake


At the end of WWII, my grandfather looked around and, devastated by the surrounding destruction and by the fall of an ideology he believed in, decided to sell for a song the family fortune, buildings, land and businesses. In my business, we would say he sold the lowest downtick as Italy went on to rebuild its infrastructures and to become at its height the fifth most industrialized country in the world.

In my career as a money manager and a speculator, I often race in my mind to this memory to remind myself that crisis breeds opportunities… as long as you don’t put yourself in the position to sell the lowest downtick, and as long as you don’t let ideologies run your decision making.

The financial crisis we have been fighting for the last year is the product of many practical distortions and ideological falsities, which Congress has loudly reminded us in its pathetic bickering over the rescue package. However, from the ashes of crisis, true and real recoveries take shape and opportunities are created. The life of an investor is about dodging, covering, attacking, covering again, retreating and attacking once more; always making sure that any losses that may come his/her way will not be terminal.

Our financial system has been under duress for over a year now and our posture at Cervino has been constantly adaptive to the difficult market conditions: we dodged, covered, and also attacked when visibility allowed. Such visibility is still very limited and therefore size and posture must be tuned accordingly. Flexibility and under-leverage are still in my opinion the name of the game until confidence is restored in the system, until people will feel safe about storing, lending, investing their money in financial institutions.

So what are we doing collectively to restore such confidence?

Treasury Secretary Paulson provided a plan that, admittedly vague, tries to address the liquidity issue most banks have been facing: leveraged balance sheets loaded with illiquid asset backed securities (affected by a collateral decreasing in value). Paulson proposed for the US Government to practically be the market maker of these complex securities, allowing the government to purchase such illiquid assets and hold them until better times, thereby backstopping the vicious spiral of lower prices forcing additional liquidation which in turn generates even lower prices.

Initially, Congress and the American people balked at the price ($700 billion) of the rescue package and the idea of rescuing fat bankers. Without spending too much time to point out that everyone is to blame in this disaster: politicians, many homebuyers, regulators and certainly bankers.

As I mentioned earlier ideologies are never good starting points for investment decisions. The rescue package is aimed to help all of us by providing stability, that in times of massive dislocations such as this, only the government can provide.

I believe in free markets and in free enterprise, but I also must be honest and pragmatic about the fact that even before this mess markets were neither free nor fair. The complexities of our society make it impossible to run a system completely free and fully meritocratic—that is just the way it is. No doubt, I keep a copy of “Capitalism and Freedom” by Martin Friedman on my nightstand but I recognize that our financial and social system is more complex than just shouting slogans like so many false free marketers (media pundits, politicians and regular Joes) have a tendency to do.

The real problem with the Paulson plan is not ideological or an issue of fairness, but with its execution if signed into law. The key to the plan is the pricing of assets, assets that in some cases have been constructed in complex and opaque ways. Price the asset too high and the tax payer will end up with a loss, price it too low and the plan will not succeed. Pricing these assets correctly is difficult but not at all impossible. After all about 95% of all mortgages are performing, and 75% of subprime mortgages are also still performing; even allowing for a haircut to cover increases in defaults and some additional decrease in the value of the collateral, most of this paper is worth more than the forced liquidation prices we are witnessing.

We may ask if this is the case, why is it that private equity is not aggressively buying them? The answer is “reflexivity.”

The uncertainty of the situation and the shakiness of the financial system make it hard for an investor to step in at this point. As a result, a vicious circle is now in full play. That is why the system must be stabilized. The uncertainty of the regulatory environment and the opaqueness of these markets are additional reasons why new investors are on the sideline. Stability and clarity must be the foundations of any rescue plan.

This is not the first time a banking crisis of this nature occurs (and certainly it will not be the last) and it is curable. Think of the banking crisis that happened in Sweden twenty years ago. Then, like now, a real estate bust caused the Swedish banking system to practically go bankrupt. The government purchased shares in its banks to recapitalize them and years later sold them at a nice profit. Sweden in the immediate aftermath of the crisis saw its unemployment numbers rise from 2% to 10% and a painful reduction in income occurred as well. However, while the crisis lasted three years, the recovery lasted fifteen years and Sweden produced a GDP growth more than 3% in average, double the rate produced by its European partners.

The idea to recapitalize the banks should also be part of the Paulson plan. George Soros has been very vocal about this lately to the extent that he thinks this should be the main element of any rescue package. I believe a combination of a transparent market making facility and a recapitalization package would go a long way to stabilize the situation.

Another element that increased instability and forced liquidation is the accounting rule FAS157 or “fair value pricing.” FAS157 requires marketable securities to be marked to market on the holder’s balance sheets. However, fair value of long maturity and illiquid securities such as Mortgage Backed Securities and Asset Backed Securities is not reflected by its market price since now there is practically no market.

In this situation, fire-sale prices become the pricing benchmark which ends up exacerbating the crisis. Changing or suspending FAS157 is a little like changing the rules in the middle of the game and it should not be done without a proper solution on how to price these securities. Most of these assets should be priced based on their cash flow and based on realistic assumptions on the price of the collateral. A few of these securities, the so called toxic waste, might prove more challenging.

Ultimately, a global approach is needed. Governments, central bankers, regulators and sovereign wealth funds should all participate in the solution of what is the most frightening crisis the financial world has experienced since the Great Depression. When credit markets completely freeze like it is now happening (the spike in the TED spread reflected a seven standard deviations move) the issue is not bailing out bankers or safeguarding taxpayers money, the issue becomes survival of the economic system that all of us used and have benefited from since the industrial revolution.

From a trading perspective, we stress again that size and posture must be adjusted for the level of volatility which in many regards is unprecedented. Time horizon also must be either really short or really long. In our absolute return programs we have shrunk our time horizon and we have also reduced size. While in our longer term portfolios, we are looking to start positioning in specific and strategic sectors maintaining a very long term horizon.

We think the dollar rally may have more to go as the deleveraging process continues and requires dollars to be repurchased to pay off the debt (not to mention that none of the currencies is on an absolute level strong). As far as US Bonds is concerned, we still expect them lower due to their historically low yields especially in the context of a rising deficit. Additionally, we don’t expect the commodities to resume their rally any time soon due to the deflationary environment and the large outflow of speculative funds. This includes gold as well with the caveat that in a panic situation, it still represents the strongest flight to safety.

In conclusion, we expect equities to be volatile for a while but we also think that the risk reward ratio is tilting in favour of being long for time horizons that are either very short or very long. However, should the credit markets fail to unlock, all bets are off.


-Davide Accomazzo, Managing Director

Moral Hazard and Aggregate Wealth Portfolio

"His name was George F. Babbitt. He was 46 years old now, in April 1920, and he made nothing in particular, neither butter nor shoes nor poetry, but he was nimble in the calling of selling houses for more than people could afford to pay."
--"Babbitt" by Sinclair Lewis (1922)

The largest financial bailout in United States history, which some traders are starting to call the ‘Securitized Housing Investment Trust’ (hint: think acronym), is causing an existential crisis amongst those who hold to purest free market ideology. Senator Jim Bunning, Republican of Kentucky, echoed this sentiment when he said, “The free market for all intents and purposes is dead in America.” These ideologues doth protest too much, methinks.

Since the 1929 crash, the last time the nation faced an economic train-wreck of this magnitude, the U.S. Government has effectively been in the insurance business and it has generally served us well. The vast majority of laws and regulations are designed to mitigate risk. Drunk driving laws minimize the number of car wrecks, and the short uptick rule (until recently eliminated) prevented unfettered short-selling from forcing solvent companies into insolvency.

Government institutions enforce these policies. What is the purpose of the military but insurance against an attack from other nations? What is the key purpose of a central bank other than insurance against a run on banks?

In fact, the present-day capital market system, which has been responsible for raising living standards to the highest in world history, relies upon laws and regulations: the Securities Act of 1933, the Securities Exchange Act of 1934, the Commodity Exchange Act of 1936, and the Investment Advisers Act of 1940. Although not perfect (and definitely requiring an overhaul), these laws have served Wall Street and LaSalle Street very well over time.

The problem with fundamentalist free market ideology is that it is only theoretical, and ultimately not pragmatic. Truth is, without government establishing the premise of private property enforced through law and justice, contract markets would soon devolve and be quickly replaced by gangster capitalism akin to Putin’s Russia. There is a term for the unfettered combination of concentrated power, ideological adherence and capitalistic greed, it is called “fascism.”

There is another term “beta,” which defines the systematic return/risk of assets. This concept is related to Modern Portfolio Theory and underlies the oft-stated investment strategy of buy-and-hold. What is not well-understood, even by many sophisticated investors, is that this theory is flawed. The issue is benchmark portfolio construction. Accordingly, the definition of “true beta” or “true market portfolio” must be extended to encompass other economic factors.

What academics came to recognize was that approximately one-third of non-governmental tangible assets in the U.S. are owned by the corporate sector, and only one-third of these corporate assets are financed by equity. As a result, Jagannathan and Wang (1993) concluded that assumptions underlying the concept of beta must be altered in order to resolve anomalies in the model. In other words, “true beta” or the “true market portfolio” must include the “aggregate wealth portfolio of all agents in the economy.” This is a revolutionary view with both political and economic ramifications.

Business balance sheets do not in practice reflect public infrastructure assets which businesses are dependent on. For example, a trucking company’s greatest asset is not its fleet of trucks, but the U.S. Highway system. Likewise, public liabilities such as the cost of pollution are also not reflected on corporate balance sheets. This is beginning to change with the idea of integrating regulations into “cap-and-trade” contract markets involving emission allowances.

It is time for a new economic ideology to take hold which adheres to the middle way. Government and free enterprise are actually joint partners in promoting economic growth and well-being. Certainly, political will effects a constant tug-of-war between interests, but this is not unlike the struggle between a sales-trading desk which drive revenues for an investment bank, and internal compliance/risk managers who ensure balance between risk and reward.

The problem with the prevalent populist stream of conversation regarding free markets versus socialism is that such dialogue is anachronistic. Rather, the conversation needs to shift to good versus bad governance, and public policy which enhances the value of the aggregate wealth portfolio of all agents in the economy.

- Mack Frankfurter, Managing Director