My Say
'WHAT A DIFFERENCE A DAY MAKES' - My Say No 38
13-10-2008 10:48:18
What a difference a day makes!
London Evening Standard, Thursday 25th September 2008; "BAILOUT HOPE BOOSTS SHARES"
London Evening Standard, Friday 26th September 2008; "BAILOUT CHAOS HITS THE CITY"
It has been an instructive few weeks for me. Sitting in London and watching the Lehman employees being turfed into the street almost allowed one to indulge in a touch of schadenfreude.
On our return, and much to my wife's chagrin, the little spare space available in our luggage was allocated to newspapers (more financial pornogr@phy) rather than duty free.
I must admit it was rather an extravagance to be picking up 3 papers a day. However, in the future, it will be important for me to be able to refer back to these current events in exactly the same way that I can presently reflect on past market turmoil.
I have been busy since we returned and am flattered by the requests for comments on present events. I am nervous that anyone should seek my thoughts as there are far cleverer commentators than I appearing with growing frequency. To me this has always been a key indicator of the degree of panic; the number of talking heads and the shortness of the interviews are usually directly correlated to the severity of the index declines.
To watch some of the American business channels is enough to make your head spin. Apparently the more useless, and often contradictory, information you can spew forth the better your ratings will be.
All this is a triumph of information over knowledge and the expression 'breaking news' is becoming a major irritant. More importantly, since no one else knows what is actually going to happen it would be stupid of me to claim any foresight. The heroic claims to having foretold this current setback will be ex-post.
It is difficult to know where to start or even what to say as the market movements have been reported minute by minute, ad nauseum. However, let's give it a go with my personal slant on events.
First and foremost we must acknowledge two things; the present situation is entirely of our own making and secondly, fear is based on ignorance. Fear is one of the most contagious and destructive diseases known to man. Even if you are not an investor, fear of current events will still strike at you or your family. Every second article has the word 'panic' and the 'D' word (depression) is appearing with greater regularity as indices are daily hitting new lows. Markets are now being suspended with increasing frequency as selling pressure overwhelms them.
Don't look for 'cause and effect' reasons for what is happening; fear is a far stronger force than greed. Useless comparisons with the very recent past abound and attempts to give some credibility to the commentary is laughable: "On Wall Street, the key Dow Jones index fell below the key psychological level of 10,000 for the first time since 2004" : "the FTSE 100 index was falling through the psychological 5000 barrier"!
What the hell is psychologically important about some big numbers? I maintain my stance that all the economic theory accounts for diddly squat when the herd is spooked; behavioural finance is the new order. After losing a staggering 20,000 pounds in the South Sea bubble Sir Isaac Newton was moved to comment that he could, "calculate the movement of the stars, but not the madness of men".
Financial Times, 20th September 2008: "Allowing investment banks to be leveraged to the tune of 30:1 is like Russian roulette with five out of the six chambers loaded."
Daily telegraph (UK), 25th September 2008; "Deutsche Bank deploys 50 time leverage and has liabilities of $US2 trillion, equivalent to 80% of Germany's GDP."
Daily telegraph (UK), 25th September 2008; "Denmark has enjoyed a blistering credit boom over recent years, fuelled by membership of Europe's Exchange Rate Mechanism. Interest rates were just 2% until the end of 2005, too low for Danish needs. The result was to push household debt to 260% of GDP, the highest in the world, and almost double the US level."
"Fortis Bank has liabilities of 300% of Belgian GDP"
"Iceland", "Spain", etc, etc. The commentary just goes on and on!
Jim Grant, publisher of 'Grants Interest Rate Monitor' pointed out in 2000 that whilst the US governments liabilities for guarantees, insurance obligations and projected future payments for social security and Medicare were around $US29 trillion; seven years later that figure was $US67 trillion, equivalent to five times the nations total economic output. Who are they to be offering guarantees!
This is not a financial crisis; this is a crisis of confidence.
A recent commentator in the AFR caned the misuse of 'value at risk (VAR)' models with the author commenting, "Thinking you could have relied on models alone to predict what happened is unrealistic". It was this sort of investment 'theology' that brought down LTCM; " managed by the Nobel Prize winning 'we're clever, we have the models' investment team!
In the same article, a company director and former New York consul-general Ken Allen said: "There needs to be a mix of historians and mathematicians to get the best result". I agree; crises of confidence have been a regular part of world history. An understanding of these past events would help put the current turmoil into some sort of context.
It will be apparent to most observers that during the last 30 years, any sign of a 'crack' in share markets has been met with a barrage of money from central banks. This behaviour became known as the 'Greenspan Put'. The aim was to ensure that the delicate flower of capitalism known as 'consumer confidence' was never allowed to wilt.
As the public and institutions used more and more of this cheap money to fund property and other speculations the government's efforts were gradually perverted to ensuring that property prices remained propped up; in fact continued to rise. Rising property prices had become the sole support for consumer confidence and had to be fed at all cost.
This has naturally led to a global bubble in property followed by the inevitable faux hand-wringing by politicians claiming they are concerned about the housing affordability crisis. The bar to entry for 'wannabee' property owners was lowered to ground level; tax breaks were offered to property speculators (negative gearing) and cash incentives were offered by some governments to potential owners. The irony is that dumb policy has exacerbated the very problem afflicting their constituents.
The seeds for the current debacle were sown some years ago but naturally no one paid any attention. Allow me to quote from an article written on the 30th September 1999 (yes, 1999). Space precludes quoting the whole article.
"In a move that could help increase home ownership rates among minorities and low-income consumers, the Fannie Mae Corporation is easing credit requirements on loans that it will purchase from banks and other lenders. The action which will begin as a pilot program involving 24 banks in 15 markets- including the New York metropolitan region- will encourage those banks to extend home mortgages to those individuals whose credit is generally not good enough to qualify for conventional loans. Fannie Mae officials say they hope to make it a nationwide program by next spring".
The rest is, as they say, history. Every opportunist opened a mortgage broking centre flogging loans to those who could not afford them and, eventually, some of them committed fraud. With a guaranteed buyer of your toxic waste why wouldn�t you? Details of this sort of activity are only now beginning to surface in Australia.
Despite the rhetoric of the real estate industry, reality is about to intrude into the world of property sycophants. The unrealistic view that what is affecting global credit/share markets would have no impact on property in Australia is about to be exposed. In fact, it is ironic that the present global share market turmoil is a direct consequence of property related transactions.
Evening Standard, Friday 19th September 2008: "Lehman was laid low by billions of dollars spent on real estate deals around the Globe, executed by bankers too arrogant, greedy, or just too young to understand the dangers they faced." The parallels with the past are only too apparent.
A cursory study of the US Savings and Loan scandal in the 1980's reveals that some 1,000 of America's 4,000-plus S&L's would eventually go belly-up in what one US economics professor later called "the largest and costliest venture in public misfeasance, malfeasance and larceny of all time". And since the federal government had insured many of the individual deposits in the S&Ls, it found itself facing a mammoth liability when they collapsed: the total cost of the bailout came to $150bn. Another regulatory triumph!
The Wall Street crash, you may not be surprised to learn, followed a decade-long speculative boom during which millions of investors piled into the stock market and borrowed to buy more. Rising share prices prompted more and more people to invest and more and more banks to lend more and more, creating a classic economic bubble. By the time the end came, brokers would lend you as much as 60% of the face value of the shares you wanted to buy. To those with a little knowledge of economics, this may sound alarmingly familiar. Also familiar may be the fact that the American president of the day declared it would be inappropriate to intervene.
The first real systemic threat to the financial system in Britain following the Second World War arrived in 1973 with the secondary banking crisis that affected the 'fringe' banks (I still have the newspaper clippings). They had provided finance to speculators during (causing?) the property boom. When the crash came, the Bank of England launched a 'lifeboat' to prevent the crisis from threatening the first tier banks.
Similarly, with Japan's problems in the 1990s which were caused by the pricking of a massive property bubble in the late 1980s that resulted in banks seeking to liquidate massive losses. Whilst the Japanese government was subjected to criticism for failing to act quickly enough at the time I think it is now a case of 'those in glass house shouldn't have thrown stones'.
An understanding of this history should have given all those in power today enough foresight to have avoided the worst but perhaps the balance of bankers/mathematicians to historians in positions of influence is wrong!
I doubt that any of what is happening presently will be enough of a scare to curb the hubris of future government's and their ill advised generosity, or to avoid the waste of productive capital inherent in artificially supporting property prices. If consumers cannot be happy without irrational rises in property or share prices then we are all off to hell in a hand cart.
I forlornly hope that consumers have had enough of a scare to understand that just as nations cannot live beyond their means; the same rules apply to them. Reckless leverage and a misguided reliance on property can destroy nations, banks, and you and me. I personally am confident that nothing will change in the long term and that the present events, whilst mildly diverting amusement, are simply 'same old-same old'!
To understand what the future holds I commend "Extraordinary Popular Delusions and the Madness of Crowds" written by Charles Mackay and first published in 1841. To help get a handle on the present I commend "Manias, Panics, and Crashes" by Charles Kindleberger. Both these books are recommended reading on my website.
I fell into the trap of browsing both volumes again and was caught by a section in Kindlebergers book where he is discussing the objects of speculation. This is a heavily abbreviated list, I repeat, heavily:
Metallic coins: Holy Roman Empire, 1618-23
Tulips: Dutch East India Company shares, canals, drainage projects, elegant houses, 1636-40
British Government Debt: Amsterdam, 1763
Import commodities: sugar coffee, 1799, 1857 in Hamburg: cotton in Britain and France, 1836, 1861; wheat in 1847.
Country banks: England 1750s, 1793, 1824. Country houses and building sites for their construction, 1780-1820.
Canals: 1793,1820s in Britain; 1823 in France.
Foreign bonds: 1825 in London; 1888 in Paris; 1924 in New York; 1931-82 and 1990s syndicated third world bank debt.
Foreign mines: Latin American in Britain, 1825; German in Britain and France, 1850; Gold mines in Australia and South Africa1880s
Building sites: 1825 in France, 1830-42,1843-62, 1853-77,1879-98, and 1898-1933 in Chicago, 1872-73 in Berlin and Vienna; 1888-1900 in Australia; 1925 in Florida; 1970s and early 1980s in the south west United States and Southern California.
The list just goes on and on; Agricultural land, Copper, Railroad shares, Private companies going public, Foreign exchange, Gold, Real estate, derivatives, Hedge funds, etc.
He mentions one perspicacious historian who commented that, "mining and sheep grazing contributed to a love of gambling, and that Australians, starting with the gold discoveries of 1851-52, developed a particular love of gambling expressed in both horse racing and speculation in land".
On the larger issue, Kindleberger goes on to say: "It is necessary now to move to a critical question, one that probably cannot be resolved. Assume that we have demonstrated that destabilising speculation can occur in a world of individuals whom it is convenient and fruitful to consider as normally rational. Permit this world to be perturbed by a 'displacement' of one sort or another, largely from outside the system, giving rise to prospects that individuals misjudge, either for themselves or for others. At some stage, investment for use gives way to buying and selling for profit. How likely is the speculation to lead to trouble?"
How likely indeed. I think I can say from my understanding of history the answer is an unequivocal YES.
Where present events will lead in the short term I wouldn't have a clue. As I indicated in my last newsletter, despite the substantial decline in our portfolio values, I have been monitoring the dividends during the current reporting season and can now update the earlier sketchy results.
Of 54 companies in our portfolio that have reported so far, five have reduced their dividends with the reductions ranging from very little to a complete suspension. Twelve have maintained their dividends and the balance have increased. I haven't yet worked out the impact in dollars as we have made a substantial number of purchases since prices began to decline so a further bit of work is required. Suffice to say, and ignoring purchases, we will have more income this year than the same time last year.
I have discussed in previous editions of 'My Say' the implications a cut in dividends would have for us so won't go over old ground. The next test for us will be in March/April 2009 when the next dividend season gets underway. Whether this is a sustained decline and a depression results I don't believe anyone knows. However, if it should come to pass then I will rely on history.
Our parents were in their late teens/early twenties when the depression arrived. Our grandparents went through two world wars and the depression. The only social security system was the community.
I do not believe that we are any less resourceful than they were (by observation I cannot speak for others). I do not wish to sound melodramatic but I am tired of all the hyperbole and self seeking wailing associated with current events. Personally, we are not over-geared so we will simply pull in our belts, live within our means, hunker down and wait for the cloud to pass; just like our parents. As for our children; hopefully they will learn a valuable lifetime lesson!
There is a famous saying; "it's always darkest just before the dawn". A perversion of this is attributed to Mao Zedong which goes; "It's always darkest just before it is completely black"!
Remember, your perception is your reality.
