Stocks rest
in June after the biggest quarterly return of the last 10 years
The S&P 500
gained 0.2% in June and gained 3.2% for the first half of the year. Stocks gained 15.9% in Q2, the best
quarterly result since 1998. From
the low on March 9th through quarter end, stocks generated gains of
36.9%, one of the steepest rallies of the last 80 years.
As volatility
continues to drop, now below the level of September 12th right before the
banking system seized up, we have some time to pause and reflect about
how the financial system will evolve to prevent futures crises, or at
least until bankers and investors forget the lessons learned from this
crisis, typically in half a generation.
We have observed
over time that accidents never happen because just one thing goes
wrong. Instead a number of things
have to go wrong simultaneously, often confounding received wisdom about
how things should be. One of the
most famous "accidents" of all time was the sinking of the
Titanic, the supposedly "unsinkable" ocean liner that was
destroyed on her maiden voyage. A
little tour through history will shed some guidance on current events.
Long story
short: ship hit an iceberg and sank
Edwardian England
(1901-1910) represented the apex of power and confidence of the British
Empire. Medicine and technology
advanced at a break neck pace; the horrors of World War I and II were
still in the future. By 1912, it
was possible for the White Star Line to conceive of the concept of an
"unsinkable" vessel. Of
course, anything made of iron will sink, but the architects thought that
their design was sufficiently advanced to keep the liner afloat under any
circumstance. Specifically, the
ship was divided into 16 compartments connected by water tight doors,
which could be closed in 25 seconds by automatic controls. So with great confidence, the ship
departed Southampton, England, and, after two short stops in France and
Ireland, set out into the open ocean on April 11th.
Ocean crossing in
the early part of the 20th century was highly competitive. To draw passengers from competing
lines, not only was Titanic furnished with the finest accommodations, but
was even fitted out with the latest in communications technology -
wireless telegraphy - which enabled passengers to deliver and receive
messages while in transit. The
Captain was under orders to make the crossing in record time to further
enhance the marketing of the new ship.
Under most
circumstances, this order would have not caused problems, except that:
that spring, sea ice flowed much further south than usual for April in
the North Atlantic.
The captain knew
of the sea ice from messages from other ships and posted lookouts who
could have given sufficient warnings except that: The White Star line
forgot to order binoculars for the lookouts.
Even so, the
lookouts would have easily seen icebergs in daylight except that: Titanic
was moving near maximum speed in the middle of the night. Other ships in the area had already
halted sailing, waiting until daybreak.
This information might have been radioed to Titanic, except that:
the nearby Californian was swamped forwarding commercial messages and the
final ice warning was not transmitted.
The lookouts might
have seen icebergs anyway, except that: there was no moon that
night. Icebergs can often be
recognized at a distance by waves splashing at their base except
that: the ocean was unusually calm
that night.
By 11PM on April
14th, Titanic entered an ice field 80 miles wide and was guaranteed to
hit iceberg sometime during the night.
At 11:40 PM, the
two lookouts spotted a large iceberg dead ahead and frantically
telephoned the bridge about the danger.
The bridge crew spun the wheel hard over turning the boat to the
left. This might have been just
enough change in direction to let Titanic escape, except that: the
engines were simultaneously ordered in reverse, which not only slowed the
ship, but critically, slowed the rate of turn.
Had Titanic hit
the iceberg dead on, the first, second, even third compartments might
have been crushed, but the "4 compartments flooded out of 16"
design would have kept the ship afloat.
Instead, Titanic grazed her right side along the length of the iceberg. In a modern ship designed with welded
plates, this contact probably would not have been fatal. However, early 20th century ships were
built with riveted plates. This
design might have been sufficient except that: the building order called
for lower quality (high sulfur) iron rivets, which become brittle when
cold. These rivets might have held
in warmer water, but immersed in the 30 degree waters of the North
Atlantic, failed.
As a result of the
impact, a seam opened up from the prow to the first quarter of the
ship. The overall length of
Titanic was 883 feet, the length of the seam was about 150 feet, and the
width was at most 6 inches and might have averaged 3 inches. The size of the entire gap was
equivalent to an opening 6 feet by 6 feet, so water moved in at a brisk
clip. Titanic still could have
stayed afloat except that about 6 to 12 feet of the seam extended into
the 5th compartment. Furthermore,
because Titanic was settling bow first, soon the hawse holes for the
anchor chains would submerge, followed by the main forward hatch. So Titanic would actually fill faster
over time.
At that point in
time, the ship was guaranteed to sink, but would remain afloat for the
next two hours. The rate of fill
might have been much slower except that: the waterproof compartments did
not extend through upper decks.
Like compartments in an ice cube tray, as one compartment filled
water would flow into the next compartments; soon water flowed into the
6th, 7th and 8th compartments.
Two hours should
have been sufficient time to move passengers into life boats, especially
in calm seas, except that: though
Titanic had been designed to carry two rows of life boats and twin davits
were installed, the White Star Line only installed one row of lifeboats
to save money. Thus, a ship with a
maximum capacity of 3,295 passengers and crew, carrying 2,261 people,
only had lifeboat capacity of 1,178.
At least that many
passengers should have been saved except that: neither passengers nor
most crew had any training in "abandon ship." Passengers were reluctant to enter onto
lifeboats in the frigid water because they believed that the ship was
unsinkable. Thus the early lifeboats
cast off filled only one third to one half of capacity.
The crew of the
Titanic frantically telegraphed to ships in the surrounding area. The lights of the Californian could be
seen at the edge of the horizon 10 miles away - stationary in the ice
field. Californian could have
reached Titanic in about half an hour except that: ships' captains were
not obliged to maintain 24 hour watches in their telegraph offices. Titanic's messages were received by the
Carpathia, 3 ½ hours away, which made all speed to Titanic's location. The crew of the Californian could see
signal flares being launched from Titanic, but were afraid to wake
Californian's captain (reputed to have a nasty temper) and did not think
to wake their telegraph operator.
Titanic gradually
upended. At 2:17 AM, the ship
broke in half,with the bow section plunging 2 ½ miles to the ocean
floor. The stern section settled
back briefly, then rose vertically and sank for good at 2:20 AM. Carpathia arrived on scene at 4:10 AM. By next day, 710 survivors were
rescued, but 1,491 passengers and crew had perished.
An interesting
story, but what does Titanic teach us about finance?
The core belief of
the designers, builders, owners, officers, crew and passengers of Titanic
was that the vessel was unsinkable.
This assumption drove other decisions, for example, the failure to
provide sufficient life boats, and the order to press on at high speed
despite iceberg warnings.
An American board
of inquiry convened in Washington DC one day after passengers disembarked
from Carpathia in New York and proceeded for 5 weeks. The British Board of Trade Inquiry
commenced May 2nd and lasted two months.
From these inquiries, new laws were implementing including the
requirement that all commercial vessels maintain 24 hour telegraph (later
radio) watches; that life boats be installed sufficient to hold all
passengers and crew; that passengers and crew conduct mandatory
evacuation drills on every voyage.
Most importantly the illusion that any ship could be unsinkable
was shattered.
The illusion of
the last decade in finance was that, with sufficient application of
computers, statisticians and economists, investment risk could be hedged
away. The US economy's quick
recovery from the Latin American debt crisis of the early 1980's, 1987
stock market crash, the savings and loan crisis of the late 1980's, the
Asian Financial crisis of 1997, the Long Term Capital Management hedge
fund meltdown of the 1998, and the "tech wreck" of 2000-2002
supported this illusion - the Federal Reserve would always step in to
"make things better."
Paradoxically, surviving these events made banks ever bigger risk
takers ("Sure we're steaming through a field of icebergs, but so far
they're just bouncing off the hull.")
Meanwhile,
starting under the Clinton administration and accelerating under the Bush
administration, safeguards that had been in place since the 1930's
(separation of investment and commercial banks, the "up-tick"
rule, limits on short selling, responsible regulation by the SEC and
Federal Reserve, limits on how much leverage banks could employ) were
systematically dismantled (the equivalent of eliminating the second row
of lifeboats. Furthermore, new
"products" such as credit default swaps and leveraged exchanged
traded funds were permitted even though these "products" allow
aggressive investors to profit by collapsing a company's stock price.
On May 20th,
President Obama signed in the law the "Financial Crisis Inquiry
Commission," which will empanel 10 members to study "how fraud,
regulatory lapses, monetary policy, accounting, lending practices and
executive pay contributed to the worst U.S. financial crisis since the
Great Depression." Unlike the
American Titanic inquiry, which began interviewing survivors one day
after Carpathia docked in New York, the Financial Crisis Inquiry is
curiously slow to staff up (could it be that the Federal government is
reluctant to reveal its own contribution to the crisis?) By comparison, the Brady Commission or "Presidential
Task Force on Market Mechanisms" commenced November 5th, 1987 to
review the events leading up to the October 19th crash and delivered a
preliminary report with recommendations by January 8th, 1988.
Risk cannot
be eliminated, only transferred
Like
"portfolio insurance" from the 1980's, credit default swaps
were sold to bond investors as a means of eliminating investment
risk. If a bond issuer defaulted,
the seller of the credit default swap would make good on the bonds at par
(i.e. pay back 100 cents on the dollar.)
Bond investors got out of the habit of doing credit analysis. But the risk wasn't truly eliminated;
it was merely concentrated, primarily in the hands of the AIG Financial
Products group, about 50 traders based in London. Over a decade, this group accumulated
$2 trillion in notional exposure to fixed income instruments. In an environment of stable interest
rates and solid economic growth, the London group reaped profits as much
as 30% of AIG's total income. We
call this a "picking up nickels in front of a steam roller strategy
- good fun until your sleeve gets caught." So far the net loss on these
derivatives, covered by the Federal Reserve and US Treasury through
various programs, exceeds $225 billion.
The peak market cap value of AIG was $185 billion (currently $9.3
billion.)
Although CDS's
were marketed as "insurance" to bond fund managers and later as
"put options" to hedge fund managers, the name of the product
remained "swaps." In
securities regulation, any product officially termed insurance is
regulated in the United States by the 50 state insurance regulators,
while any product officially termed an option is regulated by the SEC and
options exchanges, and requires margin to back up the exposure (as a AAA
credit, AIG was NOT required to post margin.)
Alan Greenspan,
while Chairman of the Federal Reserve board in the 1990's through 2006,
repeatedly opposed CDS regulation, stating that the banks were far better
equipped to manage risk. However,
in October 2008 during Congressional testimony, Greenspan commented that
he was "'partially wrong for advising against more regulation of
derivatives earlier this decade.
Credit-default swaps, I think, have serious problems associated
with them." In our opinion,
Bear Stearns and Lehman Brothers would still be in business if the CDS
market had NOT existed. Traders
bought put options on and sold short the stock of those companies, while
simultaneously bidding up the price of CDS on those companies. This created the "appearance"
that the companies were in trouble, which then became self-reinforcing as
panicked investors liquidated long positions. As the SEC had eliminated the
"uptick" rule in July 2007, there was no market mechanism left
to halt the slide.
Just as the
sinking of the Titanic generated new laws and regulations, the financial
meltdown of 2008 is also generating new laws and regulations. The Securities and Exchange Commission
(SEC) has proposed to take over regulation of credit default swaps and
other derivatives related to securities such as stocks and bonds, while
the Commodities Futures Trading Commission (CFTC) has proposed to take
over regulations of derivatives related to energy, commodities, metals
and currencies. In our opinion,
regulation can't come soon enough.
Meanwhile, though some investments firms like Goldman Sachs and
Paulson & Company made obscene amounts of money last year buying CDS,
so many other firms got their eyeballs ripped out writing CDS that the
pool of CDS is naturally shrinking.
Other learnings
from the crisis include:
· Real estate CAN fall in value
· A conglomeration of low-grade
securities is still a low grade security (no more AAA ratings for
mortgage backed securities based on sub-prime loans)
· It's a fantasy to presume that
financial models are robust or reliable
· Leverage kills!
Regardless of what
government regulators come up with, you can be sure that the capital
committees of banks and funds will be much more conservative going
forward (OK, until they forget about this crisis.)
Strategy
Even with the
massive gains of the second quarter, the S&P 500 is about unchanged
on the year. Economic reports are
generally less bad. Even though
last week's jobs report disappointed, the rate of job losses is slowing
(1.7 million in Q4 2008, 2.1 million in Q1 2009, 1.3 million in Q2
2009.) By August (data for June)
we expect to see housing prices flattening month to month. GDP declined at a 6.3% annualized rate
in Q4 2008, a 5.5% rate in Q1, and we expect a decline of about 2.5% in
Q2, flat in Q3 rising to gains of 2% by Q4 2009. We're fully invested at this point in
time and waiting for a recovering economy to lift stock prices further.
As always, please don't hesitate to call with questions and concerns.
Yours sincerely,
David Edwards
President
The Heron Capital Management
client letter is published immediately following month end and when
market conditions require comment. The views expressed in this letter
represent HCMI opinion and strategy as of the date published and can
change at any time upon receipt of new information. Data quoted in this
letter are from sources deemed reliable, but no guarantee of such data is
implied.
