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April 2009 Quarterly Review


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April 2009 Quarterly Review

  1. 1. APRIL 2009 QUARTERLY REVIEW & OUTLOOK PACIFIC INCOME ADVISERS 1299 Ocean Avenue, Second Floor Santa Monica, California 90401 Telephone: (310) 393-1424 ▲ www. T he world, or certainly the United States has think of one person I would like to see in an orange entered the “Anger” phase of the grieving jumpsuit with matching stainless steel bracelets. and mourning process for the losses and Admittedly, there is plenty of blame to go around. indignities we have all suffered during this financial Credit rating agencies are near the top of my list. crisis. The losses have been enormous -- almost hard Paid by the issuers of debt and other obligations, to fathom. Losses in the value of our homes and they have an inherent and insurmountable bias. our portfolios; losses of freedoms and flexibility; Rating agencies took issuers’ assumptions as gospel, losses of the ability to retire or support oneself; and gave virtually every security their highest rating. losses of a job, a home, the ability to send a child to While there were only five corporations that had college; losses of confidence and trust; and, importantly the loss of our sense CPI – Inflation of invulnerability, a loss of our belief that we were on the right January 1995 to Present track, and that financial Source: Bloomberg Data Systems engineering was part of the 6.0% solution. With the tally of losses being so incalculable, it is easy to 5.0% see why we must go through a grief and mourning process, just 4.0% as if we had lost a loved one. 3.0% The Anger stage manifested itself in our desire to blame 2.0% someone, anyone, for the pain we are suffering. Not only do we 1.0% Last Report Was Negative not want to pay bonuses to 0.0% employees of banks and financial institutions that must have 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 n- n- n- n- n- n- n- n- n- n- n- n- n- n- n- Ja Ja Ja Ja Ja Ja Ja Ja Ja Ja Ja Ja Ja Ja Ja caused our misery, we have also Chart #1 threatened to retroactively tax those miscreants who might have been fortunate previously earned the highest credit rating, the enough to receive a bonus in 2008. How dare they vaunted Triple-A (four now that GE has been get a bonus when I am suffering, and they have downgraded), every bond backed by mortgages, no matter how risky, was able to receive a Triple-A surely caused my pain! rating as long as there was some extra collateral The blame game is an easy one to play. Anyone there to help absorb losses. Rating agencies are part doing well in this environment must be doing of the problem, and unless their business models something counter to the needs and desires of change, they will continue to be part of the society at large. The blame game does not help problem. anyone, and yet it is so compelling that I must take a moment to vent some of my frustration at those I also find plenty of blame for those witless buyers who deserve the greatest and loudest Bronx cheer, who claim to “not understand the obligation” they or worse, for causing us so much pain. In fact I can were getting themselves into. How dare you sign a
  2. 2. APRIL 2009 QUARTERLY REVIEW & OUTLOOK multi-hundred thousand dollar contract without mandate reserve requirements for life, health, understanding! Push the stop button and ask property, auto, and other insurance products, questions. It is, after all, your home, and your life there were no requirements for AIG to hold any you have signed away. We can also blame the easy reserves against the potential liabilities created by these instruments. When Lehman went bankrupt, money available to make loans to those whose only holders of these CDS insurance products received ability to repay was based on a pulse that was only 28 cents for every dollar of insurance they greater than zero. We can also blame Wall Street thought they had. What kind of actual protection is firms that made hay issuing these loans and then this if the first bankruptcy pays only 28 cents? What selling pools of those loans to investors who did not happens if there are several bankruptcies? Will there do their own homework, and instead based their decisions on the Cliffs Notes issued by credit rating be any money to pay off in the event of catastrophe? agencies. All share blame. We did not get into this Some of the “odd” features of the CDS market are that there are no limits to how Money Supply (M1) much insurance can be issued, and no requirement that you Annual Percent Change hold any of the securities you December 1975 to Present are attempting to insure Source: Bloomberg Data Systems against loss. For example, if a company has $1 billion of debt 20% outstanding, the amount of insurance that could be written 15% to protect against a default of that $1 billion of debt remains 10% unlimited. It is conceivable for 5% there to be $10 billion or more of insurance outstanding. AIG 0% was happy to write more 1 3 5 7 9 1 3 5 7 9 1 3 5 7 -8 -8 -0 -0 -8 -8 -8 -9 -9 -9 -9 -9 -0 -0 ec ec ec ec ec ec ec ec ec ec ec ec ec ec -5% insurance because they did not D D D D D D D D D D D D D D really think they would ever -10% really have to pay, and they did Chart #2 not properly reserve against the potential loss they had insured. situation without a cascade of events that created a What a great business, and a huge profit center for perfect storm. them! An investor seeking insurance did not even My nominee for the poster child of excess is none have to own the underlying security to purchase other than the Notorious AIG (with apologies to insurance. That is akin to me buying insurance on the rapper with a similar name), the large insurance your home. Don’t mind me if I play with matches company. Credit Default Swaps (CDS) were issued behind your garage; after all, I have every incentive by the unregulated part of Notorious AIG, and an for your house to catch fire. Try insuring a car that investor could purchase CDS that were designed to is not registered in your name. It is impossible protect them against the risk of a default of any because you do not have an “insurable interest.” number of questionable securities issuers. Sadly, Yet, I can buy insurance protecting me against the there was no regulation of the CDS market. The default of a security whether or not I own that lack of any regulation allowed AIG and other CDS security. Does anyone else think something is wrong Despite rules that with this picture? issuers to “self-regulate.” Page 2
  3. 3. APRIL 2009 QUARTERLY REVIEW & OUTLOOK Don’t get me wrong. I understand that some strategic thinking to be involved in the details of investors have made huge profits speculating that each and every division. The buck must stop the prices of various securities would decline. Short somewhere, and that somewhere is ultimately the selling is one method for profiting from a decline in executive suite. the price of a particular stock. While we do not sell Banks, financial institutions, hedge funds and other short for our clients, we do recognize this as a viable investors have utilized the CDS market to help strategy. However, the number of shares that are reduce risks. This is the primary reason why AIG is sold short cannot be greater than the number of considered too big and interconnected to fail. shares of stock that exist. Additionally, investors Where was the government regulation that using the options market to speculate on the decline prohibited any firm from getting too big to fail? of the price of a particular security through the Regulation for regulation sake is not inherently purchase of put options have good, but preventing systemic position limits that prohibit failures and mitigating risks them from taking a position Some of the “odd” features of are why we require some that is too large relative to the size of the entire company. the CDS market are that there government regulations. are no limits to how much So Notorious AIG sold CDS There were no limits on the size of the CDS market for insurance can be issued, and no insurance to financial institutions across the globe, any particular issuer. requirement that you hold any and the U.S. Government has Even without regulation, AIG, of the securities you are determined that a failure of being the largest insurance attempting to insure against AIG would cause ripples to of company in the world, should damage so severe as loss... An investor seeking have had some idea about the threaten the entire world reserves that should have been insurance did not even have to financial system. Our maintained to support the government has invested they own the underlying security to hundreds of billions of dollars potential liabilities purchase insurance. That is to prevent a financial system insured. It is certainly possible that a natural disaster akin to me buying insurance on failure. If, however, we is so great as to cause an consider that CDS insurance your home. insurance company with was really a fraud, sold with ample reserves to deplete its the knowledge that there was resources, and perhaps even fail. But the no inherent ability to meet the potential liabilities, management of AIG permitted risks so large that it then why should we not recognize it for what it is? put the entire firm in jeopardy. Investors who used Bernard Madoff to manage their Management is also responsible for agreeing to portfolios were told that the firm was a large fraud, contracts to pay employee bonuses regardless of the and they have lost everything. How much different profitability of the employee, the division, or the is the potential fraud that AIG perpetrated on the entire company. It is easy to consider the hapless financial system at large? employee who is getting a bonus while the rest of us As much as I would like to see the former chairman suffer as part of the problem. Surely, however, it is of AIG in an orange jumpsuit, I also must recognize the management of the firm that agreed to those that anger is just one phase of my mourning process. contracts, and did not even consider the idea that It is time to move on to depression, resignation, and people would be paid in years when their division or then acceptance. Our problems are serious, and the entire firm was not profitable. I do not buy the serious actions are necessary to prevent the systemic excuse that the chief executive is too busy with Page 3
  4. 4. APRIL 2009 QUARTERLY REVIEW & OUTLOOK failures that threaten us. America and the rest of the from banks. Bidders will have access to non- world can only move forward by working together to recourse loans from the Federal Deposit Insurance find solutions to our crisis. At the peak of the Corporation (FDIC), and each dollar of equity invested by the partnership will be matched by a Great Depression there were only 16 Republican dollar of equity from the Federal Government. Let senators remaining in the Senate. The Democrats us say, for example, that a bidder seeks to buy a were so successful in pinning blame for the package of loans from a bank that has a face value of economic crisis on the Republicans that the GOP $100 million. The bidders agree to pay $70 million was virtually trivialized. Politicians, regardless of for this package. Of that $70 million, the bidder their party affiliation, must work together to find would need to put up $5 million of its own money, solutions. We simply cannot tolerate partisanship and they would receive another $5 million of equity for the sake of trying to regain power. We must try from the TARP. The remaining $60 million of the to regain our financial footing first and foremost. purchase price would come from a loan from the A 12- STEP PROGRAM FDIC. In this example, the investor and the In addition to the regular tools of fiscal and government share losses on the first $10 million. monetary policy, this administration and the one that preceded it have come up CAPACITY UTILIZATION with a significant number of programs to prevent our Januuary 1967 to Present current financial crisis from becoming Great Depression 90.0 II, the sequel. Those programs are far reaching, 85.0 and will most certainly help alleviate the existing malaise. 80.0 Among the steps taken include the following: 75.0 1. Troubled Asset Relief Program (TARP) – This is the 70.0 original rescue package At a Multi-Decade Low championed by former 65.0 Treasury Secretary Paulson J a -6 7 J a -6 9 J a -7 1 J a -7 3 J a -7 5 J a -7 7 J a -7 9 Ja 81 J a -8 3 J a -8 5 J a -8 7 J a -8 9 J a -9 1 Ja 93 J a -9 5 J a -9 7 J a -9 9 J a -0 1 J a -0 3 Ja 05 J a -0 7 09 which provided $700 billion n- n- n- n- n n n n n n n n n n n n n n n n n n Ja to help rebuild liquidity for Source: Bloomberg Data Systems Chart #3 the banks. Fears that banks have taken funds but are not lending are generally unfounded. The largest banks are making loans. They also share any potential profits equally, while Unfortunately, the loss of the credit available the FDIC receives interest and repayment on its through secondary sources such as loan brokers loan. overwhelms the amount of lending being completed (Sadly, the government has effectively soiled itself by by the banks. Details were non-existent, until the mandating limits on compensation paid to bank current Treasury Secretary provided greater visibility executives who have taken TARP funds. Those on how this might work through the PPIP. limitations have caused potential bidders to worry 2. Public – Private Investment Partnership (PPIP) that they will also be asked to reduce their - Bidders are encouraged to try to buy troubled assets compensation if they are successful and make Page 4
  5. 5. APRIL 2009 QUARTERLY REVIEW & OUTLOOK significant profits through their PPIP investments. consumers. This spending includes reductions in Citibank employs 323,000 employees. Do we tax withholding, and people will see the benefit of really care how much money the management those plans beginning in their paychecks in early team makes if they lead Citibank back to April. profitability? How much tax will a profitable 5. Increases in FDIC Deposit Insurance - The Citibank pay? The government argues that there are government temporarily increased the available huge numbers of effective government employees deposit insurance to $250,000 from $100,000. This willing to work for a fraction of the pay historically prevented a run on the banks because people were offered by large financial comforted by the government institutions. Those same insurance on their savings, and government employees failed to did not feel the need to remove find the fraud perpetrated by This administration and the their funds. one that preceded it have Bernard Madoff, even as 6. Commercial Paper Funding whistle-blowers screamed about come up with a significant Facility (CPFF)- The numerous telltale signs that number of programs to government provided a Madoff could not legitimately provide the returns he had prevent our current financial backstop to issuers of commercial paper. This been “generating.” The crisis from becoming Great prevented the failure of government will need to find a Depression II, the sequel. companies that rely on short- way to ensure that participants term funding for their survival. Those programs are far in the PPIP will not be penalized retroactively, and 7. Temporary Guaranty reaching, and will most trust will need to be regained Program for Money Market certainly help alleviate the Funds (TGP for MMF) – The for this program to be existing malaise. successful.) government has also decided to guarantee all money market 3. Term Asset Backed funds. This was also designed Lending Facility (TALF) - The market for securities that represent pools of loans such as automobile to prevent runs on banks caused by losses of loans has dried up. The TALF plan is designed to confidence. provide liquidity to the system so that loans can 8. Temporary Liquidity Guarantee Program once again be packaged and sold. These loans will (TLGP) – The government has agreed to guarantee be financed by the Federal Reserve Bank of New new debt issued by financial institutions to provide a York. The first sales under the TALF program were facility for these institutions to raise additional completed in late March, and while they were small funds. These guarantees continue for all debt issued compared to the size of that market more than a year through the end of 2009 with maturities through ago, they were successful, and there is hope that the June 30, 2012. securitization of loans will be brought back to life. 9. Primary Dealer Credit Facility (PDCF) – 4. American Recovery and Reinvestment Act of Following the failure of Bear Stearns, the Fed 2009 - The government is providing more than $800 decided to permit investment banks to have access to billion in spending to help prevent the economy short-term funding through the Fed’s discount from getting worse. While some people do not window. While many believe that access to the believe that enough has been done, or that the right discount window might have prevented the failure of things are being done, the fact remains that Bear Stearns, the facility is now available to prevent spending $800 billion will replace some spending further institutional failures. that was previously made by businesses and Page 5
  6. 6. APRIL 2009 QUARTERLY REVIEW & OUTLOOK 10. Federal Reserve to Purchase Treasury Bonds more? Are we just exacerbating the problem? to Provide Liquidity – The Fed has indicated its The most commonly heard criticism of the willingness to purchase treasury bonds in the open government’s actions is that such an enormous market to provide liquidity and encourage interest expansion of the Fed’s balance sheet must cause rates to fall. Lower interest rates should permit inflation. Inflation is currently quite low, as shown more homeowners to refinance their existing in Chart #1. The Nobel Prize winning economist mortgages to reduce payments. Milton Friedman is frequently quoted as saying “Inflation is always and everywhere a monetary 11. Government Plans to Encourage Financial phenomenon.” The implication is that the Institutions To Restructure Existing Mortgage monetary expansion used to fund the myriad of Debt – By working with banks and homeowners to reduce mortgage payments to a specific percentage of programs will cause inflation, and that this monetary total income, it is hoped that fewer people will lose inflation will also manifest itself in a declining value of the U.S. dollar as inflationary pressures build. their homes through foreclosure. Growth of the money supply is shown in Chart #2 12. There are many other programs that officials have put in place to prevent the failure of more The causes of consumer price inflation (CPI) are financial institutions. Accounting rules are being difficult to quantify, and there is some consensus changed to reduce the pressure exerted on banks that increases in CPI are caused by increases in and financial institutions to incur losses on labor costs, and by a lack of excess capacity in our securities held on their balance sheets. Short-selling ability to manufacture goods. Capacity utilization is rules are also shown in Chart being changed to #3. Recognizing reduce the ability that we disagree of speculators to It may, however, be time to consider that all the with Professor drive share prices Friedman at our endlessly lower. bad news is out. Companies are reporting weak own peril, we do earnings for the first quarter of 2009, but stock not believe that In recent testimony, both prices so far have been able to absorb the bad news labor costs will be the Treasury rising any time Secretary and the without swooning. The fact that we have been in soon. Factory recession for 16 months indicates that a weak Federal Reserve utilization rates Chairman have are at multi- economy is not new news. indicated they decade lows, will do everything indicating that within their factories can power to prevent additional financial institution increase production for many years before creating failures. (One critic suggested these programs be inflationary pressures. Companies do not have any renamed Bank Asset Reliquification Facility, with pricing power, anywhere. The idea that inflation the appropriate acronym, BARF.) will return is valid, but expecting it to occur in There are many criticisms of the government’s 2009, or even in 2010, seems quite remote to us. efforts to prevent this economic crisis from The same may be true of the U.S. dollar. In the land of the blind the one-eyed man is King. The becoming more severe. One appropriate criticism dollar may succumb to inflationary pressures and fall is the fact that the government is trying to borrow in value. However, this credit crisis is a global its way out of a debt bubble. Is the way to help a system burdened with too much debt to borrow event, and other nations are facing similar difficult Page 6
  7. 7. APRIL 2009 QUARTERLY REVIEW & OUTLOOK economy is not new news. Corporations have very choices: try to inflate your way out of this mess, or little visibility in their business looking into 2009, languish with sub-par growth for many years, or even decades, as have the Japanese. It is hard to but earnings estimates are already down by 50%, so make the case for a strong dollar in the face of rising weak corporate earnings can no longer be inflationary pressures that are likely over the next considered a surprise to anyone. Yes, few years, but it is even harder to find a currency unemployment continues to climb, but as we have pointed out, increasing unemployment reflects what that is in a materially stronger position right now. has already happened, and has been a very poor There are many reasons to remain negative. Credit indicator of whether the economy is beginning to problems at banks are expanding into credit cards, bottom, or perhaps even starting to improve. The Existing Home Median Price weak March employment report was widely expected, January 1968 to Present and stocks were able to rally Source: Bloomberg Data Systems despite the dire news. This 250 Great Recession is already the Year-over-year prices have declined for 31 months 225 longest since the early 1970s in a row. Since 1968, existing home prices had 200 and is likely to be the longest never fallen for more than two consecutive months. 175 since the great Depression. 150 The definition of a declining 125 stock market is one where the 100 recent lows are lower than the 75 previous lows. The definition 50 of a rising stock market is one 25 where the recent highs are 0 higher than the previous Ja 8 Ja 0 Ja 2 Ja 4 Ja 6 Ja 8 Ja 0 Ja 2 Ja 4 Ja 6 Ja 8 Ja 0 Ja 2 Ja 4 Ja 6 Ja 8 Ja 0 Ja 2 Ja 4 Ja 6 08 6 7 7 7 7 7 8 8 8 8 8 9 9 9 9 9 0 0 0 0 highs. By this definition, the n- n- n- n- n- n- n- n- n- n- n- n- n- n- n- n- n- n- n- n- n- Ja Chart #4 stock market continues to be falling. While stock prices real estate loans, and high quality mortgages. Credit continued their descent, there have been some very losses will continue to expand for quite some time. interesting underlying trends. As the S&P 500 reached a panic low on October 10th, there were Home prices continue to fall and the number of foreclosures continues to expand. Home prices are 6,762 stocks on the New York Stock Exchange shown in Chart #4. Since most of the problems we (NYSE) with prices at new 52-week lows. As the S&P 500 made a new low on November 21st, only face resulted from weakness in the housing market, many market prognosticators believe that housing 3,600 stocks printed at new 52-week lows. More must bottom before a meaningful bottom can be recently, as the S&P 500 hit a new 12-year low on March 6th, only 1,793 stocks made new 52-week reached in the financial services sector, and lows. This is a very important trend. Despite ultimately in the real economy. lower prices for the stock market index, fewer and It may, however, be time to consider that all the fewer stocks are actually participating in making bad news is out. Companies are reporting weak new lows. At some point the ability of stocks to earnings for the first quarter of 2009, but stock withstand bad news, and stop going down should lay prices so far have been able to absorb the bad news the groundwork for a meaningful bottom that can without swooning. The fact that we have been in lead to higher prices. recession for 16 months indicates that a weak Page 7
  8. 8. APRIL 2009 QUARTERLY REVIEW & OUTLOOK We mentioned that the stock market hit a 12 year By our thinking, the Treasury market remains one of low in early March. This is important because since the most overvalued markets. We do not expect the beginning of the 20th century there have been inflationary pressures to become apparent for several more quarters, but with 10-year interest rates well only three times in history that stock prices have below 3%, we find Treasury prices very susceptible to any increase in inflation. Corporate bond markets remain far more attractive relative to the rates available in the Treasury market, and high yield markets remain very attractively priced, although the potential for increased credit problems and defaults suggests some caution is warranted with regard to high yield bonds. For taxable clients, the municipal bond market, particularly the California municipal bond market, remains a very attractive investment alternative. In our stock portfolios we continue to favor those stocks that can survive and thrive in a recessionary environment. However, we recognize that our clients’ portfolios will soon need to have retreated to a 12-year low. See the chart above. changes made to reflect prospects for more robust The first was the period from 1921 through 1932. economic growth over the next several quarters. The second was 1962 through 1974, and the third was the last 12 years, 1997 through 2009. In the It is important that we know of any changes in your first two periods stock prices were materially higher financial situation. If you are nervous or in the years that followed. While history does not uncomfortable with any aspect of your investment repeat itself, it does frequently rhyme, and it may portfolio, or if you simply have questions, we once again be the case that stock prices could be encourage you to make an appointment for us to get higher over the next couple of years. together. Stock prices are forward looking, and have almost always begun a new advance prior to the end of the If you would like a copy of our Form ADV Part II, recession. While it is entirely possible that the free of charge, please contact Robin Campbell at recession will last through the rest of 2009, it is also 310.255.4469, or at likely that some modest but overdue economic improvement will be palpable by 2010. Stocks will Bennett E. Gross, CFA anticipate the economic improvement and should Director of Equity Investments begin to improve within the next several months. It is entirely possible that the lows for this terrible Marla L. Harkness, CFA bear market have already been made. Portfolio Manager—Equity Investments PACIFIC INCOME ADVISERS 1299 Ocean Avenue, Second Floor Santa Monica, California 90401 Telephone: (310) 393-1424 ▲ www.