2009 1st Quarter Report

(Download printable .pdf version here.)

But those who forget the past, neglect the present, and fear for the future have a life that is very brief and troubled; when they have reached the end of it, the poor wretches perceive too late that for such a long while they have been busied in doing nothing...They lose the day in expectation of the night, and the night in fear of the dawn .- Seneca

The current economic downturn has, in many respects, exceeded every recession since WW II. It is already the longest downturn of the post-war period. Simon Johnson, in the May edition of Atlantic Magazine observed that, "The great wealth that the financial sector created and concentrated gave bankers enormous political weight…a weight not seen since the era of JP Morgan in 1907. Elite business interests,-financiers in the case of the US- played a central role in creating the crisis, making ever larger gambles, with the implicit backing of the government, until the inevitable collapse. The government seems hopeless or unwilling to act against them."

As governments around the world have cut back their ownership and regulation of business over the past three decades and increasingly relied on markets and private enterprise, the risks of corporate abuse have been heightened and new tools are needed to manage these risks. This shift which has manifested itself through privatization, deregulation, and for-profit corporations providing services traditionally seen as the responsibility of the public sphere was sustained by the promise of a richer, better world, yet, the surge in corporate scandals, financial crises, power struggles between government and business, and displays of management greed, along with global reminders of widespread unemployment and despair, have given critics powerful arguments for government oversight and control.

President Obama has declared, "We are committed to comprehensive reform of a failed regulatory system." Internationally, the brief G-20 meeting in London on April 2nd ended with a range of new promises and a brief statement on the future regulation of the financial sector. The participating countries have promised to co-ordinate their crisis strategies and to avoid moves toward protectionism. Yet, according to the World Bank, since the previous meeting of the G-20 in November of 2008, 17 of the 20 countries introduced protectionist measures in order to shield their economies.

After so many years of welcoming laissez-faire policies and deregulation, do investors face a radical inflection point? Though ardent fundamentalists may fear this "intrusion," I am optimistic that the new direction in policy will serve to guide the "Invisible Hand" (the metaphor that Adam Smith coined in describing the cooperation without coercion that maximizes a society's wealth.) For example, US Treasury chief Tim Geithner's plan for toxic assets seems to provide a government subsidy for private investors (including the bankers and hedge funds) to buy up troubled bank assets with cheap, non-recourse government loans, guarantee against losses, and share in half of the profits. Who benefits? Clearly, the troubled banks are the biggest beneficiaries and ultimately, the public where borrowers who may eventually see lending policies loosen, but most directly, the financial oligarchy of hedge funds and entrepreneurial bankers (i.e. Pimco, BlackRock, and Goldman Sachs, etc.). Geithner's vagueness in his initial presentation about the bailout plan in early February triggered a slide in the market of some 2500 Dow points, however; once government policy became clear, confidence seemed to return to Wall Street. Evidently, despite some nattering, investors like this version of "intrusion”.

The announcement that the Financial Accounting Standards Board was weakening the somewhat obtuse (in my opinion) "mark-to-market" rules after considerable political pressure also served to boost banks' balance sheets and reported profits and buoy confidence. Academic accountants, long on theory but short on practicality, denounced this as a green light for fraudulent double-bookkeeping. In my view, mark-to-market rules were delusional in pretending that markets existed where there were none. Score another positive move for investors.

The sense of optimism in the stock market engenders the thinking that the economy and general financial conditions must be improving because equities simply foreshadow such an outcome...equities are a leading economic indicator. But credit markets have been the center of our economic distress globally and deserve our focus and attention. Let's start with a look at the actions of the Fed and the changing composition of its balance sheet.

The size of the Fed's balance sheet is now a whopping $2.17 trillion, ballooning by $1.3 trillion in a year. Careful examination of the components of the balance sheet reflect the fact that credit markets are far from robust, and that we should not get too carried away with the perceptions embedded in the current romp in equities.

Component	April 15, 2009 Balance	April 15, 2008 Balance	Change
Reserve Bank Credit	$2,169 Billion	$866 Billion	$1,303 Billion
US Treasuries	526	549	(23)
Agency Securities	61	0	61
Mortgage Backed Securities	356	0	356
Term Auction Credit (LIBOR)	456	0	456
Commercial Paper Funding Facility	238	0	238
Liability Swaps	294	38	256
Maiden Lane LLCs (AIG)	72	0	72
Credit Extended to AIG	45	0	45

Just a year ago, the Fed balance sheet consisted of what most of us would have expected, US Treasury holdings and repurchase agreements (liability swaps.) Treasury holdings represented almost 65% of the Fed's balance sheet, as one would expect versus less than 25% now. What does this change in composition mean for investors?

Let's start with agency securities. Since the demise of Fannie and Freddie, the Fed has stepped up as a buyer of these agencies’s debt as foreign investors dumped their holdings. Since the implicit guarantee of the US government of this agency debt seems to have become much stronger, the yields on this paper have dropped significantly. This market is definitely healing. Mortgage backed securities (MBS) have grown since the Fed announcement that it would buy $750 billion of MBS. I would expect this to continue in order to target mortgage rates down to around 4%. Needless to say, without Fed involvement, the nation would be facing far higher mortgage rates at this point. The securitization market for mortgages is still gasping for breath and the Fed is providing much needed oxygen. Again, score one for the intervention.

The Term Auction Credit Facility was set up to help interbank markets- that is banks lending to other banks...put otherwise, to bring LIBOR down. This intervention has been very successful as LIBOR has dropped from October peak levels of 4.5% to a current 0.41%. Whether this drop in LIBOR is a result of lessening of risk perceptions or the heavy hand of the Fed, it matters not...this highly important and influential rate represents a significant improvement in the crisis and the pricing of risk.

Following the Lehman bankruptcy, the Fed set up its commercial paper (CP) funding facility and currently owns about one quarter trillion in this paper. At the peak of its activity, the Fed had some $360 Billion, but has been able to ease back somewhat on its purchases since that time. The current level of CP ownership has been stable as the overall CP market has contracted...not good news since the Fed now represents a growing portion of a contracting market...I would estimate some 15-20% of the total CP market currently.

Looking at corporate debt, please look at these charts of Moody's Baa yields (in red) as compared to 10 Year US Treasury yields (in blue) As you can see, despite the significant drop in bond yields that occurred in the government market, the corporate market yields marched in the opposite direction. Investors continued to concern themselves about the credit outlook and demanded to be compensated for this risk. This behavior is independent of everything else we have discussed. The reason-unlike MBS, commercial paper, and government agency paper, the Fed is not directly involved in the purchase of corporate debt.

Even in the highest grade corporate debt, that rapidly dwindling AAA category, we see similar behavior though the spread (the difference in yield) is not as wide:

The intervention of the Fed in my view has been necessary and important for creating the impression of healing or stabilization in most pockets of the credit market. In those segments of the credit market where the Fed is not involved, (at least not yet) there remains continued stress, emotion and uncertainty.

Political bashing has always been a popular sport but recently, banker bashing has gained popularity. There is a widespread perception that banks are not lending, (though Federal Reserve data demonstrates otherwise) and hence, prolonging the recession. According to recent Financial Times data (quoting Dealogic,) banks issued almost $1,500 billion worth of new corporate loans across the global financial system in 2008. That was well down from 2007, when over $2,000 billion of loans were made. But the loan total last year was similar to what was seen in 2006 and twice the scale of activity in 2004. Hardly, what one would call a credit drought.

What has imploded though is the securitization world. If you exclude agency-backed bonds, in 2006 banks issued about $1,800bn of securities backed by mortgages, credit cards and other debts. Last year, though, a mere $200bn of bonds was sold in markets, and this year market issuance is minimal. The financial system needs to find a way to restart securitization or we could face a world where credit will remain a highly rationed commodity for a long time to come. Unfortunately, securitization in its worst forms foisted off risky assets to the unsuspecting buyers and divorced banks and investment banks from having a vested interest in the creditworthiness of those assets. I suspect that a revitalized securitization market will have greater transparency as well as rules such as a 5% rule that requires issuers to retain at least 5% of the securitized assets in order to more diligently monitor the end borrowers.

Some crises spread hysteria; some clear the mind and focus attention. This one has done both. Large surpluses in rapidly growing emerging economies powered western bubbles. When they burst, the crisis struck every part of the global system. We have rediscovered old truths...people are not always rational; they make mistakes and get carried away by euphoria. Speculating with borrowed money is inherently risky and riskier, and the more complex and interconnected the assets are, the greater the risk. Unregulated markets may well reduce, not improve social efficiency, another lesson that the crisis teaches.

These are indictments of capitalists not capitalism per se. The few academics who suggested that markets did not always know best were dismissed by economic liberals as living in the past or were told that the new financial system had transformed risk and raised global living standards. Reckless growth and unchecked ambition caused many markets to misprice risk and consequently, demonstrate a need for greater regulation. The ideology of free market fundamentalists has clearly become bankrupt. After all, markets do provide a check against the abuse of power of the government, just as governments should provide a check against the abuse of power of the market. Our economic and political system works because it has checks and balances, which limit the power of any group, and prevent absolute power from corrupting absolutely. Though many observers equate US style capitalism with unconstrained free markets, the story is much more complicated than that. As George Akerlof, 2001 Nobel Laureate in economics argues:

"Commercial and savings banks used to have reason to be careful initiating mortgagesthey would most likely hold the debt for years. But banks would increasingly sell the mortgages they initiated to others. And regulation did not adapt to reflect this change in the financial structure. The regulatory failure led to a profound systematic instability in our economy, which accounts for the severity of our economic crisis. Devising new regulatory structures that will allow for financial innovation to proceed and yet prevent new systemic problems is the major challenge to our creative capitalism today."

"Public antipathy toward regulation supplied the underlying reason for this failure. The US was deep into a new view of capitalism. Americans believed in a no-holds barred interpretation of the game. We had forgotten the real lesson of the 1930s: Capitalism can give us real prosperity, but it does so only on a playing field where the government sets the rules and acts as a referee."

As Akerlof puts it, “A brilliant player wants a referee, for only when the game has appropriate rules can he really show his talents." My interpretation is that the investment banks will do what they do best, running the casinos rather than playing at the tables themselves.

One area that has been woefully in need of a referee or regulator is the credit default swap arena. Credit default swaps (CDS) are the rocket fuel that turned the sub-prime mortgage fire into a conflagration. They were the major cause of AIG's demise, and by extension, many bank problems. CDSs start out as essentially an insurance policy. If you owned a bond and were concerned the underlying company might default, you bought a CDS to protect yourself. Literally, the buyer swaps the risk of default with someone else. Banks bought them to reduce the amount of capital they were required to hold against investments-in other words, to avoid regulation. Others bought CDS without owning the bond to place a bet on the company’s future. CDSs were completely unregulated. In short, whenever a financial institution issues a guarantee of an outcome, there should be a regulator that ensures that the guarantor holds sufficient capital to make good on that guarantee. Innovators such as AIG's Financial Products division should risk their own capital not the entire financial fabric. Setting that balance is where effective regulation comes in and where guarantors can ensure others that they have the capital to deliver. Keep in mind that the regulated parts of AIG, representing 90% of the company's assets were solvent and remain so. The death spiral was caused by the unregulated part, a 10% unit that sold almost $500 billion in CDS.

One of the more interesting indicators of the economy is the Chicago Fed National index,which has plummeted since 2007, the onset of the recession:

The index is a weighted average of 85 indicators of national economic activity drawn from four broad categories of data: 1) production and income; 2) employment, unemployment, and hours; 3) personal consumption and housing; and 4) sales, orders, and inventories. A zero value for the index indicates that the national economy is expanding at its historical trend rate of growth; negative values indicate below-average growth; and positive values indicate aboveaverage growth.

As you can see, the -0.7 level is highlighted in the chart. Its significance is that a penetration of this level is indicative of the beginning of a recession. Rather than penetrating, this index has plunged. In periods of such economic weakness, there is little chance of inflationary pressure. In addition, looking at this indicator on a longer time frame should kindle some optimism:

It appears that this indicator has bottomed at lows last seen in the depths of the very tough 1974 recession. Historically, every time this indicator has reached this rate of change depth, it has been temporary and it has reversed itself in very short order. So, for this to be the typical US economic recovery, the spike should literally come in the next two to three months ahead. In some way, a moment of truth or economic showdown has arrived.

There are some tentative signs that the sharp decline in economic activity is slowing, for example in some consumer spending data and even in sales of new motor vehicles. Initial evidence suggests that the turnaround will likely be shallow. The brutal truth is that the financial system is far from healthy, the deleveraging of the private sectors of highly indebted countries has not yet begun, and the rebalancing of global demand has barely started. The scale of public policy support is unprecedented. The most important central banks of the world-the Federal Reserve, the Bank of England, and the Bank of Japan- have official rates close to zero, and have adopted very unconventional policies as we have outlined for their balance sheets. Internationally, it appears that China's growth is rebounding and low inventory levels may generate a manufacturing and export revival for its trade partners.

In the letter we circulated in mid March, we essentially drew a line in the sand...sentiment had become utterly despondent, and valuations had become fire-sales. Extreme volatility in markets also creates extreme opportunities. Though figures on unemployment, industrial production, exports, world trade, and continued real estate problems remained uniformly grim, investors in the last three weeks of the first quarter, and continuing into the current quarter have rallied the market more than 20% from its early March lows.

We believe that we have seen the lows in this market and that three or four years down the road, this will have proved to be an extraordinary time to invest. Our principles remain the same. We are extremely wary about investing in companies that have debt. We do not want equity investments in companies that will be dependent on capital markets any time soon to finance the business.

As we are in the midst of proxy season, we wish to remind you of our long standing interest in corporate governance and reputation management. With executive compensation being blamed as one of the prime culprits in the blow up of the financial sector, pay-related shareholder proposals are commanding a great deal of our attention and support. We are supporting many "say on pay" proposals and withholding support of compensation committee directors that have provided egregious bonuses for managements despite poor shareholder experience. In one company, for example, a substantial stock award of over $8 million was provided the CEO despite missing four of five goals by 20-25% and beating only one by merely 4%. In another example, the compensation committee provided the CEO an unusual "other compensation" item of an $85,000 generator for his home in case the lights went out.

As the Seneca quote at the beginning of this letter suggests, living in trepidation of the future and busying oneself in doing nothing is an inappropriate stance at this market juncture. We intend to take advantage of attractive prices and decent values as the market creates them. As we have said, there is little reason to reach up the risk ladder when relatively safe investments are priced this attractively.

As always, we look forward to active discussion of your holdings as well as your concerns andquestions. We appreciate your confidence and trust.