(Endowment Like Fund Management)
This is the ELF Capital Management,
LLC Market Comment for the month ended July 2008. If you do not wish to be included in our
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Headwinds and Tailwinds in the
In a bear
market cycle, like we’re experiencing now, the emotion of fear is often exacerbated. And, decisions made from a position of fear rarely
bring any good. How do you feel about
the economy right now?
My good
friend and colleague, Dr. Dan Elash, suggests that the best remedy for fear is
education as fear stems from one’s uncertainty about what the future brings. (Dan is a behavioral psychologist whose
career has been focused on helping business owners and executives navigate
organizational change or management challenges.) Once we become familiar with the facts, we
can then begin to focus on solutions.
In this
month’s letter, I’ll set out to plainly recap the headwinds and tailwinds influencing
the
Now, for the subject
at hand. If “headwinds” represent the “bad news” and
“tailwinds” represent the “good news”, I’ll start with the “bad news” first.
Headwinds
The most
significant headwinds now facing the
The oil
crisis. While more passionately discussed in my
letter last month (see Oil
Paints the Landscape), the rapid rise in oil this year, to $147 per barrel,
has significantly boosted inflation beyond tolerable levels for both individual
and business consumers. We finally reached
a breaking point. Individuals have responded
by traveling less and reducing their oil consumption; while businesses began
taking steps to mitigate profit erosion from oil related expenses that are rising
faster than sales growth. The most
impacted industry has been the airlines, with many carriers now just trying to
stay alive. Headline seeking economists
and media pundits have increased fears by predicting $200 to $300 per barrel
oil by year end. High oil prices are
also prompting investors to bet that a greater number of individuals will default
on loan payments and have less to spend on discretionary items.
Towards the
end of July, oil prices had traded lower and, if the retreat continues, it can
only be good for both consumers and stock market investors. However, the underlying problem of increased
global consumption outstripping supply has not yet been solved. If consumers return to old habits, we may
very well see oil run up again. Yes,
consumers have reduced demand, but still drive the same cars and heat their
homes in the same fashion. And, as for
The
credit crisis and the housing crisis. I’ve combined them
together as I believe they are intertwined.
As well, both are representative of how fear and uncertainty can cause a
vicious cycle. It is my opinion that
these challenges have been more amplified by fear than by supply and demand
dynamics.
It was not
surprising that the housing market had to turn as home values rose too rapidly
for too long. It finally reversed course
after the Fed began managing it down by relentlessly increasing its target
interest rate. What seemed less
threatening, however, was the change in mortgage banking practices over the
last couple of decades or so. Rather
than holding mortgage loans on their books, banks enjoyed the ability to
convert them into securities and sell them to investors in the form of CDOs
(collateralized debt obligations). The
mortgage lenders made money by collecting origination fees and keeping a
portion of the interest in return for servicing the loans. By selling the loans, the mortgage banker’s
investment was no longer at risk. This
factor afforded banks an almost unlimited source of funding to lend from. So they believed. Unfortunately, CDO buyers and sellers relied
too heavily on the ratings agencies and left themselves vulnerable. With the Fed’s prolonged raising of interest
rates, investors began worrying about lower quality (sub prime) loans. They also came to realize that they really
didn’t understand the CDOs they owned and many headed for the exits. Bearish economic pundits, joined by
short-sellers, wasted no time in creating gloomy predictions. This created enough caution (fear) that
potential buyers were encouraged to remain on the side-lines. With more sellers than buyers, market prices
for these CDO securities dropped to unreasonably low levels. Seeing potential bargains, the banks, brokers
and funds specializing in this market became the only buyers. This is the point at which things could have gotten
better, but they didn’t. Fear overcame
and the vicious cycle began.
The market
didn’t stabilize and CDO prices continued to go lower. Promoters of fear and uncertainty had an easy
time of seeing that their warnings became self fulfilling. As a result, the banks, brokers and funds who
bought the CDOs had to then record “paper” losses even though the intrinsic values
of the underlying CDO loans were believed to be worth more. Several funds went out of business – fueling even
greater fear; and the banks and brokers now had little capital with which to
originate new loans. In fact, they saw
it as potentially more profitable to hold onto the CDOs, if they could. Anticipating that available financing was
drying up, the already “top heavy” housing market began to fall further. This only served to add significantly greater
distress to an already softening housing market. When home buyers sense a distressed market,
they will wait to see how low prices will go before they decide to make a purchase. As new and existing homes are anything but
scarce, there is now no urgency to buy one.
At the same time, many jobs relating to housing have been lost and many
of these people have mortgages to pay.
This led to warnings that a greater percentage of mortgages will default,
pushing CDO prices even lower. This, in
turn, put further pressure on financial institutions and opened the door to
rumors of impending bank failures. Confidence
became so destroyed by fear that the Federal Reserve stepped in to facilitate
an emergency sale of Bear Stearns to JP Morgan Chase in order to avoid a
potential melt-down of the financial system.
This brings us to March of this year and I’ve only attempted to give you
the highlights.
Since then,
we have been witnessing an important game of chess in the media between those
who use fear and those who seek to build confidence. So far, those on the side of fear have been
winning the match. Fear continues to
threaten our financial system; it has pushed stock markets into bear market
territory; and, it continues to threaten us with the possibility of a
recession. The oil crisis hasn’t helped
either. However, the tide may be
turning. And remember, it is my humble
opinion that this all started with fear and uncertainty in the CDO markets.
OK. So let’s take a break and discuss the insanity
in the CDO market. On July 29th,
Merrill Lynch announced that they were selling $30.6 billion of CDOs, at 22¢ on the dollar, and raising
additional capital. They decided to
forego the prospects of profiting from their positions as, unless buyers come
back to this CDO market, the risks of collecting profits through the
de-leveraging process were too great. By
doing this, they “took one for the team” and put themselves (hopefully) on the
path of reversing the vicious cycle and mending the financial system. That’s not to say that the Fed Governor
Bernanke and Treasury Secretary Paulson haven’t done positive things to help as
well – they have. But, that is a whole
other story. Let me put the 22¢ on the dollar price in
perspective. Most of the outstanding
CDOs represent pools of residential mortgages.
And, each of these residential mortgages is collateralized by a
home. In order for the new buyer, of
these CDOs, to take a loss, the entire pool of mortgages would have to default
(not very likely) and, after foreclosure, they would have to recover less than
22% of the home’s original loan value after expenses (less likely). Even though I’ve oversimplified the example,
it is not far from being representative.
A weak US Dollar.
This is a rather complex topic to try to explain in this letter. Sufficed to say, the main issue here is that
a weak US Dollar is considered inflationary.
The
Tailwinds
The most
significant tailwinds facing the
Relatively attractive asset
valuations. So far, non-financial large company earnings
have exceeded expectations. And,
relative to inflation and interest rates, equities look attractive at these
levels. Also, we have witnessed multiple
large up and down stock market swings in the last week of July, which may be
signaling that we are in a bottoming process.
There is also a significant amount of investor cash on the sidelines waiting
to come into the market.
Ben Bernanke and Hank Paulson.
The Federal Reserve Bank Chairman and Treasury Secretary have done a
good job in averting several possible “melt-down” disasters. The complexity of challenges they have faced
has been significant and the creativity and stamina that they have shown, in
the fog of economic war, is nothing less than remarkable. On top of all this, despite receiving many
politically motivated insults, their patience in working with Congress has been
quite commendable. With them in place, I
have complete confidence that “the sky won’t fall”.
Exports and a weak US Dollar.
A weak US Dollar has made exported US goods and services attractive to
the rest of the world. And, the rest of
the world has been buying from us. This
has significantly helped our economy while the
Confidence Boosting “Free-Market”
Signals
Oil.
As I’ve written about before, the
The
Credit.
It would be a huge breakthrough to see a return of confidence to the CDO
market. The crisis started with the CDO
market and the CDO market is the levered solution (think simple machines) with
confidence being the fulcrum; otherwise, other measures are simply “band-aids”
while we drag the credit crisis up an inclined plane. Fed Chairman Bernanke and Treasury Secretary
Paulson have done, and continue to do, their part in working to bring
confidence back to the markets. It would
be very encouraging if Wall Street stepped up and did more to help solve the
problem also.
In the
early 1990’s, when I played a role in helping pioneer the CBO market
(collateralized bond obligation), credit enhancement was important in drawing
the initial investors to the product.
This was long before the “street” coined the, catch-all, term of
CDO. While we utilized a financial
insurer and the ratings agencies, the greatest form of enhancement came in the
form of including active portfolio management in the mix. Back then, the CBOs were collateralized with
junk bonds, or mortgage derivatives, or variable rate bank loans. Yester-year’s CBO structure greatly
simplified the need for analytical research and the administrative support required
to successfully invest in those asset classes.
After management expenses, investors were able to receive a yield
greater than corporate bonds comparably rated.
Some CBOs even had zero coupon US Treasury securities included in them for
clients who desired principal protection.
However, the active management component ensured that the collateral
backing the CBO was “hand-picked” and substitutions were made whenever a
portfolio security no longer met the criteria for holding. In today’s version of the CDO, the portfolio
manager role no longer seems to be included in the process to protect investors
by rejecting lower quality loans. Maybe
history offers a lesson.
If we can
see Wall Street taking more steps to redevelop confidence in the CDO markets,
it would go a long way in boosting confidence in the economy. Merrill took the first step and it was a
drastic one! In fact, Wall Street could
find itself generating profits through the re-engineering of existing CDOs in
more transparent wrapping paper. The
market for it exhibits both need and scale.
So, the incentives are significant.
What can
you do as consumers and as investors?
Recognize that oil is the biggest headwind. The best thing that you can do is to continue
being conservative with your oil consumption while putting pressure on your
political representatives to ease restrictions on developing our oil and gas
resources. Shift your spending from oil
to other things, keep current with any loan payments and save a little. Have faith that, while the stock market looks
pretty ugly right now, markets do recover and equities offer the best
opportunities over the long run. Once
the CDO dust settles, financials will offer the best growth opportunities. Those who do their homework in the CDO market
will do great also and, despite the claims of some media pundits, that market
will not go away.
During
July, we held high levels of cash in our client portfolios. We will continue taking our cues from oil
prices and international economic data.
We continue our belief that we are exporting slower growth while
importing inflation. Slower growth and the
solutions described above will tame inflation.
We think the
Our
performance for July was down 1.81%.
More info is
available at this link: www.hwkfs.com/Content/IM_Performance.htm