The Long Run Quarterly Letter: April 2008
For too long, leverage has been building in every corner of the global financial system. Those who still refer to this global credit crisis as the “sub-prime credit crunch” simply don’t understand the scope of the problem. The de-leveraging of the overall system will take years and its impact will be felt well beyond the boundaries of the mortgage market. As we noted in our first quarter Long Run of last year: Brokerages and banks are just beginning to rein in their lending, and we expect more blowups. The sub-prime lending crisis is a prelude. It is also a constructive study on just how weak lending standards can get in times of easy leverage. More shoes will almost certainly drop as participants recognize that risk is not being priced accurately across a wide range of markets.
The sooner investors come to grips with the scope of the problem, the sooner the general markets will find stability. Investment banks – many still buckling under leverage approaching 30 times their balance sheet equity – no longer have any appetite for risk, and commercial banks – desperately raising capital from across the planet to stay solvent amidst a tidal wave of write-downs – have closed their lending windows. And now creditors are aggressively seeking their money back, forcing borrowers to sell what assets they can to meet the lenders’ calls when cash is not readily at hand. Until debt levels return to more reasonable historic norms and fair valuations are confirmed for all matter of collateral (everything from houses to CDOs and other structured products), this process will grind on.
A sensible observer would point out that a return to more responsible lending practices and tighter margin rules seems to be just the right medicine for reducing leverage in the system. But in an environment where even the strongest lending institutions have so little confidence in their counterparties (or so little capital standing against their debts) that they refuse to extend loans to anybody, the potential for wide-ranging systemic breakdown looms. Since last summer, when credit problems first took root, many have wondered, “What would we do if the entire financial system as it currently exists were to grind to a halt?” The fear of this potential disaster has crippled consumer and investor confidence. It has driven dramatic and historic Fed action. And it explains why the failure of Bear Stearns represents a critical turning point in this crisis.
Founded in 1923, Bear Stearns was one of the largest global investment banks and securities trading firms in the world. With more than 80% of its revenues coming from global capital markets, Bear Stearns was a central player in what Paul Volcker has called “a demonstrably fragile financial system that has produced unimaginable wealth for some, while repeatedly risking a cascading breakdown of the system as a whole.” With nearly $300 billion of outstanding debt on its balance sheet at the end of 2007, Bear Stearns was precisely the kind of exposed participant that could, if it broke down, choke the entire financial system. On March 12th, Bear Stearns reported that it had $17 billion dollars of ready capital reserves. By Friday March 14th, after a rush on its assets by lenders and counterparties, reserves were gone, and the company conceded that it could not meet its obligations independently. The potential for systemic failure was, very suddenly, on the verge of becoming a reality.
Before crisis crossed over to catastrophe, however, the Federal Reserve acted. With the Fed’s support, J.P. Morgan would purchase Bear Stearns at an extreme discount and take on the risk and responsibility of maintaining the company’s trading positions in order to avoid significant counterparty failures. By engineering and financing this takeover, The Fed signaled clearly to investors and other market participants that it would intervene to maintain the integrity (for lack of a better term) of the financial system. Some argue that with this action the Federal Reserve opened the doors to moral hazard – inviting continued risky behavior by other lenders and borrowers. We submit that concerns about moral hazard were long past due by mid-March, and few employees at Bear Stearns would agree with the notion that they were somehow “bailed out.” The Fed’s choice was either to allow a broken system to collapse under the weight of its yawning leverage (risking potentially extraordinary collateral damage) or to provide the stability that would allow for a working-off of leverage over time.
Now – for better and for worse – the Fed has spread its safety net out to allow investment banks to join commercial banks under its protection. The markets have responded positively, recognizing that the potential for systemic failure has now been reduced to the point of being highly unlikely. Historically, such significant intervention has brought with it the attendant responsibilities of supervision and regulation, so investors also know that stricter government oversight of financial institutions is certain to come and that greater transparency is on the horizon. We can argue about the merits of governmental involvement in investment markets, but capital is slowly beginning to move again, and disaster has been averted. As with any true crisis, there can be no sustainable recovery without failure. When we look back on this crisis, we will likely recognize the Bear Stearns collapse as the event that brought sobriety back to the capital markets, planting the seeds for sensible retrenchment and recovery.
So is it time to signal the All Clear? Not quite. We believe that bank write-downs will continue to surprise and that de-leveraging will compress earnings of financial companies for years to come. We recognize that tightened liquidity and high commodity prices are exerting serious pressure on the U.S. economy and that economic weakness here will have impact across the globe. But, as our clients well know, we don’t invest in financial slight of hand or in lenders. We also have only modest participation in consumer discretionary stocks. Careful selection has guided us through this crisis well so far. We are happy to report that we have registered a modest gain on equities in our core equity composite over the last three quarters while the S&P 500 index has lost more than 10%.
While the environment may recommend a cautious approach, such periods of extraordinary pessimism and low confidence often prove to be profitable entry points for long-term investors. We have been opportunistic during market sell-offs, starting modest positions in powerful growth leaders like Apple and exciting emerging companies like SunPower at advantageous prices. We have also made investments in companies that are taking advantage of disruptive change in the healthcare industry and in infrastructure companies that are providing efficient power solutions to global industries. As we look forward, we will continue to avoid those areas of the market where we cannot reasonably assess risk, and we will look to commit capital to those low-debt companies that can fund their own growth and win market share as others falter.
