Centre Street Cambridge Corporation

Private Investment Counsel

Commentary

July 2006

Credit rating agencies—the highly profitable organizations responsible for assigning the familiar “AAA” to “D” range of quality rankings to bonds—are investors’ first line of defense against issuer credit problems. Given their position of importance in the capital markets (their opinions have been shown to have a significant impact on corporations’ cost of capital), it was disturbing to read about the agencies’ internal responses to certain embarrassing failures in their procedures, as reported by the Financial Times in a May article. In the wake of the Enron collapse in 2001 (Enron maintained an “investment grade” rating until four days before declaring bankruptcy), attempts have been made to tighten ship. One big agency boasts “greater scrutiny of companies’ published accounts.” It has hired accountants to examine corporate reports: “We [now] have the ability to ask the right questions.” Really? What, pray tell, were prior rating decisions based on? One wonders what has been going on at the agencies, which, after all, have been in operation for decades in some cases, with plenty of industry and business and credit cycle experience. Perhaps the fact that the source of their revenues happens to be the very issuers they are rating has something to do with it.

Ratings aside, developments in the bond markets have been of great interest lately and are potentially a source of opportunity. For two years now U.S. monetary authorities have been tightening credit conditions—moves now being joined by foreign central banks. Yet, despite the resulting increase in money market rates to 5% from 1% over the time frame, the response in the market for longer-term debt securities has been relatively mild, at least until recently. In fact, lower quality credits (“junk” bonds) barely budged. Debt issuance remains high in spite of (or perhaps because of) rising rates. Judging by the number of debt-financed mega-merger deal announcements at the end of the quarter, animal spirits and risk tolerance are still elevated.

Although the bond market response to monetary tightening has been modest, it has been negative. Year-to-date returns for government and corporate debt have been in the -2% to -4% range. Nevertheless, yields are still below long-term averages. The yield on the two-year treasury note, for example, has risen to about 5.2% (up from 1.25% in June, 2003), but it is still below its average of 7% since 1976. Perhaps more significantly, “spreads” are still “tight.” The spread is the additional yield above a risk-free return that investors demand for acquiring risky assets. Spreads across the bond market spectrum have been relatively narrow during the last few years. Until recently, spreads for low-quality “junk” securities had even declined as short-term rates rose, and they remain relatively low. Narrow spreads indicate that the reward for taking on risk may be insufficient.

Environments like this change at some point, and sometimes with a bang. Indeed, we began to see some movement during the quarter. Market participants have become a bit more conscious of risk. Long-term bond yields rose; spreads, too, have experienced some widening. Such trends, if continued, could make fixed-income more of a buyers’ market than we have seen in several years.

Bursts of enthusiasm belie an equity market that also entered a weak period during the quarter, in stark contrast to the brisk opening months of the year. The popular averages are now slightly higher or lower year- to-date. As has often happened in the past, the areas that had drawn the most speculative interest previously—emerging markets, small companies, commodity-based businesses—bore the brunt of the selling. Nevertheless, the declines have been limited so far. Just as there are traders eager to head for the exits at the slightest sign of trouble, there are others with vast sums of money out there ready to pounce whenever it appears the market is ready to reverse course and head upward. One consequence of this tug-of-war has been increased volatility in prices, in contrast to the unusual calm the markets have experienced in recent years. Expect more volatility—over 60% of New York Stock Exchange trading is now accounted for by computer-guided strategies that quickly trade large blocks of shares.

It was good while it lasted: enthusiasm for stocks earlier in the year spawned something of a rebirth of interest in initial public offerings of shares. IPOs are fair weather phenomena and, needless to say, the ardor of their promoters has cooled somewhat of late. But deals continue to get done. One area that has drawn especially intense excitement during the latest revival of spirits has been that of ethanol production. Wall Street free-marketeers, aided and abetted by tax subsidies, government mandates and tariffs, have enthusiastically embraced corn alcohol as the answer to our dependence on foreign oil. Never mind the fact that for ethanol to make a serious dent in petroleum consumption would require the U.S. and many other countries to import food. As for using non-food-crop ingredients—switch grass, forestry waste and the like—the technology is still years away. Besides, with many of these plant materials it would be more economically efficient to simply burn the stuff to produce power. Finally, there is the not-insignificant problem of obtaining the large amounts of water required in the fermentation process. This sounds to us like yet another vast misallocation of resources in the energy sector. Who says the stock market is supposed to allocate capital to its most efficient uses?

Global Warming

Like the earth’s environment, the world economic climate has been getting warmer. In this case, however, the cause is less a subject of controversy; the worldwide “sea of liquidity” in the financial system has lifted industry and commerce around the globe, stimulated trade, and boosted commodity prices. Once alone as the world’s “engine of growth,” the U.S. has been joined by China and India; even laggards Europe and Japan appear poised for better economic performance.

In a process that can be likened to what occurs in the natural environment, economic warming causes the proliferation to new locales of certain financial “flora and fauna” that previously flourished in the financial equivalent of tropical climes: ready cash. In nature, such new biological growth is a natural response of organisms to changing conditions, but it often creates havoc in areas with no natural enemies or defenses. Likewise, risky financial operations and innovations, such as those involving heavy borrowing or sensitivity to asset price changes, that are relatively benign when confined to prescribed precincts (wealthy individuals and institutions), can become malignant when loosed upon relatively defenseless environments, such as the public marketplace.

For years now authorities in banking and investment have consistently maintained that high debt loads are not worrisome. New financial products, the argument goes, have spread risk around so much that the system has the flexibility to deal with shocks. Nevertheless, we admit to being quite old-fashioned when it comes to the issue of debt, and reliance on untested financial engineering. Admittedly, our views are based on history; heavy reliance on borrowing has often come to grief, and new financial gizmos sometimes act in unexpected ways. What we see nowadays does not encourage us—loose lending standards, for example. Banks with excess capital in a competitive environment seek to increase earning assets while glossing over the future costs of bad credits.

Anecdotal evidence suggests the potential for trouble: we learned not long ago of a banker eager to throw mortgage money at a potential borrower whose sole income consisted of disability payments. On the subject of real estate, abundant mortgage capital (thanks to stimulative federal reserve policies) fed this decade’s real estate boom (some say “bubble”). Banks with cash to lend have been creative, inventing new products—interest-only loans, mortgages with deferred payments, and so on—aimed at borrowers who otherwise would have difficulty getting credit, thereby making real estate more “affordable.” Fortunately, there are authorities who oversee lending and from time to time they encourage banks to tighten their standards.

Other financial operations are more opaque and less subject to regulation. The proliferation of “investment” pools such as hedge funds is also a byproduct of abundant liquidity—lots of cash seeking “undiscovered market anomalies” to exploit for outsized returns. (With 8000 funds looking for the same anomalies, one wonders how many can be left undiscovered.) Hedge funds use borrowed money to enhance returns (assuming they have any), and easy credit forms the basis of strategies such as the “carry trade”: borrowing in one market and lending at higher rates in another. After the Long Term Capital Management blow-up in 1998, one hopes these secretive funds are more circumspect in their use of financial leverage.

 

Prudence is needed. Access to hedge funds has been extended beyond the traditional bounds of wealthy, “sophisticated” investors to include the middle class. In a similar vein, other financial devices which may or may not have made sense even for the big boys are trickling down to average investors. Since it is unclear if even the creators of such things as “structured products” know how they would react to crisis conditions, there is little hope that the average buyer of these products really understands the risks

 

Other developments in global finance and industry could exacerbate instability. Following the crises of 1997-1998, healthy trade has helped emerging economies achieve financial strength, contributing to global financial liquidity. Beneficiaries such as China and India have been investing vast sums in infrastructure and industrial projects, fueling a broad boom in commodity prices. Aside from the social dislocation such policies are threatening (especially in China), there are economic risks to such rapid development. Commodities extraction, industrial development, infrastructure—all are endeavors requiring long lead times and heavy investment. The danger of boom times and high prices is overinvestment (especially in China where the investment has a political goal: avoiding social instability), and excess capacity. In an interlinked global economy the results could be as depressing as the boom in investment spending has been stimulative.

Periods of benign economic conditions, easy credit, and high risk tolerance tend to have a deleterious effect on financial morals, collectively and individually. Nevertheless, it is not our business to condemn risk-taking in all forms—“speculation” is a necessary and healthy part of the economic sphere—nor is it our desire to reform financial sinners. It is our responsibility, however, to look after the well-being of clients. We are frankly fearful of some practices and trends. We are skeptical of the view that new financial mechanisms that supposedly dilute risk have given financial systems immunity from unexpected stress. As always, it is best to have one’s own safeguards in place.

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An article by Dennis Butler will appear in the Summer issue of Financial History, a magazine published by the Museum of American Finance in New York City.

 

Dennis Butler, MBA, CFA