The Financial Crisis: Storm, Surge or Tsunami?

Mutual Success - Your Fund of Information

December 03, 2008

Walking along the beach recently, I was reminded that the waters are not a bad metaphor for the current economic climate. The normal daily cycle has high tides and low tides. During the low tides the waters recede leaving the little fish trapped in the rock pools and the crabs in the shallows easier to find and collect. As we walk barefoot out in the bay on the exposed sand bars we are not flustered by the gradual encroaching of the waters which are pleasantly warmed by the sun baked sands and stones. If we don’t move closer to shore we can find that the flow of the tide accelerates and we may be surprised by the occasional wave whipped up by the winds which can catch us off guard. The normal ebb and flow reflect a normal trading market with the waves representing the volatility. Each month there is usually a spring tide which coincides with the full moon and this too may be seen to represent the cyclical highs and lows of sectors.

Over the last few years we have witnessed a number of storms on our BC coast where winds have battered the trees and whipped up the waves which have pounded the foreshore undermining the foundations of the walkways to Stanley Park and tearing them away. These storms are seasonal, but their size is less predictable and provided people heed the storm warnings they can limit their exposure to the risks. These storms may be seen as market corrections which are to be expected but from which recovery is usually quite quick.

In Texas, Louisiana, and Florida the USA has experienced tropical storms and hurricanes that have lashed their coastlines and flooded towns and cities. The storm surge waves rising four to five meters above the usual spring tide high water levels invariably result in homes being washed away, and people stubborn in the face this force being killed because they ignored the evacuation orders. While there is generally some meteorological warning of the events the impact is still dramatic, and it takes time to recover and reorganize. In fact whole neighbourhoods in New Orleans remain uninhabited in the wake of Katrina, as people reconsider the wisdom of living below sea level protected by levees. These surges with their bursting levees may be likened the tech bubble bursting in 2000, where despite storm warnings and voluntary evacuation indicators investors watched their value drop by over 50%.

Who can forget Boxing Day in 2004 as we witnessed the devastation wrought by the tsunami, which engulfed the South Asia Basin from Phuket in Thailand to the Maldives. Caused by a seismic event from the shifting of tectonic plates the first signs of the event was ground shaking followed by the gradual receding of the waters out well beyond the normal low water mark. Fascinated, people were drawn out to where the trapped fish could be picked up by hand, and as they focused on the things close by they became oblivious to the building silent giant wave that was sweeping back in towards them. The surge was about 15 meters or 45 feet in some areas and washed away homes and buildings. As the waves receded, the extent of the total devastation became evident.

The Seismic Shift and the Financial Crisis of 2008

It is evident now that the first shakes to signal the seismic event were the write-downs that were reported by HSBC from its US sub-prime exposure in February 2007. These were followed by the Bear Sterns and BNP Paribas write-downs in July and August in the same year. The sub-prime crisis was enabled and magnified by the explosion of credit issuance for both consumptive and leveraged investment purposes together with the “financial engineering” of credit derivatives into Mortgage-Backed Securities (MBS) and other Asset Backed Commercial Paper (ABCP), which were then repackaged into complex Structured Investment Vehicles (SIV), which were blessed by various rating agencies and sold off through investment houses and banks globally. At the same time, “financial ingenuity” and further “financial engineering” created further credit derivatives to isolate credit default risk through unregulated insurance guarantees. Unlike traditional surety products, these Credit Default Swaps (CDS) can be traded to any party willing to bet against the financial credit worthiness of the insured investment. Perhaps more disturbing is the fact that CDS and other derivatives are considered “off balance sheet” items and the details and risk exposure is not evident in a normal review of financial statements.

You may recall that the failure of Lehman Brothers triggered an immediate $40 Billion liquidity crisis for AIG who had issued CDS guarantees on Lehman debt. In fact all of the funds distributed to AIG under the bailout program have gone to discharge CDS guarantees! The liquidity crisis stems from the concern of banks to lend to each other, which is fuelled by the lack of transparency on the real liquidity risk, which has resulted in solvency problems. The fallout has seen the Tsunami crash of the global stock markets and the liquidity sucked from the credit system.

So where are we today? Less than three months into the crash of the markets, fears of recession are giving way to fears of deflation and a depression. The deal with Citibank, which creates a government exposure of over $300 Billion, signals the lengths that the US will go to prevent further failures, but the underlying gamble that government can avert the lunacy of the financial markets and a failed banking system is yet to be determined.

As with any seismic event, the question is “Will there be any aftershocks, and how big?”

The Great Debate – Load Up on Value and Yield?

As we continue to research the markets for appropriate strategies for risk-adjusted returns, it is interesting to see the divergence of opinion over the same information. For example, Chart 1 shows that in the last few months the share price to earnings or P/E ratio has dropped below 10 signifying an opportunity to acquire shares at a good value. Since the Chart 2 shows that historically P/E ratios are in the range of 10 to 20 this may well be the case, but there is also a case for caution. If earnings drop as they did in the depression then the fall in P/E ratio appears less sharp and will take time to reach its floor. The declines in earnings result in increasing defaults in corporate debt as can be seen in the third chart. Default rates typically follow the sharp rise in the interest rate spread. Notwithstanding the cost of capital to non-investment grade borrowers has risen sharply and may well push earnings down. So while the potential incentive is there to consider investment in high yield bonds, the default risk is real and diversification in any high yield bonds is essential to reduce the specific risk of default for those seeking higher yield. However our belief is that the amount of exposure should be tempered by the volatility that flows from such spreads and increasing spreads may yet negatively impact bond values.

Market Outlook

The US is reporting an increase in defaults and refinancing issues for Commercial Mortgage Backed Securities (CBMS) as retailers such as Circuit City file for bankruptcy protection. Occupancies in US hotels are dropping and Real Estate Income Trusts are trimming distributions. The bailout agreement for Citibank creates an exposure to the US taxpayer of over $300B, and creates a bad precedent for the other banks. Fear of the collateral damage of the failure of Citibank through third party losses and Credit Default Swap calls have made Citibank “too big to fail” but the bailout focuses the size of the problem, and points to the fact that current bailout measures approved by Washington are a fraction of what will be ultimately required.

October showed the largest real price deflation of the last thirty years, and in the face of job losses, plant closures and slashing within the financial industry. Canada too is showing signs of recession, and fears of a global recession and deflation impact energy and resource demands, putting projects on hold. While we have seen six days of up market, the real concern is that fundamentals are not supporting this rise and we can expect volatility to return as the tax selling at the year end and redemptions from hedge funds add to liquidity contraction.

For those with a strong constitution and a long time horizon a small exposure may be appropriate, but for investors in retirement, the medium term outlook is weak and we would believe that keeping a conservative position is prudent. Following a six day rally the TSX gave up its largest percentage drop since 1987, and has continue the decline today as have markets around the world. This we believe is evidence of seismic activity and potential aftershocks in the financial industry. Canada will not be aided by the political shenanigans in Ottawa, but for all the posturing there is no military takeover!

For all our concern for the financial markets and our political system, some perspective may be gained by looking at Zimbabwe, a failed state with average life expectancy down from 70 in 1980 to 33 in 2007, and declining through HIV-Aids, malaria, starvation and malnutrition, state sponsored violence, and now a cholera epidemic. The healthcare system has failed, there is not even running water as there are not the chemicals to treat the water supply, and electricity is sporadic. Teachers cannot afford to teach, having been targeted for their role as supervisors and counters in the last elections they have left in droves for neighbouring countries. The army is not content, with fights breaking out repeatedly over the last four days between police and soldiers who rioted in frustration at not having been able to access the meager pay due to lack of available currency. Having removed 13 zeros off the currency earlier this year it now already over Z$1,000,000 to a USD and inflation exceeds the 231 million percent, the highest ever recorded. South Africa and the SADC have much to answer for as they have enabled Mugabe to destroy the country so badly.

Excess for a few leads to deprivation for many. Whether in Zimbabwe or Wall Street, when the greed of a few is not regulated and controlled, the fallout is significant. The short term solution may be to print more money, but before long this easy way can compound the problems. We need to watch closely the actions of our governments as they throw money at the financial crisis. Concentrated in the hands of the few that started the problems, the result may just be a bigger end problem. A disciplined approach to investment is fundamental to avoiding been caught in the traps as we go forward. Please call us to discuss any concerns you may have.

Best Regards,

Malcolm Ross, Victor Whang, Violet Smith

604.331.2521, 604.331.2524, 604.331.4465

DISCLAIMER: E&OE: Investment Fund values change frequently and past performance is not indicative of future performance. No guarantee is given or implied and there is risk of loss as well as the opportunity for gain when investing in mutual funds.

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