Doom and Gloom Print E-mail
 
“Doom and Gloom
The World According to Bob Moore”
I believe in an orderly universe governed by powerful exacting principles that corral chaos and produce symmetry. Leonardo da Vinci recognized the “systems approach” nature applied to achieve symmetry and self-perpetuation. Through his studies of nature Leonardo came to know systems are integrated and symbiotic. A valuable concept when applied to financial markets. Albert Einstein toiled in vain for much of his life to conceive of a “Unified Theory” that would explain the combination of forces that produces an elegant and orderly universe. He said he wanted to “read the mind of God”. Economists have long been in pursuit of the “unified theory” of economics, to integrate markets with human behavior. It is more important than ever to recognize the principles and systems that govern capitalism. It is within the “integrated systems” of capitalism that we find the roots of the current market and economic ills. When we contemplate the integrated systems of banking, finance, brokerage and real estate we begin to understand the path of contagion that has transported credit risk throughout the economy. When we think in terms of “principles” that govern integrated markets and a global economy we can anticipate potential consequences of this credit crunch and plan for the future shape of finance based capitalism and the debt markets that make it possible.
The World According to Me.
The best friends are the ones that make you laugh, keep you humble and inspire new thought. At a recent conference Beth Ford, the Pima County Treasurer achieved all three in a short visit. As is the case with any good communicator Beth was succinct and effective. Recognizing my propensity for enthusiasm when expressing my own opinions and in anticipation of my pending presentation about the economy and markets Beth quipped, “Gloom and Doom, The World According to Bob Moore.” While that wasn’t the title I’d selected for the presentation it seemed a good choice for this quarter’s commentary. Like any thoughtful speaker would, I immediately began revising my presentation to reflect the sentiments of my audience. I would project humble optimism. Those who know me recognize the challenge this presents. But Beth contributed much more than an attitude adjustment for one exuberant speaker. She asked two very important questions; “How will the credit crisis affect the US Dollar?” and “Where do I put short term money now?”  We will weave these questions into our analysis.
Where do I put short term money now?
Beth’s questions get to the heart of the systemic nature of the credit crisis we endure today. The plummeting dollar reflects our trading partners concern for the health of the US economy, its consumer’s ability to repay debt and the trajectory of Monetary Policy. As the buck falls we import increasing and worrisome inflation. Her second question is most intriguing because it reflects the monumental change that has occurred in the psyche of investors. The origins of the credit squeeze are found in the money markets. More precisely it is the structure of “money market instruments” that sparked a collapse of confidence in short term investments. Insufficient care has been shown for the most important feature of the liquidity markets, namely trust. Long term, high risk, leveraged and incompressible 
investments funded through the money markets have proven a disaster. Enough has been written and said about the perils of Asset Backed Commercial Paper, financial derivatives like Collateralized Debt Obligations and subprime mortgages. We have identified the culprits along with their moral and intellectual shortcomings. We see that the failed Auction Rate Securities market will add hundreds of millions of dollars in interest costs to municipal financing as local governments trade $100 billion worth of these misunderstood tools of financial speculation for plain vanilla fixed rate debt. All of this is in the past. The damage is explained in the post-mortem columns of your favorite financial publications. It can’t be undone. What so few are talking about today is “what comes next?”  A new paradigm is evolving in financial markets. Trust, credit and liquidity travel hand in hand. We are witnessing the consequences of damaged trust in the financial markets. The good Treasurer’s second question reflects the dilemma faced by money market investors short on trust and long on cash. Short Treasury yields recently plunged below 1% in a panicked flight from risk. Alternative investments leave us cold as we await the next headline of a financial institution in dire striates or an investment structure that failed to stand up. Disaster struck the money markets with the suddenness and savagery of a tornado. These markets won’t soon heal. Informed investors are cautious about the safety of higher yielding securities and uninspired by Treasury returns.
The Joy of Teaching
Most clients and colleagues know me to be an econ professor disguised as an investment advisor. Teaching is an honor that carries great responsibility and produces even greater rewards. Teaching is shared learning. When done properly the instructor stands on the shoulders of those generous and patient souls who have contributed to his or her development. Good education promotes the exploration of ideas and the formation of new and actionable knowledge. It is the responsibility of the instructor to pull others atop his shoulders so they may see further than him. In its purest form teaching is learning, a reciprocal endeavor benefiting teacher more than student. The comment of a friend and veteran banker Pat Foster reminded me of the important responsibility of treating existing knowledge as a springboard to new ideas when she pressed for a sequel to my humble and optimistic presentation. Historians report past events. Educators employ historians to provoke thought. The real joy is in examining the age old question, “What’s next?” Thanks Pat.
So What Is Next?
Being associated with the sentiments of Doom and Gloom brings few people pleasure. I consider myself a generally upbeat guy. But it is hard to argue. At ICM we have been beating the drum about potential disaster for the economy, structured finance and the housing markets over the past few years. We have worried about the falling dollar, the soundness of FNMA and the wisdom of the Greenspan Put. We argued against the wisdom of very low interest rates, adjustable mortgages, loose credit standards, mushrooming derivatives and the twisted logic that combines tax cuts, war, and ballooning deficits. We warned of the impact that globalization and technology would have on American jobs and wages, that financial power would shift eastward on the globe and that interest rates could plummet with 
little warning. I extend heartfelt thanks to those who have allowed me a perch atop their shoulders to extend my view. It is Minsky who taught that stability breeds instability and destructive credit structures. It is Schumpeter who taught that old business and investment models give way to innovation in a process of creative destruction. David Gordon wrote about the evolution of social structures that promote capital accumulation and financial infrastructures. Adam Smith and John Maynard Keynes presented their versions of the “unified theory” of economics. These “principles” of economics have allowed us to observe and forecast systemic financial difficulties that will likely result in recession.
Success Will Reward Those Who Anticipate Change
Let’s address change in the financial markets first. The social structure of capital accumulation and the supporting financial infrastructure will undergo serious alteration. The failure of self-regulation in the financial industry will bring about a new order where brokers and investment banks will endure more stringent oversight in exchange for access to the Federal Reserve’s balance sheet. Wall Street has been exposed as a place where anything goes in the pursuit of a buck, and the first thing to go is sound judgment. Investment models that quantify risk and the companies that rate risk have been revealed as compromised and ineffective protectors of investor’s interests. New accounting rules that move toward ”mark to market’’ from “mark to make believe” will provide much needed insight into the true financial condition of our banking system. Asset Backed Commercial Paper and Collateralized Debt Obligations will dwindle if not exit the fixed income landscape. Money market investments and municipal debt will come full circle to plain vanilla and yields will reflect lower risk and greater sanity, eventually. Yield curves will remain steep with short rates near historic lows until banks and brokers get healthy. More traditional lending practices will return requiring those who make loans to keep a little skin in the game rather than the “originating to securitize” model that severed prudent ties between lender, borrower and investor. Credit will be significantly tighter and more expensive in the future. Sovereign Wealth Funds will play a big role in the re-liquefaction of America if protectionist forces don’t overwhelm the need for capital investment. Mortgage lenders will be regulated and licensed and we look for serious consolidation in the industry. The monoline insurers like MBIA and AMBAC will face an uphill battle for relevance and survival in the new paradigm. US consumers will default in greater numbers on auto and credit card debt as well as on mortgages. The impact will be negative for non-mortgage Asset Backed Commercial Paper. These securities still populate many higher yielding money funds. The trust and liquidity that has been destroyed will be repaired only with time and significant changes in oversight and product transparency. The investment structures that support the current capital accumulation mechanisms will be changed. The economy is probably in recession. Housing is by far the largest stumbling block at this time. Rising unemployment, slow job creation and stagnant wages may soon be a close second. The American consumer plays an irreplaceable role in the global economy. Corporations have amassed historic profits as a result of the techno-global revolution while labor’s share of the pie has languished. Look for a rising sentiment of populism and a push for tax policies  that redirect wealth in the next election cycle. We will see commodity inflation and asset deflation simultaneously in America; food and fuel will lead the way higher, home values will retreat. An unwelcome combination for cash strapped consumers. The Fed has warned of defaults among small and mid-sized regional banks due to exposure to builders and developers. There is a short list of questions one should ask bankers if local CD’s are part of your investment strategy. We can help. Investors should remain cautious, avoiding credit and event risk. The Fed and the Treasury have demonstrated the willingness to support and expand the role of the Government Sponsored Entities, particularly Fannie and Freddie. Although we are suspect of their business models and balance sheets it seems unlikely either faces immediate downgrade risk or liquidity problems. ICM will be increasing exposure in Federal Farm Credit issues at the expense of Fannie and Freddie. Monetary policy is quite stimulative at 2.25%. Our guess is that we are very near the end of this rate cycle with another bump lower this spring. Short maturity Agencies, Treasury securities and high grade (AA/AA) non-financial corporate bonds represent the best/ safest value. We would resist extending duration and gambling on call options to maximize yield. When liquidity returns to the credit markets rates will rise quickly and call features will fall out of the money. Investors want to avoid a repeat of the last rate cycle where many were caught in long term investments at historic lows in yields. Soon floaters will be the bonds of choice. Finally, remember the lessons of an inverted yield curve. This simple indicator is a highly efficient predictor of lower interest rates and slowing economic activity. The curve steered us right in 2001 and 2007. For 2008 and 2009 we expect a bear flattening of the curve with short rates moving higher as the Fed removes stimulation and focuses on incipient inflation dangers. A slowing economy will contribute to Federal and State deficits. Shared revenue may be curtailed while unfunded mandates may grow. Slower consumption and lower property values may impact revenues while demand for social services and maintenance costs may rise. It’s a good time for cash flow analysis that incorporates revenue and expenditure projections that reflect your economic expectations for the coming year. Again, we can help. We will manage maturities and income with cash flows and liquidity in mind for 2008 and 2009.
Beware The Black Swan
There is a fascinating book circulating the trading floors on Wall Street entitled The Black Swan, The Impact of the Highly Improbable. Black Swan is gaining in popularity with traders and sales people, outselling the memoires of one Alan Greenspan. Its author Nassim Taleb does a great job of exposing the shortcomings of most risk analysis and particularly those models using bell curves. Taleb is in vogue today for his theories about “fat tails” or the surprising regularity with which highly improbable events rock the investment world. His book is a testament to the randomness of nature and markets. The flaw in his thinking in my humble opinion is that it attributes 
market disaster to random acts of fate rather than the deliberate actions of investors, central bankers and the purveyors of pigs in a blanket (Wall Street). This line of thought absolves responsible parties and denies the “principles” and symbiotic systems of modern finance. To learn the lessons of the latest financial crisis it is important to see the crisis for what it is and what it is not, lest we wish to repeat this dangerous episode. And after all, that would be anathema to good teaching strategies.