Half a century ago, the economic historian Karl Polanyi argued in the classic book The Great Transformation that self-regulating markets never work and that government intervention always becomes necessary to prevent catastrophe. Buried toward the end of the book is a short but succinct sentence that describes much of what we are seeing on Wall Street today: “The financial market governs by panic.”1
The first half of 2008 saw plenty of panic as investors and regulators scrambled to deal with unprecedented losses and the collapse of a major investment bank. Polanyi’s view is echoed today by George Soros, one of the most successful investors in history, in The New Paradigm For Financial Markets, a book published in May 2008 in the midst of a market crisis that Soros believes “marks the end of an era of credit expansion based on the dollar as the international reserve currency.” 2 The first six months of 2008 saw the U.S. dollar drop to record lows against the Euro as global investors increasingly lost confidence in America’s economic policies and watched as authorities had to intervene in the markets in novel ways.
Wall Street barely survived the first half of 2008— one of the bloodiest periods in its history—as losses from subprime mortgages, leveraged loans and the structured products constructed out of these debt obligations imploded. This led the largest financial institutions in the world to report hundreds of billions of dollars in losses and to fire tens of thousands of employees (including several chief executive officers who were too busy counting their own compensation instead of minding their stores).
Indeed, the financial crisis of 2008 proved that if we don’t learn from mistakes, we’re doomed to repeat them, for it combined aspects of the three worst crises of the past two decades: • Like the collapse of the savings and loan industry and the shutdown of the junk bond market from 1990 to 1991, the 2008 market experienced a complete shutoff of credit to less-than-investment grade companies. • Like the implosion of Long Term Capital Management in 1998, hedge funds in 2008 were battered by the withdrawal of credit by their prime brokers and large redemption requests from investors, leading to massive asset liquidations. • Like the deep credit collapse of 2001-to-2002 triggered by the failure of investment grade companies like Enron and WorldCom, today’s crisis resulted from a complete loss of faith in credit rating agencies and their so-called AAA ratings on mortgage securities.
The 2008 perfect storm has led banks to stop lending, left short-term money markets in disarray and required the Federal Reserve to take novel (and by some accounts marginally legal) actions such as initiating its new Term Auction Facility in December 2007 and a new Term Securities Lending Facility in March 2008. Both of these facilities allowed the central bank to accept, for the first time, new types of lower quality collateral for the simple reason that other lenders had lost confidence in these assets.
The federal government took other drastic steps, such as loosening the constraints on the already dangerously overleveraged mortgage agencies, Fannie Mae and Freddie Mac, and allowing the Federal Home Loan Banks to further stretch their balance sheets to purchase more mortgage-backed securities.
Rather than reduce leverage in the system, which would have only exacerbated problems in the short term, these moves effectively stuck a finger in the dike in the hope that other leaks wouldn’t burst through in the near-term.
The dike is holding for the moment. But pressure is building for a long-term monetary inflation flood. We regret to inform you that the waters are still rising.
Oil Prices and Other Troubles
Added to monetary inflation is a troubling spike in product inflation as the price of both soft and hard commodities are rising to dangerous levels. During the first half of 2008, a global food crisis materialized. More than 20 countries in the developing world experienced food riots, as such basic foodstuffs like rice and flour became unaffordable. An economic problem, the price of food is also a political problem and a humanitarian crisis worldwide that will require strong global political leadership to ameliorate.
Meanwhile, oil producers, acting as though they were playing the game of Monopoly, passed “Go” to collect $100 per barrel. They seem hell-bent on collecting $150 to $200 per barrel before long. In January 2008, I wrote in this publication: “The U.S. dollar and the price of oil will be two key macroeconomic drivers in 2008. . . As for the world economy’s 800-pound gorilla, oil, it did not require a hurricane in the Gulf of Mexico to force prices up to the feared level of $100 per barrel in 2007. Instead, strong global demand, a lack of new oil discoveries and fears about supply did the work.”3
Six months later, the picture is even grimmer—and we’re approaching another hurricane season. June saw oil trade at more than $130 per barrel. The International Energy Agency (IEA) is expected to sharply reduce its forecast for future oil supplies. For several years, the IEA has predicted that supply would keep up with demand that was expected to reach 116 million barrels a day by 2030, up from around 87 million barrels a day today. The agency is now coming to the conclusion, which believers in the “peak oil” thesis4 have been arguing for several years, that it will be difficult to squeeze 100 million barrels per day out of the ground during the next two decades.
The bottom line: Betting on lower oil and gasoline prices in the years ahead is a certain way to the poorhouse.
The spike in oil prices is nothing less than a catastrophe for U.S. consumers and businesses. At over $4.00 a gallon at most U.S. service stations, gas prices are causing changes in behavior that are harming the economy. The real problem is that the only solution in sight appears to be the very economic slowdown that high oil prices will cause.
The U.S. airline industry is taking drastic steps to deal with a three-digit-per-barrel oil world. American Airlines, generally considered the best-run and healthiest U.S. airline, announced on May 21, 2008 that it was cutting 12 percent of its capacity and reducing its workforce due to high oil prices (which account for 40 percent of its cost structure). The rest of the industry is certain to follow with similar cutbacks.
The U.S. airline industry was partially nationalized after 9/11; $100-plus per barrel oil likely will complete the job, because it will send 100 percent of the carriers into bankruptcy within a couple of years.
The trucking industry also is suffering from high prices for diesel fuel and undoubtedly will see several companies forced into bankruptcy in the coming months.
Other large consumer-oriented companies in the United States are feeling the pain. The big three automakers are quickly becoming the three blind mice, suffering as they continue to do from outmoded business plans, archaic cost structures and the fact that the world has passed them by. Never have their business models based on unionized labor and gas-guzzling vehicles looked worse than at present. Higher steel prices are also buffeting them.
Ford announced in late May that it no longer believed it would be profitable in 2009 and its continued reliance on selling trucks in a world of $100-plus oil was resulting in sharply lower sales (that the company appeared to be surprised by this news suggests that the company needs new leadership). Ford said it expects to produce 120,000 to 150,000 fewer trucks and SUVs in the third quarter of 2008 than a year earlier, and 60,000 to 100,000 fewer in the fourth quarter of this year than last year.5
The only logical inference to be made from this data was that the industry is going to begin shutting down plants in the near future. Sure enough, just a few days later, General Motors made just such an announcement. 6
For GM, three years of restructuring and tens of billions in losses have done little to solve its problems. In early June, the company announced that it will shutter four truck plants and possibly sell its Hummer brand.7 This announcement was an acknowledgement that GM’s 2005 big bet on trucks was a monumental blunder. Indeed, GM management’s belief that the future of the auto industry lay in continued demand for gas-guzzling trucks and SUVs may go down as one of the greatest management miscalculations in recent business history.
There is no place to hide for the auto companies— and for those who thought they’d profit from the automakers’ problems. In an irony of ironies, GM was thought to be selling its crown jewel when it parted with a majority stake in GMAC to private equity firm Cerberus Capital Management, L.P. in a 2007 transaction. Instead, Cerberus is scrambling to keep GMAC afloat under the albatross of its mortgage business, Residential Capital, LLC (ResCap), which has borne the full brunt of the housing collapse. In early June, ResCap received a combined $1.4 billion capital infusion from its owners GMAC and Cerberus. These funds were needed to plug a funding gap that had grown from $600 million to $2 billion in a matter of weeks—after the company found itself unable to complete asset sales and suffered losses on certain hedges. ResCap needed the funds to meet operating expenses and maintain the cash reserves lenders require for future borrowings.
Cerberus also purchased Chrysler and Chrysler Finance from Daimler A.G. Now, it’s trying to figure out how to keep that failed automobile and finance company complex from going under. Chrysler is a disaster unto itself. It has three North American plants producing full-size pickup trucks, but last year sold only 358,000, or less than two plants’ worth.8 Private equity may come to rename the entire automobile industry “Waterloo” before long.
The damage spread to other industries. The retailing business is suffering from the all-too-predictable effects of a struggling consumer. The year began with a series of small retailers throwing in the towel and filing Chapter 11, including several furniture retailers (Bombay, Levitz, Domain and Wickes,) as well as Sharper Image, Fortunoff, Harvey Electronics and catalog retailer Lillian Vernon. A larger casualty, Linens & Things, joined the scrap heap in May after struggling from virtually the day it went private to sell more of what nobody wanted. A number of other retailers that were bought up by private equity firms in recent years, including Claire’s Stores, are experiencing serious strain and could join the list of casualties before the end of 2009. Sears Holding Corp., the largest U.S. department store chain, continued its terrible performance when it announced a first quarter loss at the end of May. Same-store-sales at Sears dropped a sharp 8.6 percent, with Sears stores seeing a 9.8 percent plunge and Kmart locations suffering a slightly smaller 7.1 percent decline.9 Increasingly, it’s apparent that Sears and Kmart are yesterday’s retailers and that the companies’ management is running out of ideas to revive the chains.
Yet, inexplicably, bank lenders and bondholders continue to extend credit to leveraged buyouts in the retailing industry, especially at high multiples of cash flow. Fool me once, shame on you. Fool me twice, shame on me. Fool me multiple times, it’s time for me to find a new profession.
The Second Half
So where do we go from here? The first half of 2008 could have been a lot worse had the Federal Reserve not stepped up its interest rate cuts and engaged in some creative liquidity creation. Moreover, the world was fortunate that non-U.S. economic growth remained strong (as we predicted in January 2008) and that certain sectors, such as energy and infrastructure spending, were robust.
The second half will not be notably different in those respects. The Federal Reserve is undoubtedly finished lowering interest rates; there is little more than can be done in this respect given the weak dollar and rising inflation.
Unfortunately, the mortgage market has not responded in the traditional manner to the Federal Reserve’s sharp interest rate reductions. Mortgage rates have not dropped significantly, which in turn has not eased housing affordability. As a result, lenders (with a push from the government) have been working with some borrowers to keep them in their houses. But the U.S. landscape is littered with deserted homes that are expensive for lenders to maintain and whose physical condition is deteriorating.
It is going to take years for the housing economy to recover from this downturn, and it is hardly evident that this sector has hit bottom yet. The Office of Federal Housing Oversight reported that U.S. house prices dropped 3.1 percent in the first quarter of 2008 compared with the first quarter of 2007. Prices for previously owned single-family homes fell in 43 states, with values in California and Nevada seeing sharp 8 percent drops.10 Until there are genuine signs that the bottom has been reached, buyers are not going to start crawling out of the woodwork in sufficient numbers to turn things around.
In terms of the stock market, one place to invest remains the energy complex, which will continue to experience strong profits due to the growing demand for energy outside the United States. The energy complex includes not only companies in the oil and gas sector directly, but also the many companies that manufacture products and technology that oil and gas producers need to get oil out of the ground.
Alternative fuels are going to attract a lot of attention with oil prices at their current levels. But buyer beware: Investors will have to be careful to avoid overhyped stocks in this sector as well as the obsolescence risks that are always associated with new technologies. We are going to hear a lot about wind power in the coming months, and we can expect to see initial public offerings (IPOs) of companies in this sector come to market. Investors should be especially wary of these stocks, which have the word “bubble” written all over them.
One of the few attractive asset classes is the leveraged loan market, which has been collaterally damaged by the devastation in the mortgage markets. Readers familiar with the financial markets will know that the market for collateralized loan obligations (CLOs) was virtually closed down in 2008, as buyers of the investment grade rated paper that fund these entities fled the market due to losses suffered in mortgage securities. Most of these buyers were the structured investment vehicles (SIVs) that were egregiously leveraged and began imploding in the summer of 2007. The SIVs represented by most accounts more than half of the ultimate demand for bank loans, because they were the purchasers of the equity and mezzanine tranches of the CLOs that were the largest buyers of bank loans.11
As a result of the SIVs’ disappearance from the market, bank loan prices began plunging at the end of 2007. As of May 2008, bank loan prices were still depressed, with many healthy loans trading in the 85 percent to 90 percent of par range. Many of these loans pay interest at a floating rate of the London interbank offered rate (LIBOR) plus 225 to 400 basis points and produce an attractive return if they are capable of generating sufficient cash flow to be retired within three to four years. Many of these loans are secured by inventory and receivables as well as by plant, property and equipment (as distinguished from second lien loans or so-called “assetlite” loans) and therefore provide strong recoveries in the event of default. In a trillion dollar market, there are many opportunities to buy such loans issued by large capitalization companies with a low risk of default. In the hands of an experienced investment manager, bank loans remain ripe for attractive risk-adjusted returns even in a market as difficult as today’s.
As always, high-yield bonds should be avoided at all costs. At best, they are short candidates in the hands of an experienced manager (don’t try this at home!) Even though spreads on these bonds have widened significantly, to more than 700 basis points from their absurdly tight levels of barely over 200 basis points in early 2007, they remain insufficient to compensate investors for the risks of owning what are essentially equity securities in disguise. Also to be avoided are second lien bank loans, which are nothing other than high-yield bonds in disguise. The markets are recovering from the biggest borrowing party in history, but we are still in the early hours of the hangover.
The dollar will remain an important focus for the rest of the year (and thereafter). The real long-term dollar play, as I argued in January, is against a basket of South Asian currencies: the Singapore dollar, Hong Kong dollar, Taiwanese dollar, Thai baht, Vietnamese dollar, and then of course the Chinese remnimbi and Indian rupee.
The depreciation of the dollar against the Euro since the beginning of the year has been significant but will likely slow. After all, Europe suffers from even greater structural economic problems than the United States. But none of these Asian currencies has appreciated even 40 percent against the U.S. dollar since 2002, while the Euro has almost doubled. It is important that investors consider diversifying their currency exposure outside the U.S. dollar as long as the U.S. government and political and intellectual leaders continue to pursue policies that can only bankrupt the long-term future of America.
And that is really the problem.
Politicians, regulators and influential business leaders are fiddling while Rome burns. The recent regulatory reforms proposed by Treasury Secretary Henry Paulson were completely inadequate to address the problems that led to the current crisis. It does not take a rocket scientist to understand that allowing investment banks to leverage themselves 30-to-1 is going to lead to more near-death experiences for the markets like the collapse of Bear Stearns Companies Inc. Bear Stearns was not rescued because it was too big to fail; it was rescued because it was too interconnected (through a massive web of derivative contracts that nobody can measure with any accuracy) to other financial institutions to fail. The only certainty is that a bankruptcy of Bear Stearns would have led to the collapse of many hedge funds and other financial counterparties of the firm that would not have been able to accurately value or liquefy their positions at the failed firm.
But the leverage of investment banks is something that can be policed through intelligent and balanced regulation. Another type of financial institution that should have been better policed were the structured investment vehicles that were leveraged as much as 100- to-1. These entities never should have been allowed to exist in the first place and should be outlawed immediately (although the odds of them returning to life are about as great as those of Dracula becoming undead).
It is a sad commentary on America’s regulatory regime that politicians, regulators and prosecutors were patting themselves on the back for outlawing the types of off-balance sheet financings in which Enron engaged while completely ignoring the much larger, more highly leveraged and more systemically threatening SIVs.
Hedge funds that continue to engage in excessive leveraging are a different story because they are not as susceptible to regulation. Instead, it is up to prime brokers to limit the leverage they extend to these funds and for investors such as funds-of-funds to wake up and properly educate themselves about their investments. Three of the highest profile hedge fund failures over the past year—Sowood Capital Management, L.P., Peloton Partners LLP and Carlyle Capital Corp.—each employed leverage of at least 15 times.
It boggles the mind that supposedly sophisticated investors continue to hand over their hard-earned money to highly leveraged strategies (which in virtually all cases investors don’t understand) in the wake of so much evidence that such funds’ risk-adjusted returns are at best mediocre and that the funds themselves implode so readily in volatile markets.
It’s also puzzling that prime brokers still extend so much credit to such strategies in view of their proclivity for blowing up.
The point is that sensible regulation can enhance systemic stability. So why is Wall Street so lacking in adult supervision?
Answer: the so-called adults are compensated for doing well—not for doing good.
And therein lies the deep-seated problem that will haunt our markets until bolder voices are willing to speak out and take action. Adam Smith is best known for writing the bible of capitalism, The Wealth of Nations (1776). But two decades earlier, he wrote an arguably more important book, The Theory of Moral Sentiments (1759). There is a wonderful quotation from this earlier work that captures what is at the heart of much of the misguided thinking that has led America into its current unease: “This disposition to admire, and almost to worship, the rich and the powerful, and to despise, or, at least, to neglect, persons of poor and mean condition, though necessary both to establish and to maintain the distinction of ranks and the order of society, is, at the same time, the great and most universal cause of the corruption of our moral sentiments.”
Today, the economic landscape is lit up with the self-satisfied smiles of private equity moguls and hedge fund titans who have taken more than their fair share of the economic spoils—without returning a commensurate amount back to society and the economy. Too much intellectual capital is being spent on speculative investment activities instead of activities that would contribute to the economic, scientific, creative and humanitarian capital of the world.
Our economic problems originate in a paucity of moral education. It is time to correct that omission before it is too late.
- Karl Polanyi, The Great Transformation: The Political and Economic Origins of Our Time (Beacon Press: Boston, 1957), at p. 238.
- George Soros, The New Paradigm for Financial Markets (New York: Public Affairs, 2008), at p. vii.
- Michael E. Lewitt, “Credit Meltdown,” Trusts & Estates, January 2008, at p. 42.
- The “peak oil” thesis says that petroleum production around the world has hit its maximum output and is entering a period of permanent decline.
- Matthew Dolan, John D. Stoll, and Neal E. Boudette, “Ford Stumble Signals Rising Risks,” Wall Street Journal, May 23, 2008.
- Jeff Green and Bill Koenig, “GM to Close Four Truck Plants, Shift Output to Cars,” Bloomberg News, June 3, 2008, www.bloomberg.com.
- Matthew Dolan, John D. Stoll, and Neal E. Boudette, supra at note 5.
- Lauren Coleman-Lochner, “Sears Unexpectedly Posts Loss as Shoppers Spend Less,” Bloomberg News, May 29, 2008, www.bloomberg.com.
- Bob Ivry and Kathleen M. Howley, “Home Prices Tumble 3.1% in First Quarter, Ofheo Says,” Bloomberg News, May 22, 2008, www.bloomberg.com.
- Full disclosure: my firm manages collateralized loan obligations and bank loans. This is because we view bank loans as the most attractive sector of the corporate credit markets, for the reasons stated in this article.
Michael E. Lewitt is president of Hegemony Capital Management, Inc. in Boca Raton, Fla.