Tonight, instead of more charts that demonstrate an increasingly broken market, or links to mainstream media sources of exponentially diminishing value, I provide a selection, culled from the most recent investor letter of hedge fund Elliott Associates. The letter does an exemplary job of addressing and explaining the core issues affecting both U.S. taxpayers and investors (as well as our global readers), with either a near- or long-term horizon, and cuts through the verbiage, the rhetoric, the patronizing and the obfuscations of both the MSM and the administration and its agents, like a warm knife through butter.
THE RECESSION AND BEYOND
A fresh, enthusiastic and self-confident team has come to power in Washington, but we fear that the stimulus program that was recently enacted will not have the desired multiplier effects, and was not designed to create lasting value or solid future growth. Contrary to widespread hopes and sound practice, the spending programs are front-loaded with superficial effectiveness and back-loaded with problems.
Promising to spend, and actually spending, hundreds of billions of dollars, with “whatever it takes” waiting in the back pocket, will definitely appear to stabilize the economy. If the government spends enough money, a flush of pink will be slapped back into the pale cheeks of the stunned economy—even if the spending is mostly pork, payback and pet projects of the new gang in town. The money will be spent (at least in the beginning) at a time of underutilized capacity and falling aggregate demand.
However, the government is operating as if it does not matter where it goes, as long as it is “shovel ready” and large. That said, one is reminded, shovels can be used for both worthy long-term projects and piles of garbage.
The program to get us out of the recession should have been aimed not only at stabilization but also at fostering incentives to save and invest. It does not. It could have provided large spending for infrastructure (such as energy infrastructure) which would remove bottlenecks in the supply chain, catalyze growth and innovation, reduce dependency on uncertain and expensive foreign sources of energy, and other spending which would provide leveraged long-term benefits. It does not, except in very small doses. Instead, it focuses on hollow spending which will result in some stabilization at the cost of trillions of dollars of government debt being added, year after year. Merely shoveling money out the door is not a path to giving people confidence in America's economy, future growth and leadership in the world. We applaud the fact that the government action is big and relatively fast. However, it could be much stronger and smarter, and it could have included more strategic thought, collaboration and input from others across the political spectrum. We predict that these errors and omissions will produce ill effects much later.
To illustrate these points, ask yourself the following questions: when will the emergency measures end? What will the system look like at that point? What is the exit plan from all this extra spending? What in these programs is designed to facilitate or catalyze solid non-inflationary growth? What kind of better behavior is incentivized in the program? There clearly was a need to save the system, but also change behavior in the future. When precisely is it time to build new habits?
The scale of stimulus spending and the consequent deficits are absolutely unprecedented in global history, so that there is no chronicle or roadmap that we can examine as a guide to how it will turn out. There is also no way for investors to figure out who will be allowed to default and who will be saved in the current head-spinning, non-stop, activist government actions, guarantees, donations and pronouncements. The saddest part is that, while the leaders of our financial institutions (and the markets themselves) have failed to self-regulate, government control of the economic and financial system has a poor track record. The situation can possibly go from bad to worse.
The fiscal stimulus has been accompanied by one monetary explosion on top of another (that is, 1% or so interest rates in 2002-2004 that have now turned into zero percent interest rates). Far from enhancing stability, the modern age of finance has instead produced wild swings, fantastic volatility, and the possibility of political and social changes that can harm or destroy what made America great.
In fact, the U.S. has now joined Japan as one of three major countries with zero interest rate policies (the other recent addition is Canada). Since the Japanese experience has been so unsatisfactory for so long, we can't understand what theory or practice causes policymakers to just press on with such policies.
Our working assumption for the American economy is stabilization in the second quarter, as the spending programs and low interest rates kick in. However, there is a good chance of a relapse later in the year. We are not sure about 2010, but we would be surprised if any rebound turns into a strong multi-year period of growth. We think that odds favor a sluggish recovery, rather than a vigorous period of expansion. The distorted tilt of the economy toward consumer spending versus investment should have been addressed and modified in the government programs, but it was not, and we think this will create a longterm drag on the economy.
The experience of Japan after its asset price collapse provides the most relevant historical guidance for the current situation in the U.S., but there are significant cultural and systemic distinctions that point to different, probably quicker resolutions. Nonetheless, Japan's failure to clean up its financial institutions is particularly instructive given the inability thus far of the large American banks to de-leverage their balance sheets.
Inflation is the furthest thing from most investors' minds during this deep recession and financial crisis. It should not be. The unprecedented size of the government's spending programs, entitlements, guarantees, and its lack of strategic thoughtfulness, point to an inflationary potential that is unique in the history of this country.
Preserving the long-term purchasing power of fiat currency is really hard. Even when government officials understand the dangers and are determined to avoid debasing their currency, the drift toward inflation in fiat money regimes is virtually inevitable.
Politicians make grandiose promises in order to get elected, and if the commitments are scheduled to come due years after they leave office, most civil servants are not very disciplined about making sure that those promises are paid in the purchasing power with which they were incurred. It is considerably easier to debase the purchasing power of currency, thus diluting claims, than to exact overt taxes. Inflation is a powerful wealth transfer or wealth confiscation device, because taxes are levied not on the real accretion of wealth, but on the nominal price increase or interest payment. Governmental borrowings to spend on current items that have no lasting value can have important inflationary aspects; as debt increases, well beyond the rate of actual economic growth, powerful incentives are introduced to debase the currency rather than repay the borrowings at full value. These elements and truths are universal and reinforced by history. Ignoring them can grease the path toward societal destruction. Debt collapse, massive unemployment and negative economic growth can destroy societies and lead to violence and authoritarian governments which create large changes in the basic fabric of life. However, serious inflations can have the same effects. They can be absolutely ruinous, and history abounds with examples of societies wrecked by massive debasement of currencies and the destruction of people's savings.
It is really important to focus on this now, despite the falling prices of many commodities and assets and the lack of pricing power of businesses and wage-earners. Here is the reality of the global governmental programs meant to stem the current financial crisis and recession: if they spend enough money, they will stem the decline. If they guarantee enough financial institutions, they will prevent the fall of the global financial system like so many dominoes. The actions taken to date, and promised for the future, exceed by a very large margin all historical examples of governmental action to address economic and financial distress. Governments which have promised to do “whatever it takes” to avoid their nightmare memory of the Great Depression are certainly being straightforward about the size and speed of what they are doing. The only thing that is missing, which is far from trivial, is any real analysis of the long-term impact of their actions. We really cannot understand the thinking behind the conviction on the part of policymakers and many investment managers that the unprecedented monetary ease and governmental borrowing will not cause significant debasement of purchasing power. It is as if they think there is nothing to learn from history, but they have not revealed any basis for this mindset.
It took 20% interest rates in the early 1980s to wrestle down the inflation that kicked off in the late 1960s. It is unfathomable to consider what could happen in the ensuing stages of the current cycle, given the substantially greater excesses and lower discipline preceding this crisis. Moreover, the transition from deflation to inflation could be very abrupt. We really don't know whether this is likely to occur in the next few months (doubt it, but not impossible), or in a year or two or later, but when it inevitably gets underway, it is bound to be a very large problem.
TAX POLICY AND CLASS WARFARE
It is amazing and unprecedented to be raising taxes on investors and entrepreneurs in the midst of a deep recession, accompanied by a promise for more of the same. Indeed, in the states of New York and California, taxes and other anti-growth policies are piling on as if the residents and employers are hemmed in by some kind of barbed wire fence which prevents them from moving themselves, and their businesses, to a different locale. It may be true, in fact, that for many companies, the costs of pulling up the stakes are too high compared with “sucking it up” and making the best of a bad situation. But as soon as governments of other states or even countries actually come to the stunning realization that they can actually attract great jobs and businesses by making it appealing to locate there, the governors of New York and California, the Mayor of New York City, the leaders of Congress and the President may all find themselves standing by the alter, wondering why capital has taken flight and gone where it is welcome and fairly treated.
Right now it may look to the “populists” as if they are winning. However, people well beyond the leadership of the financial community are trying to digest the truly disgusting stories of Wall Streeters getting death threats and seeing their pictures in the tabloids because they received bonuses from firms which received government aid.
Many political leaders have joined the mob of anger at Wall Street and business and “the rich.” Although there was cupidity and stupidity galore in the boom, these folks forget that the private sector (not the government) needs to be the primary driver of new jobs and expansion to enable the U.S. to compete with countries with low wage costs. The government should facilitate such growth in the private sector by building incentives to save, invest and innovate. Unfortunately, the new administration and various municipalities are not doing that; on the contrary, they have been bashing entrepreneurs, investors, and capitalists. It is easy to say that such behavior does not hurt the country.
The simple fact that capitalists are not boarding boats and planes and leaving is not supportive of this theory. Such thin evidence is also not determinative in assessing the long-term damage that the spirit of anger and retribution is doing. Capital will go where it is welcome. It will figure out where it is mistreated and where the rules cannot be relied upon. It is delusional to think that a society can achieve growth and attract outside investment while its government is sounding, and acting, in a hostile manner toward the engines of such growth (think Venezuela and Argentina).
CLEANING UP THE BANKS
The programs that have been announced so far will not clean up the banks, are overly complicated, and could lead to cozy deals, conflicts of interest, massive taxpayer losses and concentrated large profits reaped by a small group of anointed gatekeepers. If you think any of the foregoing is an exaggeration, we encourage you to read on.
The programs, identified by innocent sounding acronyms like “PPIP”, “TARP”, and “TALF”, are rapidly changing, confusing, and interwoven. For purposes of this discussion, let us oversimplify and say that there are two programs, a “legacy loan” program and a “legacy securities” program. Legacy securities were formerly known as “toxic assets”. They are mostly mortgage-related securities, but also include instruments related to other credit. They are toxic only in the sense that their prices have gone way down. Many financial institutions falsely claim that there is no market for them, that the prices do not reflect reality (“liquidity premium” is the euphemism of the day), or that the losses are just temporary. In this program, a small number of designated asset managers will use a combination of public (non-recourse loans available on roughly a 6 or 7 to 1 ratio) and private funds to purchase such securities and manage their disposition. By contrast, the legacy loan program will package actual loans held by banks which in the past could have been used to securitize instruments in the legacy securities program. Some of the loans will be repaid more or less on time, and some of them will be workouts. The legacy securities may or may not be marked to market. The loans are less likely to be carried at market value. The first problem with both programs is that the impaired banks are not compelled to sell any particular assets, or indeed any assets at all. Furthermore, they do not have to sell at the best bid. If they offer loans they do not have to set a reserve price, nor actually follow through on the sale. Thus, there is no reasonable expectation that any impaired institution will sell enough securities or loans to create transparent balance sheets with low and sustainable levels of overall leverage. In the loan program, independent valuation firms will establish some kind of a value, but there is no requirement that transactions must be executed at that or any other price. Thus, in both programs, months of preparations, applications, wrangling and research on the part of potential buyers may result in some number of transactions but will not produce de-leveraged, sound financial institutions.
The second problem with both programs is the gatekeeper issue. The legacy securities program was devised behind closed doors in consultation with a handful of large firms which, miraculously, all meet the anticipated eligibility requirements of being a Qualified Fund Manager, including, among other criteria: managing $10 billion (market value) of mortgage assets. Aside from the fact that actually having managed that amount of mortgage securities during the crash means that such firms have lost billions of dollars for their clients, it is ridiculous to limit the market to so few participants (initially, only five managers will receive this designation). These firms will be able to charge billions of dollars of fees and profit splits for the privilege of bidding for assets at prices which (the government hopes) are inflated by the mathematics of the free option generated by non-recourse leverage on offer from the government. We will not invest in a fund where we have to pay fees to one of these gatekeepers for the privilege of overpaying for toxic securities. We reject the notion that it is good for the system to make the banks' shareholders and debtholders whole by artificially inflating prices with non-recourse leverage.
The programs as structured are overly complicated, and loaded with features that will produce costly delays in getting the process of deleveraging underway. Already, extraneous strictures are creeping into these programs: a perceived need to grant preferences to firms owned or managed by favored demographic groups; a requirement for the funds to hold the assets for a specified time instead of being free to hold, sell, work out or trade the assets as they choose; and new rumblings that purchasers under the programs could be subject to restrictions on compensation.
The third major problem with the programs is the interaction between the non-recourse leverage, the expectation that buyers will pay above-market prices, and the fact that at least in the legacy securities program almost all the securities have current market quotes.
Given the significant degree of leverage to be employed, many of these funds would be immediately insolvent on a mark-to-market basis. Although some of the discount from par in the market prices is due to an enhanced rate-of-return requirement for all securities purchased in today's marketplace, a significant portion reflects rational expectations of losses. The buyers will be working out these securities and loans over a period of time, and many of the securities will ultimately suffer losses. Moreover, some of the potential buyers also own these securities outside of the structures – will they be marked differently inside and outside the structures? What a tangled web is woven when the deceptions of the financial engineering epoch evolve into the deceptions of the fix-it period without missing a beat. Let's not forget that false assumptions, unrealistic prices and high leverage got us into this soup in the first place.
Another confusing element of this situation is the new set of rules regarding mark-to-market accounting. Loosening these rules provides a powerful disincentive for banks to sell securities which are not held on their books at the “real” market price. This is also an important factor in the opacity and untrustworthiness of the financial statements of many large financial institutions. In the absence of governmental guarantees, investors would not lend money to these institutions because their true financial condition cannot be understood even by sophisticated investors.
It is also worth asking what banks are actually doing with the money they are receiving from the government under the TARP and other programs. We wonder how much is being used for normal lending and how much for speculating in leveraged arbitrage positions. Moreover, institutions don't even need to be troubled in order to sell assets into these programs. Imagine if hedge funds are able to sell assets at well-above-market prices to other investors in these programs who are purchasing them with non-resource loans.
A basic tenet of the government programs is that their designers think that investors will overpay for securities because of the non-recourse leverage used to fund their purchases. This is supported, allegedly, by option theory. You may have seen articles “proving” that if the government lends $10 on a non-recourse basis for every dollar of investment, and the investment has an equal chance of being worth par or zero, investors can and will pay 70 cents instead of 35 cents on the dollar, or some such distortion. This is unlikely. First, almost all of these securities have outcomes subject to probability distributions rather than “on/off” switches. If they are priced at 35, what they will be worth three years from now is subject to a lot of uncertainty, and it is unlikely that they will get to 40 or 50, much less par. If you buy them at 35, you may make some money, you may make a lot of money, or you may lose money. Investors have recent experience losing large amounts of money by paying too much because they are wowed by the availability of non-recourse leverage. There is trillions of dollars of this stuff still on banks' books. The notion ofpaying considerably higher prices in these structures, together with paying BlackRock and PIMCO large gatekeeper fees and trusting that the government's control of the playing field will not hamper profits too much, is preposterous.
On the other hand, the gatekeepers get fees by merely adding assets to their new funds, so once people invest money in those funds they may find that what they have really done is facilitate the gatekeeper earning fees for little or no management finesse while their less-than-value-conscious buying is busily marking up the values of other similar securities their clients previously held outside the new programs.
If buyers pay too much for legacy assets, it is the old bank's shareholders and bondholders who are getting a gift from the taxpayers. The gatekeepers would potentially make billions in fees for just selling the funds to investors who are shut out of the bidding process by unduly restrictive (and arguably rigged eligibility) criteria, and the taxpayers would pay for losses occasioned by the inflated purchase prices. This is amazing but true, and that is why we think these programs will have great difficulty getting off the ground, at least in their current form.
The icing on the foul cake, truly, is the ability of existing government handout money and guarantees to participate in these programs as buyers. We need to run that by you in slow motion: Bank A is on welfare. It offers for sale some pool of discounted securities with a real market value of $300 million. Bank B, also on welfare, puts together a fund, charges huge fees as a favored gatekeeper, and buys the pool for $400 million because it is leveraged 7 to 1 using non-recourse government funds through the Legacy Securities and the Legacy Loan programs (it only pays, and risks, $50 million). Then, Bank A and Bank B, or their affiliates, switch roles. Results: taxpayers lending more than the securities' markets values, both Bank A and Bank B get large fees, and both own cheap and valuable options. It does not take an advanced degree in math to see that the provider of the nonrecourse leverage (the taxpayer) has a really good chance of losing money, banks will earn undeserved gatekeeper fees, and the banks' bondholders will be repaid with sales proceeds that are way higher than market, thus bailing them out for no good reason at the expense of the taxpayers.
These programs are a mess, and the government's stated willingness to adjust them is unlikely to be sufficient. If any of them get off the ground in any meaningful way, which we doubt, they will stand in stark contrast to the initial attractive concept: to clean up the banks by having them sell assets to the private sector using some government financing, and having the government participate in the upside. That model has been twisted beyond recognition.
Rather than limiting these programs to a small favored group of gatekeepers, the original goals can be better met by having the government quickly qualify a large number of bidders and forcing the banks to clean up their balance sheets by selling these toxic assets at the best price buyers are willing to pay at the full risk of their capital (meaning lending with full recourse). Alternatively, the government could set up Bad Banks to buy the toxic assets at real market prices pending their ultimate sale to willing ultimate buyers. This would clean up the impaired banks quickest, and the government could plug any holes in the banks' balance sheets by making senior secured loans while the banks' derivatives books are wound down, after which the bank holding companies could be taken through bankruptcies to crystallize the losses. Those losses should be borne by shareholders and unsecured bondholders before the taxpayers lose money.