What Keeps Us Up At Night

December 2005 Dr. Hans Black

In our September newsletter, we stated that the Chinese banking system is one of the worries that keep us up at night. Perhaps not surprisingly, we have received a number of requests to provide a more expanded list of those circumstances or financial events that would cause us a similar lack of sleep. In an attempt to satisfy our long-term clients and friends, what follows is a list of potential difficulties on which we will keep a keen eye as 2005 draws to a close.

H5N1

We must again start off by clearly underscoring our concerns about China. Although little has occurred in recent months to alter our view, it has not escaped our attention that at the heart of the current debate on China lie concerns over the possibility of an emerging bird flu epidemic. China in recent weeks has admitted to several deaths due to the H5N1 influenza virus and there are many sources, including a report in a German newspaper by a World Health Organization (WHO) official stating that he believes possibly hundreds of people have died from bird flu in China. Unfortunately, as was the experience with the SARS epidemic in 2003, the truth will not emerge until too late. However, SARS was a minor problem compared to the potential difficulties the world faces with a fully-fledged H5N1 epidemic, which could be on a scale not seen since the famous Spanish flu of 1918. Reports have of course appeared sporadically in the press and, particularly since September, worldwide attention has been focused on the possibility of such an outbreak. In the United States, President Bush has asked for — and obtained —special legislation to allow him to deal with any outbreak of this new influenza virus up to and including the possible quarantine of a major U.S. city. WHO officials have held a number of meetings on this subject and in press releases in mid-November openly discussed the existence of a “war room” in Geneva to deal with such an outbreak. Perhaps because of my background in medicine, I simply cannot dismiss these fears as anything but totally serious. In the past three years, approximately 65 people have died from this new virus from a total of about 130 infected. Tens of millions of birds have been culled in many countries to keep a lid on any possible mutation in the virus that would lead to human infection. This virulent form of influenza has caused widespread deaths among birds but so far there seems to be some controversy over the ability of the virus to jump from human to human in a mutated form. Indeed, as I dictate this, there are reports from North Korea again indicating the possibility of an outbreak there.

In an attempt not to repeat the errors of the relatively minor SARS outbreak in 2003 and emboldened by the far greater attention being paid to H5N1, the WHO seems intent on readiness to respond quickly to any outbreak. For the moment, WHO claims to have over 500 experts spread around the globe providing early warning signals of any change in this virus. At this time, the WHO lists bird flu at phase 3 on a scale of 6. This indicates there is no — or extremely limited — human-to-human transmission of the virus. Phase 6 would indicate the start of the pandemic. If in the next few weeks, as I suspect, we see some increased human-to-human transmission, this would trigger a WHO phase 4 admission and certainly a new chapter for this very real problem. We are also aware of a number of large companies that have set up contingency plans should the epidemic hit in the next year or so, such as letting key staff work from home and a number of other scenarios.

Derivatives

Any long-term reader of this letter will recall our concern, expressed here over many years, of the growth in the global derivative market. In the most recent accounts given by the Bank of International Settlements (BIS), the so-called notional value of the total debt underlying the global derivative market is currently at $270 trillion, or roughly seven times global GDP. In recent weeks, special attention has been focused on General Motors and the possibility that it may file for bankruptcy in order to help alleviate some of the cash flow problems the corporation is facing due to pension and healthcare costs, to name just two. Indeed, GM bonds have been a key element fuelling the so-called credit default swaps whereby holders of bonds can buy insurance against possible default by an issuer. Given the recent anxiety about GM, these swaps have been in hot demand. The bankruptcy filing by Delphi, the world’s largest auto parts supplier, further exacerbated concern that GM will also find a default is inevitable. This has led to an enormous increase in derivative contracts written by the likes of Deutschebank, Morgan Stanley, JP Morgan Chase and Goldman Sachs in order to insure a buyer against the underlying default. It should also be noted that the default swap section of the overall global derivative market has grown over 65 percent year to date. Central bankers have also been paying attention, as not only the International Bank of Settlements but also the U.S. Federal Reserve Board has spoken to dealers about this rapid growth. We are being told that in the aftermath of the Katrina disaster and the cash difficulties experienced by many reinsurance companies, credit default swaps were in such demand that there were very real systemic problems in processing these transactions in New York. From reports we believe accurate, the Federal Reserve Bank of New York actually spoke to a number of major dealers and threatened action if the processing backlogs were not cleared. It should be remembered that earlier this year, in April and May, similar volatility gave rise to considerable difficulties for a number of hedge funds specializing in convertible arbitrage strategies. Although we have not heard much from that sector of the hedge fund market, we can only presume that the recent mayhem in the trading of GM bonds has caused even further problems there. For example, during the height of the difficulties in mid-November surrounding the GM bonds, we saw bonds being offered with a yield to maturity of over 13 percent with less than six months to go. A mini panic if ever I saw one!

U.S. Housing

Many commentators have discussed the question of a housing bubble. While the respective housing bubbles in the United Kingdom and Australia have contracted considerably over the past twelve months, a persistent desire to push up housing prices prevails in quite a number of regions in North America. It is our view that the peak has already passed and that the weakness in some parts of the northeast, and indeed parts of the southwest, are possibly an indication of this. Markets such as Florida, Washington, D.C. and the northwest still appear to be quite firm, however. It has surely not escaped anyone’s attention that interest rates have been going up steadily, and at this point there is no reason to doubt that the Fed funds rate will be around 4.5 percent by late winter. It is worth remembering that 60 percent of all new mortgages in the United States in 2004 were adjustable rate mortgages (ARMs) and that the added surprise of considerably higher heating bills this winter should place a damper on consumers’ cash flow. Yet eager buyers of real estate have so far been unaffected by this perspective; the point of recognition seems not to have occurred — unless of course you happen to be a real estate broker who has discovered your inventory does not seem to be moving. On this latter point, sales of existing homes have been slowing notably for quite a few months and show every evidence that the slowdown is not just a statistical anomaly. It is also worth noting that much of the optimism in the overall economy has clearly slid over to housing in recent years. Is it possible that the very same investors who so carefully watched stocks in 1998 – 2000 found it much more convenient to watch housing prices between 2003 and 2005?

It will take a while for most experts to agree that a peak is behind us, but at some point during the second half of 2006 we believe the tipping point will have occurred and with it all the fallout that comes with such a downturn. Lo and behold, purchases of consumer stocks will not look so enticing and those of homebuilders (which have plunged since the summer) will look even less so. Many economists in recent months have talked about a double whammy of higher interest rates and higher fuel prices. We would add a third one to this equation: lower equity values in real estate assets. The unknown element in all of this is how the Federal Reserve Board will respond. When Dr. Bernanke takes over the Fed on February 1, he will in all likelihood try to prove his worth by speaking and acting like a tough central banker. Indeed, if he does not do it early in his tenure, will he ever have another chance to do so? Our sense is that the Fed right now sees early inflationary signs and will likely act to quell these until it is certain they have passed. Unfortunately, homeowners will have to wait until the second half of 2006 for any possible respite.

Worry is one of the things money managers do best, but while concern over these issues certainly has the potential to keep us up at night, our purpose in identifying potential problems is to take evasive action on behalf of our clients. Investors with carefully adjusted portfolios should have the confidence to sleep soundly.