Slip Slidin' Away

January 2008 Dr. Hans Black

Last year proved to be a remarkable one. How remarkable remains to be seen, as the many participants sift through the evidence to better fathom what happened or, as we prefer to say, what began to happen in 2007. One recalls that the year began with a buoyant global economy and a general sense that most things were going to continue just as before. Optimism reigned that accelerated levels of lending would be maintained, fueling the market’s appetite for risk that one year ago seemed insatiable. Few, if any, participants — with ourselves as one of the quiet exceptions — were willing to take a cautious view and warn that the problems in housing, although just emerging at that point, would continue in earnest.

By February 2007, however, about the time HSBC confessed to large mortgage securities write-downs, the world suddenly began to focus on these problems. This resulted in a two-week mini downside flurry that was neutralized by the drumbeat of the many bulls still practicing their craft worldwide — and still in denial. As we enter 2008, what is so remarkable about the past year or year-and-a-half is that the evidence for what was about to occur lay clearly in view for anybody willing to see it. Many, however, preferred not to. Our decision not to be involved with banks, investment banks, and similar kinds of enterprises appeared unconventional and something of an anomaly in the early months of 2007. Little did we know that the approaching meltdown in the banking sector, in particular, would reach such historical proportions. It is worth noting that the perennially conservative Swiss bank, UBS, has characterized what has occurred in the mortgage-backed securities market as “the biggest failure of ratings and risk management ever.” UBS should know, as their statements of early October — when they announced their losses in this sector during the third quarter and wishfully predicted that the worst was over — had to be changed once again by mid December as the losses became even larger and the bank had to go searching for capital in Singapore and in the Gulf in order to keep its capital ratios at steady levels. Citibank, as everybody reading this probably knows, has been one of the other large casualties. Their stock, which has melted down 40 percent, is heading lower as this is being written in the early hours of the new trading year. While it is anyone’s guess just how far this pendulum will now swing, we believe we are merely seeing, to borrow a phrase from Sir Winston Churchill, “the end of the beginning” and hardly more. Others have used the analogy that we are perhaps only in the third or fourth inning in what should prove to be a rather lengthy debacle for credit markets and the global economy in general.

We expect 2008 to be a lot more of the same and to continue to showcase a great deal of volatility, which should create opportunities for those with cash in reserve. Investors will react when central banks do the inevitable and add more liquidity, but at the end of the day some of the current bubbles will melt down further. First, despite the many calls to the contrary, we do not believe the current difficulties in the banking and investment-banking sectors will stop. More likely, these problems will spread beyond the now well-known subprime issues and involve many more forms of consumer lending, i.e. higher-quality mortgages, auto loans and general consumer debt as well. It is also our expectation that these difficulties will become much more global in nature. There is still a tendency among many observers to point a finger at the United States as the centerpiece of these problems. Evidently such investors have not visited what is going on in Spain, Ireland, the United Kingdom or for that matter Eastern Europe. We have stated before in these pages that we anticipated we eventually would see a breathtaking corporate failure, but for the moment we can only guess where it will originate. It has also been interesting to see the likes of UBS, HSBC and Citibank making the extremely painful but necessary steps to start rebuilding their balance sheets. Where, pray tell, are all the other banks that we know were involved in the very same shenanigans in the past several years? We leave it up to the readers to fill in the blanks. It is also noteworthy that the press and indeed many financial observers have become increasingly critical of the former chairman of the US Federal Reserve Board, Alan Greenspan. In December, a well-known French economist, Patrick Artus, who is an advisor to the current French government, published a paper calling Mr. Greenspan the instigator of many of the fires he has been credited with putting out in recent years. We believe that unfortunately this critique is only the first of many we will see scrutinizing the circumstances that brought us to the excesses we are currently seeing in the credit markets.

Several of our dear friends have been asking us if we believe we are seeing the beginnings of a replay of a substantial downturn à la the 1930s in North America, or the 1990s in Japan. First off, we must clarify that the two have very little in common. While the Japanese asset bubble did deflate and caused severe pain for many years, the relatively high savings rate in Japan at the time helped in large part to bolster the fortunes of the average Japanese consumer. Indeed, once the Japanese Central Bank began to sense the need to do something — a remarkable ten years after the problems began — things finally did get set right and the pain was kept to reasonable levels. The 1930s was, of course, a very different experience and a much more severe one that we dare not even contemplate. We should note, however, that Jim Grant, in his excellent publication Grant’s Interest Rate Observer, has noted that the words “great depression” have appeared in over 150 news stories associated with real estate in December alone. A lot of people have clearly begun to worry and the level of worry has understandably accelerated with the sharp decline in housing prices over the past year. Is there any wonder that consumers did not engage in a shopping spree this fall, as so many had predicted? Furthermore, all sorts of stocks, from discretionary retailing to travel and particularly to restaurants, have been under severe pressure recently, reporting disappointing results. While I must confess to enjoying the occasional visit to Ruth’s Chris Steak House, I was somewhat surprised to see their very poor earnings report released in recent weeks. I should also add that with the consumer seemingly intent on pulling back, many restaurant owners I know have been sharing woeful tales with me.

We will need to keep our eye particularly focused over the next one to two months on the reports from banks and other financial companies around the world. We suspect, as we have said before, that we will see more unpleasant and difficult surprises. It is our firm belief that having been too lenient in accepting the ratings services’ assurances regarding many of these structured investment vehicles or collateralized debt obligations (SIVs and CDOs), accountants in large accounting firms will now tend to err with exceedingly greater caution. Nobody could have said this better in recent weeks than Warren Buffet himself, who has coined the phrase “mark to myth”. This little phrase has gone far in explaining what has been going on and, alas, what we suspect has been going on for many more years than people wish to admit. The so-called Tier 2 and Tier 3 assets have traditionally been marked to market using models. In other words, as some of the instruments are so illiquid and trade infrequently, if at all, the only way to price them properly is to create a model by which one can hope to come up with an appropriate value. Warren Buffet’s whimsical phrase “mark to myth” will, in our judgment, be heard much more often in the coming months as people realize that very few of the instruments contained within CDOs or SIVs have traded since the summer of 2007. Who is to say what they are really worth – the people that sponsored them in the first place, or the present marketplace that at some point will determine whether or not it wishes to buy any of them at all?

While the landscape is certainly fraught with minefields, it is important to keep an eye on the openings that will be created. Investors will have to remain opportunistic, seizing on sectors that will do well despite these difficulties. One of these will probably be gold, as it seems increasingly likely that as these problems take on a global scope, investors should realize that simply hopping into the euro or the yen is hardly any help at all. We suspect we are very close to this point, as perhaps the surprise of the first half of 2008 will be just how quickly the economies of the European Union will weaken. As these words are being written, Ireland has reported dramatically weaker data from its Purchasing Manager’s Index in the early hours of 2008. The considerable weakness we are seeing is likely just a taste of what we will experience in many nations in Europe over the next several quarters. It is also worth noting that just hours previous to the Irish announcement, Singapore reported a surprising negative 3 percent for fourth quarter GDP — hardly the kind of number that many would expect given the strength in China, India and other nations in Asia. All in all, investors should soon latch on to the fact that what we are seeing is likely a global slowdown of significant proportions led by the U.S. consumer.

We hope to keep our friends and clients clear of the majority of these problems by focusing not only on gold but on the few sectors with which we feel comfortable – healthcare and biotech as well as selected technology companies. With the current global developments, these would seem to us to be the place to be. In addition, having liquidity available in order to take advantage of market opportunities as they occur is also going to be a good strategy, as sudden air pockets that should develop will lead ultimately to sharp rallies.