Shadow Banking

Shadow banking system is comprised of a plethora of opaque institutions and vehicles that have sprung up in American and European markets over the last decade. They have come to play an important role in providing credit across the financial system. These institutions, moreover, have never been part of the “official” banking system; they are unable, for example, to participate in Fed Treasury auctions. But as the credit crisis enters its sixth month, it has become clear that one of the key causes of the turmoil is that parts of this hidden world are imploding, sparked by the failure in mortgage-backed bonds. This in turn is creating huge instability for “real” banks, partially because regulators and bankers alike have been badly surprised by the degree to which the two (official and shadow banks) are entwined. Financial derivatives of all descriptions are involved, including SIVs, CDOs, and the most egregious CDSs. If you want to understand the shadow banking world you must learn this new alphabet soup of entities and investment vehicles. So follow along as we trace our way through the rubble.
Until this summer, structured investment vehicles (SIVs), collateralized debt obligations (CDOs), and credit default swaps (CDS) attracted little attention outside specialist financial circles. Though often affiliated with major banks, they were not always fully recognized on a bank’s balance sheets.
Structured investment vehicles, or SIVs, are bank-linked funds. In a way, they are a virtual bank. The SIVs issued short-term debt at relatively low interest rates and used the proceeds to buy longer-term debt carrying higher rates, including debt backed by mortgages. They have an open-ended structure which could stay open forever as long as they keep buying long term assets and selling short term debt. Why do this? Banks profited by setting up these structures because they pocketed the difference between the short term and long term rates, and they did not have to hold reserves for these loans that were placed off balance sheet. At their peak, SIVs held some $340 billion in assets, a figure that fell to a still whopping $265 billion by early December as they sold off some holdings.
When debt markets froze up in August the fear was that the SIVs would be forced to unload their assets in a panic. That would create big losses, the theory went, and set artificially low market prices for the assets -- forcing financial institutions to take huge write-downs. A government effort to stabilize the markets with the help of three major banks ultimately failed, but it did ward off a complete meltdown. The banks claim they are not responsible for the losses caused by these SIVs. Interestingly, despite their protestations, they are stepping up and taking the write-downs associated with these shadow entities they created.
CDOs are actually bonds, unlike SIVs which are entities which that hold assets. These collateralized debt obligations are structured products backed by an asset that has a cash flow, like a pool of mortgages. Other assets that collateralized these products are corporate bonds in various forms. Here’s were it gets really complicated; there are synthetic CDOs that never owned the asset backed bonds or loans. They gained exposure to these asset-backed loans through the use of credit default swaps. Many SIVs purchased CDOs and synthetic CDOs.
So what is a credit default swap (CDS) and why are these contracts a problem? Brace yourselves, this is a mind bender. This is a vast, barely regulated market in which banks, hedge funds and others trade insurance against debt defaults. This isn't like life insurance or homeowners' insurance, which states regulate closely. It consists of financial contracts called credit default swaps (CDS) in which one party, for a price, assumes the risk that a bond or loan will go bad. This market is vast - about $45 trillion, a number comparable to all of the deposits in banks around the world.
Originally, these contracts were intended to protect Wall Street firms from losses on mortgage securities and other debt they own. However, not everyone who buys one of these contracts has bonds to insure. Some players bought them just to speculate on market movements. These investors were basically betting on which direction the value of an insurance contract would rise or fall, which they did daily based on the market’s perception of risk. In much the same way gamblers make side bets on football games, a financial institution, hedge fund or other player can make unlimited bets on whether corporate loans or mortgage-backed securities will either strengthen or go sour.
If they default, everyone is supposed to settle up with each other, the way gamblers settle up with their bookies after a game. Even if there isn't a default, if the market value of the debt changes, parties in a swap may be required to make large payments to each other (just the way an investor would have to put in more capital if the stock he bought on margin fell). Of course, Wall Street investors often use heavy borrowing to magnify their wagers. Recently, the ability of institutions to make good on their many trades with one another is beginning to falter. The turmoil on Wall Street could rock the foundations of the financial system around the globe if the major insurers of these contracts go under.
“What we are witnessing is essentially the breakdown of our modern-day banking system, a complex [or composite] of leveraged lending [that is] so hard to understand,” Bill Gross, head of Pimco Asset Management Group recently wrote. “Colleagues call it the ‘shadow banking system’ because it has lain hidden for years, untouched by regulation yet free to magically and mystically create and then package subprime loans in [ways] that only Wall Street wizards could explain.” By any standards, the activities of this shadow realm have become startling. Traditionally, the main source of credit in the financial world was the official banks, which typically forged businesses by making loans to companies or consumers. They retained this credit risk on their books, meaning that they were on the hook if loans turned sour.
Why has the financial model changed so radically in the last few decades? Why did the shadow banking system develop? Banks began to increasingly sell their credit risk to other investment groups, either via direct loan sales or by repackaging loans into bonds. This was made possible by new regulatory reforms, which have permitted the banks to reduce the amount of capital that they need to hold against the danger that borrowers default. They did this by passing their loans to new vehicles (SIVs) either by creating these themselves or by sponsoring outside fund managers to run them. This was a huge incentive because it allowed banks to make many more loans without having to raise more capital. These new entities have been instrumental in vastly increasing credit over the past three years. Paul Tucker, head of markets at the Bank of England, has described this as the age of “vehicular finance”.
Bob Janjuah, credit analyst at Royal Bank of Scotland, estimates that these shadow banks could have accounted for half of all net new credit creation in the past two years. Because these vehicles typically borrow heavily to finance their activities, they have also been a key reason why leverage (or debt levels) across the financial world has risen so fast without regulators or ordinary investors being fully aware of this boom.
Hedge funds have had an oversized impact on the increase in the supply of credit. Satyajit Das, author and derivatives industry expert, cites an example where just $10 million of real (non-leveraged) hedge fund money supports one $850 million mortgage-backed deal. This means $1 of real money is being used to create $85 of mortgage lending. This is a level of credit creation that is far beyond the wildest dreams of any banker.
Since SIVs and CDOs have never been in the business of gathering deposits from customers, their significance to the economic and financial system has not been widely recognized by regulators and policymakers. The problem now is that the business model behind parts of this shadow banking world looks increasingly shaky. Essentially, the role of regulators in this world was replaced by the credit rating agencies, which awarded high, ultra-safe ratings to the debt issued by SIVs and other vehicles on the basis of historical analysis of the probabilities of defaults and losses across the shadow banking system. Now these vehicles’ credit ratings are being downgraded. As the credit market absorbs this debt, it is contracting. The holders of these synthetic CDOs and SIVs are having the equivalent of a margin call, hence the large write downs
Jan Hatzius of Goldman Sachs estimates that mortgage related losses of $200-400 billion alone might lead to a pullback of $2 trillion of aggregate lending. Even if this occurs gradually, he writes, "The drag on economic activity could be substantial. Add to that my $250 billion loss estimate from CDS, as well as prospective losses in commercial real estate and credit cards in 2008 and you have a recipe for a contraction in credit leading to a recession.” (I have to thank Bill Gross from PIMCO for this quote).
The problem is that it is difficult to quantify the losses and impossible to confidently forecast how restrictive credit will be and for how long. There is also fear that credit problems will spread to other areas, such as credit cards which have also had permissive underwriting standards. At this point, it seems pretty clear that banks will have more write-offs over the next few months or quarters and that structured investments (pools of debt that have been turned into securities), which are often highly leveraged, will suffer through more ratings downgrades as collateral values decline further. This suggests that the current trend of less credit and higher costs probably has a way to go. This is true not just in the mortgage market (subprime and prime) but in the consumer and small-business loan market as well.
Problems like these do not get fixed overnight. They take months and sometimes years to unravel. It is obvious that whole parts of this economy (automotive industry) as well as whole regions of the country (Detriot with almost 8% unemployment) are in recession. The temporary fiscal plan proposed by Bush can’t plug this breach. It will, at best, be a small levee holding back a briskly flowing river.
The housing market will still fall, lenders’ underwriting criteria will tighten, consumers will spend less and the economy will slow to a crawl. Why? Because borrowing will no longer be cheap. The Fed can lower the interest rate to 1% but it won’t take the 30 year mortgage rate past 5%. The mortgage lenders aren’t offering teaser loans based on short term rates anymore. Only the 30 year mortgages are primarily available. So now you’ll need to put down a 10% deposit to buy a house and can only borrow at the higher 30 year rates. Fewer consumers will now qualify for homes, cars, and credit card debt. So the consumer is out of the picture. Businesses won’t be able to attain loans as liquidity continues to dry up. As I said before that just leaves the government and its stimulus package is a joke.
This is a mess that will be cleaned up by the next administration. Until then, the economy will bungle along. It will neither recover nor fall precipitously. The economy will be in a coma. The U.S. market should bumble along in the same trading range. As long as the stock market doesn’t get an unexpected big shock (i.e. terrorist attack), we should weather the storm, a little care worn but a good deal wiser. The best scenario for 2008 is nothing happens. This is not very inspiring, but it’s unfortunately realistic. Holding the course will be this year’s mantra.

Mortgage-Backed Securities and the Housing Market

Most mortgages are not held by the lender who made them to you. They are pooled with others and sold to investors such as insurance companies, mutual funds, foreign banks and pension funds. A different company processes your loan payments. Yet another company represents the investors as the trustee.

The very innovation that made mortgages so easily available, an assembly line process known on Wall Street as securitization, has caused our current problems.

The idea of pooling loans and selling them to investors dates back to 1970, but the practice has exploded in recent years. At the end of last year, $6.5 trillion of securitized mortgage debt was outstanding. In the last few years, securitization led to this explosion of bad loans because the agents writing the loans didn’t care if they would ever be paid back. They made a fee by originating the loan and then sold the mortgage (passed on the risk) to another middleman who then passed it on to some anonymous investor. The incentive was to originate loans and to heck with proper underwriting (screening the borrowers to see if they qualified).
The process begins with the entity that originates the loan, either a mortgage broker or lender. The loan is assigned to a company that will service it (collecting borrowers’ payments and distributing them to investors). A Wall Street firm then pools thousands of loans to be sold to investors who want a steady stream of cash from loan payments. The underwriters separate them into segments based on risk called tranches.

Once a pool of mortgages (trust) is sold, a trustee bank oversees its operations on behalf of investors. The trustee makes sure that the terms of the pooling and servicing agreement are met; this document determines what a servicer can do to help distressed borrowers.
By its nature, the complex design of mortgage securities creates unwanted difficulties, which are written to ensure that the middlemen make their profit with little to no risk. Almost nothing in this process is done in favor of the borrowers’ interests. In fact, the agreements require that any modifications to loans in or near default should be “in the best interests” of those who hold the securities. Loan modifications are restricted which explains why many borrowers are having difficulty renegotiating their loans.

Fifteen years ago, the last time the housing market ran into stiff trouble, government-sponsored enterprises like Fannie Mae did most of the work pooling and selling mortgage securities. These enterprises readily agreed to loan modifications, but not so this time. In fact, it is in many cases impossible to determine who really is holding the title.

This is a mess, and many more home owners will lose their homes, keeping the housing market depressed until well into 2009. Why has the implosion of mortgage-backed securities been so destructive to the financial markets? The failure of mortgage-backed bonds has rippled through the markets, hurting financial institutions and the newer non-traditional banking system. This unregulated shadow banking system is comprised of a plethora of opaque institutions and vehicles that have sprung up in American and European markets over the last decade. They have come to play an important role in providing credit across the financial system. In the next few days I'll post more information about this sahdow banking system as well as credit swaps, SIVs and more.

The Math: Economy Less Consumer Equals Recession

Without a doubt, investors will remember 2007 as the year that the housing market collapsed and triggered a credit crunch. The earnings of just about any company that was involved in homebuilding or lending were crushed, and resulting economic worries triggered stock declines for many consumer goods companies. Simultaneously, U.S. exports boomed, reaching an all-time high of 12.1% of GDP. Not surprisingly, companies with significant foreign-based earnings did well. Overseas stocks also delivered great returns, and as these economies continued to grow so did their demand for energy and raw materials commodities from China and other high-growth developing countries.
The last four months have been difficult for stocks as prices have declined substantially from their highs in October 2007. The markets have broken through many technical support levels -- this is true for every major index (Dow Jones, Russell, Nasdaq and S&P), which means that technical damage has been done.
The good news is that the Federal Reserve has finally woken up to the severity of the situation and is working diligently to respond to escalating economic concerns. On January 22, 2008, the Fed unexpectedly cut the fed funds rate by 75 basis points (0.75%) from 4.25% to 3.50% in advance of its policy meeting. The Fed has not cut rates in one stroke by such a large amount since 1982. In making the cut, the Fed cited the “weakening of the economic outlook and increasing downside risks to growth.” This move was desperately needed to ensure market stability and sooth investor fears. Sinc then, the Fed has continued to cut rates and has stated its willingness to cut rates further to shore up the markets.
It appears that the combined impact of the housing implosion and the fallout from the structured finance debacle has pushed the U.S. into recession - or at least whole sectors of the economy are now in recession. How protracted the economic weakness will be and what its full impact on the markets are the new questions to be answered.
The key to an economic turnaround is consumer spending because it accounts for 70% of our economy (Gross Domestic Product—GDP). The falling housing market and the resulting tightening of mortgage lending have hit consumers hard, causing them to spend significantly less. Consumers who are more and more worried about the overall economy have triggered stock declines for many consumer goods companies.
A volatile stock market does not help consumer sentiment either. When you add rising unemployment to the mix, it is obvious that the U.S. consumer isn’t going to go on a spending spree anytime soon. It will be tough to entice the consumer to start spending when it is difficult to borrow, and many are already heavily in debt. Until credit markets are repaired, the consumer won’t start spending enough to cause a recovery, and businesses will curtail spending. If consumers and businesses aren’t spending, that only leaves the federal government, a scary thought. Even the proposed fiscal stimulus plan by the President won’t be enough to turn the tide. When credit becomes this tight, a recession is almost inevitable.
How did credit get so tight? Why are funds more scarce and underwriting criteria toughening? It all started with the mortgage-backed securities and how they are packaged and sold through our unregulated shadow banking system.

Bill Fries with Thornburg International Mutual Funds

Bill Fries is the lead portfolio manager manager for Thornburg's international mutual funds. He recently participated in the International Herald's global investing roundtable.
Many of my client's hold institutional shares of the Thornburg funds that Bill Fries co-manages.

Friday, December 7, 2007
The International Herald Tribune's 11th annual round table on global investing convened at The New York Times on Nov. 29. Participants in the discussion moderated by Judith Rehak were:
George Evans, portfolio manager of the Oppenheimer International Growth Fund; William Fries, portfolio co-manager of the Thornburg International Value Fund, and David Winters, portfolio manager of the Wintergreen Fund.

We are meeting amid fears that more subprime losses and a credit crunch could turn a U.S. economic slowdown into a recession, affecting Europe and Asia and even the robust emerging markets. Add worries about high-priced oil, the battered U.S. housing sector, and inflation in Europe, and it has been a year of turbulent markets. Against this background, what do you see for 2008?

Fries: After a year like we've been through, I think you have to be more cautious, because one of the things we've learned is that we don't know everything we thought we knew in terms of problems that companies might have. As far as the U.S. influence on the global economy, our monetary authorities are walking on a tightrope, because if they are too aggressive in trying to support the U.S. housing market by dropping interest rates, they likely will end up trashing the dollar even more than it has been trashed. It might be good for some U.S. exporters, but generally speaking I think it's maybe a factor of disequilibrium and would possibly lead to more inflationary pressures from industrial and energy commodities.
I think you need to be careful about company business models and the independence of companies' prospects from direct economic consideration. You want to have companies that have pricing power and the opportunity for volume gains because of innovation.

Asia has been one of the strongest markets in the past year. David, what is your view on that part of the world now?
Winters: I believe that in the history of human beings, there has never been so much material
progress by so many in such a short period of time. And it's our impression that it's not only the people who have progressed so far, but waves of other people coming behind them. So we're very enthusiastic about Asia in the long run. It doesn't mean that there are not going to be bumps along the way, but you've got enormous wealth being created, enormous demand for resources, and a wonderful work ethic. So long term, if you're any kind of investor, you've got to pay attention to what's going on in the Asia sphere.
In Europe and the U.S., I think there's lots to worry about and we think there is also quite a bit of inflation. So I think Bill is right on about pricing power and being cautious. That said, there are some gems in the U.S. and Europe, so we're optimistic long term.

Evans: The biggest story for the rest of my life is what's going on in China and India. But there's a lot that makes me more cautious now than I have been in three or four years. My caution is related to the effect that this subprime issue and related issues are going to have on the availability and price of credit, which inevitably has to have some effect on the real economy over the next few quarters. It depends also on what the monetary authorities do, but one of the marvels of the last two years is just how fantastic business has been for just about everyone. There's a lot of pricing power on everything from a diesel engine to a second-hand hull for a tanker.

Given these uncertain times, where are you finding the most interesting opportunities?
Fries: If the standard of living in emerging markets continues to move toward what Western Europe and the U.S. have had, we will probably have considerable progress in a lot of places, including infrastructure and retailing. The economic boom in China has been going on now for more than a decade at a 10 percent rate essentially, and probably has a long way to go, although it may change character. Some of the things we held when we met last year still look interesting. China Mobile, the cellular phone company, and China Merchants Bank are two that have performed very well. I like to look at history and if you accept the idea that China is in a development stage that might have been like the U.S. in the '50s, we have a long way to go in some of these institutions. Growth rates will be above average and I'm content to stay with those.

What about the more developed markets?
Fries: Europe is showing the way to develop an energy policy, and I think the price of a kilowatt of electricity at the margin from gas-fired sources is creating an umbrella that will ultimately bring green utility generating companies to the forefront. A couple of the stocks we like are E.ON, the German utility, and Fortum, a Finnish utility that is 60 percent hydro, with a big piece of nuclear and a very small part of gas.

Winters: In the U.S, the problems are well flagged, but there are opportunities as well. We do have stakes in a number of companies, and a big stake in Berkshire Hathaway, the conglomerate run by Warren Buffett. Berkshire has come back into fashion because having $40 billion in cash is a good thing in this environment.
In Western Europe, we own shares in Swatch, the Swiss company that makes watches from the basic plastic watch to the middle-range Longines to Breguet. As you have increasing wealth around the world, not everybody can have a big car or a big house, but they all can have a watch. Swatch is very conservative; they have had a stock buyback program and we like that. We also own shares in Schindler, a Swiss elevator and escalator company that is debt-free, and with the urbanization and improvements around the world, they're a beneficiary. And they also have the elevator-escalator service business. We're trying to find niches that should do well, almost no matter what happens.

Evans: We're looking for themes defined by an industry or a group of industries that will grow
sustainably faster than global average growth over the long term, and then look for the winning
companies. Obviously, in emerging markets, a theme is mass affluence. Wealth creation is creating a slew of opportunities, and we have long-standing positions in luxury goods companies like LVMH Moët Hennessy Louis Vuitton. We own Swatch as well and also Richemont, which is the parent company of Cartier and Van Cleef & Arpels. Luxury brands are selling hand over fist in emerging markets. These are not lands of modesty and when you make it, you flaunt it. Also, the vast majority of luxury goods opportunities are European companies with bullet-proof barriers to entry, high margins, and high growth. They're fantastic long-term investments.
We have quite a few investments that are benefiting indirectly from the emerging markets boom, such as ABB, a Swiss-Swedish firm in the electricity transmission business, and Alstom, the French train and subway car manufacturer, and Siemens.
Restructuring is another theme, particularly in the context of Eastern Europe. We own Continental, which is half tire business and half automotive electronics. Their tire manufacturing in Western Europe was very expensive, about €30 per tire and labor. They moved it to Romania where labor costs went down to about €3 and revolutionized the profitability of the business. Another theme we have been investing in for a long time is aging. We own the top three hearing aid makers in the world: William Demant of Denmark, Sonova in Switzerland and Siemens.

What else interests you?
Evans: I am looking at a lot of self-financed growth. When the banks are worried about lending to each other or anyone, it's a healthy thing when a company has the wherewithal to generate enough cash on a sustainable basis to finance their own opportunities. Luxury goods companies are cash generative; so are clothing retailers like Inditex, which has the Zara shops, and Hennes & Mauritz.

Winters: We have certain ways of investing in emerging markets that are different from others. Our biggest position is Japan Tobacco. They have extensive emerging markets positions and they recently acquired Gallaher, the U.K. tobacco group. By putting the two companies together they have a wonderful franchise, a play on emerging markets and developed markets as well, in Japan and Western Europe.
We also like hard assets - for example, real estate. We own a Hong Kong company called Shun Tak with significant historical real estate holdings in Macao, which is on its way to becoming the favorite entertainment destination in Asia. Real estate prices have gone up a lot and we think Shun Tak's management is very good.

I note that you own a number of gambling-related stocks. Is this also related to Macao?
Winters: We like the term "repeat human behavior," and people enjoy gaming and entertainment, so we are involved in the sector. We have a stake in Wynn Resorts, a U.S.-listed company, which is extremely well run and very shareholder oriented. It has assets not only in Las Vegas but Macao and we think they have the premiere properties in both.

And what's your take on energy and materials stocks, which have had a terrific run?
Winters: We own shares in Anglo American, the mining company. They have a big position in
platinum, which is used in catalytic converters, and as the world goes green, Anglo American is a
beneficiary. You also have base metals in there, too, and Anglo owns 45 percent of DeBeers, the
diamond company. We think Anglo is kind of a unique asset play.
And there are niches in this commodity boom. Another company we own in the U.S. is Chesapeake Energy, a natural gas enterprise. Natural gas prices haven't gone up a lot, but it has significant assets, it's well run and natural gas burns cleanly. They have a very significant land base which they are continuing to exploit in terms of looking for more assets.

Fries: One of our holdings is Gazprom, the Russian natural gas producer. To me, natural gas is the next commodity that's going to go global. It has been a local commodity and because of that you have pockets of excess supply. But as oil prices move higher I believe that ultimately, natural gas will follow. One of the principal uses of natural gas in a world that is conscious of global warming will be as the marginal source, because you can't put nuclear power plants in place fast enough. Natural gas will provide the power that will be required in Western Europe and emerging markets so that's a good place to be.

Evans: I own a bit of CVRD (Companhia Vale do Rio Doce), the Brazilian iron ore miner, and I own Impala Platinum for the same reasons as David. We're not overweight, though. The thing that has really powered the materials stocks over the past few years has been a stronger commodities market than has existed on a sustainable basis since the 1970s. Prices won't go up as aggressively in the future but arguably they are sustainable, given emerging-market demand.

Fries: We own Freeport McMoRan, but that's about the only mineral exposure in out international portfolio now. We have owned Rio Tinto and BHP Billiton in past years.

What about the beleaguered banking industry? You both own UBS.
Fries: UBS certainly got caught up in the subprime trading, and a lot of that business is just flat out going to go away. I don't think the institutional end markets that you must have in order to have viable trading are going to be buying some sliced and diced mortgages from the U.S. anymore. In the long run that's a good thing if they pay attention to where they are really strong. I think the [UBS] franchise is too powerful to be ignored and you can buy that at less than 10 times earnings.

Evans: I own UBS and some Credit Suisse, both primarily because of the wealth management
business. Credit Suisse has been a little accident-prone over the last 10 years, but I believe that
management is a lot more aware of the risk they're taking. We're typically very underweight in banks and insurance companies. I like being able to analyze things I understand and if managements at some of these institutions can't tell you what is on their balance sheets there is very little probability that I can. But, the world is getting significantly wealthier, and people want professionals to manage that money. Wealth management is a great business with a great long term trend of more and more assets being accumulated. And it's a very resilient business, too.

Another thing we've been hearing about lately is health, or health care stocks as a defensive measure.
Fries: We own Roche, which has a 54 percent interest in Genentech, the U.S. biotech leader in
terms of creating products, especially in oncology. They have over 20 products in their potential pipeline, and they have the first right of refusal for products that Genentech develops outside the U.S. The other franchise we own is Novo Nordisk, which makes diabetes products. They continue to gain share in the U.S. where there is an aging population impact of diabetes and it has a limited number of competitors. These stocks are inexpensive now because people believe that whoever wins the U.S. presidential election is likely to make it more difficult to sustain high profit margins. That's a way off, and there will be an overhang on these stocks, but we think there is good value in these businesses.

Evans: Most of our health care is franchises in medical devices like Smith & Nephew in the U.K.,which does trauma products, and Synthes in Switzerland, which does the same thing, putting bones back together with bolts and plates and helping repair hips. There are patents, and it's a competitive business but the margins do remain pretty robust and there are new products coming out. So clearly, despite uncertain times, you all are still finding opportunities around the globe, and especially directly or indirectly in emerging markets.

Winters: As an investor, it's just a wonderful time. Things have changed so much, and you've also seen now the principles of Anglo-American finance filter all over the world.

Fries: On that point, it's interesting that we haven't been able to necessarily get people converted to the idea of democratic institutions, but we've had no trouble having them embrace the capitalistic market economy.

Understanding the Emotional Side of Investing

“There is a steady flow of wealth from the hopeful gambler to the men who know what the odds really are. Most people ignore probabilities and exaggerate risk.”
Tversky and Kohneman

Behavioral finance has become a very popular subject. Quantifying how people emotionally deal with their money (what mistakes they make over and over again and why) has produced many interesting findings. The late Amos Tversky, a Stanford professor, and Daniel Kohneman, a Princeton professor, did much of this pioneering work. One of their major discoveries is that a dollar of gain is not equal to a dollar lost in most people’s minds, certainly not when the dollar stakes were high. Who would bet his car against a neighbor’s similar car at even odds? Very few people would take this bet, because having no car is more of a bad than having two cars is a good. So, the value function is non-linear, which means most people have more displeasure in losing a large sum than the pleasure associated with winning the same amount. Most individuals want a two-thirds chance of winning to venture a big bet. Interestingly enough, most individuals don’t invest this way.
In addition, Tversky and Kohneman studied how investors used context in their decision-making process. In other words, people made up their minds differently depending on how the problem was presented to them. Perversely, when the potential gain in a transaction is stressed, people get nervous and wary; and when potential losses are played up, they are willing to assume what are in reality greater risks in order to avoid the losses.

For example, suppose a person has spent the day at the race track, and lost $140, and is considering a $10 bet on a fifteen-to-one long shot in the last race. This decision can be framed in two ways, which corresponds to two natural reference points. If the bettor focuses on the cash flow on hand, the outcomes are framed as a gain of $140 or a loss of $10. On the other hand, if the bettor frames his decision in the frame work of the whole days losses, then it’s a chance to get back to even (from a $140 loss) or to increase his loss a mere $10. Individuals do not adjust their reference points as they lose and can be expected to make bets they normally would find outrageous, even on dubious nags at fifteen to one. This is exactly how many investors have handled their investments. In reaction to huge losses in technology stocks, they have continued to not build a conservative balanced portfolio but have instead tried to chase gains. These investors are speculators still hoping that some day they may break even again.
It is always better to take your lumps and reset your reference points. Interestingly enough, the same reset is necessary with investment wins as losses. If your portfolio does exceptionally well, don’t start believing you are the new Superman of the investment world. Remember every time you flip a coin, it could come up heads or tails. The next flip of the coin isn’t influenced by results of the last toss.

If you want to minimize your investment risk, then don’t bet all your money on one filly or one spin of the roulette wheel. Instead invest in a balanced diversified portfolio; hold for the long term; and keep systematically investing each month through your 401(k) plan 403(b), IRAs and taxable account. Also, don’t forget to forgive yourself for all the wacky investment decisions you’ve made in the past. Remember to reset your reference points.

What can patience and diversification and rebalancing regularly get you? Well rewarded. The chart below is worth studying. Owning high-quality bonds in a down market can save you from serious losses. The value of being diversified is apparent when you consider the entire period returns (third column). Small cap, mid-cap and bonds all generated positive returns for the entire period while international stocks, Nasdaq composite and large cap stocks were all negative. If you had put everything you owned in the Nasdaq Composite in March 2000 at its peak and then held (not resetting your reference point) hoping to get back to breakeven, you just proved Tversky and Kohneman’s behavioral finance theories. I could update the chart above to include the last few years but it just further proves the point. Stay diversified and rebalance at least once a year.

Happy Holidays!

Emerging Markets Appear Vulnerable

Emerging markets appear vulnerable compared to the developed international markets. For instance, China is currently facing an inflation spike (+6.5%). Inflation is rising at the fastest pace in China in more than 10 years. The culprit is almost entirely food costs, caused by supply constraints. The Chinese government is trying to contain the inflation with price controls.

Chinese consumer spending (retail sales +17.1% year over year) remains too hot and is not sustainable. Unless China can begin to rein in its growth and control inflation we could be looking at a major correction. Investing in only one country or region is risky. The investment inflows into Asian and Chinese oriented investment vehicles have been of tsunami proportions.

Is the Chinese market ready for a correction? Given the alarming growth of the iShares FTSE/Xinhua China 25 Index over the last three years, I wouldn't be surprised. It looks surprisingly like many historic investment bubbles such as the Nasdaq high tech/internet bubble and the more recent housing bubble. Will the Chinese stock market suffer the same fate as the NASDAQ or the housing market anytime soon? That is unclear, but a pullback sooner or later is inevitable.
I have not allocated a significant portion of international investments to emerging market mutual funds. Most international funds have over 5% invested in emerging markets. It is dangerous to then allocate another 10% to this sector given its inherent risk. I am firmly committed to increasing the allocation to international stocks and bonds in each client’s portfolio but not to over emphasize the emerging markets.

My goal is to structure each portfolio so that the overall equity allocation is equally-weighted between U.S. and international stocks. As we become a global economy this equally-weighted allocation just makes intuitive sense, but in the investment world this is a radical strategy. Most investment strategy is fashioned by looking at history (backwards) and frequently misses indicators that signal major shifts in the economic paradigm. The world is no longer U.S.-centric and this shift in growth is recognized in your portfolio allocation. If you decide to increase your international allocation, just make sure you do not overweight the risky emerging markets sector.

What Happens When the Easy Money is Gone? Go Global!

Consumers can no longer tap their homes to support their lifestyle nor can they run up their credit cards forever (credit card debt is reaching a historic high). The subprime mortgage debacle has made it difficult for consumers to withdraw funds from their homes and caused housing prices to fall. Add in a falling stock market to this mix and the American consumer must be feeling less wealthy. Historically, a falling housing market has caused consumers to rein in their spending. As credit continues to dry up, the American consumer will have to begin living within their means. That could make things uncomfortable for a while and leave the U.S. economy in a bind.

In the past when the U.S. economy caught a cold, the contagion spread around the world. The world economy has been too dependent upon the U.S. consumer to buy its good but the world is becoming a different place. Hopefully, the global economy can slowly wean itself from the American consumer and become more dependent upon the emerging middle class in India, China, and South America.

The falling U.S. dollar will help this global shift by making imported goods more expensive. On the plus side, exported U.S. goods will become more affordable to the new world emerging middle class. This new demand for U.S. goods and a falling demand for imported goods to the U.S. could correct the trade imbalance caused by years of over spending by and over dependence upon the U.S. consumer. This scenario would allow the U.S. economy to grow albeit slowly and the world to grow apace.

Credit is drying up for the U.S. consumer making him played out as the engine for global growth. The U.S. consumer won’t be able to borrow and may have to begin to save. The easy money has dried up and we are about to find out what the world will look like without the U.S. consumer in the drivers seat. Hold onto your hat! The ride is going to be bumpy especially in the U.S.

In short, emphasizing global investments will be crucial if your portfolio is going to generate decent returns over the next few years. That means allocating half of your equity investments abroad which is a stark change from the past when the U.S. markets dominated the world.