"If you have bad banks then you very urgently want to clean up your banks because bad banks go only one way: they get worse. In the end every bank is a fiscal problem. When you have bad banks, it is in a political environment where it is totally understood that the government is going to bail them out in the end. And that's why they are so bad, and that's why they get worse. So cleaning up the banks is an essential counterpart of any attempt to have a well functioning economy. It is a counterpart of any attempt to have a dull, uninteresting macroeconomy. And there is no excuse to do it slowly because it is very expensive to postpone the cleanup. There is no technical issue in doing the cleanup. It's mostly to decide to start to grow up and stop the mess."
MIT Economist Rudiger Dornbusch, November 1998
...Debt burdens have not been meaningfully reduced in the mortgage sector - they have only been extended. Home values are still well above their historical norm relative to incomes. Yet more than 20% of homeowners already have "negative equity" - mortgages that exceed the current prices of their homes. A few months ago, Deutsche Bank projected that the negative equity rate may rise to 48% in 2011. Yet even if we ignore the mortgages that have been "modified" by slapping delinquent payments onto the back of the obligation, one in seven U.S. homes is presently delinquent or in foreclosure. As much as we have done to make lenders whole, nothing apart from a major restructuring of mortgage obligations will ease the continuing vulnerability on the debtor side.
Meanwhile, the dependence of the banking system on short-term deposits is worse than it was prior to the crisis. The FDIC reports that time-deposits have declined for the 7th consecutive quarter, while the cost of funding assets has dropped below 1%, as banks rely on the shortest liabilities possible in order to earn higher interest spreads. So while the month-to-month progress of the economy has been somewhat encouraging, our policy makers have put us in the position of continually revisiting a can that they simply kicked down the road.
Hard Money and Clean Banks
In 1998, MIT economist Rudi Dornbusch gave a set of lectures in Munich on "International Financial Crises." I've excerpted some of his remarks below. Much of what Dornbusch discussed is particularly relevant to the present credit strains in Europe and various small countries across the globe, but is also important with respect to how we continue to approach difficulties in the United States. Dornbusch highlighted three essential concerns: 1) the vulnerability of banking systems that are dependent primarily on short-term deposits and funding that can be withdrawn on demand, 2) the risk of having national liabilities denominated in a foreign currency (which is essentially the case with Ireland, Portugal, Greece and Spain, all of which are constrained by the European Monetary Union and cannot simply print their own money), and 3) the importance of restructuring bad debt and avoiding bank bailouts.
"So let me focus on these new financial crises and ask where do they come from? It's very easy to predict a crisis, but then you have to wait for two years until it happens. There is the issue of contamination. Why innocent bystanders get hit. And there is the last issue of the depth of crisis. Why are they so traumatic, leaving a crater that is unbelievably deep?
"The argument is that the national balance sheet is extremely vulnerable. You could live for years and years and years with a balance sheet like that, and nothing ever happens, and nobody ever talks about you, and you are a great story of success, with high growth and a miracle. In a very rich country you can afford to do bad things very, very long.
"And then something happens and then it turns out that that very vulnerability is such that it's a dramatic end of all success. Suddenly in the afternoon of an otherwise sunny day, the world financial system wants 50 billion dollars from a country, and the country doesn't have the 50 billion dollars, and the IMF cannot get there fast enough, and the next thing, the place blows up, and there is a massive depreciation of the currency, pervasive bankruptcy, and the fire spreads to the next country.
"A banking system is a very important part of how a country hangs together... Very, very large, very, very short term liabilities can in no time become a bankruptcy issue for an entire banking system, more so if it's unregulated. And that means people can want to get their money back tomorrow afternoon, and when someone wants their money back, they all want their money back. And if they all want their money back, there is no way for an economy to pay at short notice. And if I can't repay, then they'll be much more eager to get their money, and as the bank run occurs, of course the rest of the economy will collapse with it. Maturity is the first issue.
"The second issue is denomination. There is a very big risk for a country to denominate its liabilities in foreign exchange. Something that they cannot print, something that they cannot get their hands on, and therefore something that is very vulnerable if in fact the exchange moves, the burden of those liabilities increases and bankruptcy of the country and the underlying companies becomes a big issue. Because if that is seen to be happening, then of course, everybody wants their money before it happens, and as they try to get it, they provoke the very collapse that I'm describing.
"If a country has an extraordinary withdrawal of short-term credit and they made the mistake of having short-term credit positions, then they should have a debt restructuring. Then they should say, 'We are now going to default on our debt and we are very, very sorry and what you thought was an overnight loan actually isn't an overnight loan - it is a long-term stabilisation loan.' That makes an extraordinary important distinction between direct investment, which should be favoured at all times, and you should create a history of always treating direct investment extremely well, and short-term debt, which if things go bad may turn out to be long-term debt.
"If you have bad banks then you very urgently want to clean up your banks because bad banks go only one way: they get worse. In the end every bank is a fiscal problem. When you have bad banks, it is in a political environment where it is totally understood that the government is going to bail them out in the end. And that's why they are so bad, and that's why they get worse. So cleaning up the banks is an essential counterpart of any attempt to have a well functioning economy. It is a counterpart of any attempt to have a dull, uninteresting macroeconomy. And there is no excuse to do it slowly because it is very expensive to postpone the cleanup. There is no technical issue in doing the cleanup. It's mostly to decide to start to grow up and stop the mess.
"If you have a hard money and if you have clean banks then you don't have macroeconomics as a problem anymore. Yes, you have slowdowns in the economy and yes you have booms and the key macro problem, the government, has been taken out of it. That's very important to understand that in the economies we are talking about, the problem is the government. The government is not the solution. Hyperinflations are made by governments, debt defaults are made by governments, exchange rates crises are made by governments. And if they don't know how to do it well, and the assumption is: no they do not know how to do it well, then take them out of the business."
Dornbusch likens an unsound financial system to drunk driving. "Think of someone who has made a great expertise of drunk driving, regularly drives drunk, tells you that he never has a problem, and one day there is a terrible, terrible accident. And he'll say, “Well, it was the red light. It wasn't my being drunk. Normally that light is green.” Drunk driving, which for years has worked, with a financial structure that is recklessly, recklessly unsound. But the light was green and then one day it wasn't green, and then the house of cards came crumbling down."
In applying Dornbusch's observations to the recent financial crisis, it is important to distinguish liquidity from solvency. During a bank run, it is essential to provide sufficient liquidity to ensure that depositors can get their money back. That is the only way to stop the run. But if the government does that, the only thing it should buy outright when providing liquidity is its own Treasury debt - everything else should be on a repurchase basis. The Treasury can even provide capital provided that its claims are senior to those of the bank's bondholders. U.S. policy makers did some of this correctly during the recent crisis, but they also bought bad mortgage debt outright, suspended disclosure, and avoided every attempt to restructure, which stemmed the bleeding without addressing the underlying problem.
As I've frequently noted, even if a bank "fails," it doesn't mean that depositors lose money. It means that the stockholders and bondholders do. So if it turns out, after all is said and done, that the bank is insolvent, the government should get its money back and the remaining entity should be taken into receivership, cut away from the stockholder liabilities, restructured as to bondholder liabilities, recapitalized, and reissued. We did this with GM, and we can do it with banks. I suspect that these issues will again become relevant within the next few years.
Market Climate
As noted above, the Market Climate in stocks remains characterized by overvalued, overbought, overbullish, rising-yield conditions that have historically been associated with poor market returns. Strategic Growth and Strategic International Equity remain tightly hedged at present.
In recent weeks, we've observed a decided tendency toward "risk on" and "risk off" days, where entire classes of securities are treated as if they were a single object. During "risk on" days, the market advances, paced by financials, cyclicals, commodities, and smaller speculative issues, while the dollar weakens. During "risk off" days, the market declines, with relative strength in consumer, health, and high-quality stocks, while the dollar rallies. Since our stock selection generally focuses on higher quality issues, which has served us very well over the long-term, this type of pointed "risk on/risk off" behavior creates a situation where our stocks appear to have a smaller "beta" on a day-to-day basis than we actually believe is applicable over large moves or longer horizons.
As a result, the equity funds may respond slightly counter to general market movements on a day-to-day basis. While I expect that this is short-term behavior, we are still gradually modifying our hedge ratios in response. We are doing this carefully, since it is likely that our stock holdings will pop back to having their normal, full betas in the event of a serious market decline. Suffice it to say that our emphasis on what we view as higher quality stocks (e.g. stable revenue growth, profit margins and balance sheets) makes us a bit more sensitive to the recent risk on/risk off pattern of market action, and while we see this primarily as local, day-to-day behavior, we are gradually modifying our hedge ratios accordingly.
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