Wealth Management Blog

Definition: “In economics, crowding out is any reduction in private consumption or investment that occurs because of an increase in government spending” (source: Wikipedia).   The government spends more, financed by raising taxes (reduces consumer demand) or increased government borrowing (reduces capital available to other asset classes).  Global governments (excluding China) have high single digit deficits for 2010 (US is around 10%, Spain is around 9%).  They will need to, and have indicated they will, increase taxes AND issue more government debt.  Macroeconomic schools of thought are varied on the effect on consumer consumption and the effect on financial markets when a government issues more debt than historically seen.

Analysts have calculated that around $9 to $14 trillion of government debt will need to be issued in 2010 (US around $1.5 trillion) to finance their deficits.  If governments print money (US 2009 occurrence) this will eventually lead to inflation.  If governments issue more debt than the markets deem prudent, this will eventually lead to a Greece-type of problem.   However, there is a knock-on effect to corporate bond spreads (difference between the yield on US Treasury bond with comparable maturity and the yield on a corporate bond).  The global government bond market is changing from viewing government bonds as a rate product (based on inflation differentials) to a credit product (based on credit quality of underlying issuer).   For example, an emerging market bond fund will now view corporate bonds and government bonds in the same sphere.   Corporate bonds will also have a “push” factor incorporated into their attractiveness, based on increased tax rates and reduced consumption leading to lower overall net profit margins, thus affecting their attractiveness (this is more of an emerging market story than a developed market story).   If the yields on government debt increase and the corporate/government debt spread decreases, this will make it difficult for corporations to issue the debt needed (especially relevant in the US and UK for CMBS and RMBS re-financing in 2010 - 2012). 

After the dramatic spread compression from fall 2008 highs to current spreads, corporates have an added uncertainty with regard to spread increases, not because of credit quality challenges but because of global government debt issuance.  Markets are already pricing in this uncertainty.  The relationship between government and corporate issuance should be discussed with your bond manager who invests in taxable bonds. 

Bottom line: Investing in bonds carries different types of risks than investing in stocks.  Bond investors need to understand those risks and plan for the needs they expect their bond investments to meet.  Investing in bonds is neither good nor bad.  It depends on the goals you expect the bonds to help achieve.     

Always Asking, Never Assuming™

Christopher Holtby

In 1999, Richard Bookstaber wrote a seminal article called Risk Management in Complex Organizations (Association for Investment Management and Research, March/April 1999).  I must have read this article over 20 times over the last ten years (I keep a folder of seminal articles for my continued education).  To a family, their goals and needs are complex and confusing.  To an investment bank, their trading operation is a complex organization.  Below are quotes for your consideration:

a) The paradox of risk management: “How can we manage a risk we do not know exists?”

b) “Precision and focus in addressing the known comes at the cost of reduced ability to address the unknown.”

c) “The root of the problem is not the complexity of the unseen risks.  The unforeseen events turn out to be simple.  The root of the problem is the complexity of the organization” in dealing with risks.

Bottom line:  Risk management is about having options.  Do you know your options?

Always Asking, Never Assuming™

Christopher Holtby

Since January 2010, there has been a sharp rebound of the US dollar, fiscal tightening policies from China, and a debt crisis brewing in Europe.  Washington is following the example of the Japanese government by not allowing the real estate foreclosure process to proceed at a normal pace (partly due to low capital ratios at the banks).   What is interesting is that the investment strategists believe 2010 will see an earnings recovery, with the same intensity they believed 2009 would be a “tough year” and 2008 would be a “slow year.”  If my memory is correct, the economists believing the US economy would have soft landing in the summer of 2008, are now touting a strong recovery in 2010 (GDP growth of 5%).  Looking back to the 1940s, seven out of the last eight recessions saw two quarters of positive “headline” growth (source: Gluskin Sheff).  What makes an end to a recession is sustainability, such as increasing retail sales tax receipts. 

Any crisis creates a change in behavior.  There appears to be a disconnect between the actions of consumers and corporations and the forecasts of investment strategists:  1) home-ownership is no longer considered to be a stable asset, 2) lower gas prices and a strong stock market rebound in 2009 didn’t influence Americans to drive more miles for the second year in a row (source: WSJ), 3) consumers are spending less on non-essentials (source: NYT), and 4) households are paying down credit card debt in never-before-seen amounts.  Our government, in order to prevent an all-out-deflationary depression, has had to expand its balance sheet to offset the actions of the American household.  The question will be how these two competing actions balance themselves out over the long-term. 

Investors are piling into bond assets.  Over the last 25 years, investors have a had very low allocation to bonds, around 7%.   In 2009 stock mutual funds saw net redemptions of $4.1 billion (source: Gluskin Sheff) whereas bond mutual funds saw a $349 billion in-flow.  The grass is not always greener on the other side of the fence and nobody knows with scientific certainty why this change of allocation is occurring (I expect fear and not concrete thought).  According to Haver Analytics, stock mutual fund managers are at the low end of their cash allocation (around 3.9%) whereas bond mutual fund managers are at the high end of their cash allocation  (3.3% for government bond mutual funds and 7.7% for corporate bond managers). 

Bottom line:  As the American economy and financial markets re-calibrate to the new realities of a less leveraged world, investing will be a difficult process.

Always Asking, Never Assuming™

Christopher Holtby

Definitions:  Discount rate is the “penalty rate” for banks needing emergency funds from the Federal Reserve (normally around 1% higher than the Fed Funds Rate).  Fed Funds Rate is the interest rate at which banks lend their balances (known as federal funds) held at the Federal Reserve to other banks, usually overnight.  The Discount Rate is set by the Fed Board of Governors, and the Fed Funds Rate is set by the Federal Open Market Committee (FOMC).

Last week the Fed’s Board of Governors raised the Discount Rate from 0.5% to 0.75% inter-meeting.  The surprise was not the amount, but the timing.  Two weeks ago, Bernanke’s prepared text to Congress stated the intent to raise the Discount Rate soon (defined normally as “in the future”, and market didn’t really appreciate that would be in 7 days).  The Fed also reduced the length on discount window borrows to the normal overnight term (since the Fall of 2008 the term had been extended to 28 days).  Currently, only $14.9 billion of window borrowing is outstanding, compared with over $1 trillion of cash held in Federal Reserve funds.  The Dow Jones rallied 233 points with the first discount rate decrease (Aug 2007), and markets declined with the discount rate increase.  The effect on the economy, bank lending and non-bank company profitability has nothing to do with the discount rate over the long-term.  It took increasing the Fed’s balance sheet to almost $2 trillion to arrest the downward spiral in the economy and markets (current financial crisis was a credit crisis, not a liquidity crisis, so reducing Fed Funds Rate and Discount Rate had a negligible effect on arresting the downward spiral).

For months, the Fed has written and talked extensively about exiting from the various strategies used to stabilize the financial markets.   The raising of the discount rate means the exiting has started, even if done gradually.  Markets of any kind really dislike uncertainty.  The inter-meeting change created uncertainty about the market pricing of all financial assets.  Interest rates, foreign exchange rates, and implied volatility of all assets have now been priced into the market.  This is reflected in an uncertainty premium.  The dollar has strengthened and solidified it’s strong trend relative to the Euro, Pound and commodity exporting countries.

Bottom Line:  1) Uncertainty is now firmly entrenched into the markets, 2) Investors need to be very clear on the timeline of their investments - short-term, intermediate and long-term - and the acceptable level of uncertainty on those investments, and 3) Looking at over 200 years of financial and economic history, this is a normal process.

Always Asking, Never Assuming™

Christopher Holtby

Beginning with the creation of the European Union through the Maastricht and Lisbon Treaties, a generation of investors no longer worried about European country risk.  German bonds and Greek bonds traded within a few basis points of each other up to late 2007/early 2008.  Economic historians will point to the periods between 1946 and 1999 as being very challenging.  Deciding which European countries to invest in and how was tough.  You had the Club Med countries experiencing several periods of currency devaluation.  The markets provided guidance on the risk between these European countries with credit spread differentials on corporate and government debt.   Since the creation of the European Union, German and Greek bonds traded based on interest rate differentials.  No longer.  They now trade based on credit differences.  Risk and return eventually come back into balance.  The only question is when.

One great aspect of capitalism is that it allows a society to get richer (source: Schumpeter).  Capitalism also brings about creative destruction.  The global stock and bond markets are in this current phase.  I experienced such a phase in Canada during the late 1980s through the mid-1990s (family businesses and investments).   There is opportunity in a crisis.  There is also the need to ensure one’s assets are intact at the end of the crisis or the creative destruction phase.

Money managers will need to avoid the pressure thrust upon them from pension consultants and the like over the last 25 years to base their country weightings on the EAFE Index.   Sometimes it makes sense to have a zero weighting to Japan (currently a 23.5% weighting in the MSCI EAFE Index).

Bottom line: Stock picking, not country allocation, has historically provided a balanced risk/return trade off.  Policy/political risk during a creative destructive phase is very real (US is especially included in this category).

Always Asking, Never Assuming™

Christopher Holtby

Here is a situation:  Hedge fund A has a long concentrated position in a unsecured bond with a small issue size.  This bond does not trade very often.  The hedge fund feels this company could go into bankruptcy or hit a rough patch.  If they sell the bond, it could tip the hand of the market or cause a large decrease in the bond price because of such a large sell order.  Subsequently they purchase a CDS (basically a bond option) in an amount less than, equal to, or greater than the notional value of their bond position.  A few months later, the company declares it is entering bankruptcy.

On 1/9/10, a bankruptcy judge in Delaware ruled in the bankruptcy case of Six Flags (re: Premier International Holdings, Inc. Case No. 09-12019 Bankr.D. Del. Jan.9, 2010) that the ”members of an ad hoc committee of note-holders are not required to comply with the disclosure requirements of Bankruptcy Rule 2019.   This ruling is different than two other bankruptcy cases involving Northwest Airlines Corp (Southern District of NY 2007) and Washington Mutual (District of Delaware 12/2/09).

Bankruptcy Rule 2019 states that any committee representing more than one creditor should list each creditor’s claim, date of acquisition, price of acquisition and other claims or interests.  Normally, these committees list each of the creditors and the aggregate holdings of the committee.   Bankruptcy workout groups such as Alvarez & Marsal assume they will never learn which unsecured creditor owns what as the creditors are likely to have constant movement of their holdings (e.g. derivatives, options, equities, swaps).

In the situation of our hedge fund, if they own more CDS exposure than their underlying bond exposure, they want the company to be worthless and will vote as such.  There is an industry movement to enforce CDS restrictions so that the interests of the company will match the interests of unsecured bond holders.

Bottom line:  If you make an allocation to a junk bond manager or a distressed bond manager, ask how Bankruptcy Rule 2019 and the current disparity of rulings from bankruptcy courts will affect his/her strategy.  As an aside, Deutsche Bank just downgraded FTI from a buy to a hold as they expect corporate bankruptcies to hit a plateau and decrease after 2010.  Analysts are sometimes right and sometimes not.

Always Asking, Never Assuming™

Christopher Holtby

There is a type of insurance which, in concept, is rather bleak - kidnap and ransom - which is commonly referred to as K&R insurance.  According to Clayton Consultants and International Maritime Bureau, Mexico, Venezuela, Nigeria, Somalia, Pakistan, Iraq and Afghanistan ranked as the top countries for kidnapping in 2008.  Insurance companies such as Chubb, Charitis (formerly AIG), and other insurers provide K&R insurance.  They contract with firms such as Clayton Consultants, G4S, Control Risks and others to provide the service of bringing the kidnapped individual back safely.

These firms use force as a last resort.  According to these consultants, out of every 100 kidnappings about three or four hostages are killed (excludes Iraq numbers).  Most kidnappings are essentially a form of business.  For example, last year, off the coast of Somalia, the Saudi Arabian ship, Sirius Star, paid a $3 million ransom.  Last week a similar situation resulted in a $7 million ransom being paid to the Somalian pirates.  Insurance companies do not advertise, discuss, disclose, etc. what is paid to the kidnappers.  It results in the kidnappers seeing foreigners as human ATMs (see examples in Nigeria).

Those most at risk are very wealthy families and politicians in the high risk areas.  Consultants mention that high profile Americans in high risk areas (celebrities, politicians, business people or related family members) are most at risk. 

Bottom line: Sometimes it pays to be a nobody.  If you are thinking of purchasing or do purchase K&R insurance, DO NOT TELL ANYBODY except as instructed by the security consultants who will brief you before your departure.     

Always Asking, Never Assuming™

Christopher Holtby

As you probably aware, by March 31, 2010, the US Federal Reserve will have completed the purchase of $1.25 trillion of federal agency mortgage paper from Fannie, Freddie and broker-dealers.  The mechanics of this process starts with the Fed printing money and paying this newly minted money to the sellers of the mortgage paper.  When the sellers are private companies, such as banks, this can cause the money supply and monetary base in the US to rise significantly.  The banks can choose to invest, lend or deposit the funds at the Federal Reserve in an interest bearing account.  Because the velocity of money has not increased (as of 1/15/10), this means that, so far, the banks, constrained by current or future loan problems, have deposited the sales proceeds at the Federal Reserve.  Currently, analysts do not know exactly how much of the mortgage paper was sold by banks versus Fannie and Freddie, which makes the analysis more difficult.  These details will not be available for another few months.

As long as these deposited reserves remain at the Fed, the monetary base has increased, but the money multiplier has not started ($1 of reserves can be leveraged around 10x).  The worry for all investors is: when and why will the banks move money from their Fed interest bearing accounts and lend and/or invest the money for a higher rate of return?  This would increase the money multiplier and eventually cause inflation. Right now, the largest part of the Fed’s balance sheet is comprised of GSE-based residential mortgages.  The great debate centers around the how to “unwind” or “exit” the program of holding GSE-based residential mortgages.  If the Fed signals they will begin to sell, these securities will drop in value very quickly in anticipation of the largest owner of these securities coming to market.  That is not a good option.  The Fed could just hold the mortgages until maturity, but that would cause another set of problems.  The Fed could completely stop purchasing mortgage bonds from Fannie and Freddie.  In essence, the Fed is trapped, as all options have less than perfect outcomes.

The Fed can increase the reserve deposit rates offered to banks holding deposits there at any time.  The Fed could raise those reserve deposit rates if they feel banks are beginning to loan or invest those original mortgage paper proceeds.  They can also engage in term deposit auctions of bank’s deposits at the Fed, thus “locking in” money and avoiding this money leaking into the economy.  These actions do not withdraw liquidity from the banking system as asset sales would; they only temporarily limit the effects of the money multiplier.  It appears likely the Fed can manipulate and extend this system for quite some time.

Bottom line:  This is a complicated topic.  Investors should pay attention to the reserve deposit rate, as well as other policy interest rates.  The inflation debate centers on more than just the increase of the Fed’s balance sheet.

Always Asking, Never Assuming™

Christopher Holtby

As a partially central-planned and partially market-based economy, China’s approach to acquiring non-Chinese assets is not understandable through a CNN headline.  Through various agencies (e.g. National Development and Reform Commission), Beijing has promoted a type of “going out” policy which encourages China’s companies to invest abroad.  Those investments have included natural resources, finance, technology, consumer brands and distribution channels.  The general areas of China’s private and state-owned companies’ acquisitions are: 1) natural resources, 2) prestige deals, 3) acquisitions of foreign firms whose brand or technology can assist Chinese companies’ domestic positions, 4) bargain hunting, and 5) desperation deals for Chinese companies needing growth/distribution channels abroad because of tight margins at home (source: Dragonomics).

The big state-owned companies use the first two approaches.  Private and/or entrepreneurial local state-owned companies use the last three approaches.  The private and entrepreneurial companies have their own narrow interests.  They have raised the flag of national interests only when it assists them individually and not on the direction of Beijing.  In 2009, state-owned companies were big purchasers of resource assets, driven by Beijing wanting to control the states needs for economic growth.  As commodity prices were low, this made sense.  Australian veterans believe resource assets sold to Chinese companies were overvalued.  Time will tell.

As China transitions into a mature, industrialized country, many acquisitions will be driven based on industrial policy (driven partly by the China investment Corp).  For example, since January 2009, Beijing has released plans for 11 industries to be consolidated to smooth-out economic growth and increase domestic demand.  Domestic companies will continue to acquire international assets to protect them or to provide more leverage during this consolidation phase (e.g. they will be the acquirer not the acquiree, such as Beijing Auto making bids for Opel and Saab). 

Bottom line:  In order to make a decision regarding the investment merits of China, investors should understand the internal and external investment strategies of Chinese companies and how they are spending shareholder capital.  Their success or failure depends, in part, on internal party politics.

Always Asking, Never Assuming™

Christopher Holtby

That is a long title, in German, for estate attorneys in the upcoming year (I spoke German growing up, as my mother and grandparents are Austrian).  The estate planning world is in a state of flux.  On 1/1/2010, the gift tax drops to 35% (it’s currently 45% and increases to 55% on 1/1/2011 based on current law).  The gift tax is calculated on the tax-exclusive basis, making it a more tax-efficient transfer process than waiting to pay the estate tax rate.   For taxpayers living more than 3 years from the date of the taxable gift, only the value of the interest transferred will be used to calculate the deceased’s taxable estate.  For taxpayers living less than 3 years from the date of the taxable gift, the gift tax paid will be included in the deceased’s taxable estate.  In both cases, appreciation in the value of the gift would not be included in the taxpayer’s adjusted taxable estate (source: Leimberg).  There are some additional benefits, subject to the facts and circumstances, such as valuation differences between assets transferred and the value of the interest itself.

Always Asking, Never Assuming™

Christopher Holtby