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Third Quarter 2012 Investor Letter
“I can assure you, my intentions are strictly honorable.”
We give financial regulators more credit than typical, or even atypical, investors. We think they
work hard under difficult conditions. We think they are largely underfunded and asked to
achieve the impossible: match wits with people paid millions to not lose. Politicians deride
them, Chief Executives dismiss them and traders and bankers pay them no attention
whatsoever. Even the man in the street, as opposed to the man on the Street, thinks they are
nothing more than incompetent bureaucratic bumblers. Better to simply give up on them
altogether and let market forces dictate behavior.
We wear our bias on our sleeve. We think that information efficiency is low and that the more
arcane a bit of information the less efficient is its dissemination. Let’s take for instance the
widely documented fact that investment bankers were running credit exception reports on the
mortgage loans they were buying from originators. We find it extraordinary that very few people
we meet know that independent analysis flagged 46% of U.S. mortgage loans underwritten from
January 2006-June2007 as having at least one exception.1 But even more amazingly, it’s also
been made clear that even if loans were flagged as not having appropriate integrity, they would
be resubmitted for inclusion into mortgage pools in the knowledge that the sampling
percentages were low enough that it was very unlikely they’d be caught in a second or third go-
around.
In other words, issuers knew that the loans they were buying and packaging into MBS were full
of documentation errors which likely made them substantially riskier than was widely perceived.
Given the size of the U.S. mortgage market, this information was worth, conservatively, trillions
of dollars. I find a particular letter2 from the CEO of Clayton Holdings quite extraordinary
because it gets to the heart of informational efficiency; Paul Bossidy wrote the Financial Crisis
Inquiry Commission to clarify that,
1 http://bit.ly/RueuF8 (page170)
2 http://bit.ly/YrCpGM
180 Varick Street, Suite 416 – New York, NY 10014
“at no time did Clayton share any client reports or data…with
any rating agency.”
What was Mr. Bossidy so concerned about? Clayton otherwise looked like a good corporate
citizen coming out of the FCIC. Why would Bossidy want to contradict the perception left in the
minds of the commissioners and the American public?
One very simple reason: the client reports that Bossidy noted are not the property of Clayton
Holdings and are further very carefully guarded by Non-Disclosure Agreements between
Clayton and its customers. Any violation of those agreements would open Clayton up to
significant liability.
And why would Clayton’s customers be so concerned about that? Because the customers, issuers
of MBS, knew the loans they were pooling into securitizations were full of underwriting
deficiencies. That in turn made the information they provided to the ratings agencies inaccurate
and unreliable which in turn made the ratings inaccurate and unreliable.
Even more sinisterly, with information about which loans contained underwriting inaccuracies,
the issuers could tailor mortgage backed securities to contain unusually large volumes of those
loans which would allow them to create securities they knew were relatively weak. And relative
is Wall Street’s game…
So if you agree with us that valuable information is information you try to leverage for your
benefit, then it should not be hard to conclude that the regulatory apparatus should be geared
toward making sure that firms do not use their informational advantage to disadvantage others.
That is different from saying you cannot make more money than others, just that you cannot
intentionally steal money as a result of your advantage.
Sadly, this naïve belief that I’ve just inexplicably expressed outside of my own shower, was
pretty much what the UK’s disastrous “light touch” concept was all about. Since we’re a month
from a national election, I’ll get in the spirit and suggest a sound bite for the masses: “Be
ethical.” Of course, on Wall Street or in the City, that’s pretty much like telling people, “Be a
muppet,” or worse still, “behave in a way that will get you ridiculed by your peers and fired by
your boss.” Perhaps when port followed claret at a typical lunch, that policy worked. When being
ostracized by Etonians fell on deaf French, to say nothing of American, ears, not so much.
180 Varick Street, Suite 416 – New York, NY 10014
But there has been of late a renaissance of sorts for the light touch concept – with the added
twist of putting very bright lines on the court. Andrew Haldane, most certainly not an Etonian,
hiked up to Wyoming to tell the Fed about how dogs chase down Frisbees without PhDs in
economics. In short, why not rely on heuristics? Why not free firms up from oppressive
regulation and simply have regulators set broad goals and then make sure the banks meet them?
Why not simply demand banks hold 10 cents for every dollar of assets on the Balance sheet?
I have a lot of time for the argument. Financial regulation has undoubtedly gotten out of hand.3 4
But there is a big fly in the ointment and it’s unfortunately one that we are having a mighty hard
time handling here in the Empire State. If we are going to transition from micromanagement to
macromanagement, we need legal and jurisdictional ground rules. At present we know that
when a 28 year old equity hedge fund analyst tells his Portfolio Manager about a hot tip he got
from a fellow hedge fund analyst who spends her time following management around the
country, everyone is going to go to jail. Amazingly, such behavior never surfaces in the
traditional asset management space, and so we know the rules. I’m joking, what I meant was we
know that it’s totally verboten to make $25,000 trading a few shares of a tech stock on inside
information, but you can certainly issue hundreds of millions of dollars in stock, take companies
private, issue debt to your own captive debt funds or even structure CDOs to blow up all while
jealously guarding information material to the value of those deals and all with total impunity.
Oh my, I’ve seem to have gone off the rails.
Let me start again: Here in the USA, we have rules, principles being for weak-kneed foreigners.
We base our nomocracy on the belief that limiting the government’s ability to create rules sets
us free. Further, once we have collectively agreed on a rule, knowing if it has been broken should
be obvious. Break a paradigm and we need a fair bit of judgment to decide what should be the
punishment for such behavior. Paradigms introduce randomness to the regulatory-judicial
process. The founders of the United States were a bit touchy, following the Sugar Act, Currency
3
http://1.usa.gov/Vetny4
4
http://bit.ly/RxgyKS and
http://bit.ly/RxhrD3 and
http://bit.ly/Vez66S
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Act, Stamp Act and Townshend Acts, about the arbitrary application of laws. But now, a quarter
of a millennium later, it seems that we’re filling the shoes of George III quite nicely.
An obvious recent, financial services, case in point is the decision by Superintendent Lawsky of
the New York Department of Financial Services to indict Standard Chartered over their business
process failing at the 99.9% confidence interval. Leaving aside the fact that U-turns were legal
during the period in question, how did we determine that assisting the Iranian banking system
to clear USD prior to sanctions is judged to be a $350M violation while bilking the world of
billions prior to the crisis is apparently not a violation at all? Superintendent Lawsky, lest you
forget, is also in charge of the mortgage brokerage and investment banking businesses in New
York. Frankly, we have descended to arbitrary application of expansive and yet ultimately facile
rules. The U.S. judicial system can blackmail firms into coughing up settlements, but it cannot
ultimately convict firms of wrongdoing.
We currently have the worst of outcomes. The rules that should exist to proscribe predatory
commercial behavior do not exist and the rules that do exist to circumscribe business process
are so baroque as to effectively make firms unmanageable and unanalyzable. Further, since
corporate money controls the legislative process, not mind you to streamline the rules, but to
make them so outlandishly complex as to effectively deter competition and prevent effective
legal challenge, market positions are protected. Out of this morass, information becomes all the
more valuable.
This is not an issue unique to financial services. Information arbitrage is key to the profitability
of many firms. As price transparency has soared on the back of internet aggregators, price
complexity has soared in response. Whether it’s the auto insurance market in the UK or baggage
fees in the U.S. airline industry, knowing what you will really pay for a good or service, and what
you will actually get once you do pay, is becoming increasingly opaque. If the point of a business
is to supply customers with something they are willing to pay more for than it cost the business
to make, then maybe this strategy makes sense. If the point of a business is to generate goodwill
with your customers so that they continue to come back to buy your products over and over, in
other words to develop your brand, then this strategy is catastrophic.
Customers rightly view many of the companies that they depend on for goods and services as
adversaries. And of course in the case of the capital markets, where I spend most of my life, our
180 Varick Street, Suite 416 – New York, NY 10014
suppliers cheerily admit that we are not actually customers – we are counterparties. That of
course is legalese for saying that our suppliers have absolutely no legal or ethical obligations to
us. We may pay them for a service, but that service does not need to be even remotely diligently
supplied. Unsurprisingly –choosing suppliers becomes a core business function for an asset
manager. And, frankly, many potential suppliers have developed such an enormous reservoir of
bad will with us, at least, that no matter their competence or profitability, dare I say even
perhaps because of them, we would likely never buy something from them.
So regulation should be geared towards making sure that businesses “stand behind” the goods
and services they sell. If you manufacture cars, they should achieve a minimum safety rating. If
you are a “high street” bank, you should hold enough capital to make good on your promise to
return a depositor’s cash. It’s really pretty simple.
But, Mr. Haldane’s comments notwithstanding, the likelihood that we get simple, clear rules is
astronomically low. Simple rules would lower barriers to entry and raise the ability of regulators
to win convictions. Simple rules would mean thousands of compliance experts would find
themselves working the traffic ticket beat. Simple rules benefit customers and investors, not
regulators and the regulated.
Risk-Adjusted Return Alert
What comes next is not earth shattering, unless you manage fixed income portfolios. An
investment in my new favorite bond, the 2+3/4 15 Aug 2042 UST bond will generate a -26.7%
return should the bond trade back to its current 200-month moving average at October 1st, 2014.
For a bond against which the vast majority of regulated financial institution investors are
currently holding no capital, that’s a pretty neat trick. Should we be asking: is interest rate risk
the new subprime?
My New Favorite Stock: AERL US
First off, I know nothing about the financial merits of owning this stock and the title above is
meant to be tongue in cheek:
Asia Entertainment and Resources Ltd. runs VIP rooms in Macanese casinos. Having never
been in a Macanese casino, to say nothing of a VIP room in one, I can only speculate on what
takes place. The nice folks at AERL, however, point to baccarat and high stakes. I have my
180 Varick Street, Suite 416 – New York, NY 10014
doubts. It’s not that I don’t think people with lots of money are playing high stakes baccarat in
Macau, it’s that I don’t think inviting people to play in a casino is a real business.
Here’s how I figure it: If I had a ton of money I wanted to blow on a game of chance, I don’t
think I would need someone to invite me to Las Vegas. So why does a big business exist to
facilitate gamblers finding their way to Macau – a place generating four times more gambling
revenue than Las Vegas… If you read these meanderings on a regular basis, you know already.
The only possible explanation is that these firms are facilitating capital flight, and subgenres
thereof, by various actors that place a fairly high premium on obscuring their personal financial
transactions. Like high dollar life insurance and high dollar real estate, mainland Chinese
gamblers can convert RMB into hard currency and then leave some of that behind on the craps
table in Macau while wiring the rest of it on to a quiet account in Singapore.
While I understand that capital controls can be rough, this really seems a nutty way around
them.
Regardless, the main reason that I love AERL is that it’s a fantastic indicator for the China
bezzle, which in turn is directly related to Chinese malinvestment and growth.
Of course, we could also just watch this:
Chinese FX Reserves YoY
40.00%
35.00%
30.00%
25.00%
20.00%
15.00%
10.00%
5.00%
0.00%
-5.00%
180 Varick Street, Suite 416 – New York, NY 10014
That indicator tells its own fascinating story, namely that the Chinese are no longer plowing
their foreign currency export earnings into foreign currency cash. Over the longer term, this is a
healthy development. Near-term, I suspect it is telling us that China is going to have a different
impact on the next decade than the last. In particular, China is going to increase direct
investment and decrease portfolio investment. But the decline in reserve accumulation is also a
function of a current account that is returning to balance as China turns toward domestic
consumption and away from external demand. The impact of this policy shift is only starting to
be felt and will reverberate through many economies. We expect exporters of high value added
goods and services to benefit and exporters of low value added goods and services to lose out.
Should be fun to watch.
Fiscal Follies
It’s perhaps not terribly important, but still interesting: the French translation of “the madness
of crowds” is folie a plusieurs.
Here in the United States, on the verge of a national election, we’re looking forward to the
impact of the plusieurs’ folly. The crowd of course is the 535 voting members of the 112th U.S.
Congress. For some inexplicable reason, they seem hell bent on driving the U.S. economy over
the precipice. This is particularly extraordinary given the green shoots that have emerged over
the past few months. In the end, I would wager they’ll agree to a solution that kicks the can
down the road. But I’ve been wondering if we are not better off embracing the cliff and the
inevitable economic contraction.
Here’s my thought: Why not allow discretionary spending sequestration and the expiry of the
Bush tax cuts? We’d reduce public spending a bit and we’d increase public revenues a lot. Of
course, the economy would contract and so the deficit as a percentage of GDP would not come
close to disappearing, but it would close a bit.
In return, Congress should create an infrastructure fund with an explicit mandate and term. The
goal of the fund should be to maximize RoI – in other words, the fund should focus on building
infrastructure that can be sold on to the private sector over time. And the fund should be big.
Really big. A $3 Trillion dollar fund with a five year mandate would have a noticeable impact.
The fund, via the Treasury, should issue a special class of non-transferrable debt to the Federal
Reserve in order to finance itself. The debt should be of infinite duration and pay no coupon.
180 Varick Street, Suite 416 – New York, NY 10014
And it should be redeemable at any point in time. In case you missed it, that’s called cash. And
there’s a funny thing about cash. It’s a liability of the government, which means it’s a liability of
the citizens of the United States, but it’s that funny kind of liability that does not pay regular
coupons and has no maturity. In the parlance of corporate financiers, it’s called equity. And
there is an amazing thing about equity – when you issue it, leverage decreases.
I appreciate that many Americans are incensed by the idea that the government might be asked
to do something to help the economy recover. But the fact of the matter is that the private sector
cannot play enough of a role presently (paradox of thrift blah, blah). It must delever and make
its balance sheet stronger. This is especially true of households – and while households retrench,
so Corporate America will avoid investing at rates that will spur recovery. Economists refer
(with increasing frequency and alarm, I should add) to the fiscal multiplier to describe the
condition of developed world economic performance. In short, fiscal policy is more impactful
(both positively and negatively) when the rest of the economy is sitting in the doldrums and
monetary authorities do not or cannot act.
Under current expenditures, the public sector is simply shifting wealth from net taxpayers to net
tax-receivers: the elderly and poor and infirm. This is simply a policy of rearranging the deck
chairs on the Titanic. It’s high time for the United States, and the United Kingdom and
European Union, to realize that standard monetary policy is not enough. Sure, we’ll eventually
get back on track, but the years we are losing will have a profound and permanent effect on both
regions. Even non-traditional monetary policy is a fairly limited tool. We must introduce
substantial near-term stimulus in the form of fixed asset investment and longer term fiscal
consolidation in the form of nondiscretionary spending reduction. Can we do that? Of course we
can. Should we do it? Of course we should. Will we do it? I doubt it.
Since I doubt that advanced countries will enact non-traditional fiscal and monetary policy
measures in the near term, I also doubt that we’ll see any sustained recovery over the coming
decades. That sounds bleak, but let me be clear: It’s not that the developed world cannot grow in
fits and starts, but that growth will inevitably be subsumed by periodic, mild recessions caused
by the continued unwinding of indebtedness. In other words, Japan from 1990-2012.
But it’s really quiet tragic that we are going to allow excess leverage prevent young people from
developing skills when we could address that leverage with a very simple solution – issuing
180 Varick Street, Suite 416 – New York, NY 10014
equity. We need to increase employment and as any Austrian will tell you, that only happens
when entrepreneurial agents risk capital. Would General Electric refuse to issue equity if it
thought the capital would help it increase profits? Of course, not. So why would the nation as a
whole? Simply because we cannot think of the government as being an agent of capitalism?
Unfortunately, we live in a country where we take economic advice from television journalists
and stock brokers. Our universities are filled with Nobel laureates, but we prefer sound bites to
math formulae. Hopefully, many of us will vote come November 6th, but it won’t make any
difference. The Republocrats are uninterested in policy. They believe in self-preservation and
the electoral cycle.
“That’s just as bad as listening to the Beatles without earmuffs”
It’s important to understand a bit about demographics. Supposedly, there was a time when lots
of young people enjoyed the Beatles, for instance. Today, not so much. But there are lots of old
people who may still have fond memories of smoke-filled rooms, highballs and of course a
record player wheezing out “there’s one for you, nineteen for me.”
The Fed thinks about demographics. And they publish a lot of data too. One of the issues that
they have kindly dug into is household finance and especially net worth of households. In the
aftermath of a financial crisis, household finances are really pretty important. They tell us where
consumption, round about 70% of the U.S. economy, is headed. And in my opinion, the answer
is nowhere. You see, for some reason Americans like to consume not only out of current income
but we really love to borrow against our assets. And so the more our assets grow, the more we
borrow. That works OK in a market where assets are gradually rising, but it’s insanely painful in
a falling market. Anyway, the market that has had the toughest run over the past five years is the
market for single family residential real estate.
Before I continue I know that what I’ve just written is basically illegal to air publically in this, or
any other English speaking, country. Just the other day NPR ran a story telling people that
buying a home was much better than renting because mortgage rates were so low. When NPR
has joined hands with the NAR you know we’re headed down the wrong road… Next thing,
they’ll be running puff pieces on the merits of handgun ownership. But let’s point out the
obvious: If you are pricing a home off of the current carrying cost, then the price of that home is
going to decline as rates move higher. A $125,000 home with $25,000 down costs $450 per
180 Varick Street, Suite 416 – New York, NY 10014
month to carry at 3.5%. At 5%, $450 can carry a $106,250 with 20% down. I would suggest that
the potential to lose nearly 80% of your investment might suggest caution is warranted. Maybe?
Anyway, back to demographics and net worth. No one younger than about 50 has any. So, either
they are waiting for their parents to die or they are waiting for social security. The former is a
good bet, but a bad solution. The latter is just plain dumb. And the folks who are worst off are
the Generation X’ers. Unfortunately for them, there is a demographic bulge behind them. The
Echo Boom generation will eventually come into view and the cost of providing for that giant
bulge will effectively kill off the fiction that Social Security and Medicare can continue in their
present form. I assume that process starts in about 2025. That’s when the front end of the echo
boom gets into their 40s. Retirement for that group will be 25 years away and their parents will
be entering retirement putting twice as many people into social security on an annual basis than
in 2005.
Anyway, the same old, same old will not work from that point. The Boomers don’t have any real
money as their asset mix was relatively house heavy and they consumed much of the pre-crash
gains through equity extraction. Those born before them have done better. Their children cost
less to educate and so they extracted less equity from their homes. Further, their asset mix
contained more financial assets (you know, the kind that pay interest and dividends) and so the
rebound of their net worth out of the crisis has been more pronounced.
Anyway, Americans between the ages of 35 and 45 appear to get it.5 In short, getting crushed by
the falling housing market seems to have awoken them from their fantasyland of riches for all.
As those folks work their way through the next decade, like their grandparents in the 1930s and
40s, they are going to save from current income. That is going to reduce domestic consumption
and the trade deficit and so interest rates will stay low and generating real return will be tough
to come by. The riches their parents are sitting on will be an attractive target for the taxman.
And finally, what you came here for
Europe. They continue to ride Rocinante in the general direction of a solution. What adventures
lay in front of them is a story still to be told. But we can be sure that regular beatings and ritual
5
http://bit.ly/VeAgzn
180 Varick Street, Suite 416 – New York, NY 10014
humiliations are in store. We can be sure that the Eurocrats will tilt at plenty of windmills and
fall in love with policies that appear more lovely than they really are.
Alas, for Europeans, Europe has a history that it cannot escape. So decisions that would be
straight forward in the United States – aggressive monetary policy, rational banking policy,
countercyclical fiscal policy – are beyond the intellectual and political reach of Europe. Mind
you, not because the Europeans are uneducated on these issues, but rather because their
education is too complete. After all, it was a Swiss who wrote of the contradictions of natural
man adopting civil society.
Europe is pushing beyond democracy. That push is painful and dangerous and not entirely
legitimate. But Europe has institutions that cannot be replicated on a supranational basis by any
other region and it has national institutions that are as robust and complete as any on earth.
European leaders are in the process of convincing their people to cede sovereignty to the
government. After 300 years of inventing and fighting for the concept of popular democracy, it
should not surprise us that Europeans are holding on to what power they have left to them fairly
tightly.
It’s easy to be derisive from the far side of the Atlantic. And it’s easy to look on with shock and
horror at the erosion of individual participation (how many Americans will vote come
November?). But I suspect that the entire developed world is transforming governance from
popular democracy, which anyway has always been a farce, to a system of government whereby
economic decisions are taken by technocrats. The rise of the Central Bank is a part of this
process and has been playing out for half a century. Now it is the time for fiscal policy to be
managed far away from local election halls. Many will suggest this path leads backward and they
may well be right. Frankly, I would humbly suggest the fact that Congress has not declared war
since June 5, 1942 is an abdication of greater import. And yes, before you ask, I have read my
Hayek; I know where this all ends.
More interesting, though, is whether the technocrats are up to the job. And herein I suspect we
have more room for vigorous debate. It’s clear that some entrenched beliefs are the result of
painful histories that certain peoples are loath to confront. It’s easier to simply say never again
and leave it at that. It’s harder to ask why something happened, to learn from our past mistakes
and to apply them to our current conditions. When we fight the next war with the last war’s
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methods, we tend to lose. Certain factions in Europe are clearly fighting the next war with
outdated methodology. I understand and appreciate their fears, but it is the reaction of the
governed that they should fear most of all.
Our central thesis is we move in the right direction but we move there more slowly than would
be optimal. As a result, we are locked into a low growth environment for many years.
Underneath that low growth, however, are some extraordinary changes in the form of
technological improvements to energy, health, transport and communications. All is not lost and
the developed world will still lead the global order in ultra-high value added commerce.
The future of banking, deferred
We are going to explore this theme in greater detail in the coming quarter, but here’s a preview.
There is a really interesting (if you’re a nerd like me) groundswell of thought on banking policy
and structure that I suspect will have a substantial impact on the banking system as we know it.
In short, I am more convinced than ever that 2009 was a turning point in history. We set up
Elanus on that premise, so our actions speak louder than our words.
We think that we might look back in fifty years and consider the past fifty years an aberration, a
historical anomaly. Envision an end to fractional reserve banking or even to deposit liabilities or
wholesale funding. Imagine if banks were quite simply much, much different beasts.
In fact, some people are imagining. And they are rethinking the banking system on a scale that
we have not seen since the 1930s and 40s.
Hiding in plain sight
For two and a half years we have told anyone who was willing to listen that we think low growth
means you invest up the capital stack and low interest rates means you apply leverage to your
investments. We think that strategy outperforms. We see no reason to suspect that we should be
more aggressive in the capital stack or less aggressive in terms of applying appropriate leverage.
We think that the core commercial banking model is not only not broken but is enjoying its most
robustly profitable run in years and that this cycle will extend as a result of higher capital
charges, slow growth and elevated perceived risk.
180 Varick Street, Suite 416 – New York, NY 10014
CMA - Profit Margins
5.0%
4.5%
4.0%
3.5%
3.0%
2.5%
2.0%
1.5%
1.0%
0.5%
0.0%
FY 2005 FY 2006 FY 2007 FY 2008 FY 2009 FY 2010 FY 2011
PPOP NIM
Anyway, we’re awful happy that the world thinks that financials stink and are uninvestable. That
drives implied cost of capital higher and prevents managers from doing dumb stuff with
shareholders’ money. In the meantime, banking margins are increasing and the world is slowly
settling into something that looks and smells more like balance, at least from an economic
standpoint. Sure, the next year or two are going to be rough. Labor in the developed world will
continue to feel the pain of economic transformation and political paralysis. But we’ll still eat
and watch television and drive our cars and heat our homes. Providing capital to firms that
support us in those activities, however, seems sensible.
Post Script: The quotations used as section titles above quote from two of Ian Flemings’ James
Bond novels. I think we can all agree that he’s one government bureaucrat that gets things done.
Imagine if we fantasized about CBO as much as we fantasize about MI-6.
180 Varick Street, Suite 416 – New York, NY 10014
