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Newsletter Q4 2002
October 15, 2002
Does Credit (a.k.a.
Debt) Really Matter?
According to the Federal Reserve, total U.S.
debt (both public and private sectors) reached $30.6 trillion at the end of the
second quarter, nearly 300% of GDP. The previous peak in this ratio was 260%,
reached in 1929. From 1948 to 1976, the ratio of debt to GDP remained below
130%. Since 1976, the debt/GDP ratio has climbed steadily to reach its current
level. Some economists contend that our historically high level of debt does not
represent a risk to the economy because we were too fiscally conservative in the
past and we are now more comfortable with a higher, sustainable level of debt.
Others such as Doug Noland, who writes the "Credit Bubble Bulletin" on
PrudentBear.com, believe that the rapid expansion of debt and derivatives have
sown the seeds of the next recession.
Federal Reserve Chairman Alan Greenspan
believes in the new age of financial innovation which has accompanied the debt
expansion. In London for a speech recently, he offered comments which were
reminiscent of his justification of internet stock valuations: A major
contributor to the dispersion of risk in recent decades has been the wide
ranging developments of markets in securitized bank loans, credit card
receivables, and commercial and residential mortgages. These markets have
tailored the risks associated with holding such assets to fit the preferences of
a broader spectrum of investors. Especially important in the United States has
been the flexibility and size of the secondary mortgage market. Since early
2000, this market has facilitated the large debt financed extraction of home
equity that, in turn, has been so critical in supporting consumer outlays in the
United States throughout the recent period of cyclical stress. This market's
flexibility has been particularly enhanced by extensive use of interest rate
swaps and options to hedge maturity mismatches and prepayment risk.
Corporations have continued to experience
deterioration of their credit ratings. During the third calendar quarter,
Moody's downgraded 124 companies and upgraded 35, for a ratio of 3.5 to 1. It
represents the 18th consecutive quarter that downgrades exceeded upgrades. John
Puchalla, a senior economist at Moody's, said that the deterioration in
corporate credit quality will likely continue during the next two quarters and
reach a record-setting five years. During the third quarter, Moody's put seven
times as many companies on review for rating downgrades as upgrades.
Corporations are going through a period of
credit contraction and consumers may not be far behind. Many people have talked
about the economic benefits of lower interest rates on mortgages and home equity
loans. However, Stephen Roach, economist at Morgan Stanley, points out that
interest income received by households is nearly twice the amount of interest
paid. Thus, many households are hurt by lower interest rates and a surge of
mortgage refinancing is unlikely to be accompanied by a consumption boom.
Jane D'Arista of the Financial Markets Center
also provides a cautionary opinion regarding the boom in mortgage and housing
prices: During the second quarter, outstanding home mortgages rose to a new high
of 55 percent of GDP (up from 45.8 percent in 1990), pushing total household
debt to 103.2 percent of disposable income (up from 89 percent in 1990). If
housing prices begin to stagnate or fall in the absence of an alternative source
of economic stimulus, household net worth will likely shrink further,
debt-service burdens will intensify and a major source of consumption spending
will contract. In all likelihood, some portion of homeowners will be forced to
sell at prices below the value of their mortgages, too.
The availability of credit greases the wheels
of commerce. When the ratio of debt to income climbs to unsustainable levels,
however, relationships between creditors and debtors become more tenuous. The
probability of default rises and creditors become more concerned about the
return of their principal. In response to the contraction of credit, business
transactions and the economy slow down.
The Federal Reserve's ability to avoid a credit
contraction is somewhat limited. Utilizing a fractional reserve system, the Fed
increases reserves at banks by buying U.S. Treasury securities in the open
market, which increases reserves of the commercial banks. With higher reserves,
banks may make additional loans that create additional transaction deposits and
increase the money supply. Thus, the Fed controls the money supply indirectly
with the cooperation of commercial banks that make loans. The Fed cannot force
banks to make loans if the risk premium is inadequate. Banks now appear to be
more cautious, at least when it comes to making corporate loans. At the end of
August, commercial and industrial loans at banks had declined 7.3% from the
prior year, while U.S. Government securities had increased by 19.1%.
As for derivatives, the stabilizing benefits
that Alan Greenspan talks about are questionable. The derivatives market has
grown enormously in the last decade. According to the Office of the Comptroller
of the Currency, at the end of June, the notional amount of derivatives
outstanding at U.S. insured commercial banks was $50.1 trillion. The notional
value of a derivative represents the basis for the calculation of obligations
between counterparties, so the amount of money at risk is generally much less.
Nevertheless, the notional amount of derivatives outstanding is a big number,
nearly five times the GDP of the United States. J.P. Morgan Chase & Co.
alone accounts for over half of the total. Given the large notional amount
outstanding, derivatives are more likely to be a destabilizing force in the
financial markets.
Given the current high level of debt in the
U.S. economy, I believe that the probability is high of a credit contraction,
accompanied by a recession and possibly deflation. Accordingly, during the past
quarter I have talked with many of you about lowering the allocation to equities
to reduce risk. The S&P 500 Index currently sells at 31X earnings, more than
double it historical average P/E (during 1926-2001) of 13.5.
Additions
Several fixed income closed-end funds were
added during the quarter. Municipal Partners Fund (MNP), Managed Municipals
Portfolio (MMU), and the Blackrock Broad Investment Grade 2009 (BCT) were added
to accounts. The credit quality of the funds is high and all were selling at
discounts to net asset value.
Preferred stocks of three real estate
investment trusts were purchased for many accounts during the quarter. New Plan
Excel Realty Trust (NXL), Mid-America Apartment Communities (MAA) and Equity
Inns (ENN) all have preferred issues with high dividend yields that should be
sustainable.
D&K Health Resources, Inc. (DKWD) was added
to many accounts in early October. DKWD is a regional pharmaceutical distributor
that provides approximately 25,000 different products to independent and
regional pharmacies and other healthcare providers. Approximately 80% of
prescription sales are distributed by wholesale firms such as DKWD, and the
industry should benefit from an aging population which drives higher per capita
prescription usage. The stock price reached a high in June of $39 and declined
sharply in September when the company announced that sales and margin objectives
for its national chain business were not being achieved. The company currently
sells for 8X estimated earnings for the current fiscal year. This represents a
low valuation, considering that its earnings have grown at a compound annualized
growth rate of 45% during the last five years.
Deletions
First Energy (FE) was sold, based upon concerns
that the company may have to reduce its dividend to strengthen the balance
sheet.
Aquila (ILA) was sold at a loss. After the
company announced a scaling back of its wholesale energy marketing and trading
business in June, ILA decided to exit the business completely in August. This
resulted in further reductions to earnings estimates. ILA also announced asset
sales to improve its balance sheet but I was not convinced that the overall
effect would be positive. In the current buyers' market for utility assets, it
was doubtful that the company would realize prices that would be favorable
enough to offset the decline in operating income from the asset sales.
Positions in Large Scale Biology Corp. (LSBC)
were reduced. The company appears to be making progress and has announced
several agreements, but it will have to raise additional funds next year unless
it receives some significant licensing fees or other revenue. I decided to
reduce positions to lower the risk of the portfolios.
Profits were taken on Blackrock Income Trust (BKT),
a closed-end fund. The sale price was at a premium to its net asset value.
Updates
Petroleo Brasileiro (PBR) has declined in price
along with the rest of the Brazilian stock market due to concerns about Lula da
Silva, presidential candidate for the left-wing Workers' Party, who has a big
lead in the polls. Although, Mr. da Silva has replaced his party's former threat
to "renegotiate" Brazil's government debt with a pledge to repay it,
investors have concerns that his moderate statements may be insincere. The
Brazilian currency and government bonds have fallen sharply. PBR has a strong
balance sheet and currently sells for 3X estimated earnings for the current
year.
If you have any questions regarding your
accounts, please do not hesitate to call me.
Sincerely,
Robert
G. Kahl,
CFA,
CPA, MBA
Sabino
Investment Management, L.L.C.