Gary Gorton and Andrew
Metrick are both professors of economics at Yale University and research
associates for the National Bureau of Economic Research. They are some of the
preeminent analysts of the sale and repurchase agreement (repo or shadow
banking) market, which is used by institutional investors. The repo market is
unregulated. Due to limited public disclosure, nobody knows exactly how large
the market is but Gorton and Metrick estimate that it is nearly equal to the
size of the $12 trillion regulated banking system in the United States. In
2008, the average daily trading volume of the repo market was $3.6 trillion,
much higher than the $80 billion average daily volume of the New York Stock
Exchange.
The main reason why the repo
market is so enormous in the US is that accounts at regulated banks have an
insurance limit of $250,000. Institutional investors and nonfinancial firms
with large deposits need a short-term, safe, interest-bearing device to store
money. Most participants in the repo market think of the transaction as a
collateralized loan in which the borrower gives collateral in the form of
marketable securities to the lender who provides cash. Technically, the
borrower sells the securities for cash and agrees to repurchase the securities
at a pre-determined price, where the difference between the sale and purchase
transactions represents the “repo rate” or interest. Repo transactions are
short-term, often overnight, so the money can be withdrawn easily by not
renewing or “rolling” the repo if there is a significant decline in the credit
quality or price of the collateral. If the counterparty that borrows cash
declares bankruptcy, the nondefaulting party can unilaterally terminate the repo
transaction and sell the collateral in its possession. Repo transactions are
excluded from the bankruptcy process.
The preferred form of
collateral for repo transactions are US Treasury and agency securities. A wide
variety of other fixed income securities have been used in repo transactions
during the last decade. Among them are asset-backed securities (ABS),
mortgage-backed securities (MBS), collateralized loan obligations (CLO), and
collateralized debt obligations (CDO).
Gorton and Metrick call the
difference between the collateral value and the cash provided a “haircut.” As
an example, if an institutional investor lends $80 million and requires
securities with a fair market value of $100 million as collateral, the haircut
is 20%.
Gorton and Metrick and
others argue that the financial crisis of 2008 was caused by demands for
overcollateralization (haircuts) on repo transactions by institutional investors
that provided cash. During the first two quarters of 2007, haircuts were not
required for any type of collateral used in repo transactions. By the end of
2008, the average haircuts were 2-3% for investment-grade corporate bonds, 20%
for non-subprime MBS and 40% for structured products (ABS, CLO, CDO). Subprime
MBS could no longer be used as collateral. Gorton and Metrick write: “To
understand the impact of this run on repo, take the estimate of the size of the
repo market to be $10 trillion….If the average haircut goes from zero
(pre-crisis) to 20 percent during the crisis, then $2 trillion is the amount
that the securitized banking system must find from other sources to fund its
assets.
The Federal Reserve reacted
to the problems in the repo market by selling US Treasury securities (prime
collateral for repo), making loans, and buying assets that were most likely
subject to haircuts in the repo market. During calendar 2008, the Fed sold
$278.5 billion of US Treasury securities and increased other assets by $1,612.4
billion. Although the Fed increased its quantity of assets by 144% during 2008,
there was not much inflationary impact as it was essentially offset by the
reduced size of the shadow banking system.
There is another aspect of
the repo market that has drawn more attention recently. Securities received as
collateral in a repo transaction may often be rehypothecated – used as
collateral in another transaction with another party. Since 2008, due to
concerns about securities lending activities of prime brokers and other dealers,
institutional investors have been changing custodial relationships to reduce the
amount of collateral available for lending or repo activities.
Similar to the Federal
Reserve, the European Central Bank and the various European national central
banks have made extraordinary efforts to offset the collapse of the European
shadow banking system as sovereign debt has become questionable collateral in
their system. Kyle Bass, Managing Partner of Hayman Capital Partners, LP,
believes that Europe’s leaders are fighting a losing battle:
As European leaders press forward with failed
attempt after failed attempt to suppress borrowing costs, control spending,
reduce deficits and prop up what the markets have already told us is a broken
monetary system, the data tells us that the citizens of the most troubled and
profligate nations are losing confidence in the Euro dream. Trust has been
lost, confidence in the system is being lost, and the ultimate consequence of
this break down – sovereign defaults – are imminent. We continue to move ever
closer to a great restructuring of sovereign debt.
Bass also believes that we
have reached an inflection point of global debt saturation:
As it stands today, total credit market debt is
310% of GDP. We are saddled with the largest accumulation of peacetime debts
without any playbook for what happens next. Throughout history, whenever total
credit market debt breached 200% of GDP, it was commonly due to deficit spending
fueled by borrowing as nations prepared for and then fought wars. To the victor
went the spoils (and debt pay-downs) and to the loser went defeat and default.
Given the enormity of the debt burdens of the PIIIGSBF (Portugal, Italy,
Ireland, Iceland, Greece, Spain, Belgium and France) coupled with those of Japan
(and at some point the US), lending schemes designed to lend more into an
intractable debt problem are destined to fail miserably. There is no savior
large enough with a magical pool of capital to stave off this unfortunate
conclusion to the global debt super cycle. We think hard defaults are imminent.
As for the “Tail Wags Dog”
portion of the title, I have been a long-time reader of Doug Noland’s “Credit
Bubble Bulletin” commentaries that are published weekly on
www.prudentbear.com. Noland believes that our economy has evolved in stages
from commercial capitalism (bankers providing merchant finance for goods trading
and manufacturing) to our current stage that he calls “financial arbitrage
capitalism.” He writes:
I believe the vast majority of modern financial
apparatus over the years gravitated to speculative spread trading and various
leveraged risk arbitrage strategies – especially at the expense of funding sound
investment in the U.S. and other advanced economies. The system’s focus turned
to financing the securities and asset markets, an extremely lucrative business
that so dwarfed opportunities available from financing capital investment. The
intense focus on credit market spread/arbitrage “profits” – as our central
banking incentivized leveraged speculation – made economic returns virtually
irrelevant to the broader economy’s development (home mortgages were much
preferred over business investment loans as fodder for risk intermediation and
financial arbitrage). Never before had the possibilities for credit creation –
and resulting fees and speculative profits – been so unfettered and
incentivized. That is, as long as asset prices continue to inflate. Over time,
this resulted in “money” and credit becoming dangerously and increasingly
detached from real economic wealth and wealth-producing capacity.
Some of the key
macroeconomic issues for 2012 will be:
·
The repo market is a large,
unregulated overnight lending market in both the United States and Europe which
is sensitive to changes in the credit quality of collateral.
·
Derivatives are another large
market with few regulations. The magnitude of financial derivatives outstanding
is a potentially destabilizing force for the financial markets. According to
the Bank for International Settlements, the total notional amount outstanding
for all over-the-counter derivatives at the end of June 2011 was $707.6
trillion. This is a large number compared to the world’s GDP of approximately
$65 trillion.
·
Loans by supranational
organizations such as the IMF and ECB normally create a claim which has a higher
priority than other pre-existing government debt. The creation of the superior
claims often diminishes the market value of pre-existing debt.
·
Leveraged buyers of securities
(broker-dealers, banks, and hedge funds) that employ leverage depend upon a
positive interest rate differential between the securities they own and their
short-term borrowing rate. Any rise in short-term rates or a flattening of the
yield curve could create significant selling pressure on fixed income
securities. The Federal Reserve and ECB will continue attempts to peg interest
rates that are favorable to leveraged buyers of securities.
·
Banks in Europe are
undercapitalized. There will be significant pressure in 2012 for European banks
to raise capital – either from private investors or their host governments.
·
Assets of banks and the shadow
banking system (repo market) are large relative to the GDP of their countries,
especially in Europe. Continuing support of the financial system by governments
is likely to result in further credit downgrades of sovereign debt.
·
As governments attempt to reduce
budget deficits by reducing expenditures and raising tax revenue, there will be
a negative impact on the economy as many businesses and households will have
reduced income available for expenditures.
·
There will most likely be reduced
demand for sovereign debt by the private sector, which will require the Federal
Reserve and other central banks to be the buyers of last resort. The
monetization of debt (often called “money-printing”) is likely to lead to higher
inflation.
·
The probability of a war with Iran
appears to be increasing. If a war starts, many analysts expect world oil
prices to reach $150-200 per barrel.
·
Central banks of the world will
continue to be net buyers of gold and the role of US Treasury debt as an
official reserve holding will continue to decline. Central banks have been net
buyers of gold since the second quarter of 2009 and the World Gold Council
reported that they had net purchases of 148.4 metric tons in the third quarter
of 2011.
Additions
Penn West Petroleum Ltd. (PWE)
was purchased for both tactical and moderate risk accounts. PWE has all of its
proven and probable reserves in Canada. According to estimates by Kurt Wulff of
McDep LLC, PWE sells at a discount of approximately 30% to the net present value
of its reserves. PWE currently has a dividend yield of 5.3%.
NAL Energy Corporation (NAE.TO
or NOIGF) is a Canadian oil and gas company that produces approximately 29,000
barrels of oil equivalent per day in southeastern Saskatchewan, central Alberta
and northeastern British Columbia. It has been bought and sold twice before in
portfolios and now purchased again after the stock price has declined. NOIGF
sells for approximately 5X cash from operations and has a dividend yield of
10.4%.
AdvisorShares Active Bear
ETF (HDGE) was purchased for tactical accounts as a hedge against a decline in
equity prices. The ETF is sub-advised and actively managed by Ranger
Alternative Management, L.P., which attempts to achieve capital appreciation
through short sales of overvalued domestically traded equity securities.
A Brazilian Government bond
(12.5% due 1/5/2022) was purchased for both tactical and moderate risk
accounts. At the time of purchase, the bond had a yield-to-maturity of 9.4% and
was rated BBB-. An improvement in Brazil’s credit rating is justified and lower
interest rates in the country are likely as the global economy slows down.
Telecom Argentina S.A. ADR (TEO)
was purchased for all accounts. Positions of 3% and 2% of portfolio values were
established for tactical and moderate risk accounts, respectively. 70.7% of its
year-to-date revenue as of September 30, 2011 was generated from mobile
telephony and 9.5% from internet services, both of which are growing at a much
higher rate than fixed telephony. The Argentine government has imposed
restrictions on some currency transactions but the CEO does not expect any
restrictions on dividend payments to US shareholders. In my opinion, at the
current stock price, shareholders are compensated for the risk. TEO has
virtually no long-term debt and sells for 5.5X 2012 estimated earnings. TEO
currently has a dividend yield of 11.6%.
Deletions
The European Bank of
Reconstruction and Development (EBRD) bond (9.5% due 11/6/13 and denominated in
Brazilian reals) was sold. Given the problems with European sovereign debt, it
is possible that the AAA credit rating of the EBRD could be negatively
impacted. The proceeds were used to buy a Brazilian Government bond with a
longer maturity to benefit from expectations of lower interest rates.
The New Zealand Government
bond (6.0% due 5/15/2021) was sold. The country’s debt was recently downgraded
to AA from AA+ by Fitch and Standard & Poor’s. The yield-to-maturity at the
time of sale was 4.43%, which is lower than the inflation rate of 5.3% during
the second quarter of 2011.
Total S.A. ADR (TOT) was
sold. Although TOT has a low valuation, it was sold due to concerns about the
potential negative impact of problems in the French banking system and
disruptions to its production in the Middle East.
Yellow Media Inc. (YLWPF)
was sold. The investor relations department of the company did not respond on a
timely basis to several of our attempts to contact them to discuss developments
at the company. Given the low market value of the holding and lack of
communication by the company, I could no longer justify the time spent to follow
the company.
Tele Norte Leste
Participacoes S.A. (TNE) was sold. The company experienced declines in average
revenue per customer and earnings during the third quarter that were unexpected.
For taxable accounts only,
three positions were sold to realize losses and partially offset realized gains
before year-end. Canadian Oil Sands Ltd. (COSWF), Centrais Electricas
Brasileiras S.A. (EBR), and Templeton Global Bond Fund (TGBAX) were sold and may
be repurchased in the future.
Updates
In late December, positions
in Gazprom (OGZPY) were increased to 4% of tactical portfolios. OGZPY continues
to sell at a bargain price of 2.5X 2011 estimated earnings.
Positions in IShares Gold
Trust (IAU) have been increased for all accounts that have approved the revised
investment guidelines which authorize a higher allocation for commodity ETFs.
The model portfolio allocations to precious metals are now 30% for tactical
accounts (split evenly between SLV and IAU) and 20% for moderate risk accounts
(with a slightly higher allocation to IAU than SLV, since it has been less
volatile).
If you have any questions regarding your accounts, please contact me.
Sincerely,
Robert G. Kahl
CFA, CPA, MBA
Sabino
Investment Management, L.L.C.