Shared Sacrifice

Turmoil In The Credit Markets
During the last 2 years there has been considerable turmoil in the credit markets due to the rapid decline in the credit quality of borrowers in the corporate, mortgage, and agency markets. The sub-prime mortgage crisis, collapse of Fannie and Freddie, banking and investment banking crises, stress on insurers and guarantors of debt, and collapse of 2 of the 3 largest auto makers are all examples of the deterioration in the credit quality which has taken place. Even the credit quality of the U.S. Government (the heretofore standard for a riskless borrower) has been called into question.

Fixed Income Credit Analysis and Risk
This decline in credit quality has made credit analysis more important than ever. Fixed Income money managers who were able to avoid major problems with credit issues have achieved superior performance to those who were unable to foresee potential credit problems. The penalty for being “wrong” on the credit of an issuer has been harsh as credit spreads blew out to very wide levels. A good credit analyst is able to identify and understand the risks in any given security. Most investors lose money because they grossly underestimate the amount of risk they are taking. The other mistake they make is “reaching for yield”. This leads to creating portfolios that consist of all the weakest credits, because they are the ones that yield the most. These portfolios do not perform well in stressful times for the markets. A good credit analyst is also able to determine what the “worst case” is for any security he owns. This is extremely important when things “go bad” for a credit. There are different layers of security for a bondholder. These include debt service coverage, the issuers ability to pay, and where the bondholder stands as a creditor in bankruptcy. In bankruptcy, there are long established rules that apply to secured and unsecured creditors, as well as to equity holders. These rules provide comfort to secured bondholders when things “go bad” for one of their borrowers. The current economic cycle has allowed the government to become involved in the economy to an unprecedented extent, which has revealed a new level of risk a good credit analyst needs to consider. We will call this ‘political risk”, which is the risk of confiscation of secured creditor assets for the benefit of a junior class of creditors. This is a risk that is more prevalent in unstable less developed countries, and was unthinkable in the U.S. until Chrysler.



The Chrysler Bankruptcy
The auto industry was particularly hard hit in the recent economic slide with both Chrysler and GM going into bankruptcy. The actions taken by the government in the Chrysler bankruptcy were unprecedented. The President introduced the concept of “Shared Sacrifice” in the media as he called upon secured creditors to take less than they were entitled to legally so that one of his political supporters, the UAW (a junior creditor), could get a larger share of the new firm. TARP participants who represented the majority of senior secured creditors were then coerced into voting for a government sponsored cram down which gave the secured creditors only 30% of the company while the junior class of creditors (UAW) received 50% of the firm. The secured creditors who did not vote for the plan were labeled as speculators and were portrayed as all around bad guys to the public. This creates an enormous amount of uncertainty for investors in fixed income securities in the U.S., because laws which were deemed sacrosanct have been rendered meaningless as assets are confiscated from one class of creditor and given to another class of creditor based on political whim instead of rule of law.

Bankruptcy Law
Existing bankruptcy law is designed to protect debtors from creditors seizing their assets without giving them time to come up with a plan to pay creditors in a fair and equitable manner. When bankruptcy is declared an estate is created, similar to when a person dies. The assets of the estate are then valued, and creditor claims are processed and organized into order of their priority. Some claims are secured, and have a priority over junior claims. A first mortgage claim is entitled to receive full payment before the second mortgage holder receives any funds. Priority of claims is a well established principle of bankruptcy law. Debtors are not allowed to pay some creditors to the detriment of others immediately prior to or during bankruptcy. The debtor in possession of the assets is allowed to form a plan which is equitable to it’s creditors, and the creditors can then vote on the plan. If a majority of the creditors vote for the plan, the dissenters will suffer what is caused a cram down, as the plan is approved over their objections. In the Chrysler case there are problems with the asset valuation process, priority of claims issues, and the nature of the government’s cram down. The concept of “shared sacrifice” violates bankruptcy law and discourages lending, particularly to weaker credits.


Conclusion
We believe the government has now re-written bankruptcy law in this country. Since the Chrysler case, GM has been put into bankruptcy. A similar approach to a rushed asset valuation process has been taken in GM as well. Virtually every secured creditor in the country has now found their position in bankruptcy lowered, as the government ignores the established rules of bankruptcy law. We were fortunate that we did not own any bonds for the auto companies, because our credit analysis deemed them too risky. We also avoid high yield bonds, because they are very highly correlated to equities, and don’t offer enough diversification to the investor’s overall portfolio. However, even though we dodged the Chrysler bullet, we are still very concerned by the government’s actions and our level of “trust” for our system has been shaken. Why would any investor want to invest in high yield fixed income with the additional risk of confiscation in bankruptcy? Without the established priority of claims in bankruptcy there is now no such thing as a secured or priority claim. “Shared sacrifice” does considerable harm to encouraging lending during these difficult times, because it makes it nearly impossible to determine the lender’s worse case. It makes more sense for the lender to avoid lending to riskier firms, because a secured loan to a struggling creditor suddenly has become much riskier.

Nominal GDP and Inflation

The Current View of Inflation
Investors have become increasingly concerned about future inflation due to massive governmental intervention and growth in the money supply. These investors argue that the large increase in money supply has to go somewhere, and it will cause inflation. They may also argue that this increase in money will cause the dollar to go down, which will in turn cause prices to rise even further. They frequently feel compelled to throw in their thought that the deficits we are currently running are so large, that the only way out of this situation is to inflate our way out. This is currently the consensus view. While this view may be intuitively obvious to most investors, we believe high rates of inflation are not necessarily a foregone conclusion.

Review of Inflation
The chart below shows the annual rates of inflation as measured by the U.S. CPI Index for Urban Consumers on a non-seasonally adjusted basis since 1926 through 2008.

This information is available from the U.S. Department of Labor and may also be found in the Ibbotson SBBI 2009 Yearbook. The average annual rate of inflation during this time period was 3.0%. During the period from 1926-1933 we experienced deflation. In fact, it took until 1945 for the Consumer Price Index to get back to the level it was at in 1926. During the 1950’s and 1960’s inflation experienced a slow rise. The 1970’s saw inflation rise until it peaked at 13.3% in 1979. This was the year gold reached $850.00 per ounce and silver peaked out at $50.00 an ounce as Bunker Hunt tried to corner the silver market. WIN buttons were passed out which stood for “Whip Inflation Now”. OPEC proclaimed an oil embargo and the price of oil went shockingly high. This was an inflection point for inflation. During the 1980’s inflation steadily declined and this trend continued through the 1990’s until last summer when oil reached $150.00 a barrel. Since then the economy has continued to decline and price increases have been under control. Last year the CPI was only up 0.1% even though gas prices had reached prices of over $4.00 a gallon during the summer. Last summer many investors “knew” inflation had returned and feared interest rates were going higher. So far, during this year the index has increased 1.3% through April. The chart below shows the average annual inflation rate by decade since 1926. By looking at inflation over longer time periods the data is smoothed and we are able to see the long term trends more clearly.

Inflation and Economic Growth
Our research shows a high correlation between economic growth and inflation when the economy grows faster than trend. We used data from the Bureau of Economic Analysis to measure growth of GDP. GDP grew at an average annual nominal rate of 6.68% during the period from 1926-2008. Let’s call this the trend rate of growth for the economy in the U.S. In the chart below we compare the annual rate of growth of nominal GDP minus the trend rate by decade, and compare this growth versus trend to the CPI. The results show a high correlation. During the 1930’s the economy contracted below trend and we had deflation. During the 1940’s, 1970’s, and 1980’s the economy grew above trend and we had high levels of inflation. Economic growth during the the 1950’s and 1960’s was at trend and inflation was low. The last 20 years has shown growth below trend with declining rates of inflation.

Conclusion
Investors would be wise to pay attention to indicators which
are leading indicators of the economy such as the LEI Index or the Chicago Fed National Activity Index. These indicators are currently still showing economic weakness which is way below the trend rate for the economy of 6.68%. Inflationary pressures are not likely to appear until growth in nominal GDP approaches levels in excess of trend.

The Government To The Rescue?

Some large cities and states are seeking help from the federal government. So far, help has not been forthcoming. We expect this to change soon, because budgetary cutbacks by municipalities will put additional pressure on an already weak economy. There is increasing talk of helping municipalities with infra-structure needs such as bridges, roads, and energy.

We believe the best option for the government in assisting municipalities is to create some sort of replacement for the bond insurers. This would help reduce borrowing costs for municipalities, and would ensure that financing would be available to issuers who need to borrow. It would also help to restore confidence in the financial system by eliminating the de-leveraging that has been taking place in most asset classes.

What Did The Government Do Wrong Last Year?

When the government let Lehman go down in mid-September, the strains on our financial system were so great the credit markets ground to a halt. The counter party risk involved with Lehman and other counter-parties were revealed to all, and resulted in widespread fear throughout the system. The government greatly under-estimated the systemic risk they were taking when they let Lehman collapse.

The government also didn’t understand how important the bond insurers were to our funding mechanism for credit. Our system relied on guarantees to create AAA credits in the short term markets. These AAA ratings were the key to cheap funding by all sorts of borrowers. The demand for money market eligible paper was so great, a financially strong issuer could borrow at low rates. This system worked well for years and allowed for various leveraged strategies to exist which lowered borrowing costs for most borrowers. The financial shock to our system from rising default rates of Sub-Prime mortgages, and falling housing prices put immense stress on guarantors who had become over-exposed to this market. As insurers got downgraded, investors began to panic in the short-term markets. First, funding dried up for SIV’s which funded Sub-Prime mortgages. Next, investors sold insured notes by FGIC and XLCA, and bought notes guaranteed by MBIA and AMBAC as it became clear these companies were going to lose their AAA ratings. This steady stream of downgrades of guarantors created an absolute panic in the short term markets as they realized no AAA rating was safe. This resulted in the collapse of the Auction Rate Securities market. As funding costs sky-rocketed in the short-term markets de-leveraging took place in earnest in all fixed income markets. We believe the government’s lack of understanding of the importance of guarantees in the short-term markets led to our funding mechanism breakdown last year. This created a crisis in confidence, de-leveraging, and the decline in asset values.

Inflation Worries

Investors are becoming increasingly concerned about inflation as a result of the massive governmental intervention which is taking place. Their argument is that “the government is running large deficits and the money supply is growing out of control”. They feel sooner or later we will experience inflation, and they are worried about a dramatic fall in the dollar and the possibility of hyper-inflation as a result. We feel inflation fears are currently overblown since the economy is still contracting and is very weak. The chart below shows the Chicago Fed National Activity Index. It is a combination of several leading indicators and shows how we are doing

compared to the long term trend growth rate of the economy which is represented by the line at 0. Inflationary warnings flash when this indicator is at 0.7%, and recession is likely to occur when the index falls below –0.7%. The current reading is about –3.4% which is nowhere near the inflationary warning level of 0.7%.


Most investors have grossly underestimated the deflationary forces at work in the economy due to deleveraging caused by tight money conditions in a highly leveraged economy. The cheap funding through the short-term markets which allowed leveraging to take place has disappeared, because the bond insurers are no longer AAA rated credits. This has reduced the supply of credit dramatically because the “borrow short and lend long” trades no longer work. These trades represented the “Shadow Banking System” which funded leveraged buy-outs, no money down housing loans, and hedge fund activity. The contraction of this form of financing has led to economic weakness, which has caused the velocity of money to fall, which has offset the increase in the money supply. It will most likely take a long period of time for these forces to work themselves out before inflation becomes a problem.