Letter from New York

Perhaps we shouldn’t have expected to come away in anything but a deep depression from last week’s research trip to see strategists and economists at Wall Street’s investment houses, after all this is the epicentre of the job losses and zero bonuses.  At times though, there was a real background hum of anxiety – about their own personal prospects, about the economy and about the future of banking.  Somebody once pointed out that the plural of anecdote is not data (except in homeopathy) – but one of the strategists we talked to has bought a gun, in case things get really bad, and one of our flights from London to New York had just 38 people on it.

First then, the banks.  Whilst we were there, equity markets had a burst of excitement over talk of the creation of a “bad bank”.  But estimates of the size of the “bad” asset pool grow day by day.  As one bank analyst put it, there’s $4 trillion of bad assets out there, before you even start thinking about commercial property – so the market’s going to tank if the bad bank is worth only a $1 trillion bailout. (And as a friend who works for a now partly state owned UK bank put it, “why do they want to set up a bad bank? We are the bad bank. They’ve already got one.”)  There is a chance that subordinated bank bonds could be rescued by the authorities in the UK, as to allow them all to default could have systemic implications for pension funds and other institutional investors who have significant holdings of the instruments.  In the US though, this is not the case – their subordinated bank bond investor base is more speculative in nature (hedge funds, distressed debt players).  Bank common equity is now regarded as having only option value, and with no systemic risk, losses can be pushed right up the capital structure.  The American public wants to see bank investors (and employees) get punished.  The most likely mechanism for this would be through a series of debt exchanges – Upper Tier 2 bonds would be offered terms to convert into Tier 1, and Tier 1 would be offered terms to convert into common equity.  Why would investors do this?  Well the alternative might be immediate bankruptcy, and the pill would be sweetened with better than current market terms (if you are a distressed debt investor who bought a Tier 1 issue at a price of $45, and you get offered $55 worth of equity, you might well accept).  This form of “voluntary” restructuring would not count as an event of default, or trigger CDS contracts, nor would it be seen as the state over-riding the law – President Obama lectured law at Harvard, and the market believes this means that he regards existing property and contractual rights as paramount.

“Regulatory forbearance” is the phrase du jour.  There is an argument that the problem isn’t the bad debt, it’s the recognition of bad debt.  In a few years time we’ll be through this economic nightmare, and house prices will recover and toxic loans could well end up being money good (the Swedish state actually made money from such assets when it bailed out its bust banks).  Why not then keep them marked at 100 on the portfolio, and only mark them down if they actually default rather than showing the low mark to market valuations which are due as much to forced sellers of risky assets as to credit fundamentals?  That’s what the US banks did in the 1980s following the Latin American debt crisis, when they were, like now, insolvent.  This would allow the banking sector to limp through the next few years, gradually repairing their balance sheets.  But under this model they couldn’t start lending again and doing new business – the velocity of money would continue to fall even as the money supply rises, and a prolonged period of Japanese style deflation could ensue.   Only “good”, well capitalised and properly solvent banks can facilitate a return to the normality of the lending of the past two decades (if you think that’s desirable).  And in the meantime you have to bypass the banking system by putting taxpayer and Treasury Bond investor money directly into the hands of US consumers and businesses.

The Obama stimulus package was coming under a lot of scrutiny whilst we were there (and 200 economists signed this full page advertisement in the New York Times protesting that not everyone is a Keynesian nowadays).  Obama said yesterday that it would be a catastrophe if the Senate doesn’t pass the package quickly – it has has risen from $800 billion to $900 billion in the past week (and now totals 7% of GDP).  The original bill had a strong focus on education and transport, and longer term infrastructure projects, but the Republicans want immediate tax cuts which they argue will act much more quickly in stimulating the economy.  Away from the package, other ideas for bypassing the banks to get cash into the pocketbooks of Americans included a wholesale cutting of mortgage rates from (effectively state owned) Freddie Mac and Fannie Mae – by cutting mortgage rates from over 6% now, to under 4%, whilst being able to finance those loans by issuing government bonds (yielding around 3%) the government would be able to confer the benefits of the flight to safety in the bond market to homeowners.

Were there any rays of sunshine?  Perhaps – at least a couple of economists (Larry Kantor of Barclays, and I see today that the historically very bearish David Rosenberg of Merrills has joined him) are predicting a significant US growth rebound in the second half of 2009.  Partly this is due to some rebuilding of inventories after the expected violent destocking of Q1 and Q2, but also there is some expectation that the monetary and fiscal stimulus packages will have had an impact by then.  There was also some excitement about the prospects for an early recovery in Asia – particularly in China which announced its own stimulus package (3.5% of GDP) and where direct state control of the banking sector means that lending volumes can be maintained.

We usually visit the Fed when we are in New York – and we did this time too, although we did it as tourists rather than investment managers.  You can prearrange a free tour, which includes some exhibitions (including a display for kids which included a 4 page multicoloured book featuring cuddly animals and called “How the Federal Reserve Regulates Banks” which would have made a good photo had our cameras not been confiscated), the screening of an education film about banknote distribution (“Hi, I’m Troy McClure.  You may remember me from such educational films as “Lead Paint: Delicious but Deadly” and “Here Comes the Metric System””), and best of all a trip down to the bedrock of Manhattan to see the gold vaults.  There’s more gold there than at Fort Knox – $180 billion at today’s prices – but in a fairly small store room.  I’m not convinced the stuff should have any value, other than for making trinkets.

Finally inflation.  Deflationists hold sway, at least for the short term.  There can be no return of inflation until credit demand returns, and we remain deeply in a world of deleveraging and recapitalisation, both on a personal and a corporate level.  However, although we were only able to yell a hurried question to the barkeep from the window of our still moving cab back to JFK, it seems that a can of Pabst Blue Ribbon in Welcome to the Johnsons has risen to $1.75, from $1.50 in the autumn and $1 a year ago.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.

Jim Leaviss

Job Title: CIO Public Fixed Income

Specialist Subjects: Macro economics and fixed interest asset allocation

Likes: Cycling, factory records, dim sum

Heroes: Brian Clough, Morrissey, Neil Armstrong

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