Tuesday, November 28, 2006

Hot potato

You probably remember that child's game hot potato? Much like musical chairs. In essence, the kids all race around or pass around an object for an indeterminate time. When time is called the person left holding the hot potato or without a chair is eliminated from the game. Guambat has never known a Guambat-kid who didn't just love the game.

One reason it is so enticing is that everyone is a winner so long as "time" isn't called. It's only when "time" is called that the looser becomes apparent.

The grown-up equivalent of that game is leveraged debt. Debt is something we all take on and most of us pay. But we know for a certainty that at some point someone is not going to honour their debt. For whatever reason, design or misfortune or happenstance, some debt is at some time not repaid.

That's why we pay people to take our debt; if noone ever defaulted there would be no rational reason to pay interest (apart from future income discounting). We
pay for our debts as insurance against the certainty that at some point someone will bail. And that greases the wheels to make sure that debt gets extended to those who will pay.

Now hold onto that thought whilst Guambat relates a story told long ago to Guambat about cows and the Chicago cow yards.

At one time Chicago was slaughter city. Almost all of the cows from the great mid-west USofA were sent to Chicago abbatoirs, and they supplied the world with all that beef.
But there was more to it than just beef. There were hides, as well. And bone, and blood and gall stones and everything else between hoof and horn that the canny butchers learned to exploit.

The saying that rings in Guambat's ears is, "By the time they got through with a cow, the only thing left was the "moo"."

And this is where we return to the debt story. Modern finance has developed means of extracting all the various benefits to be had from the cashflows resulting from debts of all sorts, including credit cards, low-doc mortgages, car rental contracts, sovereigns, whatever. They e
xtract and trade in the near-term cashflow, the medium term cashflow, the long term cashflow, and the expectancies of whether the debt will be repaid or not.

Indeed, when the modern financier get through with a debt, the only thing left is the "due".

The game of this world of modern finance is not unlike the childhood games of hot potato and musica chairs. The premise of the game is that time will not be called while you are holding the potato or between chairs. The marketing of the game of modern finance is that you can take your share of the cashflow and pass off any of the risk that the debt will not be repaid. It is, in reality, a shell game.

And what happens when everyone is racing around the chairs, passing around the hot potato, and time just goes on, is that people get sloppy. Or tired. Or even if they don't, at some unexpected time, "time" is called.

The inevitable event occurs. And no amount of racing or passing w
ill save you if you are the one on the outs when time is called. You are simply dead meat regardless of your best efforts and high expectations.

No matter how often or fast you pass off the risk of the hot potato or the risk of no chair, you do not eliminate the risk. It is the defining character of the game. And you are only fooling yourself if you think that by playing the game you have eliminated the risk.

Bill Gross doesn't put the story in quite the same fashion, but he tells essentially the same story in his most recent essay,
Alpha/Beta Anemia:
[I]f the “Beta” or return from various asset classes is correlated to the growth rate of nominal GDP, then what we have to look forward to is a rather anemic “Beta” in future years. In turn, if because of that increasing realization, investors have responded by compressing risk spreads and therefore potential Alpha, then what’s looming over the immediate horizon is an Alpha/Beta anemia that can’t come close to meeting investor expectations or for that matter come close to immunizing this nation’s collective liabilities.

As nominal GDP growth rates have declined from 11%+ to a recent 5-year average of less than 5%, future asset returns of a similar magnitude are foretold. While Chart 1 suggests that a 5% GDP growth rate can be levered up to perhaps 6% or 7%, that levering is certainly more difficult with a Fed Funds policy rate higher than the current growth rate of GDP and with disinflation near its end. In any case, we appear to be looking at maximum 6-7% average annual returns over the immediate future from stocks, bonds, and real estate in total (stamps too!).

A recent study by the Bank for International Settlements points out that the annualized volatilities for stock, bond, and currency markets are approaching historic lows, with the implicit assumption that the pricing of risk is following in lock step.

To be fair, the BIS also points out that there may be numerous fundamental reasons that justify lower risk spreads. Globalization, the “great moderation” of economic growth in recent decades, increased central bank transparency, and the innovation and promulgation of financial derivatives, which can disperse and spread risk as well as promote increased liquidity are but a few of their major arguments. I concur with much of their logic.

But I also agree with Alan Greenspan and economist Hyman Minsky that stability can in time be inherently destabilizing as overconfidence leads to lower and lower risk spreads, more and more financial leverage (Ponzi finance as Minsky called it) and an ultimate vulnerability to the economy and its financial markets on the downside. The BIS points out that financial institutions in recent years may have ultimately increased their overall risk exposure despite the reduction in asset volatility.

Playing by the new rules which in part require an assumption of levered risk spreads at historic lows could likely lead to low absolute returns and/or negative Alpha should instability return. Your asset returns – and active portfolio management itself – are now both at risk in this seemingly riskless and increasingly anemic investment return environment.

Financial innovation, central bank transparency, and even globalization’s great moderation of economic volatility are powerful arguments suggesting the old days of copious Alpha and Beta are over because 5% GDP growth and compressed risk spreads are not likely to permanently return to historic levels. Yet we have a collective sense that risk spreads will not remain so low over the next 12-24 months, and that instability – whether it be sparked by U.S. housing, global overinvestment, or geopolitical events – will one day temporarily resurface.

If both major assumptions have merit, then the strategic and structural case for now should be guided by the New Age acceptance of change and the Old Age wisdom that bad things can happen to apparently good assets in the short term.


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