Fund Manager
What began as a healthy correction in the SUB-PRIME segment of the mortgage market in the U.S., accelerated last week, and spiraled into a worldwide crisis of confidence in the global world of banking and finance. The proverbial “run on a bank”, in this case, a run on the financial system, forced the U.S. Federal Reserve to take the unusual move of lowering the discount rate, the rate at which the banks can borrow from the Central Bank. Given the Fed’s view of “deteriorating financial market conditions” and the increasing risks to the growth picture, the Fed signaled it would also be ready to cut its main interest rate as well.
Last week’s action reminds us of how fragile the financial system is, not withstanding the strong economic fundamentals. Yes it is true that the Western economies of North America, Europe and Japan are growing at 2-3%. Latin American economies this year have been growing in the 4-7% range while those of China and India,..., well we get the picture! Corporate Earnings have also been healthy, growing at double digit rates, while corporate balance sheets have never been better.
So why is there a run on the financial system? And why are investors running for the exits in full “flight-to-quality” speed? The recent decade of ultra-low interest rates created a need for interest rate alternatives and Wall Street delivered with increasingly sophisticated securitized investment instruments e.g. CDO’s, Collateralized debt obligations.
Traditionally, lenders such as banks and mortgage lenders would have “skin-in-the-game”. That is, a bank offering a 30 year mortgage would due-diligence the home buyer and demand their next born as collateral. In this age of securitization, financial institutions could sell their mortgage, auto and credit card loans in bundles to yield hungry investors. Hedge Funds, Pension Funds, traditional Mutual Funds, as well as corporations and individuals bought large quantities of these high quality (perceived) rated paper. Investors are today questioning their value as their risks are very difficult to measure. In the meantime, investors fear everything and lenders have stopped lending!
The week of August 20-24 will be a crucial week for Ben Bernanke (Fed Chairman) and his central bank colleagues from around the world. The Fed originally chose to stay on the sidelines and welcomed the early correction and panic in the collateralized debt instruments as it would bring back logic and sanity. Refusing to bail-out the greedy purveyors of these products, the Fed may have waited too long, according to some. Unlike the debacle of 1998 that required the bail-out of troubled Hedge Fund, Long-Term Capital (and of many emerging nation governments), today’s crisis touches many. Even “small Mom & Pop” investors with monies in Money Market Funds may find themselves with less liquidity and capital than they had previously planned for.
The market is currently over- pricing risk in these securitized instruments. Investors and banks alike need time to fully evaluate these risks. Unfortunately for Central Bankers and the financial system, time is not an option! Central Bankers will likely need to implement a system wide “bail-out”! Not only will interest rates fall from here but there will likely be some arm twisting on the part of the Central Banks to get the banks lending again.
When confidence comes back, the dust will begin settling again, and investors’ time horizons will lengthen, and bids will re-appear. We don’t expect the market to bounce back to previous high soon, as it has during the previous dips, as real pain has been inflicted to the debt side of the investment world.
If Bernanke and the Boys can instill calm through liquidity and lower rates, then the world economy could be better off in the longer run, in a saner and lower interest rate world. The massive capital spending cycle worldwide, as a result of the industrialization of the emerging nations should continue to drive world economic growth and drive the commodity cycle further.
In the meantime, we are also waiting for the right signals from the central bankers before we start deploying our cash balances. Flight-to-quality mentality can be very challenging short-term for the small-to-mid cap equities. They can also represent great buying opportunities.
Looking forward, our strategy is to seek out quality liquid companies whose share price has been over sold. Phelps Dodge has seen its share price fall 33% while cash flows remain strong as copper prices are still robust at $3.25/ USlb. Teck Cominco is another market leader in the base metals space that provides liquidity and stability in a turbulent market. In the uranium sector many stocks are off 50%-60% from their highs. Names such as Aurora Energy Resources and UEX Corp fit our criteria of quality stocks that have been oversold.
As we have noted in previous commentaries, the cash component of our funds remains high.
Norm Lamarche
Portfolio Manager
Front Street Capital