Spiritus Animalius

Everyone agrees that helping small business is crucial

The senate is debating a bill that would create a $30 billion government fund to help small banks lend to small firms. Negotiations played out while President Obama visited a New Jersey sandwich shop and plugged for the package of loan guarantees and tax breaks designed to encourage small companies to hire.

It’s well-known that small businesses and new businesses do most of the hiring in a growing economy. That’s part of the reason America has always had such a dynamic economy: the rate of new-business formation is higher here than just about anywhere in the world.

But what’s really needed to get small businesses going again isn’t loans but animal spirits—a sense of optimism and élan that encourages individuals to risk their capital, their time, and their reputations on a new venture. Keynes coined the term 75 years ago as a way to describe how sentiment affects economic decisions

Without animal spirits, enterprise would collapse. Policy-makers debate how to encourage them, but if you really want animal spirits, you need animals: visionaries like Sam Walton or Sergey Brin to start the next Wal-Mart or Google. How to help? The best idea is to just get out of the way.

Douglas R. Tengdin, CFA
Chief Investment Officer
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A Free Lunch?

Some mortgage folks are stumping for a free lunch. Are they right?

Some analysts have made waves by advocating for changes in the mortgage market. If Fannie and Freddie ease some of their underwriting requirements—just for refis, and just for households that already have a government mortgage—it could yield a consumer windfall of up to $50 billion, and it wouldn’t directly cost the taxpayers a dime.

Here’s how it would work. Currently, when a homeowner wants to refinance a conventional mortgage, he has to have a qualifying home value, income, and credit report. After passing all three tests, the borrower can refinance via the government agencies. It makes sense to re-approve the loan because Fan or Fred package it up and sell it to the market, guaranteeing the principal. What has them in hot water is loans they’ve guaranteed that have since gone bad. What if they relaxed their underwriting criteria for existing borrowers—ones whose mortgage the Feds already guarantee?

It wouldn’t mean any more credit risk: they’re already on the hook for the principal. If the borrower’s a bad risk, they’d actually be helping themselves by reducing the payments. The average consumer could save about $2500/year—real money. Who loses? The owners of high coupon mortgage pass-through bonds; investors reaping a windfall now due to lower than expected refis.

But there’s no free lunch. Changing the rules of the mortgage market in mid-stream could have unforeseen consequences down the road. But we’re going to change the rules dramatically for home finance pretty soon anyway. This way, consumers get a break. Heaven knows they need one.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Banking on Stress

So where is the next banking crisis going to hit?

The bursting of the housing bubble in the US wiped out about $300 billion in bank capital here. That led to the demise of WaMu, Wachovia, Merrill, Lehman, and Bear. It followed a classic boom/bust pattern: innovation leading to price gains, followed by leveraged momentum investing, followed by a bust and financial crisis. After the shake-out and bailouts of 2008, the stress tests of 2009 restored faith in our banking system.

In the aftermath, governments around the world borrowed and spent to prop up demand. In Europe, the banks lent to countries on the periphery, and when the market questioned the sustainability of that sovereign borrowing, phase two of the financial crisis kicked in and the Europeans needed a stress test of their own to restore faith in their system.

Now that the results are in and it looks like most European banks are okay, where is the crisis headed? My money is on Asia. News out of China indicates that Chinese banks lent about $1 trillion to provincial governments during the crisis. But only a fraction of the projects financed are paying for themselves. And $250 billion face serious default risks.

If Chinese banks see these kinds of losses, they also may face solvency issues, reigning in lending and growth. Could a stress test there help? Maybe. But the stress tests restored confidence because they were transparent about assumptions, risks, and results. When I think of China, transparency is not the first word that comes to mind.

Douglas R. Tengdin, CFA
Chief Investment Officer
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The Education of Money

Investing isn’t so tough, the world is saying. Take my money … please!

That’s what the tone seems to be today. Forget credit risk. Forget inflation risk. Forget about geopolitical, technological, or even criminal issues. Investors are competing to lend money for 30 years or longer if they find a Aaa counterparty.

Recently the University of Virginia came to market with a taxable issue that matures in 2040. They borrowed $190 million at 4.9% to build dorms, improve labs, and expand the hospital. The bonds aren’t even obligations of the University—just secured by its revenues, along with a Federal subsidy.

Now I have the highest regard for the university President Jefferson founded. But this is nuts. The school runs a chronic operating deficit of about $250 million a year; only income from their $2.5 billion endowment and state appropriations plugs the hole. It may seem like $190 million 30-year borrowing is chump change, especially when the Feds are paying part of the interest. But 4.9%?

Let’s do a thought experiment. Long term growth is 2%, because of the “new normal.” Inflation is 2%, because that’s the Fed’s target. Short term rates should be 3%; 30-year Treasury bonds 5%. Why lend money to a school that can only pay its bills because of state aid for 30 years at the same rate?

I’ll tell you why: too much cash chasing too few investments. Today marquee names like UVA are issuing bonds. Tomorrow will we see the next sub-prime? Or will it be different next time?

Douglas R. Tengdin, CFA
Chief Investment Officer
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Chinese Fortunes (Part 3)

Is China destined to overtake us?

That’s what the trends indicate. If you take the average Chinese economic growth rate and the average US rate over the past 20 years and apply these rates to the future, China’s economy will equal our economy by 2025. Are we ready for this?

Yes, if China grows 8% faster than the US for the next fifteen years, it will indeed have a larger economy than ours. That’s just mathematics. But the only constant in the world’s economy is change. What could slow Chinese growth?

First, China needs to develop internal consumption by investing in social infrastructure. Such investment may encourage internal markets, but it isn’t as productivity-enhancing as building roads and bridges. Internal consumption makes sense, but it delivers a slower growth rate.

Second, China has been pursuing a mercantilist export policy. This works as long as imports are cheap and export markets expand. But slowing growth and in Europe may have a leveraged effect on China, which has relied on increasing market penetration. And contracts for raw materials are often renegotiated when in the sellers’ interest. That could mean higher import prices for China.

Finally, environmental issues may cramp Chinese growth. At some point, unhealthy air and water become an economic concern China may face this issue as they grow. Almost every nation has. China is unlikely to be the exception.

These are some of the reasons why the past may be a poor predictor of the future. The economic path between two points is rarely a straight line.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Chinese Fortunes (Part 2)

So what would a changed China mean?

Up until now, China has invested in traditional infrastructure: roads, bridges, airports, etc. And it’s helped them grow to be the world’s third largest economy. But for China’s growth to continue at an above-average pace, they need to switch gears. Up until now they’ve levered their economy off of demand from the US and Europe, betting that western consumers would lift them out of poverty.

It’s worked pretty well. Over the past 20 years their economy has grown from 300 billion to 4.3 trillion—a 13% annual growth rate. This is an amazing feat for an entire economy. Partly as a result, domestic tranquility has generally been the rule—something that hasn’t always been the case in China

But if growth slows, this may not continue. That’s why it’s so important for the Chinese to shift their economy from being export-driven to being consumption-driven. Because after the Great Recession western consumers aren’t what they used to be. Increased savings over here means fewer exports and slower growth over there, and that could spell problems for the Chinese leadership.

But to become more consumption-oriented, the Chinese need to build out their social infrastructure: health care, pensions, and social insurance. So instead of buying tractors and cranes, the Chinese may be importing databases and insurance actuaries. Because for the Chinese to consume more, they have to save less. And for them to save less, they have to have confidence that someone will need them and feed them when they’re 64.

China knows what it needs to do to continue to grow. How it does it is another story.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Chinese Fortunes (Part 1)

Can the Chinese miracle continue?

Sometime in the next 50 years the Chinese economy could equal that of the US. This is astounding, considering that as recently as 1990 their economy was only equal to 6% of ours. It’s now number three in the world and the size of almost one third of our economy.

What have they done right, and can it continue? Within the context of central planning, the Chinese leaders have unleashed entrepreneurial spirits by encouraging exports, building infrastructure, and liberalizing labor laws. As a result, about 300 million workers have entered the global market.

But can their export-driven economy continue to post double-digit growth? By focusing their economy on western consumers, the Chinese were able to hitch themselves to the American and European economic engines. But consumption growth in the West has slowed as a result of deleveraging and reregulation. So what will happen to their export machine?

Well the short answer is their economy has to shift from exports to consumption. That’s not so easy. The Chinese save a lot because they have no social safety net: no pension, no health insurance, no welfare. If you’re hurt, you’re out of luck. So the government needs to develop their social infrastructure just as they built out their physical infrastructure over the past 20 years.

Can they pull it off? Maybe. But this new phase has profound investment implications.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Hungarian Goulash?

Are the financial markets making progress?

Sometimes it doesn’t seem so. The stock market appears pretty volatile, up 200 points one day and down 300 the next. What are we to think?

One item that’s pretty encouraging, though, is how the markets have responded to the news from Hungary. In May Hungary had an election, and the new government indicated that servicing their debt could be a problem. The Hungarian Forint weakened, and global markets tumbled. At the time, it all seemed pretty silly. The Hungarian economy is pretty small—about 1% the size of the US, or the same as Morocco. And their debt is pretty small as well. But the markets were looking for any excuse to plunge in June and they did.

Yesterday’s news out of Hungary was a lot more serious and the market responded with a big yawn. The talks they’ve been having with the IMF about assistance broke down. But the markets outside of Budapest didn’t even seem to notice, and neither the Forint nor spreads on Hungary’s bonds are any wider than they were in June.

This is what progress looks like. Bad news happens and the markets put it into perspective. Sure some investors will get hurt, but that doesn’t mean that Hungary is going to send the global economy into a tailspin. These news cycles pass like a summer thunderstorm, full of sound and fury and signifying nothing. Let’s hope that any tempest in the Hungarian Forint, isn’t.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Stressing Out

The European bank stress test results are due Friday. What are we likely to learn?

On Friday the European bank regulators will release the results of stress tests on 91 banks. The tests have been done on a bank-by-bank basis and the results are supposed to be released on an individual bank basis and in aggregate. The tests include a macroeconomic shock and a sovereign debt shock—at least something worse than this last May.

Banks being tested include the usual suspects, like Royal Bank of Scotland, Lloyds, Societe Generale and Deutsche Bank. Also included are the Spanish cajas and German regional banks. All-in-all, 65% of Europe’s banking sector is being examined.

But what will be disclosed? Ah, there’s the rub. Because the genius of the American stress test was its fairness and the fact that some of the banks had to go out and raise capital. The tests were tough enough that some failed. But what we hear Friday may be different. Already France’s economic minister is predicting that the tests will show “That European banks are solid and healthy.” Well, I’m glad that he’s so confident. Or maybe he’s just “talking his book.”

One thing’s certain: if the stress tests come out and every bank passes—if all the children are above average–they will have no credibility and the markets will assume that they were just an elaborate charade. The sell-off will then resume. Because when everybody’s special, nobody is.

Douglas R. Tengdin, CFA
Chief Investment Officer
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The 3 Billion Dollar Question

What are they going to do with all that cash?

Over the past 3 years, corporations have built up quite a nest egg. Over $3 trillion in cash sits on corporate balance sheets, the fruit of years of rising margins and a formerly booming economy. When the downturn came, corporations cut costs to protect themselves. Now they have a cash war-chest. What are they going to do with that money?

Conventional wisdom says that firms do share buybacks with one-time cash bonanzas, they expand their business when the margins improve, and they increase their dividends when sales grow. Since the economy is still in the doldrums, and margins seem to be falling back to earth, share buybacks seem to be in the offing. But is this smart?

Share buybacks are supposed to decrease the cost of capital by increasing the percentage of tax-deductible debt in the capital base. But we’ve learned the hard way in the past two years that increased leverage means increased risk. And shares bought back in a rising market can be reissued when cash is scarce and markets are low, destroying value.

So what should companies do when cashflow is strong but investment opportunities are few? Well wow about giving shareholders the cash? If the company can’t put it to work, shareholders can. Either that, or find new managers.

Douglas R. Tengdin, CFA
Chief Investment Officer
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