Nick P. Calamos, CFA, senior executive vice president and chief investment officer, discusses the recent turmoil in the financial markets.
Q. Should investors move to a more conservative position within their portfolios?
Nick: In our second quarter outlook, we said that more defensive positioning would probably not make sense at this point. Despite how hard financial stocks have been hit, the overall market has only retreated back to the low point it reached on July 15; a low that was tested just yesterday. At this point the markets are discounting a normal recession with regard to duration and impact. The S&P 500 is down approximately 22% from its all time high and, although the markets are very volatile, history is on our side regarding both the extent of the decline in the equity markets and the economy's resiliency. We expect more problems in the financial industry but the markets have already significantly drawn down the value of these assets. Ironically, when it is uncomfortable and even intimidating to invest —we believe that is when investors stand to profit most — when valuations are low and buying opportunities are unveiled.
Q. Why not sell my equity holdings and buy them back when the news improves?
Nick: By the time the media provides the comfort we all seek, the markets will already have rebounded considerably. History and experience prove that the time to buy is at the point of maximum pessimism and the time to sell is at the point of maximum euphoria. We don't know if we are close to maximum pessimism, but we do know that we are closer to this low point to buy than to the sell signal (maximum euphoria).
It is very difficult to correctly time the moves in and out of the markets and we don't know of any one who has successfully accomplished this more than a few times consecutively. The highest probability of success by a long shot is to establish a financial plan that addresses your investment objectives and risk tolerance and then stand by it. Emotions and overreactions can and will have significant negative impact on your financial well being.
Q. Every day I read or hear press reports about the next retail bank, commercial bank, investment bank or insurance company that may go bankrupt. How can I sit idle while this is occurring?
Nick: We are actively positioning the portfolios and seeking the next opportunity. This financial crisis is more than a year old and everyone is aware of it; therefore, financial stock prices, for the most part, reflect the damage as a whole. The correction thus far in financials already rivals any past crisis.
Keep in mind, if the media has the information; then so do all investors. The markets are de-leveraging the financial system, but the extent of the liquidations is uncertain. Markets hate uncertainty as do most people. The markets will overshoot to both the upside and the downside. With the problems we face today the odds are that the overshoot has been to the downside.
Q. I have heard that the financial crisis is the worst since the depression of the 1930s, so why shouldn't I move to cash to protect my wealth?
Nick: The current financial crisis has very little in common with the Great Depression. The economy in the 1930s ground to a halt as a result of protectionist legislation (Smoot-Hawley Tariff Act) that caused other countries to do the same, thereby ceasing global trade. The money supply was sharply curtailed adding a liquidity squeeze to the already weak economic environment. Because tax revenues declined as a result of a weak business sector, the government raised taxes and injected another level of pain to the economy. As a result, unemployment surged and banks failed in large numbers.
Today, we have many differences. The economy outside of housing, autos and financials is remarkably strong. In the second quarter of 2008, most sectors of the economy reported strong earnings growth and GDP grew 3.3% in the second quarter (a large improvement over first quarter GDP growth of 0.9%). The Fed and the Treasury have added liquidity and the fiscal stimulus has also been in place. We have not seen significant anti-trade legislation or additional trade barriers constructed. Finally, the banking system has insurance in place that did not exist during the 1930s. The lack of insurance created panic and lead to a run on banks. Today, consumers have significantly more wealth, more insurance and more safety nets than they did during the depression.
Q. Won't all the bank failures create additional problems and push the economy into the same depression scenario?
Nick: The financial institutions operate on a high degree of leverage (debt-to-equity) with a fairly lean margin of safety. Banks typically operate with leverage of 8 or 10 times equity while investment banks operate with leverage of 20 or 25 times equity. Consumers typically will have a high debt-to-net-worth (equity) ratio of approximately 10-to-1 in the early years of buying a home, establishing a career and building a family. As consumers build wealth the ratio is closer to 1-to-1. Basically, the financial industry has a lot of leverage and the institutions that had the most are the ones that are in trouble.
So far, the financial institutions that have imploded had a couple things in common: too much leverage and significant exposure to the mortgage markets. Bear Stearns had leverage of 33-to-1; therefore, just a 3% decrease in assets values would wipe out their equity! Lehman also had a similar leverage ratio to Bear Stearns and Merrill Lynch was not far behind. Fannie Mae and Freddie Mac's leverage ratio was upwards of 50-to-1! These institutions also had significant exposure to the mortgage markets in risk-laden sub-prime and Alt-A loans.
As assets decline in value, leverage increases and equity is diluted or wiped out. This asset deflation may have significant impact on other financial institutions that have counter party relationships such as credit default swaps and other derivatives. The major concern is that this de-leveraging will cause systemic damage to the financial markets and the economy.
The good news is that the amount of capital that has been injected into the problem banks from private equity, healthy banks, sovereign wealth funds and others has been remarkable. Lehman and AIG both turned down capital because they did not like the price or the terms of the bail out. The hedge funds have made some of the large investment banks obsolete since capital and liquidity is provided by large hedge funds and private equity firms. The wholesale and retail banking and brokerage model may be obsolete, or at least over staffed, as consumers have many options with the internet providing the transparency and information that many financial advisors provided in the past. Banks are on every corner in this country so maybe we have room for fewer of them. Certainly, the industry will change as a result of this crisis.
Of course liquidity and capital has also moved to the unregulated parts of the market where Sarbanes-Oxley and FASB 157 and bank regulators cannot reach you. Food for thought: What does this mean for the future? Most likely a crisis in financials again similar to those we have seen in this country every decade or so.
Q. If things continue to deteriorate from here, what actions will the Federal Reserve or U.S. Treasury take to support our markets?
Nick: We have many examples of past financial crises to pull from to understand the potential actions. During the 1970's many broker dealers went out of business, just ask Calamos Chief Executive Officer John P. Calamos, Sr. who worked for a half dozen or so that no longer exist. This crisis in the financials was left to its own accord for the most part since the industry did not need the breadth of competitors and the crisis had little impact on the overall financial markets.
The Latin American debt crisis in the early 1980s was a much more significant crisis with the potential to wipe out almost all equity capital of the major U.S. banks. Most major banks extended significant loans to Latin American countries that were made in dollars not in the foreign debtor's currency. As Latin American countries fell into recessions, their currency weakened against the dollar and the countries could not pay back the loans. Valuing the loans at a near defaulted rate would have destroyed the banking system so the U.S. Treasury stepped in and declared that countries can not go bankrupt; therefore, these loans did not require to be marked down. The crisis was avoided and Brady Bonds were created to provide liquidity for these loans in the future.
The savings and loan crisis of the late 1980s and early 1990s was also very significant. At its conclusion 50% of all S&L's went out of business; over 1,600 thrifts in all! The government insurance program did not have the capital to support even 25% of the crisis so Washington stepped in and seized assets and created the Resolution Trust Company. Taxpayers paid a significant portion of the bill and the government once again learned about the "moral hazard" of insuring institutions regardless of the risk taken. The economy endured a recession for a few quarters while the markets corrected 20% and subsequently rebounded.
This time is different, as it always is, but the Fed and Treasury are responding. As an economy, we will work through this. Many of the new mortgage companies and banks that were created during last decade's bubble may be unnecessary in the next decade. We have already come a long way in solving these issues and will get past this current banking and housing debacle.
Q. You have stated that the Fed and Treasury have responded to this crisis but the problems persist. Does the market want further action?
Nick: The Treasury and Fed's actions have been measured to this point. The yield curve and short-term rates at 2% allow banks to rebuild balance sheets with very little risk (borrow at 1.5% and purchase treasury bonds at 3.7%). Mortgage refinancing and ARM rolls are at prices that are at or near the level of the existing mortgage rate. ARM mortgages rolling over that were established with teaser rates are another story. The strong dollar is deflationary and provides some room for additional Fed liquidity injections. The Fed discount window moves in order to provide additional access for more financial institutions. A broad number of assets as collateral helps move less liquid assets to the Fed without adding additional liquidity to the system. This is both helpful and conservative.
The Fed and Treasury's refusal to bail out Lehman is their way of "drawing a line in the sand;" signaling that not everyone will survive this crisis. Of course, it is not healthy to socialize all financial risks and have tax payers' bailout the weak institutions. Ironically, the strength in our capitalist system is its willingness to let weak or poorly managed institutions fail. Only then can markets clear, allowing the strong to move forward. After the Japanese economy collapsed in the late 1980's they did not let the weak banks fail, they did not allow companies to fail or even layoff staff, and they did not let the markets clear. All business, strong and weak, suffered. We have done the same thing with a few industry groups that have been considered "important" to the nation's safety or infrastructure. The airlines have been hampered with a significant number of weak competitors that operated under Chapter 11 bankruptcy protection but were not dissolved. These weak players operated without significant capital costs and then tried to compete with price discounts, thereby cutting profitability of the strong airlines in the process. The result has been a significant decay in the financial strength of all airlines. The survival of the weak without the same capital costs impaired the strong competitors. The government does not want to see the same result with the financial institutions.
Q. What, if any, implications are we going to face as a result of the government's actions to support the crisis?
Nick: In the near-term the moves by the Fed and the Treasury are going to add liquidity and support the workings of the financial system. In the long-term the backing of Fannie Mae, Freddie Mac and the liquidity injections are inflationary and may result in future additional secular inflation bias. Short-term inflation is not the current issue, as the asset bubble implosion is highly deflationary and the recent decline in commodity and energy prices provides some relief on the inflation front.
Q. Can we assume that the government will not let AIG fail? Are they "too big to fail?"
Nick: AIG is the largest insurance company in the U.S. and it is too big to fail. This means that the liabilities that this firm carries will be supported in some manner by the government. The impact to the insurance customers and debt holders may be minimal. Unfortunately, it is likely that the equity holders may not recover capital and some sort of government or industry wide support will be put in place to support the assets of this mammoth institution. AIG is solvent, just not liquid, and in this environment liquidity is king.
Q. What is your outlook for the next year as this crisis passes?
Nick: The market will rebound as the news becomes less negative and will look forward 12-to-18 months, so even when earnings are turning negative and the economy seems to be stuck in a rut, the market is a forward looking indicator. It has historically recovered well before the economy, or you and I, feel better. Now is not the time to sell.