The Quarterly Report

  • The Quarterly Report
  • First Quarter 2010
  • Chuck Osborne

Details Matter

When I was in college, I got involved in a long-distance relationship. I met a girl over the summer and we continued dating when I went back to school at Wake Forest. Her birthday was coming up and we were going to be apart. With the advantage of several more years and hopefully a little more wisdom this seems like no big deal, but at the time I was young, in love, and stupid. The thought of not being with my girlfriend on her birthday was just too painful.

I scraped together all the money I could, flew to her town, and surprised her with champagne, roses and a reservation at her favorite restaurant. She was beside herself with excitement when she opened the door and saw me standing there. I gave her the gifts and told her about our dinner plans, and her response was, “Where is my card?” Card? What card? Webroke up shortly after that expensive trip, but I had learned a valuable lesson: details matter.

Last quarter we began a conversation about the big structural changes that the United States must go through to remain relevant in the 21st century. I promised I would get back with specifics throughout the year, so I will start with the topic about which we know most here at Iron Capital, regulation of the financial industry. I will begin with an assertion that most likely will surprise you: I believe the vast majority of people within the financial world today would welcome intelligent regulatory reform. I base that first on my own opinion as the owner of an investment counseling firm, and secondly on 19 years of experience and relationships in this business. I can honestly say that I do not know anyone in our industry who does not believe we need reform.

That is probably a surprise because it seemingly contradicts what you hear from the mass media who report how Wall  Street is standing in the way of the administration’s efforts to pass financial reform. I believe Jamie Dimon of JP Morgan said it best after being summoned to the White House along with his fellow big-bank CEO’s. Dimon told reporters that he was in favor of reform, but details matter. You simply cannot succeed in business like he has succeeded without understanding that details matter.

One of the primary problems we face in today’s effort to fix the financial regulatory framework is a lack of understanding of what actually went wrong during the financial crisis. The reason for this is that it is human nature to operate with a closed mind. Most humans make up their mind before any facts are known and then look only for facts that support their views. Today that is made easier than ever, as depending on your particular political persuasion you just turn on MSNBC or FOX News. One might read the New York Times and refuse to read the Wall Street Journal or vice-versa. Online one can swim in crazy extreme ideas until they start sounding sane.

Having an open mind is extremely difficult, and not natural. John Maynard Keynes said it best when he commented that, “the difficulty lies not so much in developing new ideas but in escaping from old ones.” In his book Socrates’ Way, Ronald Gross describes the effort the ancient Greek philosopher went to be open-minded. He suggests an exercise where you purposely seek out sources written from a view with which you disagree, and not just read them but really consider their arguments and “grade them” on whether they have actually proved their case. This exercise has proven very useful for us at Iron Capital. Before we make any investment decision, we seek out contrary views and truly consider them. It is not easy because it goes against human nature, but I would like us all to try it now.

There are two popular explanations for the financial crisis: first, the whole thing was created by bankers, all of whom are simply evil greedy people. The second view is that the entire crisis was caused by government regulators who want to crush the free market and create in America a communist utopia.

I have purposely positioned these arguments as so extreme that hopefully no reasonable person would agree with either one, but while I state them in the extreme, the fact remains that almost everyone falls into one of those perceptions. If they were being honest, most people would admit that they thought this way before the crisis. If they disliked free markets, then the crisis just proved that free markets don’t work, and if they disliked government regulation, the crisis simply proves it causes more harm than good.

Both sides can point to facts that support their case. There are certainly cases of what seems like hubris and greed in several large financial institutions, and these undoubtedly played roles in the crisis. This is a detail which is largely ignored and/or brushed aside by many who defend capitalism.

However, there is also no doubt that banks were pushed to make loans to certain groups of people for political reasons regardless of credit worthiness. Without the strong public support for home ownership regardless of cost, the sub-prime market never would have existed. In addition, the financial firms never would have acted so recklessly if there had not been a record of the government bailing them out every time they got into trouble. These are details that just don’t fit the world view of the pro-regulation crowd, so they must simply be ignored.

Unfortunately, details do matter and cannot be ignored, particularly when they challenge one’s view of the world. The problem with all the details is that they paint a different picture of what happened in the financial crisis than what either view wants to see. First, there is no one thing that caused the crisis. People want a villain, someone to blame. Greedy bankers did it. No, it was the Federal Reserve. Banks became “too big to fail.” Regulators pushed sub-prime mortgages and subsidized the entire mortgage market.

The problem is that all of these statements are half-truths. The whole truth is that this crisis was a perfect storm. No one of these issues independently could have caused a crisis of this magnitude.

Once one understands that, one starts to see regulatory reform through a different lens. Reform needs to be more comprehensive and address all the various contributors to the crisis and at the same time needs to be more restrained since nothing is completely broken. In other words, what is needed is lots of little tweaks not one big new initiative.

There are two areas that need tweaking that I want to address specifically: accounting standards and the shear number of regulators. These are little details that matter dramatically. University of Virginia economics professor Edwin Burton has written one of the best and most thought-provoking papers on how accounting practices helped lead to the crisis. At the heart of the crisis, he says, was the valuation of assets on the balance sheets of banks and other financial organizations. Balance sheets of non-financial companies are relatively simple to understand – on one side you have assets, and on the other side you have liabilities. If a company owns a building out right on their balance sheet and the building burns down, they now have fewer assets. However, the fact that this company has fewer assets does not impact any other company.

Financial firms don’t work this way. Financial firms exist largely to loan money. Their assets are mostly loans to others. While that loan is an asset to the financial firm, it is also a liability to someone else. Increasingly in our interconnected world those loans are being made to other financial firms. If the ability of the borrower to pay back the loan for some reason becomes in doubt, then the firm’s accountant might say this asset must be written down, or recorded at a lower value than it was before. This leads to the much-talked about “mark to market account-ing.” Mark to market means you write the loan down because of doubt about the borrower’s future, not because of an actual default. Furthermore – and this is the interesting insight added by Professor Burton – if the borrower has not actually defaulted, then that firm is still carrying the liability at its full value. This is what Burton calls an asymmetric write-down – the asset has been reduced in value, but the matching liability has not. Because financial firms are so interconnected, making countless loan transactions with each other, financial firms begin to look weaker and weaker on paper as assets are written down but corresponding liabilities are not. This leads to a panic and a run on the bank.

Professor Burton’s ideas need further exploration. The flaw in accounting methods for financial firms could be fixed with a small tweak, but it would have huge consequences. One other accounting rule that has not gotten as much attention on the reform front is the ability of financial firms to hold assets and liabilities “off-balance sheet.” In my opinion there should be no such thing as off-balance sheet. These two seemingly simple fixes would eliminate the entire too-big-to-fail myth. It was the opaque and asymmetrical nature of accounting, not size, that led to panic, which could have brought down not just poorly run companies but the entire system.

The other problem that was discussed initially by the adminis-tration but has faded is the fact that the financial world has far too many regulators. As former Merrill Lynch head John Thain stated in a speech at Wharton last fall, the numerous regulators gave some firms an ability to shop for the regulation they liked the most. For example, AIG could have put their now-infamous financial products group under one of their insurance operations, but they would have been more heavily regulated. Instead they were able to move it to the parent holding company and avoid almost all regulation. In my own career I have been subject to multiple regulators at once and have been given conflicting guidance. This allows less scrupulous firms to play regulators off one another much like a manipulative child who knows whether to ask mommy or daddy depending on the desired answer.

The current proposals in Washington only make this worse, by adding yet another regulator, the new Consumer Protection Agency. This may sound politically appealing – who would possibly be against protecting the consumer? But, isn’t that what every regulator is really supposed to be doing? In the meantime the real issues that led to this crisis are being ignored and business as usual is back on Wall Street.

Why does all this matter to our clients? Regulation is real, and it costs money. Regulation done correctly can help ensure that everyone is playing by the rules, which makes it easier to make investment decisions and therefore have investment success. Regulation done poorly will increase costs, reduce investment opportunities, and have a negative impact on your portfolio. You have a vested interest in what happens with financial reform, so please pay attention, keep your mind open and remember that details matter.

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Charles E. Osborne, CFA, Managing Director

Review of Economy

INCREASED OPTIMISM was the theme this quarter. GDP growth for the fourth quarter was 5.7% and expected growth in the 1st quarter is 2.9%. This is lower than past recoveries but better than expected with everything that is happening in Washington. Every week there seems to be some slight improvement in the macro economic news.

Unemployment remains a big issue at 9.7%, and while it seems to have leveled off there are no signs of real job market improvement any time soon. While much of the economic data suggests recovery, it will not feel like a recovery until job growth occurs.

The actions of our policy leaders continue to surprise and alarm us. Just this week an executive order goes in force which mandates the use of union labor on any governmental construction project with a value over $25 million. This eliminates the 85% of construction industry employees that are non-union from any potential government contracts. This happens why there is a 27% unemployment rate within the construction industry. As long as policy decisions are made based on political expediency and not sound economic thinking, our future growth will be in question.

Review of Market

IT WAS ANOTHER POSITIVE QUARTER. The S&P 500 was up 5.39%. It is always fun to be right and last quarter was one of those quarters where we were right about almost everything. We were right to overweight domestic equities as the MSCI EAFE was up only 0.94%. We were right to over-weight small cap stocks as the Russell 2000 was up 8.85%.

We were also correct to overweight high-yield bonds within our fixed income portfolios as the Merrill Lynch High Yield Master index was up 4.85% compared to the Barclays Capital US Aggregate index which was up only 1.78%.

Don’t worry we won’t let it go to our heads.

Market Forecast

I remain fairly optimistic about the markets’ chances in 2010, as corporate profits should continue to recover from their lows and inventories continue to rebuild. We are sticking with our 12% forecast for the S&P500. We still like domestic over developed international as Europe is a complete mess. Having said that, there will come a time when all the bad news from Europe is baked in and international stocks will look like a value, but we do not believe that time has come.

While emerging markets cooled off a little in the first quarter, the fundamentals remain strong. Small caps should also continue to do well as the economic recovery takes hold.

We are growingly concerned about the bond market. Treasuries seem to be set to lose value as a combination of low yields, high supply and decreasing demand does not bode well. Corporate and high yield bonds are also starting to look fully valued. We proceed with caution in what is supposed to be the safe areas of the market.